By Danielle T.
Zaragoza, Esq., Morrison & Foerster LLP
The basic concept of a unitrust is
that a fixed percentage of the fair market value of a trust's assets,
redetermined each year, is paid out to the "income" beneficiary, regardless of
the availability of income to fund the payment.
There are two features that make a unitrust an attractive alternative to
a traditional income beneficiary trust, where a lifetime beneficiary receives the
trust's net income and the remainder beneficiary receives the principal: (a) total return investing and (b) expectation
setting/certainty for income beneficiaries.
First, a untriust allows a
fiduciary to determine how the trust portfolio should be invested based on risk
and overall return goals rather than being forced to seek ways to generate
interest and dividends, items traditionally defined as "income" of the trust,
to ensure that an income beneficiary has sufficient income. While many states, including California, give
trustees the power to make adjustments between income and principal and
classify a receipt as income when it would have been classified as principal
under the normal default rules, or vice versa, this "power to adjust" is an
exercise of discretion, resulting in a fair amount of uncertainty of the levels
of distributions from one year to the next.
With a unitrust, less discretion is required from the fiduciary, and the
income beneficiary has more certainty about the amount of trust distributions
he or she will receive each year.
However, this certainty about the
amount of trust distributions means that the beneficiary is entitled to a specific
dollar amount, rather than the net income of the trust. As a result, if a trustee distributes
property in kind to satisfy a unitrust payment, such distribution may cause the
trust to recognize gain or loss for tax purposes. This may be an issue when a unitrust's assets
are low basis properties that do not produce income sufficient to pay the
unitrust amount. Rather than trigger
gain by making a distribution in kind, the trustee could issue the trust's
promissory note to the current beneficiary for the unitrust amount. The issuance of a promissory note is not a
distribution in kind and would not be a recognition event for capital gain
Realization of Gain on Distribution in Kind
Under section 1.661(a)-2(f)(1) of the Income Tax Regulations, if
an estate or trust distributes property in kind to satisfy an obligation to
distribute in a specific dollar amount or specific property other than that
distributed, then the distribution will cause the estate or trust to realize
gain or loss.
1001(a) of the Code provides that the gain from the sale or other
disposition of property shall be the excess of the amount realized therefrom
over the adjusted basis provided in section
1011 for determining gain. A
disposition may occur when a trustee is required to distribute an annuity to a
beneficiary and distributes property in kind to the annuity beneficiary. To the extent the annuity is paid out of
income, no taxable disposition should occur. To the extent the annuity is paid out of
principal, a taxable disposition will occur. A unitrust amount is similar to an annuity
because they are both considered the obligation by the trust to distribute a
specific dollar amount.
For example, in Rev. Rul. 83-75, the trustee of an irrevocable trust was
required to pay qualified charities an annuity equal to 8% of the initial fair
market value of the stock transferred to the trust. The annuity was to be paid out of income, then
capital gains, then principal. In one
year, there was insufficient income and capital gains in the trust, so the
trustee distributed $48x worth of stock. The basis of the stock was $38x. The IRS ruled that the trust had gain of $10x
($48 - $38x) because it transferred appreciated stock to satisfy its obligation
to pay a fixed annuity amount.
Issuance of Promissory Note Does Not Trigger
Recognition of Gain
As an alternative to making a
distribution in kind to satisfy an obligation to make a unitrust payment, the
beneficiary of a unitrust could accept a promissory note in the face amount of
the unitrust payment. Assuming the trust
instrument or governing law provides the trustee with the power to borrow money
for any trust purpose, as most do, the trustee could borrow money to make the
unitrust payment. Rather than borrow
money from a third party, the trustee and beneficiary could agree to defer the unitrust
payments in exchange for a promissory note that would evidence the legal
obligation for the future payment of the unitrust amount. The promissory note could bear reasonable
interest and be secured by the trust property.
As discussed below, a promissory
note is generally considered evidence of a loan transaction rather than the
current payment of a specific amount.
Therefore, the issuance of a promissory note by a trust would not be an
in kind distribution of property in satisfaction of the unitrust amount and
would not be a recognition event for capital gain purposes.
Support for the conclusion that
promissory notes may be used as a mechanism to defer payment of an amount due
from a trust and is not the in kind distribution of trust property in payment
of such amount can be found in PLR 9604005 and TAM 0458296. Both
the PLR and the TAM discuss the use of promissory notes to satisfy annuity
payments in connection with determining if a grantor's retained interest in a
trust meets the requirements of a qualified annuity interest under section 2702, which provides that a non-qualified interest
retained by a grantor is valued at zero, and determined that a promissory note
is evidence of a promise to make a future payment and is not the current
distribution of trust property in satisfaction of such payment.
In PLR 9604005, the Service
determined that a grantor retained annuity trust that used funds borrowed from
the grantor to make the annuity payments failed to meet the requirements of section
2702. In this case, the grantor
anticipated that the trust would not have sufficient cash flow to pay the
annuities and rather than have the trustee of the trust make an in kind
distribution of the stock held by the trust to satisfy the annuity payments,
the taxpayer implemented a mechanism where the trust could borrow funds from a
separate trust (established by the same grantor) to make the annuity payments
when due. The Service found this
mechanism provided for the use of promissory notes to satisfy the annuity
payments, which effectively deferred the grantor's actual receipt of payment
and the trust's actual payment of the annuity.
In essence, the trustee gave the grantor a note that represented a
promise to make a future payment.
Therefore, the grantor in this PLR was deemed to have retained the right
to receive an annuity payable in the form of notes from the trust, which is not
equivalent to an irrevocable right to receive a fixed amount for each year of
the trust term, and as such was not a qualified annuity interest under section
Similarly, in TAM 0458296, the
Service concluded that because a promissory note was used to satisfy an annuity
payment, the annuity interest retained by the donor did not satisfy the section
2702 requirements that the annuity be paid (1) in a stated dollar amount, and
(2) not less frequently than annually.
The Service concluded the donor authorized the trustee to satisfy the
annuity amount with a promissory note payable as late as the termination date
of the trust for the purpose of enabling the trustee to continue to hold all
stock in the trust for additional growth.
The effect would be that the trustee could apply appreciated stock to
pay the matured note and thus, apply fewer shares to satisfy the note than
would have been needed if the original annuity was satisfied with shares
(instead of with a note), resulting in a greater number of shares available for
distribution to the remainder beneficiary at the termination of the trust. In this case, the donor received nearly all
of the first annuity amount in the form of a promissory note to be paid when
the trust terminated. Because the note
(1) created a legal obligation for future payment, (2) provided for interest
payments, and (3) provided for a maturity date when the note was to be fully
paid, and because (4) the trust clearly would possess sufficient property to
satisfy the note at maturity, the promissory note bore all the indicia of a
loan transaction, rather than the current payment of a certain amount. As a result the Service, determined that the
donor's retained interest in the trust did not constitute a qualified annuity
Additionally, the Service pointed
out that for tax purposes, the issuance of a promissory note (by a debtor who is
seen as able to pay the note on maturity) and the creation thereby of legal
obligations inherent in lending transactions, such as provisions for interest
payments and a maturity date, are generally considered documentary evidence of
a loan transaction rather than the current payment of a certain amount. As a result, a promissory note cannot be used
to satisfy the requirements of a qualified annuity under section 2702. This supports the conclusion that the
issuance of a promissory note would not be viewed as the current payment of a
unitrust amount with an in kind distribution of trust property, but rather the
creation of a legal obligation to pay that amount at some time in the future.
Morrison & Foerster's Trusts
and Estates group provides sophisticated planning and administration services
to a broad variety of clients. If you
would like additional information or assistance, please contact Patrick McCabe
at (415) 268-6926 or PMcCabe@mofo.com.
© Copyright 2012 Morrison &
Foerster LLP. This article is published
with permission of Morrison & Foerster LLP.
Further duplication without the permission of Morrison & Foerster
LLP is prohibited. All rights reserved. The views expressed in this article are those
of the authors only, are intended to be general in nature, and are not
attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be
applicable in all situations and should not be acted upon without specific
legal advice based on particular situations.
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