of certain arbitrage profits are not applicable to bonds issued after 3:00 P.M., E.D.T., Thursday, July 17, 1986, for (1) Pools the proceeds of which are to be used to make loans to governmental units other than subordinate governmental units within the jurisdiction of the issuer (or the jurisdiction of the governmental unit on behalf of which the issuer acts); or (2) Pools with respect to which— (a) Less than 75 percent of the proceeds of the issue is to be used to make loans to initial borrowers to finance projects identified (with specificity) by the issuer on the date of issue as projects to be financed with the proceeds of such issue; or (b) on or before the date of issue, commitments have not been entered into by such initial borrowers to borrow at least 25 percent of the proceeds of such issue. Paragraph (2) applies only if bonds were not issued by the issuer before 1986 to fund similar pools, or, if the issuer had established a pool before 1986, the issuance in 1986 exceeds 250 percent of the average annual issuance for such pools during the period 1983 through 1985; or (3) Pools where the term of the bonds exceeds 30 years if the principal repayments on any loans are to be used to make or finance additional loans. For purposes of this announcement, an issue of bonds sold to a securities firm, broker, or other person acting in the capacity of an underwriter or wholesaler is not treated as issued before such bonds have been re-offered to the public (pursuant to final offering materials) and at least 25 percent of such bonds actually have been sold to the public. This statement is not intended to address the issue of whether interest on these bonds is tax-exempt under present law or whether such bonds qualify for temporary periods when unlimited arbitrage profits may be earned. That determination must be made on a case-by-case basis by the Treasury Department. We believe that this limited action will permit continued access to tax-exempt financing for actual needs of States and local governments while preventing a further rush to market of tax-motivated transactions. We are, however, instructing our staffs to continue to monitor the tax-exempt bond market as the conference committee meets and to report to us any evidence of further tax-motivated transactions. TITLE XIV-TRUSTS AND ESTATES; MINOR CHILDREN; GIFT AND ESTATE TAXES; GENERATION-SKIPPING TRANSFER TAX A. Income Taxation of Trusts and Estates 1 1. Rate schedule of trusts and estates (Sec. 101 of the Act and sec. 1 of the Code) In general Prior Law Under both present and prior law, the income taxation of a trust depends on whether the trust is a grantor or nongrantor trust. In the case of a grantor trust (i.e., one where the grantor (or other person with the power to revoke the trust) has certain powers with respect to the trust), income is taxed directly to the grantor. In the case of a nongrantor trust, each trust is treated as a separate taxable entity. Nongrantor trusts Under both present and prior law, trusts and estates generally are treated as conduits with respect to amounts that are distributed currently and taxed as individuals with respect to amounts retained in the trust or estate. The conduit treatment is achieved by allowing the trust or estate a deduction for amounts that are distributed to beneficiaries during the taxable year to the extent of the distributable net income of the trust or estate for that taxable year. Such distributions are includible in the gross income of the beneficiaries to the extent of the distributable net income of the trust or estate. In general, the character in the hands of the beneficiary of amounts distributed by a trust or estate is the same as it was in the hands of the trust or estate. When a trust distributes previously accumulated income to a beneficiary, the tax on that distribution is determined by special averaging rules. Under those rules (called the "accumulation distribution" or "throwback" rules), such income is taxed at the average of the top tax rates of the beneficiary during three of the previous five years, excluding the highest and lowest years. Exemptions and deductions Estates are entitled to a deduction, in lieu of a personal exemption, of $600. Trusts which are required to distribute all of their income currently are entitled to a deduction of $300. All other For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1211; H.Rep. 99-426, pp. 804-19; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, secs. 101, 1611-14; S.Rep. 99313, pp. 866-74; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 763-66 (Conference Report). trusts are entitled to a deduction of $100. No zero bracket amount or standard deduction is permitted. An unlimited charitable deduction is available. Tax rates Under prior law, trusts and estates generally were taxed at the same rates as a married person filing a separate return. Under both present and prior law, in the case of gain derived from the sale or exchange of property contributed to the trust within the preceding two years, that portion of the gain attributable to the difference between the fair market value of the property at the time it was contributed to the trust and the grantor's basis in the property is taxed at the grantor's marginal tax rates. Taxation of distributions to beneficiaries Under both present and prior law, distributions to beneficiaries are taxed to beneficiaries and deductible by the trust to the extent of the distributable net income (DNI) of the trust. DNI is allocated first to distributions that are required to be made out of income for the year, secondly to distributions made to charity out of trust income, and lastly to other distributions. Accumulation distributions Special rules (referred to as the so-called "accumulation distribution" or "throwback" rules) apply to the taxation of beneficiaries of a trust where the trust distributes amounts of income (other than capital gain) that had previously been taxed to the trust. Under these rules, the income is first increased (grossed up) by the taxes previously paid by the trust on the distributed income. The grossedup income is then included in the gross income of the beneficiary. A tax is then computed on the grossed-up amount by using the av erage top marginal rate of the beneficiary during three of the five preceding taxable years, excluding the two taxable years with the highest and lowest incomes. In determining the amount of this tax, all of the distribution is treated as ordinary income, other than distributed income that was tax-exempt income to the trust. Finally, the amount of the tax on the distribution of the previously accumulated income is the amount of this tax reduced (but not below zero) by the amount of taxes previously paid on the distributed income by the trust. The accumulation distribution rules do not apply to distributions by estates. The accumulation distribution rules generally do not apply if the income was accumulated while the beneficiary was a minor. However, this exclusion from the accumulation distribution rules does not apply if distributions had been made of income from two other trusts, which income also had been accumulated in that same year. In addition, if distributions from two other trusts previously had been made of income that was accumulated in the same year as the present distribution of accumulated income, the gross-up and credit otherwise provided for the taxes previously paid by the trust on the distributed income is not allowed. In the case of distributions by a foreign trust of previously accumulated income, the exemption from the accumulation distribution rules for amounts accumulated while the beneficiary was a minor does not apply. In addition, any tax on distributions of previously accumulated income is increased by an interest charge computed at 6 percent for each year from the time the income was earned until it was distributed. Multiple trusts Under both present and prior law, two or more trusts are treated as one trust for Federal income tax purposes if (1) those trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries and (2) a principal purpose of such trusts is the avoidance of Federal income tax. Reasons for Change The prior rules relating to the taxation of trusts and estates permit the reduction of taxation through the creation of entities that are taxed separately from the beneficiaries or grantor of the trust or estate. This result arises because any retained income of a trust or estate was taxed to the trust or estate under a separate set of rate brackets and exemptions from those of its grantor and beneficiaries. Moreover, the present accumulation distribution rules are not adequate to prevent the avoidance of tax through the use of trusts and estates. In the case of estates, distributions of previously accumulated income are not subject to the accumulation distribution rules and are not taxed to their beneficiaries. In the case of trusts, the accumulation distribution rules permit the deferral of taxation without any interest accruing on the deferred taxes. Moreover, the corrective effect of the accumulation distribution rules can be mitigated by making the distribution of previously accumulated income during years that the beneficiaries are in low tax brackets. The Congress believed that the tax benefits which result from the ability to split income between a trust or estate and its beneficiaries should be eliminated or significantly reduced. On the other hand, the Congress believed that significant changes in the taxation of trusts and estates are unnecessary to accomplish this result. Accordingly, the Act attempts to reduce the benefits arising from the use of trusts and estates by revising the rate schedule applicable to trusts and estates so that retained income of the trust or estate will not benefit significantly from a progressive tax rate schedule that might otherwise apply. This is accomplished by reducing the amount of income that must be accumulated by a trust or estate before that income is taxed at the top marginal rate. The Congress believed that these changes will significantly reduce the tax benefits inherent in the prior law rules of taxing trusts and estates while still retaining the existing structure of taxing these entities. Explanation of Provision The Act revises the tax rate schedule applicable to trusts and estates. Under the revised rates, the first $5,000 of taxable income of trusts and estates is taxed at 15 percent. Any taxable income of trusts and estates in excess of $5,000 is taxed at 28 percent. In addi tion, the benefit of the 15 percent bracket is phased-out where the taxable income of the trust or estate is between $13,000 and $26,000. An additional rate schedule 2 is provided for taxable years beginning in 1987. Effective Date The provision applies to taxable years of both new and existing trusts and estates beginning after December 31, 1986. For 1987 returns, a blended rate schedule based upon the present law rates and new rates would apply. Revenue Effect The revenue effect of this provision is included with item 2, below. 2. Revision of grantor trust rules (Secs. 1411 and 1412 of the Act and secs. 672, 673, 674, 676, and 677 of the Code) Prior Law Overview Where the grantor transfers property to a trust and retains certain powers or interests over the trust, the grantor is treated, under both present and prior law, as the owner of that trust for Federal income tax purposes under the so-called "grantor trust provisions." As a result, the income and deductions attributable to that trust are included directly in the grantor's taxable income. In addition, a beneficiary is treated as the owner of a trust where the beneficiary has given up a power to revoke the trust but retains any of such powers or interests in the trust. Reversionary interests Under prior law, a grantor is treated as the owner of that portion of a trust in which he has a reversionary interest in corpus or income therefrom if the interest will or may reasonably be expected to take effect in possession or enjoyment within 10 years of the transfer to the trust. An exception was provided under which a grantor was not treated as having such a reversionary interest if the possession or enjoyment did not take effect until the death of the income beneficiary of that portion of the trust. Power to control beneficial enjoyment Under both present and prior law, a grantor is treated as the owner of any portion of a trust over which the grantor, or a nonadverse party, without the consent of an adverse party, has the power to control the beneficial enjoyment of the corpus or income from 2 The income tax schedule for estates and trusts for 1987 would be as follows: If taxable income is Not over $500 Over $500 but not over $4,700. Over $4,700 but not over $7,550.. The tax is 11% of taxable income $55 plus 15% of the excess over $500 |