Trusts are legal entities created by individuals to manage their assets for the benefit of themselves or their designated beneficiaries. Trusts are an important part of estate planning and asset protection, as they allow individuals to transfer ownership of assets while maintaining control over how those assets are used.
One key aspect of trust management is the distribution of income and capital gains to beneficiaries. The 65-day rule is an important provision that governs how distributions can be made from a trust for tax purposes. In this article, we will provide a detailed explanation of the 65-day rule and its implications for trust distribution.
What Is the 65-Day Rule?
The 65-day rule is a provision in the Internal Revenue Code (IRC) that allows trustees of certain types of trusts to make distributions during the first 65 days of the following tax year and have them treated as if they were made in the previous tax year. This means that these distributions will be taxed at the lower tax rates applicable to the previous year rather than at higher rates that may apply in future years.
The 65-day rule applies only to trusts that meet certain criteria. These include:
- The trust must be a complex trust under IRC section 661.
- The trustee must make an election to use the rule on a timely filed Form 1041.
- The distribution must be made within the first 65 days of the following tax year.
- The distribution must be attributed to income earned in the previous tax year.
If these conditions are met, then any distributions made within 65 days after the end of a tax year can be treated as having been made during that earlier tax year for tax purposes.
Why Is the 65-Day Rule Important?
The main reason why trustees may want to use the 65-day rule is to minimize taxes on trust distributions. By making distributions within this window, trustees can avoid having to pay higher tax rates that may apply in future years.
For example, if a trust earns $100,000 in income in Year 1 and makes no distributions, it would be subject to the highest marginal tax rate of 37% on that income. However, if the trustee distributes all of that income within the first 65 days of Year 2, then the distribution can be attributed to Year 1 and taxed at lower rates. This could save the trust thousands of dollars in taxes.
Additionally, trusts may want to use the 65-day rule to take advantage of any losses incurred during the previous year. If a trust had losses in Year 1 but did not make any distributions, it may be able to distribute those losses to beneficiaries within the first 65 days of Year 2 and have them applied against taxable income earned during Year 1.
How Does the 65-Day Rule Work?
To use the 65-day rule, trustees must comply with certain requirements. These include:
Timely filing Form 1041
The trustee must file a timely Form 1041 for the trust for each tax year. The form must accurately report all income earned by the trust and all deductions claimed by the trustee.
Making a valid election
The trustee must make an election on Form 1041 to use the 65-day rule for any distributions made within the first 65 days of the following tax year. This election is irrevocable once made.
Timing of distributions
All distributions made under the 65-day rule must be made within this window or they will be treated as having been made during the following tax year instead.
Distributions made under this rule must be attributed to income earned in the previous tax year. Any remaining undistributed income from that year will carry forward and be taxed at higher rates applicable for future years.
Exceptions to The 65-Day Rule
There are some exceptions to the 65-day rule that trustees should be aware of. These include:
If a trust is classified as a grantor trust for tax purposes, then the 65-day rule does not apply. Instead, all income earned by the trust is attributed to the grantor and taxed at their individual tax rates.
Simple trusts are trusts that must distribute all of their income to beneficiaries each year and cannot accumulate any earnings or profits. These trusts do not meet the criteria for the 65-day rule since they must distribute all income each year.
Charitable remainder trusts
Charitable remainder trusts are a type of trust designed to provide income to beneficiaries while donating assets to charity upon termination. Since these trusts are tax-exempt organizations, they do not qualify for the 65-day rule.
The 65-day rule is an important provision in the Internal Revenue Code that governs how distributions can be made from certain types of trusts. By allowing trustees to make distributions during the first 65 days of the following tax year and have them treated as if they were made in the previous tax year, this rule provides an opportunity for trustees to minimize taxes on trust distributions.
However, there are important qualifications and conditions that trustees must meet in order to use this rule effectively. It is essential that trustees work closely with qualified legal and financial advisors when managing trust distributions in order to comply with all applicable laws and regulations, including those related to the 65-day rule.
What is the 65-day rule for trust distribution?
The 65-day rule is a tax provision that allows an estate or trust to distribute income from the previous tax year.
Who benefits from the 65-day rule?
Beneficiaries benefit from the 65-day rule because it allows them to receive their share of the previous year’s income without incurring heavy taxes.
How does the 65-day rule work?
The trustee must make a final distribution before filing form 1041 within 65 days after the end of the tax year to take advantage of this provision.
Is there any limit on the amount distributed under this provision?
There is no limit on how much can be distributed under section 663(b) of the Internal Revenue Code.
What if a trust fails to distribute income within the period allowed by law?
If a trust fails to distribute taxable income timely, it will result in late-payment penalties, interest charges, and even an extension request denial.
Can distributions be made only in cash or check form?
No, distributions can be made in kind as well, such as stocks, bonds, or other assets held by trusts.
How does one report distributions under this provision?
The trustee must fill out Schedule K-1 to report each beneficiary’s share of taxable income due at year-end.
Can beneficiaries allocate distributions between principal and income?
Yes, beneficiaries may choose whether to allocate distributions between principal and income so long as they comply with governing documents and state laws.
Are all trusts eligible for this provision?
No, only complex trusts with retained net income are eligible for this provision. Simple trusts must distribute all income yearly.
Is it advisable to seek professional help when dealing with trust distributions?
Yes, it is highly recommended to seek the advice of a tax professional or financial advisor when dealing with trust distributions to ensure compliance and maximize tax savings.