The 65-Day Rule for Trusts and Estates and Its Interplay with Form 1041-T
Are you the fiduciary of a complex trust? Did you recently receive a 1099 in the mail for the trust with substantial interest and dividend income reported? This may not be the best tax scenario due to the compressed tax rates of trusts, so what does the trustee do?
Fear not! There is something called the 65-Day Rule that can help the trust’s tax situation by distributing the income to the beneficiary and eliminating the tax at the trust level.
But what if the beneficiary didn’t pay in estimates? No worries! The 1041-T can alleviate that problem as well.
The 65-Day Rule, codified under §663(b) of the Internal Revenue Code, provides a strategic tax planning tool for fiduciaries of complex trusts (and estates). It is an election designed to provide flexibility in managing the taxable income of a trust. According to Section 663(b), if a trustee makes a distribution within the first 65 days of the tax year, the trust can elect to treat this distribution as if it were made during the previous tax year. This election is particularly useful for trusts that need to manage their distributable net income (DNI) and optimize the income distribution deduction.
Important provisions of the 65-Day Rule
- Election Requirement: The trustee must make an election for each taxable year they wish to apply the 65-Day Rule. This election is made by filing a statement with the IRS, typically as part of the trust’s tax return.
- Amount to Distribute within 65 days: The amount that can be treated as distributed in the prior year is limited to the lesser of the trust’s fiduciary accounting income for the prior year or its DNI, reduced by any amounts already distributed during that year.
- Effect of Election: Once the election is made, the distribution is treated as having been made on the last day of the preceding tax year. The complex trust (or estate) will get the deduction, and the beneficiary will pick up the income reported to them on Schedule K-1 from the trust.
The result could reduce the taxable income of the trust to zero and shift the income to the beneficiary, with a presumably more favorable tax bracket.
Allocating Estimated Taxes and Filing Requirements for Form 1041-T
In order to cover the tax on the above income distributed to the beneficiary, the trustee has the ability to allocate estimated tax payments made at the trust level to the beneficiary. Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries, is used by trustees to do such allocation. This form must be filed by the 65th day after the close of the trust’s tax year, aligning with the 65-Day Rule for distributions. This form can allow the trustee to move the estimated tax payments from the trust level to the beneficiary, following the flow of where the income is ultimately being reported and taxed. For calendar year trusts, this typically means the form is due by March 6 of the following year (but watch out for leap year)!
In summary, the 65-Day Rule offers fiduciaries a valuable tool for managing the taxable income of a trust and optimizing the income distribution deduction. By making the timely election and distributing within 65 days, fiduciaries can effectively allocate income to beneficiaries and avoid tax at the trust level. Pair this with the filing of Form 1041-T to allocate the estimated tax payments to the beneficiary, and you could end up with a favorable tax result for both the trust and the beneficiary. And don’t forget this rule applies to estates as well, so if you’re an executor in a similar position, reach out to your tax advisor for help!
