The following rules apply to determine how deductions that enter into the computation of distributable net income that is taxable to an estate or trust beneficiary are allocated among the items of trust income.

First, deductions not directly attributable to a specific class of income can be allocated to any item of income (including capital gains) included in distributable net income. However, a reasonable proportion must be allocated to tax-exempt income.

Allocations to tax-exempt income may be made in the proportion that tax-exempt income is of the total income of the trust (but any other reasonable method may also be used).

Example 1: Your client is the trustee of a simple trust that is required to distribute all of its income (other than capital gains) on an annual or more frequent basis to the beneficiaries. In its tax year ending Dec. 31, 2003, the trust, after deducting direct expenses, has income (other than capital gains) of \$100,000. This amount consists of \$40,000 of dividends, \$40,000 of taxable interest and \$20,000 of tax-exempt interest. Indirect expenses (“neutral expenses”) total \$15,000. Thus, \$3,000 (20 percent of the neutral expenses of \$15,000) are allocated to tax-exempt interest, since tax-exempt interest (\$20,000) is 20 percent of total income (\$100,000). Your client may allocate the \$12,000 balance of the neutral expenses to either dividends or interest, or part to each in any proportion that she determines.

In determining the part of neutral expenses that have to be allocated to tax-exempt interest, capital gains not included in distributable net income are not included in the total income of the trust for purposes of determining the proportion that tax-exempt interest is of total trust income.

Example 2: The same facts apply as in Example 1, except that the trust also has capital gain income of \$100,000. The result is the same, since the capital gain income is not taken into account in determining the amount of neutral expenses that is allocated to tax-exempt income.

Example 3: The same facts apply as in Example 2, except that the trust is a complex trust and all the capital gain income is distributed to the beneficiaries. Thus, total income for purposes of determining the amount of neutral expenses that must be allocated to tax-exempt interest is \$200,000. This means that only 10 percent of the neutral expenses of \$15,000 (or \$1,500) must be allocated to tax-exempt interest, since the tax-exempt interest of \$20,000 is only 10 percent of \$200,000.

Reg. § 1.652(b)-3(c) say that examples of neutral expenses are trustees’ commissions (both income and corpus), safe deposit rental, and state income and personal property taxes.

Observation: The costs of construction proceedings, accountings, and the preparation of fiduciary income tax returns are expenses peculiar to trust administration and should be treated as neutral expenses. Investment advisor fees should also be treated as a neutral expense.

Note, however, that the Tax Court and the Federal and Fourth Circuit Courts of Appeal ruled that investment advisor fees are miscellaneous itemized deductions of a trust, and thus are deductible only to the extent that total miscellaneous itemized deductions exceed 2 percent of the trust’s adjusted gross income. The Sixth Circuit disagreed and ruled that investment advisor fees are not subject to the 2-percent-of-AGI limitation. The AGI of a trust is computed in the same way as an individual’s AGI, except that the following are treated as allowable deductions in arriving at AGI:

• Deductions for costs that are paid or incurred in connection with the administration of the trust and that would not have been incurred if the property were not held in the trust;
• The personal exemption deduction;
• The deduction for income required to be distributed currently; and,
• The deduction for other amounts properly paid or credited or required to be distributed.

Second, deductions that are directly attributable to one class of income, e.g., rental or business income, are allocated to that class. For example, repairs, taxes and other expenses that are directly attributable to maintenance of rental property are allocated to rental income, and expenditures that are directly attributable to a business carried on by the trust are allocated to the business income.Third, if deductions directly attributable to a class of income exceed that class, the excess may be allocated to any other class of income (including capital gains) included in distributable net income in the same manner as for deductions that are not directly attributable. However, excess deductions directly attributable to tax-exempt income may not be used to reduce any other class of income.
Thus, if a trust has income from rents, taxable interest, dividends and tax-exempt interest, and deductions directly attributable to rents exceed the rental income, the excess may be allocated to the taxable interest or dividends. But if the excess deductions are directly attributable to the tax-exempt income, they may not be allocated to the rents, taxable interest or dividends.

Observation: There seems to be no requirement that a reasonable part of the excess of those deductions that are allocable to a class of income (other than tax-exempt income) has to be allocated to tax-exempt income, as is the case with “neutral” deductions. This makes sense, since the deductions were first allocable directly to a class of taxable income.

Allocate neutral expenses to income that will minimize the amount of tax that beneficiaries will have to pay. Neutral expenses should be allocated to the class or classes of income that will be taxed at the highest rate to beneficiaries.

Thus, even if long-term capital gains are distributed to the beneficiaries, neutral expenses usually should be allocated to ordinary income or short-term capital gains, since those types of income usually are taxed at higher rates than the rates at which long-term capital gains are taxed.

Observation: An exception to this general rule would be if 28 percent rate long-term capital gain (e.g., collectibles gain) is distributed to a beneficiary in the 25 percent tax bracket. In that case, the 28 percent rate gain would be taxed at a higher rate than ordinary income would, so it would make sense to allocate neutral expenses to the 28 percent rate gain before allocating them to ordinary income.

For trusts and estates that do not distribute capital gains to their beneficiaries, it used to make little difference how neutral expenses were allocated, since the items of ordinary income distributed to beneficiaries were usually subject to tax at the same rates. In tax years beginning on or after Jan. 1, 2003, however, qualified dividends are taxed at a maximum rate of 15 percent (5 percent to the extent that the beneficiary’s maximum tax bracket is less than 25 percent after taking income from the trust into account).

Thus, a trustee should make sure that neutral expenses are allocated to income other than qualified dividends first. Only that part of neutral expenses in excess of the amount of non-qualified dividend income should be allocated to qualified dividends.

Example 4: Your client is the trustee of a simple trust for the benefit of her 25-year-old niece. The trust is required to distribute all of its income (other than capital gains) to the niece at least annually. For its tax year ending Dec. 31, 2003, it has distributable net income of \$70,000 (taxable income of \$90,000, less neutral expenses of \$20,000). The taxable income consists of interest income of \$10,000, and ordinary dividends of \$80,000, \$75,000 of which are qualified dividends. The beneficiary is in the 35 percent tax bracket.

You should advise your client to allocate \$10,000 of the neutral expenses to completely offset the interest income of \$10,000, and to allocate \$5,000 of the neutral expenses to completely offset the \$5,000 of dividends that are not qualified dividends. The remaining \$5,000 of neutral expenses should then be allocated to the qualified dividends to reduce the amount of those dividends taxable to the beneficiary to \$70,000 from \$75,000. If this is done, the beneficiary will pay a federal income tax of \$10,500 on the qualified dividends (15 percent of \$70,000).

On the other hand, if the entire \$20,000 of neutral expenses were allocated to the qualified dividends, the beneficiary would pay a total tax of \$13,500 on her income from the trust, made up of the sum of the following:

• \$3,500 (35 percent of interest income of \$10,000); plus,
• \$1,750 (35 percent of non-qualified dividends of \$5,000); plus,
• \$8,250 (15 percent of qualified dividends of \$55,000 (\$75,000, less neutral expenses of \$20,000).

If the neutral expenses were allocated proportionately to each class of income, the beneficiary would pay a total tax of \$12,833. This would still be \$2,333 more than she would have to pay if all the neutral expenses were allocated first to the income other than the qualified dividends.Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.