8101 / What are the ordering rules that are used to characterize distributions from a charitable remainder trust?

Assignment of income to categories and classes. A trust’s income, including income includible in gross income and other income, is assigned to one of three categories in the year in which it is required to be taken into account by the trust. These categories are: (1) gross income, other than gains and amounts treated as gains from the sale or other disposition of capital assets (the “ordinary income category”); (2) gains and amounts treated as gains from the sale or other disposition of capital assets (the “capital gains category”); and (3) other income.²

Items within the ordinary income and capital gains categories are assigned to different classes based on the federal income tax rate applicable to each type of income in that category in the year the items are required to be taken into account by the trust. For example, the ordinary income category may include a class of “qualified dividend income” as defined in IRC Section 1(h)(11) (see Q 702) and a class of all other ordinary income.

In addition, the capital gains category may include separate classes for short-term and long-term capital gains and losses, such as: (1) a short-term capital gain class; (2) a 28 percent long-term capital gain class (i.e., gains and losses from collectibles and IRC Section 1202 gains); (3) an unrecaptured IRC Section 1250 long-term capital gain class (i.e., long-term gains not treated as ordinary income that would be treated as ordinary income if IRC Section 1250(b)(1) included all depreciation); (4) a qualified five-year long-term capital gain class (as defined by IRC Section 1(h)(9) prior to amendment by JGTRRA 2003); and (5) an all other long-term capital gain class.³

After items are assigned to a class, the tax rates may change so that items in two or more classes would be taxed at the same rate if distributed during a particular year. If the changes to the tax rates are permanent, the undistributed items in those classes are combined into one class. However, if the changes to the tax rates are only temporary (for example, the new rate for one class will “sunset” (i.e., expire) in a future year), the classes are kept separate.⁴

Order of distributions. The categories and classes of income (determined under Treasury Regulation Section 1.664-1(d)(1)(i)) are used to determine the character of an annuity or unitrust distribution from the trust in the hands of the recipient regardless of whether the trust is exempt from taxation under IRC Section 664(c) for the year of the distribution. The determination of the character of amounts distributed or deemed distributed at any time during the taxable year of the trust must be made as of the end of that taxable year.

The tax rate or rates to be used in computing the recipient’s tax on the distribution will be the tax rates that are applicable in the year in which the distribution is required to be made, to the classes of income deemed to make up that distribution, and not the tax rates that areh applicable to those classes of income in the year the income is received by the trust.⁵

The character of the distribution in the hands of the annuity or unitrust recipient is determined by treating the distributions as being made from each category in the following order:

(1) First, from ordinary income to the extent of the sum of the trust’s ordinary income for the taxable year and its undistributed ordinary income for prior years;

(2) Second, from capital gain to the extent of the trust’s capital gains (determined under Treasury Regulation Section 1.664-1(d)(1)(iv));

(3) Third, from other income to the extent of the sum of the trust’s other income for the taxable year and its undistributed other income for prior years; and

(4) Finally, from trust corpus (with “corpus” defined for this purpose as the net fair market value of the trust assets minus the total undistributed income (but not loss) in Treasury Regulation Sections 1.664-1(d)(1)(i)(a)(1)-(3)).⁶

If the trust has different classes of income in the ordinary income category, the distribution from that category is treated as being made from each class, in turn, until exhaustion of the class, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest federal income tax rate.⁷

If the trust has different classes of net gain in the capital gains category, the distribution from that category is treated as being made first from the short-term capital gain class and then from each class of long-term capital gain, in turn, until the exhaustion of the class, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest rate.⁸

If two or more classes within the same category are subject to the same current tax rate, but at least one of those classes will be subject to a different tax rate in a future year (e.g., if the current rate “sunsets,” or expires), the order of that class in relation to other classes in the category with the same current tax rate is determined based on the future rate or rates applicable to those classes.⁹

Within each category, if there is more than one type of income in a class, amounts treated as distributed from that class are to be treated as consisting of the same proportion of each type of income as the total of the current and undistributed income of that type bears to the total of the current and undistributed income of all types of income included in that class. For example, if rental income and interest income are subject to the same current and future federal income tax rate and, therefore, are in the same class, a distribution from that class will be treated as consisting of a proportional amount of rental income and interest income.¹⁰

Treatment of losses. In the ordinary income category, a net ordinary loss for the current year is first used to reduce undistributed ordinary income for prior years that is assigned to the same class as the loss. Any excess loss is then used to reduce the current and undistributed ordinary income from other classes, in turn, beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest federal income tax rate. If any of the loss exists after all the current and undistributed ordinary income from all classes has been offset, the excess is carried forward indefinitely to reduce ordinary income for future years.¹¹

A net loss in the other income category for the current year is used to reduce undistributed income in this category for prior years. Any excess is carried forward indefinitely to reduce other income for future years.¹²