The 2/37 Haircut and Trusts: Navigating a New Fiduciary Income Tax Challenge

Understanding the 2/37 Haircut

At the center of the discussion is Section 68 of the Internal Revenue Code and its potential application to deductions taken by trusts and estates.

Under the interpretation discussed during the webinar, once a trust or estate reaches the top 37% income tax bracket, certain deductions may effectively be reduced by two thirty-sevenths, or approximately 5.4%.

That reduction becomes especially important in the fiduciary income tax context because trusts and estates reach the highest federal income tax bracket at comparatively low levels of taxable income.

Traditionally, when a trust distributes income to a beneficiary, practitioners generally expect the corresponding distribution deduction to move that taxable income from the trust to the beneficiary. If Sections 651 and 661 deductions are subject to the Section 68 reduction, however, the trust may no longer receive a deduction equal to the full amount distributed.

The result could be taxable income remaining at the trust or estate level even though the cash associated with that income has already been distributed.

The Potential for “Phantom Income

One of the most significant concerns discussed during the program is the creation of what the speakers describe as “phantom income.”

Consider a trust that distributes all of its income to a beneficiary. Under traditional assumptions, the trust generally receives a corresponding distribution deduction, leaving the beneficiary responsible for the income tax associated with the distributed income.

If the deduction is reduced by the 2/37 haircut, the trust may still have taxable income remaining after making the full distribution.

That creates an immediate practical question: Where does the money to pay that additional tax come from?

Depending on the trust instrument and applicable state law, the tax may ultimately affect income beneficiaries, remainder beneficiaries, or trust principal. Determining who should bear that cost can become particularly difficult when the beneficiaries have competing economic interests.

QTIP and Credit Shelter Trusts May Require Closer Review

The webinar devotes considerable attention to trusts that distribute income to a surviving spouse.

For a QTIP trust, the surviving spouse generally must receive all trust income. If the trust distributes that income but receives only a partial deduction because of Section 68, practitioners must consider how the resulting tax should be allocated and whether an adjustment could affect the trust’s administration.

Similar questions arise with credit shelter trusts.

A trust may direct or encourage the trustee to distribute income to a surviving spouse while preserving principal for children or other remainder beneficiaries. If the trust must pay additional tax because the distribution deduction is reduced, paying that tax from principal could reduce what ultimately passes to the remainder beneficiaries.

In blended families, where a surviving spouse and children from a prior relationship may have different economic interests, those allocation decisions could become particularly sensitive.

The speakers emphasize that there may not be a single answer. The appropriate treatment may depend on the language of the governing instrument, applicable state principal and income rules, fiduciary accounting principles, and the trustee’s authority to make equitable adjustments.

Charitable Planning Is Not Immune

Charitable deductions present another potentially significant concern.

Section 642(c) generally allows an estate or trust to deduct certain amounts of gross income paid to charity pursuant to the governing instrument. The interpretation discussed in the webinar raises the possibility that this deduction could also be reduced by Section 68.

For a trust making substantial charitable payments, even a relatively small percentage reduction in the deduction could create a meaningful tax liability over time.

The issue may be especially important for long-term charitable structures, including non-grantor charitable lead trusts. If a portion of the charitable deduction is lost each year and the resulting tax is paid from trust principal, the cumulative impact could reduce the assets eventually available to remainder beneficiaries.

The speakers therefore encourage practitioners modeling new charitable arrangements to account for the potential Section 68 effect rather than relying on assumptions that applied under prior law.

The “Daisy Chain” Effect in Estate Administration

Another important concept explored during the webinar is what the speakers call the “daisy chain” effect.

A typical estate plan may involve several levels of administration. Assets and income might move from a probate estate to a revocable trust, then from the administrative trust into a credit shelter or QTIP trust, and eventually from those trusts to an individual beneficiary.

Historically, fiduciary income moving through those entities could often operate largely as a conduit, with distribution deductions shifting the income from one taxpayer to the next.

If the 2/37 haircut applies at multiple stages, however, each transfer could potentially result in another reduction to the available deduction.

The result may be progressively more taxable income remaining at the entity level as income moves through the estate planning structure.

That possibility could make the timing of estate and trust funding more important. The speakers discuss whether practitioners may want to move assets through administrative entities more efficiently when circumstances permit, thereby reducing the amount of income exposed to multiple levels of fiduciary taxation.

Fiduciaries May Face Difficult Allocation Decisions

The tax calculation is only part of the challenge.

Trustees must also determine how the resulting economic burden should be allocated among beneficiaries.

If a trust distributes all income to one beneficiary but pays the additional tax from principal, remainder beneficiaries may effectively bear the cost. Conversely, reducing the income distribution to preserve funds for the tax could affect the current beneficiary.

These competing interests can place fiduciaries in a difficult position, particularly when the trust document was drafted long before anyone contemplated this particular tax issue.

The webinar discusses several factors trustees and their advisers may need to evaluate, including:

• The specific language of the governing instrument
• State principal and income law
• The trustee’s authority to make equitable adjustments
• The settlor’s expressed intent
• The economic impact on different beneficiary classes
• Whether beneficiary consent or court guidance may be appropriate
• How the fiduciary documents and communicates its decision

The speakers repeatedly emphasize the importance of bringing the attorney, CPA, fiduciary, and other advisers together early in the administration process.

Documentation and Communication Take on Greater Importance

Because the law remains uncertain, fiduciaries may also need to give greater attention to documenting how they reached a particular administrative decision.

A trustee faced with competing interpretations may need to demonstrate that the issue was identified, analyzed with appropriate advisers, and handled reasonably under the governing instrument and applicable law.

Communication with beneficiaries may also become important.

If a tax allocation affects what one beneficiary receives today or what another beneficiary may receive in the future, addressing the issue proactively may help avoid confusion or disputes years later.

For larger or more contentious matters, the speakers discuss whether court guidance may sometimes be appropriate. In other situations, the cost and public nature of a court proceeding may make other approaches more practical.

Planning and Drafting Considerations Going Forward

The uncertainty surrounding Section 68 may also influence how practitioners draft new trust agreements.

Many existing documents were created under assumptions that did not contemplate a reduction in the fiduciary distribution deduction. Going forward, practitioners may want to consider whether trustees should have greater flexibility to respond to unexpected tax consequences.

Potential considerations discussed during the webinar include:

• Providing broader authority to make equitable or economic adjustments
• Reviewing how tax liabilities are allocated between income and principal
• Considering the interaction between distribution provisions and fiduciary income tax rules
• Evaluating whether certain beneficiary withdrawal powers or grantor trust structures could provide alternatives in appropriate circumstances
• Including protections for trustees exercising discretionary adjustment authority
• Coordinating trust drafting with applicable state principal and income law

The speakers caution that many of these ideas remain highly dependent on the facts, the governing instrument, state law, and future guidance.

Key Takeaways

The potential application of the Section 68 haircut to trusts and estates creates questions that extend far beyond a single income tax calculation. If the current interpretation stands, practitioners may need to rethink longstanding assumptions about how income moves through estates and trusts and how the resulting tax burden is allocated among beneficiaries.

For fiduciaries, early coordination may be particularly important. Attorneys, CPAs, trustees, and financial advisers should consider how the provision may affect existing trusts, current estate administrations, charitable structures, and future planning before distributions or funding decisions are made.

Significant uncertainty remains, and future Treasury or IRS guidance could change how these rules are ultimately applied. In the meantime, understanding the issue and identifying potentially affected trusts and estates can help practitioners prepare for the administrative, tax, and fiduciary questions that may follow.

Watch the full webinar above as Martin Shenkman, Jonathan Blattmachr, and Robert Keebler examine the 2/37 haircut, its potential impact on Subchapter J, and the planning and administrative considerations practitioners should be evaluating now.