The Separate Shares Rules and Their Nuances

“The Separate Shares Rules and Their Nuances,” that’s the subject of today’s ACTEC Trusts and Estate talk.

Transcript/Show Notes

This is Alvi Aggarwal, ACTEC Fellow from Fairfax, Virginia. At first glance, the separate share rules are relatively intuitive. However, the nuances involved with IRD and S Corporation stock, among others, the well-founded rules are less straightforward and merit careful consideration. ACTEC Fellow Jim Lee of Phoenix, Arizona will explain these nuances. Welcome, Jim.

Jim: Thank you. So, the separate share rule, it comes from Section 663(c) of the Internal Revenue Code. It requires that separate and independent shares of different beneficiaries in the same estate or trust be treated as separate shares or trusts in determining distributable net income. It’s important to note that these rules do not apply to anything else. They don’t apply to tax filings or anything like that. It’s just in the determination and allocation of distributable net income, or DNI, allocable to the respective beneficiaries.

So, the regulations tell us that the definition of “separate shares” provides that a separate share ordinarily exists if the economics of one beneficiary or class of beneficiaries, neither are affected by economic interests occurring to another beneficiary or class of beneficiaries. Said another way, we have a separate share that exists when we have people that have similar economic interests in a trust or an estate and we can separate out those interests for purposes of allocation of income and deductions. And a separate share generally exists only if it includes both the corpus and the income attributed to it and its independent from any other share.

And I’ll give some examples here so that you’re aware – bequests of specific properties, specific sums of money (at least those that are described in (a)(1) of Section 663) are not separate shares and income on bequeaths of property is a separate share if the recipient of this specific request is entitled to income. So, this can get just a little tricky when you’re dealing with pecuniary amounts that are required to have statutory interest. That doesn’t help us – and statutory interest isn’t deductible anyway. But if it’s entitled to income, yes, separate share rules may very well apply.

So, separate shares come into existence upon the earliest moment that the fiduciary may reasonably determine – this is right out of the Regs – may reasonably determine based upon known facts that a separate economic interest exists. This is not an election. Either the separate shared rules apply, or they don’t.

What Triggers Separate Shares Rules

Now, there are circumstances where beneficiaries, or trustees even, are given discretion and choices, and once those choices are made or known to the fiduciary, that can affect as to whether separate share rules then begin to apply. The separate share rules will often begin just in connection with somebody passing away and that’ll be the triggering point. But, as you’ll see, there are others that can come into play here that are not quite so straightforward.

In computing distributable net income for each separate share, the portion of gross income, that is, income within the meaning of 643(b), which is what just kind of normally think of as trust income, just kind of regular income, must be allocated among the separate shares in accordance with the amount of income each share is entitled to under the terms of the governing instrument or applicable law, as the case may be in with the Principal and Income Act or similar law of your state.

Similar allocation rules are provided for original issue discount and distributing share of partnership tax items. The pro rata shares of S Corporation tax items, which we’ll talk about in a moment, and other gross income that is not attributable to cash received by the trust or the estate. Any expense or loss that is applicable only to one separate share is not available as a deduction to any other share. So, if you have expenses that are attributable to a particular asset and that asset is going to one particular separate share, the losses are going to generally follow that, and it’s not going to affect any of the other shares.

Okay, so let’s use an example of one where separate share rules could apply. For example, the elective share of the surviving spouse constitutes a separate share of the estate. It’s under local law. It’s entitled to income and shares, and appreciation or depreciation, it will have a pro rata portion of the estate DNI allocated to it. Also, if we’re talking about a qualified revocable trust, meaning a revocable trust that qualifies for a 645 election to be treated as part of the decedent’s estate, that is always a separate share of the estate. But a trust does not necessarily have to make a 645 election for the separate share rules to apply.

At one point, the separate share rules did not apply to trusts. They do now, per the Regulations, whether or not a 645 election is made. But if a 645 election is made, that trust in and of itself is a separate share. Then you can have separate shares within separate shares, obviously. A pecuniary formula request that’s entitled to income, not just statutory interest, but income in shares and appreciation or depreciation, is a separate share under the general rules and will have a pro rata portion of the estate’s DNI allocated to it.

If income is not allocated to it and it does not share in the appreciation or depreciation, it too is treated as a separate share as long as the governing instrument does not provide that it is to be paid or credited in more than three installments. So, one nuance there.

Income in Respect to the Decedent

Income in Respect to the Decedent, IRD, is allocated among the separate shares that could potentially be funded with the IRD irrespective of whether the share’s entitled to receive any income under the terms of the governing instrument or applicable law. So, IRD carries with it tax consequences, right?

And so, here’s an attempt by Congress or the Treasury to try to say, “hey, we’re trying to treat people equally, and if we have IRD that’s involved, then no matter who receives this, that or the other, the IRD is going to be allocated among the separate shares in a pro rata basis among any of the shares that could potentially be funded with that IRD.” So, it’s an attempt to treat things equally. Now, does it always work that way? No. And you can end up with some very unusual circumstances and, perhaps, nasty consequences for beneficiaries that they’re not anticipating.

Understanding this rule and being able to talk with beneficiaries about it ahead of time so they don’t get surprised when they get their tax bill can be very helpful. So, IRD gets spread out on a pro rata basis among all of the shares that could potentially receive the IRD, whether they actually receive it or not. And the amount that’s allocated each of those shares, when I talk about it being pro rata, is based on the relative values of the shares that could be potentially funded with that IRD. So, a little bit of a review and then some more nuances.

The separate share rule only applies if a single trust or estate has multiple beneficiaries and those beneficiaries have substantially separate and independent shares. When we have independent shares, those shares are treated for DNI purposes only as if they’re separate trusts, okay?

The rule is mandatory, it’s not elective. The rule does not apply to beneficial interests in simple trusts, discretionary sprinkling or spray trusts or separate trusts created under the same trust instrument, even though those trusts themselves may contain separate shares. We’re talking about some of the exceptions. The separate share may, itself, have multiple beneficiaries with equal, disproportionate or even indeterminate interests and the same person may be the beneficiary of more than one separate share. When the separate and independent shares exist, the DNI allocation rules are applied separately to each individual share as if it were, as I said before, a separate trust or estate.

This means one beneficiary could receive, possibly, a distribution greater than the trust’s or estate’s total DNI, yet only be taxable on a ratable portion of the DNI. Again, so, we can end up with some of these strange sort of outcomes.

The separate share rule does not permit the treatment of separate shares as separate trusts under Subchapter J for any other purpose other than for allocation of DNI. Now, we often talk about separate shares in the context of GST allocations and the like. And they’re related to this, but these particular rules apply only for DNI purposes.

Any deduction or loss that is attributable solely to one separate share must be used and calculated into the DNI for that share, and it’s not available to any other shares, as I had mentioned earlier. So, let’s go through an example or two.

Separate Share – A Simple Example

So, even for a simple estate, the separate share rule can come into play here. So, let’s take the first situation. Mother’s Will divides the residuary estate equally between son and daughter. During its first fiscal year, the estate receives $10,000 of dividend and interest income and let’s just assume no deductions at this point. Also, during the first fiscal year, the estate makes a $100,000 principal distribution to son, and distributes nothing to the daughter.

So, what’s the outcome of that? Well, the interests of the son and daughter in the residuary are sufficient to constitute separate shares. So, only 50% of the estate’s $10,000 DNI is allocated to the son. If we didn’t have the separate share rules, all of the DNI would have been allocated to the son, and the son would have born all of the income tax consequences. But the separate share rules allow us to look at those shares differently as if they’re different trusts, and so we can allocate the DNI 50/50. The distribution to him will carry out $5,000 of income, of course, and the other $5,000 of income will be taxed to the estate.

It’s going to depend on your own state law whether the tax burden will be apportioned against the daughter’s share of the estate or whether the estate will just be required to end up paying it.  So you’ll have to look at your own state’s law for that.

Note that prior to the Taxpayer Relief Act of 1997, the distribution to the son would have carried out, as I said, the whole thing, which seems pretty inequitable.

Separate Share – S Corporation Stock Example

Let’s turn to an example of S Corporation stock. And we’ll kind of close on this for sake of time. Specific to the bequest of income producing assets causing separate shares to be created, and that can require some pretty careful planning, particularly, as I mentioned, where S Corporation stock is involved.

So, let’s take a new situation. Dad’s Will leaves S Corporation stock to his son and the residue equally to son, daughter 1 and daughter 2. So, all the stock goes to son, but then after that happens, there’s a residuary clause that says, everything else is equally to son, daughter 1 and daughter 2. Under local law, the son is entitled to all the S Corporation dividends received by the estate. So, during the administration period before allocation of the stock, we have income that’s being produced, and it says that all of the dividends received by the estate – all of those go to who? Go to the son.

So, because of the financial needs of daughter 2 – here’s a special circumstance- a partial distribution of the residue is made to her during the same fiscal year as the S Corp pays a dividend out to the estate.  And that’s important because, in this particular situation, the estate needs money to be able to pay the income taxes on the S Corporation K-1 income, or rather the daughter to pay that – and the estate, for that matter.

So, the separate share rule applies in this example, creating four separate shares. What are they? So, the stock itself is not a separate share, right, but the specific bequest of its income or the dividends associated with this specific bequest is a separate share. And this is – the Will specifically said in this case – this isn’t just some application of local law necessarily, but the Will specifically said that the dividends follow the asset even during the period of administration. So, in other words, they follow the asset of where the asset is going to be once the initial administration is terminated. So, that needs to be treated as a separate share.

The interest that the son, daughter 1 and daughter 2, and the residuary are also separate shares, so that’s a total of four separate shares. If we assume that there isn’t any other income of the estate, the partial funding of daughter 2’s bequest, because she has monetary needs, would not carry out any DNI resulting from the K-1 income. Why not? Because all of the income has to go to the son and that’s a separate share – K-1 income – S Corp income, we’re talking about.

So, were there to be income from other sources other than the S Corp, only 1/3 of the residue separate share DNI would carry out to daughter 2 with a principal distributable to her. So, that’s the concept.

So, once you start getting into S Corp stock and once you start getting into situations where – and there’s some other examples with S Corp stock that we just don’t have time to go into – but just even the idea of saying, “hey, all the income from the S Corp stock during the period of administration prior to allocations, distributions, goes to the son,” is enough to invoke, even further, the separate share rule so that the income itself is a separate share.

I think that has taken up our time with separate share rules. So, just kind of those things that you think you kind of know and then you kind of dig into them, and you go, “oh wait a minute, I forgot about that little piece of it.”  So, it’s a good review for all of us to refresh our memories on this.

Alvi: Thank you, Jim, for guiding us through this complex topic.

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