Tax Bill 2017

The Senate passed the Tax Bill for 2017 on Tuesday-yesterday. After that a few more changes are made to the language. It is sent down to the House for voting on Wednesday-today. It is expected to pass.

Here is the analysis of the new Tax Bill.

 

 

Explanation of TCJA (Tax Cut & Job Act) Conference Report and Final Version of the Tax Bill

This article provides an in-depth explanation of the final legislative text (“Conference Bill”) of the Tax Cuts and Jobs Act. On Friday, December 15, 2017, the conference committee reconciling the House and Senate versions (“House Bill” and “Senate Bill”, respectively) of the bill reached agreement on a conference report that includes the final version of the tax bill and the committee’s explanation of its provisions. H.R. 1-Conference (December 15, 2017).

Introduction

With respect to individuals, some of the more notable items included in the Conference Bill are:

  • (1) the provision of seven tax brackets, with a top rate of 37 percent (the top rate under present law is 39.6 percent);
  • (2) a repeal of the personal exemption deductions and an increase in the standard deduction amounts to $24,000 for joint filers and surviving spouses, $18,000 for heads of household, and $12,000 for unmarried taxpayers and married filing separately (additional amounts for the elderly and blind are retained);
  • (3) a $10,000 limit on the deduction for state and local taxes, which can be used for both property taxes and income taxes (or sales taxes in lieu of income taxes);
  • (4) a $750,000 limit on the loan amount for which a mortgage interest deduction can be claimed by individuals, with existing loans grandfathered, and the repeal of interest deductions on home equity indebtedness;
  • (5) a repeal of miscellaneous itemized deductions subject to the 2 percent of adjusted gross income floor ;
  • (6) a repeal of the personal deduction for casualty and theft losses, except for losses incurred in presidentially declared disaster areas;
  • (7) an increase in the child tax credit to $2,000 ($1,400 is refundable) and an increase in the phaseout threshold amounts to $400,000 for joint filers and $200,000 for all others (the credit is $1,000 under present law and is fully refundable);
  • (8) an increase in the alternative minimum tax (AMT) exemption amounts and the adjusted gross income thresholds at which the exemption amount begins to phase out;
  • (9) a repeal of the deduction for alimony paid and corresponding inclusion in income by the recipient, effective for tax years beginning in 2019 (alimony paid under separation agreement entered into prior to the effective date is generally grandfathered);
  • (10) permanent repeal of the individual shared responsibility payment (individual healthcare mandate) enacted as part of the Affordable Care Act (ACA); and
  • (11) the expiration of most individual tax provisions after December 31, 2025.
  • The Conference Bill also provides a 20 percent deduction against qualified business income from passthrough business entities. The provision includes relatively relaxed rules for calculating qualified business income for individuals with taxable income below certain thresholds ($315,000 for joint filers, $157,500 for all others), and stricter ones that are phased in for individuals with taxable income above the thresholds.
  • The Conference Bill would reduce the corporate tax rate to 21 percent and fully repeals the corporate alternative minimum tax. Both changes would be effective for tax years beginning after December 31, 2017.

Other important business-related changes include (1) 100% bonus depreciation for qualified property placed in service before January 1, 2023; (2) a permanent increase in the Section 179 expensing limit to $1,000,000 (up from $500,000 under present law) and a permanent increase in the phase-out threshold amount to $2,500,000 (up from $2,000,000 under present law); (3) a reduction in the gross receipts amount under which a business can qualify to use the cash method of accounting; and (4) an exemption from the requirement to use inventories for certain taxpayers .

The Conference Bill also makes changes to certain partnership rules, including (1) the repeal of the technical termination of partnership rule in Code Sec. 708(b); (2) the recharacterization of certain gains in the case of partnership profits interests held in connection with the performance of investment services; (3) the modification of the definition of substantial built-in loss in the case of the transfer of a partnership interest; and (4) a modification of the basis limitation on partner losses to account for a partner’s distributive share of partnership charitable contributions and foreign taxes.

  1. Changes Affecting Individuals

Affordable Care Act (ACA) Individual Healthcare Mandate

Under the Conference Bill, the amount of the individual shared responsibility payment (aka, the “individual healthcare mandate”) enacted as part of the ACA would be reduced to zero, effective with respect to health coverage status for months beginning after December 31, 2018.

Individual Tax Rates and Brackets

The Conference Bill would replace the current set of seven individual tax rates with a different set of seven individual tax rates. Under the Conference Bill, the highest marginal tax rate is 37%, as compared to the top tax rate of 39.6% under present law. The current tax rates of 10%, 15%, 25%, 28%, 33%, 35%, 39.6% rates would be replaced with tax rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Observation: The highest tax rate in the Conference Bill (37%) is lower than the top rates in either the House or Senate Bills (39.6% and 38.5%, respectively). The reduction was reportedly intended to offset the effect, for high income taxpayers, of capping the state and local tax deduction at $10,000.

The income tax bracket thresholds are all adjusted for inflation after December 31, 2018, and then rounded to the next lowest multiple of $100 in future years. Unlike present law (which uses a measure of the consumer price index for all-urban consumers), the new inflation adjustment uses the chained consumer price index for all-urban consumers.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Estate and Trust Tax Rates and Brackets

Under the Conference Bill, the tax rate for estates and trusts would be 10% of taxable income up to $2,550, 24% of the excess over $2,550 but not over $9,150; 35% of the excess over $9,150 but not over $12,500; and 37% of the excess over $12,500.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Simplification of Tax on Unearned Income of Children

The Conference Bill simplifies the “kiddie tax” by effectively applying ordinary and capital gains rates applicable to trusts and estates to the net unearned income of a child. Thus, taxable income attributable to earned income is taxed according to an unmarried taxpayer’s brackets and rates. Taxable income attributable to net unearned income is taxed according to the brackets applicable to trusts and estates, with respect to both ordinary income and income taxed at preferential rates. The child’s tax is no longer affected by the tax situation of the child’s parent or the unearned income of any siblings.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Maximum Rates on Capital Gains and Qualified Dividends

The Conference Bill generally retains the present-law maximum rates on net capital gain and qualified dividends. The breakpoints between the zero- and 15-percent rates (“15-percent breakpoint”) and the 15- and 20-percent rates (“20-percent breakpoint”) are the same amounts as the breakpoints under current law, except the breakpoints are indexed using the Consumer Price Index for all Urban Consumers (C-CPI-U) in taxable years beginning after 2017. Thus, for 2018, the 15-percent breakpoint is $77,200 for joint returns and surviving spouses (one-half of this amount for married taxpayers filing separately), $51,700 for heads of household, $2,600 for estates and trusts, and $38,600 for other unmarried individuals. The 20-percent breakpoint is $479,000 for joint returns and surviving spouses (one-half of this amount for married taxpayers filing separately), $452,400 for heads of household, $12,700 for estates and trusts, and $425,800 for other unmarried individuals.

Observation: Therefore, in the case of an individual (including an estate or trust) with adjusted net capital gain, to the extent the gain would not result in taxable income exceeding the 15-percent breakpoint, such gain is not taxed. Any adjusted net capital gain which would result in taxable income exceeding the 15-percent breakpoint but not exceeding the 20-percent breakpoint is taxed at 15 percent. The remaining adjusted net capital gain is taxed at 20 percent.

As under current law, unrecaptured Code Sec. 1250 gain generally is taxed at a maximum rate of 25 percent, and 28-percent rate gain is taxed at a maximum rate of 28 percent.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Increase in Individual AMT Exemption and Phaseout Amounts

The Conference Bill provides for increased AMT exemptions. For 2018, the exemptions would be $109,400 (up from $84,500 in 2017) in the case of a joint return or the return of a surviving spouse; $70,300 (up from $54,300 in 2017) in the case of an individual who is unmarried and not a surviving spouse; $54,700 (up from $39,375 in 2017) in the case of a married individual filing a separate return. Additionally, the Conference Bill would increase the alternative minimum taxable income limit where the exemptions begin to phase out. Under the Conference Bill, the exemption amount of any taxpayer is reduced by an amount equal to 25 percent of the amount by which the alternative minimum taxable income of the taxpayer exceeds $1,000,000 (up from $160,900 in 2017) in the case of a joint returns; and $500,000 for all others (up from amounts ranging from $80,450 to $120,700 in 2017).

This provision would be effective for tax years beginning after December 31, 2017.

Paid Preparer Due Diligence Requirement for Head of Household Status

The Conference Bill directs the Secretary of the Treasury to issue due diligence requirements for paid preparers in determining eligibility for a taxpayer to file as head of household. A penalty of $500 would be imposed for each failure to meet these requirements.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Increase in Standard Deduction

The Conference Bill increases the basic standard deduction for individuals across all filing statuses. Under the provision, the amount of the standard deduction is increased to $24,000 for married individuals filing a joint return, $18,000 for head-of-household filers, and $12,000 for all other taxpayers. The amount of the standard deduction is indexed for inflation using the chained consumer price index for all-urban consumers for taxable years beginning after December 31, 2018. The additional standard deduction for the elderly and the blind is not changed by the provision.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Repeal of the Deduction for Personal Exemptions

The Conference Bill repeals the deduction for personal exemptions.

In addition, the provision modifies the requirements for those who are required to file a tax return. In the case of an individual who is not married, such individual is required to file a tax return if the taxpayer’s gross income for the taxable year exceeds the applicable standard deduction. Married individuals are required to file a return if that individual’s gross income, when combined with the individual’s spouse’s gross income for the taxable year, is more than the standard deduction applicable to a joint return, provided that: (1) such individual and his spouse, at the close of the taxable year, had the same household as their home; (2) the individual’s spouse does not make a separate return; and (3) neither the individual nor his spouse is a dependent of another taxpayer who has income (other than earned income) in excess of $500 (indexed for inflation).

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Observation: Withholding rules under present law are based partly on the number of personal exemptions claimed by a taxpayer. Form W-4 and withholding tables would need to be changed to reflect the repeal of personal exemptions. The Conference Bill provides that the Secretary may, at his discretion, administer wage withholding in 2018 without regard to the repeal of the deduction for personal exemptions.

Repeal of Deduction for Alimony Paid

The Conference Bill repeals the deduction for alimony paid and the corresponding inclusion of alimony in income by the recipient. The provision is effective for any divorce or separation instrument executed after December 31, 2018, or for any divorce or separation instrument executed on or before December 31, 2018, and modified after that date, if the modification expressly provides that the amendments made by this section apply to such modification. Thus, alimony paid under a separation agreement entered into prior to the effective date is generally grandfathered.

Temporary Reduction in Medical Expense Deduction Floor

The Conference Bill provides special rules for medical expense deductions for years 2013 through 2018. For a tax year beginning after 2012 and ending before 2017, in the case of a taxpayer or a taxpayer’s spouse who has attained age 65 before the close of the year, and for a tax year beginning after 2016, and ending before 2019, in the case of any taxpayer, the adjusted-gross-income floor above which a medical expense is deductible is reduced from 10 percent to 7.5 percent.

Observation: The medical expense deduction is one of a few areas where the Senate and House Bills went in opposite directions. Whereas the Senate Bill retained the deduction and enhanced it for certain tax years (the provision discussed above that was included in the Conference Bill), the House Bill would have repealed it altogether.

Limitation on Deduction for State and Local Taxes

The Conference Bill limits the deduction for state and local property, income, war profits, and excess profits taxes to $10,000 ($5,000 in the case of a married individual filing a separate return), unless such taxes are paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212 (relating to expenses for the production of income). The Conference Bill also repeals the deduction for foreign property taxes. As under current law, taxpayers may elect to deduct state and local sales taxes in lieu of state and local income taxes.

Observation: An earlier version of this provision that was included in both the House and Senate Bills, would have permitted only the deduction of state, local, and foreign property taxes within the $10,000 limit. The Conference Bill expanded the scope of the deduction to include state and local income taxes (or sales taxes in lieu thereof), as under current law, but eliminated the deduction for foreign property taxes.

Caution: The Conference Bill includes a provision blocking taxpayers from prepaying state and local income tax relating to the 2018 tax year in 2017 in order to circumvent the new limitation on the deduction. Specifically, the bill provides that, in the case of an amount paid in a tax year beginning before January 1, 2018, with respect to a state or local income tax imposed for a tax year beginning after December 31, 2017, the payment will be treated as paid on the last day of the tax year for which such tax is imposed for purposes of applying the provision limiting the dollar amount of the deduction.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Limitation on Mortgage Interest Deduction

The Conference Bill provides that a taxpayer may treat no more than $750,000 as acquisition indebtedness ($375,000 in the case of married taxpayers filing separately) for purposes of the mortgage interest deduction. In the case of acquisition indebtedness incurred before December 15, 2017, the limitation is the same as it is under current law: $1,000,000 ($500,000 in the case of married taxpayers filing separately).

Observation: A provision in the House Bill, that was omitted from the Conference Bill, would have disallowed an interest deduction for debt used to acquire a second home. Thus, interest on such debt remains deductible within the overall limits that apply to the deductibility of acquisition indebtedness.

The Conference Bill repeals the deduction for home equity indebtedness.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Modification to Deduction for Charitable Contributions

The Conference Bill make the following modifications to the deduction for charitable contributions –

(1) increases in the income-based percentage limit described in Code Sec. 170(b)(1)(A)for certain charitable contributions by an individual taxpayer of cash to public charities and certain other organizations from 50 percent to 60 percent;

(2) denies a charitable deduction for payments made in exchange for college athletic event seating rights; and

(3) repeals the substantiation exception in Code Sec. 170(f)(8)(D) for certain contributions reported by the donee organization.

The Conference Bill provisions that increase the charitable contribution percentage limit and deny a deduction for stadium seating payments would be effective for contributions made in taxable years beginning after December 31, 2017. The provision that repeals the substantiation exception for certain contributions reported by the donee organization would be effective for contributions made in taxable years beginning after December 31, 2016.

Partial Repeal of Deduction for Casualty and Theft Losses

The Conference Bill temporarily modifies the deduction for personal casualty and theft losses. Under the provision, a taxpayer may claim a personal casualty loss, subject to the applicable limitations in Code Sec. 165(h), only if such loss was attributable to a disaster declared by the President under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act.

The above-described limitation does not apply with respect to losses incurred after December 31, 2025.

Repeal of Miscellaneous Itemized Deductions Subject to the 2-Percent Floor

The Conference Bill repeals all miscellaneous itemized deductions that are subject to the two-percent of adjusted-gross-income floor.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Increased Percentage Limitation for Charitable Contributions of Cash to Public Charities

The Conference Bill increases the income-based percentage limit described in Code Sec. 170(b)(1)(A)for certain charitable contributions by an individual taxpayer of cash to public charities and certain other organizations from 50 percent to 60 percent.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Repeal of Charitable Deduction for Athletic Event Seating

The Conference Bill provides that no charitable deduction is allowed for any amount described in Code Sec. 170(l)(2), generally, a payment to an institution of higher education in exchange for which the payor receives the right to purchase tickets or seating at an athletic event.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Repeal of Overall Limitation on Itemized Deductions

The Conference Bill repeals the overall limitation on itemized deductions.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Relief for 2016 and 2017 Disaster Areas – Relaxation of Casualty Loss Deduction Rule s

The Conference Bill provides tax relief relating to a “2016 disaster area,” which is defined as any area with respect to which a major disaster was declared by the President under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act during calendar year 2016 and 2017. In the case of a personal casualty loss which arose after December 31, 2015, and before January 1, 2018, and was attributable to the events giving rise to the Presidential disaster declaration, such losses are deductible without regard to whether aggregate net losses exceed ten percent of a taxpayer’s adjusted gross income. Under the provision, in order to be deductible, the losses must exceed $500 per casualty. Additionally, such losses may be claimed in addition to the standard deduction.

Observation: While the Senate Bill originally applied only to calendar year 2016, the Conference Bill expanded the relief to 2017 without changing the description in the proposal as applying to the “2016 disaster area.”

The provision is effective on the date of enactment.

Relief for 2016 Disaster Areas – Relaxation of Retirement Plan Distribution Rules

The Senate Bill provides special rules for using retirement funds and taking a casualty loss deduction with respect to a “2016 disaster area.” The term “2016 disaster area” means any area with respect to which a major disaster has been declared by the President under Section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act during calendar year 2016. The term “qualified 2016 disaster distribution” means any distribution from an eligible retirement plan made on or after January 1, 2016, and before January 1, 2018, to an individual whose principal place of abode at any time during calendar year 2016 was located in 2016 disaster area and who has sustained an economic loss by reason of the events giving rise to the Presidential declaration which was applicable to such area.

Under the provision, the early withdrawal penalties under Code Sec. 72(t) do not apply to a qualified 2016 disaster distribution to the extent the amount withdrawn does not exceed $100,000 over the aggregate amounts treated as qualified 2016 disaster distributions received by such individual for all prior years. Amounts required to be included in income as a result of such distributions may be included ratably over a three-taxable year period. The provision also allows a casualty loss deduction with respect to a loss relating to a 2016 disaster area.

Although the Conference Bill’s relaxation of retirement plan distribution rules only applies to disasters occurring in 2016 (for which qualified retirement plan distributions can be made in either 2016 or 2017), victims of several major 2017 disasters were granted similar disaster relief by Pub. L. 115-63.

Rules for Exclusion of Gain from the Sale of a Principal Residence Unchanged

Both the House and Senate Bills included similar provisions tightening the rules for the exclusion of gain from the sale of a principal residence. Both bills would have made the exclusion available only if the taxpayer had owned and used the residence as a principal residence for at least five of the eight years (as opposed to two out of five years under current law) prior to selling it, and both would have allowed a taxpayer to benefit from the exclusion only once every five years (as opposed to once every two years under current law).

These provisions were not included in the Conference Bill. Thus, the rules for exclusion of gain from the sale of a principal residence under current law will remain in effect.

Repeal of Exclusion for Qualified Bicycle Commuting Reimbursement

The Conference Bill repeals the exclusion from gross income and wages for qualified bicycle commuting reimbursements.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Repeal of Exclusion for Qualified Moving Expense Reimbursements

The Conference Bill repeals the exclusion from gross income and wages for qualified moving expense reimbursements except in the case of a member of the Armed Forces of the United States on active duty who moves pursuant to a military order.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Repeal of Deduction for Moving Expenses

The Conference Bill repeals the deduction for moving expenses. However, under the provision, rules providing for exclusions of amounts attributable to in-kind moving and storage expenses (and reimbursements or allowances for these expenses) for members of the Armed Forces of the United States (or their spouse or dependents) are not repealed.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Repeal of Certain Deductions Relating to Employee Achievement Awards

The Conference Bill prohibits a deduction for cash, gift cards, and other non-tangible personal property given to an employee as an achievement award, effective for amounts paid or incurred after December 31, 2017.

Repeal of Deductions for Living Expenses of Members of Congress

The Conference Bill repeals a provision which allows members of Congress to deduct up to $3,000 annually for certain living expenses, effective for tax years beginning after the date of enactment.

Modification to Gambling Losses

The Conference Bill clarifies the scope of “losses from wagering transactions” as that term is used in Code Sec. 165(d). The provision provides that this term includes any deduction otherwise allowable incurred in carrying on any wagering transaction.

The provision is intended to clarify that the limitation on losses from wagering transactions applies not only to the actual costs of wagers incurred by an individual, but to other expenses incurred by the individual in connection with the conduct of that individual’s gambling activity. The provision clarifies, for instance, an individual’s otherwise deductible expenses in traveling to or from a casino are subject to the limitation under Code Sec. 165(d).

Observation: This provision would reverse the result reached by the Tax Court in Mayo v. Comm’r, 136 T.C. 81 (2011). In that case, the court held that a taxpayer’s expenses incurred in the conduct of the trade or business of gambling, other than the cost of wagers, were not limited by Code Sec. 165(d), and were thus deductible under Code Sec. 162(a) as trade or business expenses.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Reform of Child Tax Credit

The Conference Bill increases the child tax credit to $2,000 per qualifying child under the age of 17.

Observation: The Senate Bill would have increased the maximum age of a qualifying child 17. The Conference Bill retains the current law maximum age of 16 (i.e., “under the age of 17”).

The credit is further modified to provide for a $500 nonrefundable credit for qualifying dependents other than qualifying children. The provision generally retains the present-law definition of dependent.

Under the Conference Bill, the modified adjusted gross income threshold at which the credit begins to phase out is increased to $400,000 for joint filers and $200,000 for all other taxpayers. These amounts are not indexed for inflation.

The provision lowers the earned income threshold for the refundable child tax credit to $2,500 . The maximum amount refundable may not exceed $1,400 per qualifying child (up from $1,000 under present law). Under the provision, the maximum refundable amount is indexed for inflation with a base year of 2017, rounding up to the nearest $100. In order to receive the refundable portion of the child tax credit, a taxpayer must include a social security number for each qualifying child for whom the credit is claimed on the tax return.

This provision would be effective after December 31, 2017, and expire after December 31, 2025.

Increased Contributions to ABLE Accounts and Allowance of Contributions to be Eligible for Saver’s Credit

The Conference Bill increases the contribution limitation to ABLE accounts under certain circumstances. While the general overall limitation on contributions (the per-donee annual gift tax exclusion ($14,000 for 2017)) remains the same, the limitation is increased with respect to contributions made by the designated beneficiary of the ABLE account. Under the provision, after the overall limitation on contributions is reached, an ABLE account’s designated beneficiary can contribute an additional amount, up to the lesser of (1) the federal poverty line for a one-person household; or (2) the individual’s compensation for the taxable year. Additionally, the provision allows a designated beneficiary of an ABLE account to claim the saver’s credit for contributions made to his or her ABLE account.

The provision would be effective for tax years beginning after the date of enactment and would sunset after December 31, 2025.

Use of 529 Plan Distributions for Elementary or Secondary Schools

The Conference Bill modifies Section 529 plans to allow such plans to distribute not more than $10,000 in expenses for tuition incurred during the tax year in connection with the enrollment or attendance of the designated beneficiary at a public, private or religious elementary or secondary school. This limitation applies on a per-student basis, rather than a per-account basis. Thus, under the provision, although an individual may be the designated beneficiary of multiple accounts, that individual may receive a maximum of $10,000 in distributions free of tax, regardless of whether the funds are distributed from multiple accounts. Any excess distributions received by the individual would be treated as a distribution subject to tax under the general rules of Code Sec. 529.

The provision also modifies the definition of higher education expenses to include certain expenses incurred in connection with a homeschool. Those expenses are –

(1) curriculum and curricular materials;

(2) books or other instructional materials;

(3) online educational materials;

(4) tuition for tutoring or educational classes outside of the home (but only if the tutor or instructor is not related to the student);

(5) dual enrollment in an institution of higher education; and

(6) educational therapies for students with disabilities.

The provision would apply to distributions made after December 31, 2017.

Rollovers Between 529 Plans and Qualified ABLE Programs

The Conference Bill allows for amounts from qualified tuition programs (also known as Section 529 accounts) to be rolled over to an ABLE account without penalty, provided that the ABLE account is owned by the designated beneficiary of that Section 529 account, or a member of such designated beneficiary’s family. Such rolled-over amounts count towards the overall limitation on amounts that can be contributed to an ABLE account within a taxable year. Any amount rolled over that is in excess of this limitation will be includible in the gross income of the distributee in a manner provided by Code Sec. 72.

The provision would apply to distributions after December 31, 2017, and would sunset after December 31, 2025.

Extension of Time Limit to Contest IRS Levy

The Conference Bill extends from nine months to two years the period for returning the monetary proceeds from the sale of property that has been wrongfully levied upon. The provision also extends from nine months to two years the period for bringing a civil action for wrongful levy.

The provision would be effective with respect to: (1) levies made after the date of enactment; and (2) levies made on or before the date of enactment provided that the nine-month period has not expired as of the date of enactment.

Treatment of Certain Individuals Performing Services in the Sinai Peninsula of Egypt

The Conference Bill grants combat zone tax benefits to the Sinai Peninsula of Egypt, if as of the date of enactment of the provision any member of the Armed Forces of the United States is entitled to special pay under Section 310 of title 37, United States Code (relating to special pay; duty subject to hostile fire or imminent danger), for services performed in such location. This benefit lasts only during the period such entitlement is in effect.

The provision would generally be effective beginning June 9, 2015. The portion of the provision related to wage withholding would apply to remuneration paid after the date of enactment.

Treatment of Student Loans Discharged on Account of Death or Disability

The Conference Bill modifies the exclusion of student loan discharges from gross income, by including within the exclusion certain discharges on account of death or total and permanent disability of the student. Loans eligible for the exclusion under the provision are loans made by (1) the United States (or an instrumentality or agency thereof), (2) a state (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a state, county, or municipal hospital and whose employees have been deemed to be public employees under state law, (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation, or (5) private education loans (for this purpose, private education loan is defined in Section 140(7) of the Consumer Protection Act).

The provision applies to discharges of loans after December 31, 2017, and before January 1, 2026.

Deduction for Certain Educator Expenses Retained

The House Bill would have repealed the for the deduction of up to $250 for certain expenses of eligible educators. The Senate Bill would have doubled the current law deduction to $500. The Conference Bill adopted neither the House nor Senate Bill and instead keeps the current law $250 deduction .

Deduction for Student Loan Interest and the Exclusion for Graduate Student Tuition Waivers Retained

The Conference Bill omits provisions from the House Bill that would have repealed the above-the-line deduction for student loan interest and the exclusion from income of tuition waivers for graduate students, thereby retaining current rules for both provisions.

Business Loss Limitation Rules Applicable to Individuals

Under the Conference Bill, for taxable years beginning after December 31, 2017 and before January 1, 2026, excess business losses of a taxpayer other than a corporation are not allowed for the taxable year. Such losses are carried forward and treated as part of the taxpayer’s net operating loss (“NOL”) carryforward in subsequent taxable years. Under this provision, NOL carryovers generally are allowed for a taxable year up to the lesser of the carryover amount or 80 percent of taxable income determined without regard to the deduction for NOLs.

An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a taxable year is $250,000 (or twice the otherwise applicable threshold amount in the case of a joint return). The threshold amount is indexed for inflation after 2018.

In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder. Regulatory authority is provided to apply the provision to any other passthrough entity to the extent necessary to carry out the provision. Regulatory authority is also provided to require any additional reporting as the Secretary determines is appropriate to carry out the purposes of the provision.

The provision applies after the application of the passive loss rules.

For taxable years beginning after December 31, 2017, and before January 1, 2026, the present-law limitation relating to excess farm losses does not apply.

The Conference Bill provision would be effective for taxable years beginning after December 31, 2017.

  1. Estate and Gift Tax Changes

Increase in Estate and Gift Tax Exemption

The Conference Bill doubles the estate and gift tax exemption amount. This is accomplished by increasing the basic exclusion amount provided in Code Sec. 2010(c)(3) from $5 million to $10 million. The $10 million amount is indexed for inflation occurring after 2011.

The provision would be effective for decedents dying, generation-skipping transfers, and gifts made after December 31, 2017, and would expire for years beginning after December 31, 2025.

The Conference Bill omits a provision from the House Bill that would have repealed the estate and generation-skipping transfer tax beginning in 2025.

III. Deduction for Qualified Business Income of an Individual (Passthrough Break)

Under the Conference Bill, for taxable years beginning after December 31, 2017, and before January 1, 2026, an individual taxpayer generally may deduct an amount equal to the sum of –

(1) the lesser of (a) the combined qualified business income amount for the taxable year; or (b) an amount equal to 20 percent of the excess (if any) of taxpayer’s taxable income for the taxable year over the sum of any net capital gain and qualified cooperative dividends, plus

(2) the lesser of 20 percent of qualified cooperative dividends for the taxable year or taxable income (reduced by net capital gain).

This sum may not exceed the taxpayer’s taxable income for the taxable year (reduced by net capital gain).

Observation: As discussed below, trusts and estates are also eligible for this deduction.

Under the provision, the 20-percent deduction with respect to qualified cooperative dividends is limited to taxable income (reduced by net capital gain) for the year. The combined qualified business income amount for the taxable year is the sum of the deductible amounts determined for each qualified trade or business carried on by the taxpayer and 20 percent of the taxpayer’s qualified REIT dividends and qualified publicly traded partnership income.

The deductible amount for each qualified trade or business is the lesser of –

(1) 20 percent of the taxpayer’s qualified business income with respect to the trade or business; or

(2) the greater of 50 percent of the W-2 wages (defined below) with respect to the trade or business or the sum of 25 percent of the W-2 wages with respect to the trade or business and 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.

The 20-percent deduction is not allowed in computing adjusted gross income, and instead is allowed as a deduction reducing taxable income. Thus, for example, the provision does not affect limitations based on adjusted gross income.

Observation: This deduction is available to both nonitemizers and itemizers.

Qualified Trade or Business

For purposes of the deduction for qualified business income, the Conference Bill provides that qualified business income is determined for each qualified trade or business of the taxpayer. The term “qualified trade or business” means any trade or business other than –

(1) a specified service trade or business (defined below); or

(2) the trade or business of performing services as an employee.

Specified Service Trade or Business. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. For this purpose, a security and a commodity have the meanings provided in the rules for the mark-to-market accounting method for dealers in securities (Code Sec. 475(c)(2) and Code Sec. 475(e)(2), respectively).

The rule disqualifying specified service trades or businesses does not apply to taxpayers with taxable income at or below specified threshold amounts and is phased in for taxpayers with taxable income above the thresholds (threshold amounts and phase-in provisions for specified service trades or businesses are discussed below).

Qualified Business Income

Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.

For any taxable year, qualified business income is the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. The determination of qualified items of income, gain, deduction, and loss takes into account these items only to the extent included or allowed in the determination of taxable income for the year.

Example: During the taxable year, a qualified business has $100,000 of ordinary income from inventory sales, and makes an expenditure of $25,000 that is required to be capitalized and amortized over five years under applicable tax rules. Qualified business income is $100,000 minus $5,000 (current-year ordinary amortization deduction), or $95,000. The qualified business income is not reduced by the entire amount of the capital expenditure, only by the amount deductible in determining taxable income for the year.

If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business in the next taxable year. Similar to a qualified trade or business that has a qualified business loss for the current taxable year, any deduction allowed in a subsequent year is reduced (but not below zero) by 20 percent of any carryover qualified business loss.

Example: Sean has qualified business income of $20,000 from qualified business A and a qualified business loss of $50,000 from qualified business B in Year 1. Sean is not permitted a deduction for Year 1 and has a carryover qualified business loss of $30,000 to Year 2. In Year 2, Sean has qualified business income of $20,000 from qualified business A and qualified business income of $50,000 from qualified business B. To determine the deduction for Year 2, Sean reduces the 20 percent deductible amount determined for the qualified business income of $70,000 from qualified businesses A and B by 20 percent of the $30,000 carryover qualified business loss.

Domestic Business Items

Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States. In the case of a taxpayer who is an individual with otherwise qualified business income from sources within the commonwealth of Puerto Rico, if all the income is taxable under Code Sec. 1 (income tax rates for individuals) for the taxable year, the “United States” is considered to include Puerto Rico for purposes of determining the individual’s qualified business income.

Treatment of Investment Income

Qualified items do not include specified investment-related income, deductions, or loss. Specifically, qualified items of income, gain, deduction and loss do not include (1) any item taken into account in determining net long-term capital gain or net long-term capital loss, (2) dividends, income equivalent to a dividend, or payments in lieu of dividends, (3) interest income other than that which is properly allocable to a trade or business, (4) the excess of gain over loss from commodities transactions, other than those entered into in the normal course of the trade or business or with respect to stock in trade or property held primarily for sale to customers in the ordinary course of the trade or business, property used in the trade or business, or supplies regularly used or consumed in the trade or business, (5) the excess of foreign currency gains over foreign currency losses from Code Sec. 988 transactions, other than transactions directly related to the business needs of the business activity, (6) net income from notional principal contracts, other than clearly identified hedging transactions that are treated as ordinary (i.e., not treated as capital assets), and (7) any amount received from an annuity that is not used in the trade or business of the business activity. Qualified items under this provision do not include any item of deduction or loss properly allocable to such income.

Phase-in of Specified Service Business Limitation

There is an exclusion from the definition of a qualified business for specified service trades or businesses for certain taxpayers. This exclusion phases in for a taxpayer with taxable income in excess of a threshold amount. The threshold amount is $315,000 for joint filers and $157,500 for all other taxpayers (the “threshold amount”). The threshold amount is indexed for inflation. The exclusion from the definition of a qualified business for specified service trades or businesses is fully phased in for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return). For a taxpayer with taxable income within the phase-in range, the exclusion applies as follows.

In computing the qualified business income with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 wages. The applicable percentage with respect to any taxable year is 100 percent reduced by the percentage equal to the ratio of the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return).

Example: Tom, and unmarried taxpayer , has taxable income of $187,500 , of which $150,000 is attributable to an accounting sole proprietorship. Assume that the sole proprietorship’s W-2 wages are high enough that the W-2 wage limitation (see below) will not affect Tom’s deduction. Tom has an applicable percentage of 40 percent [$187,500 – $157,500 (Tom’s threshold amount) = $30,000 / $50,000 (phaseout range) = 60 percent; 100 percent – 60 percent = 40 percent]. In determining includible qualified business income, Tom takes into account 40 percent of $150,000, or $60,000. Because we’re assuming that the W-2 wage limitation doesn’t apply, Tom’s deduction for qualified business income is 20 percent of $60,000, or $12,000.

W-2 Wage Limitation on Deduction for Qualified Business Income

There is a limitation on the deduction for qualified business income which is based on either W-2 wages paid, or wages paid plus a capital element. This limitation is phased in above a threshold amount of taxable income (see below). Specifically, the limitation is the greater of (1) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.

Example: Susan owns and operates a sole proprietorship that sells cupcakes. The business is not a specified service business and Susan’s filing status for Form 1040 is single. The cupcake business pays $100,000 in W-2 wages and has $350,000 in qualified business income. For the sake of simplicity, assume the business had no qualified property, and that Susan has no other items of income or loss (putting her taxable income at a level where she’s fully subject to the W-2 wage limitation). Susan’s deduction for qualified business income is $50,000, which is the lesser of (a) 20 percent of $350,000 in qualified business income ($70,000), or (b) the greater of (i) 50 percent of W-2 wages ($50,000) or (ii) 25 percent of W-2 wages plus 2.5 percent of qualified property ($25,000) ($25,000 ($100,000 x 25 percent) + $0 (2.5 percent x $0)).

For purposes of this provision, qualified property means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year, and which is used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year. The depreciable period with respect to qualified property of a taxpayer means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (1) the date 10 years after that date, or (2) the last day of the last full year in the applicable recovery period that would apply to the property under Code Sec. 168 (without regard to Code Sec. 168(g)).

Example: Walter (who is subject to the limitation on the deduction for qualified business income) does business as a sole proprietorship conducting a widget-making business. The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of (a) 50 percent of W-2 wages, or $0, or (b) the sum of 25 percent of W-2 wages ($0) plus 2.5 percent of the unadjusted basis of the machine immediately after its acquisition: $100,000 x .025 = $2,500. The amount of the limitation on the Walter’s deduction is $2,500.

In the case of property that is sold, for example, the property is no longer available for use in the trade or business and is not taken into account in determining the limitation. The Conference Bill provides that the IRS must provide rules for applying the limitation in cases of a short taxable year of where the taxpayer acquires, or disposes of, the major portion of a trade or business or the major portion of a separate unit of a trade or business during the year. The IRS is required to provide guidance applying rules similar to the rules of Code Sec. 179(d)(2) to address acquisitions of property from a related party, as well as in a sale-leaseback or other transaction as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W-2 wages and capital. Similarly, the IRS must provide guidance prescribing rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions as needed to carry out the purposes of the provision and to provide anti-abuse rules, including under the limitation based on W-2 wages and capital.

Reasonable Compensation and Guaranteed Payments

Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services.

W-2 Wages

W-2 wages are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer. W-2 wages do not include any amount which is not properly allocable to the qualified business income as a qualified item of deduction. In addition, W-2 wages do not include any amount which was not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return.

In the case of a taxpayer who is an individual with otherwise qualified business income from sources within the commonwealth of Puerto Rico, if all the income is taxable under Code Sec. 1 (income tax rates for individuals) for the taxable year, the determination of W-2 wages with respect to the taxpayer’s trade or business conducted in Puerto Rico is made without regard to any exclusion under the wage withholding rules for remuneration paid for services in Puerto Rico.

Phase-in of W-2 Wage Limitation

The application of the W-2 wage limitation phases in for a taxpayer with taxable income in excess of the following threshold amounts: $315,000 for joint filers and $157,500 for all other taxpayers, indexed for inflation. For purposes of phasing in the wage limit, taxable income is computed without regard to the 20 percent deduction.

The W-2 wage limitation applies fully for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return). For a taxpayer with taxable income within the phase-in range, the wage limit applies as follows. With respect to any qualified trade or business, the taxpayer compares –

(1) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business; with

(2) the W-2 wage limitation (see above) with respect to the qualified trade or business.

If the amount determined under (2) is less than the amount determined (1), (that is, if the wage limit is binding), the taxpayer’s deductible amount is the amount determined under (1) reduced by the same proportion of the difference between the two amounts as the excess of the taxable income of the taxpayer over the threshold amount bears to $50,000 ($100,000 in the case of a joint return).

Qualified REIT dividends, cooperative dividends, and publicly traded partnership income A deduction is allowed under the provision for 20 percent of the taxpayer’s aggregate amount of qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income for the taxable year. Qualified REIT dividends do not include any portion of a dividend received from a REIT that is a capital gain dividend or a qualified dividend. A qualified cooperative dividend means a patronage dividend, per-unit retain allocation, qualified written notice of allocation, or any similar amount, provided it is includible in gross income and is received from either (1) a tax-exempt benevolent life insurance association, mutual ditch or irrigation company, cooperative telephone company, like cooperative organization, or a taxable or tax-exempt cooperative that is described in Code Sec. 1381(a), or (2) a taxable cooperative governed by tax rules applicable to cooperatives before the enactment of subchapter T of the Code in 1962. Qualified publicly traded partnership income means (with respect to any qualified trade or business of the taxpayer), the sum of the (1) the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss (that are effectively connected with a U.S. trade or business and are included or allowed in determining taxable income for the taxable year and do not constitute excepted enumerated investment-type income, and not including the taxpayer’s reasonable compensation, guaranteed payments for services, or (to the extent provided in regulations) Code Sec. 707(a) payments for services) from a publicly traded partnership not treated as a corporation, and (2) gain recognized by the taxpayer on disposition of its interest in the partnership that is treated as ordinary income (for example, by reason of Code Sec. 751).

Special Rules for Partnerships and S Corporations

The Conference Bill provides that, in the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level. Each partner takes into account the partner’s allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the taxable year equal to the partner’s allocable share of W-2 wages of the partnership. The partner’s allocable share of W-2 wages is required to be determined in the same manner as the partner’s share of wage expenses. For example, if a partner is allocated a deductible amount of 10 percent of wages paid by the partnership to employees for the taxable year, the partner is required to be allocated 10 percent of the W-2 wages of the partnership for purposes of calculating the wage limit under this deduction. Similarly, each shareholder of an S corporation takes into account the shareholder’s pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the taxable year equal to the shareholder’s pro rata share of W-2 wages of the S corporation.

Treatment of Agricultural and Horticultural Cooperatives

For taxable years beginning after December 31, 2017, but not after December 31, 2025, a deduction is allowed to any specified agricultural or horticultural cooperative equal to the lesser of (1) 20 percent of the cooperative’s taxable income for the taxable year or (2) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. A specified agricultural or horticultural cooperative is an organization to which subchapter T applies that is engaged in (1) the manufacturing, production, growth, or extraction in whole or significant part of any agricultural or horticultural product, (2) the marketing of agricultural or horticultural products that its patrons have so manufactured, produced, grown, or extracted, or (3) the provision of supplies, equipment, or services to farmers or organizations described in the foregoing.

Treatment of Trusts and Estates

The Conference Bill provides that trusts and estates are eligible for the 20-percent deduction. Rules similar to the rules under present-law Code Sec. 199 (as in effect on December 1, 2017) apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital.

Effective Date

The Conference Bill provision is effective for taxable years beginning after December 31, 2017, and does not apply to taxable years beginning after December 31, 2025.

  1. Business-Related Changes

Reduction in Corporate Tax Rate

The Conference Bill eliminates the graduated corporate rate structure and instead taxes corporate taxable income at 21 percent. It also eliminates the special tax rate for personal service corporations and repeals the maximum corporate tax rate on net capital gain as obsolete. For taxpayers subject to the normalization method of accounting (e.g., regulated public utilities), the Conference Bill provides for the normalization of excess deferred tax reserves resulting from the reduction of corporate income tax rates (with respect to prior depreciation or recovery allowances taken on assets placed in service before the date of enactment).

The Conference Bill proposals would be effective for taxable years beginning after December 31, 2017.

Reduction of Dividends Received Deductions to Reflect Lower Corporate Tax Rate

The Conference Bill reduces the 70 percent dividends received deduction available to corporations who receive a dividend from another taxable domestic corporation to 50 percent. It also reduces the 80 percent dividends received deduction for dividends received from a 20-percent owned corporation to 65 percent.

The Conference Bill proposals would be effective for taxable years beginning after December 31, 2018.

Corporate Alternative Minimum Tax

The Conference Bill repeals the corporate alternative minimum tax (AMT).

In the case of a corporation, the Conference Bill allows the AMT credit to offset the regular tax liability for any taxable year. In addition, the AMT credit is refundable for any taxable year beginning after 2017 and before 2022 in an amount equal to 50 percent (100 percent in the case of taxable years beginning in 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the minimum tax credit would be allowed in taxable years beginning before 2022.

The Conference Bill provisions would be effective for taxable years beginning after December 31, 2017.

Enhanced Expensing Through Bonus Depreciation

Bonus Depreciation. The Conference Bill extends and modifies the additional first-year (i.e., “bonus”) depreciation deduction through 2026 (through 2027 for longer production period property and certain aircraft). Under the Conference Bill, the 50-percent additional depreciation allowance is increased to 100 percent for property placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for longer production period property and certain aircraft), as well as for specified plants planted or grafted after September 27, 2017, and before January 1, 2023.

The 100-percent allowance is phased down by 20 percent per calendar year for property placed in service, and specified plants planted or grafted, in taxable years beginning after 2022 (after 2023 for longer production period property and certain aircraft). Thus, for property placed in service after December 31, 2022, and before January 1, 2024 (January 1, 2025, for longer production period property and certain aircraft), the bonus percentage is 80 percent; for property placed in service after December 31, 2023, and before January 1, 2025 (January 1, 2026, for longer production period property and certain aircraft), the bonus percentage is 60 percent; for property placed in service after December 31, 2024, and before January 1, 2026 (January 1, 2027, for longer production period property and certain aircraft), the bonus percentage is 40 percent; for property placed in service after December 31, 2025, and before January 1, 2027 (January 1, 2028, for longer production period property and certain aircraft), the bonus percentage is 20 percent. The general bonus depreciation percentages also apply to certain specified plants bearing fruits or nuts.

Observation: Under current law, the bonus depreciation is scheduled to end for qualified property acquired and placed in service before January 1, 2020 (January 1, 2021, for longer production period property and certain aircraft) and the 50-percent bonus depreciation amount is scheduled to be phased down for property placed in service after December 31, 2017, including certain specified plants bearing fruits or nuts planted or grafted after such date. Thus, the Conference Bill repeals the current-law phase-down of the additional first-year depreciation deduction for property placed in service after December 31, 2017, as well as the phase down also scheduled for certain specified plants bearing fruits or nuts planted or grafted after such date.

The Conference Bill also provides that the present-law phase-down of bonus depreciation is maintained for property acquired before September 28, 2017, and placed in service after September 27, 2017. Under the provision, in the case of property acquired and adjusted basis incurred before September 28, 2017, the bonus depreciation rates are as follows: 50 percent if placed in service in 2017 (2018 for longer production period property and certain aircraft), 40 percent if placed in service in 2018 (2019 for longer production period property and certain aircraft), 30 percent if placed in service in 2019 (2020 for longer production period property and certain aircraft), and zero percent if placed in service in 2020 (2021 for longer production period property and certain aircraft).

The Conference Bill maintains the bonus depreciation increase amount of $8,000 for luxury passenger automobiles placed in service after December 31, 2017.

Observation: Under current law, the $8,000 increase in depreciation for luxury passenger automobiles (as defined in Code Sec. 280F(d)(5)) is scheduled to be phased down to $6,400 and $4,800 for property placed in service in 2018 and 2019, respectively.

As a conforming amendment to the repeal of the corporate AMT, the Conference Bill repeals the election to accelerate corporate AMT credits in lieu of bonus depreciation.

The Conference Bill extends the special rule under the percentage-of-completion method for the allocation of bonus depreciation to a long-term contract for property placed in service before January 1, 2027 (January 1, 2028, in the case of longer production period property).

Qualified Property. The Conference Bill removes the requirement that, in order to qualify for bonus depreciation, the original use of qualified property must begin with the taxpayer. Thus, the provision applies to purchases of used as well as new items. To prevent abuses, the additional first-year depreciation deduction applies only to property purchased in an arm’s-length transaction. It does not apply to property received as a gift or from a decedent. In the case of trade-ins, like-kind exchanges, or involuntary conversions, it applies only to any money paid in addition to the traded-in property or in excess of the adjusted basis of the replaced property. It does not apply to property acquired in a nontaxable exchange such as a reorganization, to property acquired from a member of the taxpayer’s family, including a spouse, ancestors, and lineal descendants, or from another related entity as defined in Code Sec. 267, nor to property acquired from a person who controls, is controlled by, or is under common control with, the taxpayer. Thus, it does not apply, for example, if one member of an affiliated group of corporations purchases property from another member, or if an individual who controls a corporation purchases property from that corporation. The Conference Bill also removes computer equipment from the category of listed property (as defined in Code Sec. 280F(b)(2)), thus eliminating the depreciation limitation on such property.

The Conference Bill also expands the definition of qualified property eligible for the additional first-year depreciation allowance to include qualified film, television and live theatrical productions, effective for productions placed in service after September 27, 2017, and before January 1, 2023. For this purpose, a production is considered placed in service at the time of initial release, broadcast, or live staged performance (i.e., at the time of the first commercial exhibition, broadcast, or live staged performance of a production to an audience).

The Conference Bill excludes from the definition of qualified property certain public utility property, i.e., property used predominantly in the trade or business of the furnishing or sale of:

(1) electrical energy, water, or sewage disposal services;

(2) gas or steam through a local distribution system; or

(3) transportation of gas or steam by pipeline, if the rates for such furnishing or sale, as the case may be, have been established or approved by a state or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any state or political subdivision thereof.

The Conference Bill also excludes from the definition of qualified property any property used in a trade or business that has had floor plan financing indebtedness, unless the taxpayer which has such trade or business is not a tax shelter prohibited from using the cash method and is exempt from the interest limitation rules by meeting the small business gross receipts test of Code Sec. 448(c).

The Conference Bill proposals would generally apply to property placed in service after September 27, 2017, in taxable years ending after such date, and to specified plants planted or grafted after such date. A transition rule would provide that, for a taxpayer’s first taxable year ending after September 27, 2017, the taxpayer may elect to apply a 50-percent allowance.

Enhanced Expensing Through Section 179 Expense Deductions

Expansion of Code Section 179 Expensing. The Conference Bill increases the maximum amount a taxpayer may expense under Code Sec. 179 to $1,000,000, and increases the phase-out threshold amount to $2,500,000. Thus, the proposal provides that the maximum amount a taxpayer may expense, for taxable years beginning after 2017, is $1,000,000 of the cost of qualifying property placed in service for the taxable year. The $1,000,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2,500,000. The $1,000,000 and $2,500,000 amounts, as well as the $25,000 sport utility vehicle limitation, are indexed for inflation for taxable years beginning after 2018.

The Conference Bill expands the definition of Code Sec. 179 property to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging.

Observation: Property used predominantly to furnish lodging or in connection with furnishing lodging generally includes, for example, beds and other furniture, refrigerators, ranges, and other equipment used in the living quarters of a lodging facility such as an apartment house, dormitory, or any other facility (or part of a facility) where sleeping accommodations are provided.

The Conference Bill also expands the definition of qualified real property eligible for Code Sec. 179expensing to include any of the following improvements to nonresidential real property placed in service after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.

The Conference Bill proposals would apply to property placed in service in taxable years beginning after December 31, 2017.

Modifications to Depreciation Limitations on Luxury Automobiles and Personal Use Property

The Conference Bill increases the depreciation limitations under Code Sec. 280F that apply to listed property. For passenger automobiles that qualify as luxury automobiles (i.e., gross unloaded weight of 6,000 lbs or more) placed in service after December 31, 2017, and for which the additional first-year depreciation deduction is not claimed, the maximum amount of allowable depreciation is $10,000 for the year in which the vehicle is placed in service, $16,000 for the second year, $9,600 for the third year, and $5,760 for the fourth and later years in the recovery period. The limitations are indexed for inflation for luxury passenger automobiles placed in service after 2018.

The Conference Bill removes computer or peripheral equipment from the definition of listed property. Such property is therefore not subject to the heightened substantiation requirements that apply to listed property.

The Conference Bill proposal would be effective for property placed in service after December 31, 2017.

Modifications of Treatment of Certain Farm Property

The Conference Bill shortens the recovery period from 7 to 5 years for any machinery or equipment (other than any grain bin, cotton ginning asset, fence, or other land improvement) used in a farming business, the original use of which begins with the taxpayer and is placed in service after December 31, 2017.

The Conference Bill also repeals the required use of the 150-percent declining balance method for property used in a farming business (i.e., for 3-, 5-, 7-, and 10-year property). The 150-percent declining balance method will continue to apply to any 15-year or 20-year property used in the farming business to which the straight line method does not apply, or to property for which the taxpayer elects the use of the 150-percent declining balance method.

The proposal in the Conference Bill would be effective for property placed in service after December 31, 2017.

Modification of Net Operating Loss (NOL) Deduction

The Conference Bill limits the NOL deduction to 80 percent of taxable income (determined without regard to the deduction). Carryovers to other years are adjusted to take account of this limitation, and may be carried forward indefinitely.

The proposal repeals the two-year carryback and the special carryback provisions in current law, but provides a two-year carryback in the case of certain losses incurred in the trade or business of farming. In addition, the Conference Bill provides a two-year carryback and 20-year carryforward for NOLs of a property and casualty insurance company.

The Conference Bill provision would apply to losses arising in taxable years beginning after December 31, 2017.

Modification of Like-Kind Exchange Rules

The Conference Bill modifies the provision providing for nonrecognition of gain in the case of like-kind exchanges by limiting its application to real property that is not held primarily for sale.

The Conference Bill proposal would generally apply to exchanges completed after December 31, 2017. However, an exception is provided for any exchange if the property disposed of by the taxpayer in the exchange is disposed of on or before December 31, 2017, or the property received by the taxpayer in the exchange is received on or before such date.

Modification of Alternative Depreciation System Recovery Period for Residential Rental Property

The Conference Bill shortens the alternative depreciation system (ADS) recovery period for residential rental property from 40 to 30 years. It also allows an electing real property trade or business to use the ADS recovery period in depreciating real and qualified improvement property.

Observation: The Senate Bill had shortened the recovery period for determining the depreciation deduction with respect to nonresidential real property from 39 years to 25 years and for residential rental property from 27.5 years to 25 years. Under the Senate Bill, such property placed in service before 2018 would have been treated as having a new placed-in-service date of January 1, 2018, if it resulted in more advantageous deductions. However, this provision was eliminated in the Conference Bill.

Elimination of Separate Definitions Relating to Qualified Leasehold Improvements, Qualified Restaurant, and Qualified Retail Improvement Property

The Conference Bill eliminates the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property, and provides a general 15-year recovery period for qualified improvement property, and a 20-year ADS recovery period for such property. Thus, for example, qualified improvement property placed in service after December 31, 2017, is generally depreciable over 15 years using the straight line method and half-year convention, without regard to whether the improvements are property subject to a lease, placed in service more than three years after the date the building was first placed in service, or made to a restaurant building. Restaurant building property placed in service after December 31, 2017, that does not meet the definition of qualified improvement property is depreciable over 39 years as nonresidential real property, using the straight line method and the mid-month convention.

As a conforming amendment, the Conference Bill replaces the references in Code Sec. 179(f) to qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property with a reference to qualified improvement property.

The Conference Bill also requires a real property trade or business electing out of the limitation on the deduction for interest to use ADS to depreciate any of its nonresidential real property, residential rental property, and qualified improvement property.

The Conference Bill proposals would be effective for property placed in service after December 31, 2017.

Modification of Treatment of S Corporation Conversions to C Corporations

The Conference Bill provides that any Code Sec. 481(a) adjustment of an eligible terminated S corporation attributable to the revocation of its S corporation election (i.e., a change from the cash method to an accrual method) is taken into account ratably during the six-taxable-year period beginning with the year of change. An eligible terminated S corporation is any C corporation which (1) is an S corporation the day before the enactment of the Conference Bill, (2) during the two-year period beginning on the date of such enactment revokes its S corporation election under Code Sec. 1362(a), and (3) all of the owners of which on the date the S corporation election is revoked are the same owners (and in identical proportions) as the owners on the date of such enactment.

Under the provision, in the case of a distribution of money by an eligible terminated S corporation, the accumulated adjustments account shall be allocated to such distribution, and the distribution shall be chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits.

The Conference Bill provision would be effective upon enactment.

Modification of Orphan Drug Credit

The Conference Bill reduces the Orphan Drug Credit rate to 25 percent (instead of current law’s 50 percent rate) of qualified clinical testing expenses, has reporting requirements similar to those required in Code Sec. 48C and Code Sec. 48D, and, would strike any base amount calculation and strike the limitation regarding qualified clinical testing expenses to the extent such testing relates to a drug which has previously been approved under Section 505 of the Federal Food, Drug, and Cosmetic Act.

The Conference Bill provision would apply to amounts paid or incurred in taxable years beginning after December 31, 2017.

Small Business Cash Accounting Method Reform and Simplification

The Conference Bill expands the universe of taxpayers that may use the cash method of accounting. Under the provision, the cash method of accounting may be used by taxpayers, other than tax shelters, that satisfy a gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. The gross receipts test allows taxpayers with annual average gross receipts that do not exceed $25 million for the three prior taxable-year period (the “$25 million gross receipts test”) to use the cash method. The $25 million amount is indexed for inflation for taxable years beginning after 2018.

The provision expands the universe of farming C corporations (and farming partnerships with a C corporation partner) that may use the cash method to include any farming C corporation (or farming partnership with a C corporation partner) that meets the $25 million gross receipts test.

The Conference Bill retains the exceptions from the required use of the accrual method for qualified personal service corporations and taxpayers other than C corporations. Thus, qualified personal service corporations, partnerships without C corporation partners, S corporations, and other passthrough entities are allowed to use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of such method clearly reflects income.

The Conference Bill provisions to expand the universe of taxpayers eligible to use the cash method apply to taxable years beginning after December 31, 2017. The change to the cash method is a change in the taxpayer’s method of accounting for purposes of Code Sec. 481

Modification of Inventory Classification Rules for Small Businesses

The Conference Bill exempts certain taxpayers from the requirement to keep inventories. Specifically, taxpayers that meet the $25 million gross receipts test are not required to account for inventories under Code Sec. 471, but rather may use a method of accounting for inventories that either (1) treats inventories as non-incidental materials and supplies, or (2) conforms to the taxpayer’s financial accounting treatment of inventories.

The Conference Bill expands the exception for small taxpayers from the uniform capitalization rules. Under the provision, any producer or reseller that meets the $25 million gross receipts test is exempted from the application of Code Sec. 263A. The provision retains the exemptions from the uniform capitalization rules that are not based on a taxpayer’s gross receipts. Finally, the provision expands the exception for small construction contracts from the requirement to use the percentage-of-completion method. Under the provision, contracts within this exception are those contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and (2) is performed by a taxpayer that (for the taxable year in which the contract was entered into) meets the $25 million gross receipts test.

Under the Conference Bill, a taxpayer who fails the $25 million gross receipts test would not be eligible for any of the aforementioned exceptions (i.e., from the accrual method, from keeping inventories, from applying the uniform capitalization rules, or from using the percentage-of completion method) for such taxable year.

The Conference Bill provisions to exempt certain taxpayers from the requirement to keep inventories, and expand the exception from the uniform capitalization rules is a change in the taxpayer’s method of accounting for purposes of Code Sec. 481. Application of the exception for small construction contracts from the requirement to use the percentage-of-completion method is applied on a cutoff basis for all similarly classified contracts (hence there is no adjustment under Code Sec. 481(a) for contracts entered into before January 1, 2018).

The Conference Bill provisions to expand the universe of taxpayers eligible to use the cash method, exempt certain taxpayers from the requirement to keep inventories, and expand the exception from the uniform capitalization rules apply to taxable years beginning after December 31, 2017. The provision to expand the exception for small construction contracts from the requirement to use the percentage-of-completion method applies to contracts entered into after December 31, 2017, in taxable years ending after such date.

Exceptions to Using Uniform Capitalization Rules Expanded

The Conference Bill expands the exception for small taxpayers being subject to the uniform capitalization accounting method rules. Under the proposal, any producer or reseller that meets a $25 million gross receipts test is exempted from the application of Code Sec. 263A. In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. The proposal retains the exemptions from the uniform capitalization rules that are not based on a taxpayer’s gross receipts.

If a taxpayer changes its method of accounting because it is either no longer required or is required to apply Code Sec. 263A by reason of this proposal, such change is treated as initiated by the taxpayer and made with the consent of the Secretary.

The Conference bill proposal would apply to taxable years beginning after December 31, 2017. Application of these rules would be a change in the taxpayer’s method of accounting for purposes of Code Sec. 481.

Increase in Gross Receipts Test for Construction Contract Exception to Percentage of Completion Accounting Method

The Conference Bill expands the exception for small construction contracts from the requirement to use the percentage-of-completion accounting method. Under the proposal, contracts within this exception are those contracts for the construction or improvement of real property if the contract:

(1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract; and

(2) is performed by a taxpayer that (for the taxable year in which the contract was entered into) meets the $25 million gross receipts test.

In the case of a sole proprietorship, the $25 million gross receipts test is applied as if the sole proprietorship is a corporation or partnership. The Conference Bill proposal would apply to contracts entered into after December 31, 2017, in taxable years ending after such date. Application of this rule would be a change in the taxpayer’s method of accounting for purposes of Code Sec. 481, but is applied on a cutoff basis for all similarly classified contracts (hence there is no adjustment under Code Sec. 481(a) for contracts entered into before January 1, 2018).

Modification of Accounting Method Rules Relating to Income Recognition

The Conference Bill revises the rules associated with the recognition of income. Specifically, the proposal requires a taxpayer to recognize income no later than the taxable year in which such income is taken into account as income on an applicable financial statement or another financial statement under rules specified by the Secretary, but provides an exception for long-term contract income to which Code Sec. 460 applies.

The proposal also codifies the current deferral method of accounting for advance payments for goods and services provided by the IRS under Rev. Proc. 2004-34. That is, the proposal allows taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes.

In addition, the proposal directs taxpayers to apply the revenue recognition rules under Code Sec. 451before applying the OID rules under Code Sec.1272.

Observation: Thus, for example, to the extent amounts are included in income for financial statement purposes when received (e.g., late payment fees, cash-advance fees, or interchange fees), such amounts generally are includable in income at such time in accordance with the general recognition principles under Code Sec. 451.

In the case of any taxpayer required by this proposal to change its method of accounting for its first taxable year beginning after December 31, 2017, such change is treated as initiated by the taxpayer and made with the consent of the Secretary.

The Conference Bill proposal would apply to taxable years beginning after December 31, 2017, and application of these rules would be a change in the taxpayer’s method of accounting for purposes of Code Sec. 481.

Changes to Interest Deduction Rules

Under the Conference Bill, in the case of any taxpayer for any taxable year, the deduction for business interest is limited to the sum of business interest income plus 30 percent of the adjusted taxable income of the taxpayer for the taxable year. There is an exception to this limitation, however, for floor plan financing, which is a specialized type of financing used by car dealerships and certain regulated utilities.

The Conference Bill also exempts from the limitation taxpayers with average annual gross receipts for the three-taxable year period ending with the prior taxable year that do not exceed $25 million. In addition, for purposes of defining floor plan financing, the Conference Bill modifies the definition of motor vehicle by deleting the specific references to an automobile, a truck, a recreational vehicle, and a motorcycle because those terms are encompassed in the phrase, “any self-propelled vehicle designed for transporting persons or property on a public street, highway, or road.”

At the taxpayer’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business is not treated as a trade or business for purposes of the limitation, and therefore the limitation does not apply to such trades or businesses. The limitation also does not apply to certain regulated public utilities. Specifically, the trade or business of the furnishing or sale of (1) electrical energy, water, or sewage disposal services, (2) gas or steam through a local distribution system, or (3) transportation of gas or steam by pipeline, if the rates for such furnishing or sale, as the case may be, have been established or approved by a State or political subdivision thereof, by any agency or instrumentality of the United States, or by a public service or public utility commission or other similar body of any State or political subdivision thereof is not treated as a trade or business for purposes of the limitation.

The amount of any interest not allowed as a deduction for any taxable year may be carried forward indefinitely. The limitation applies at the taxpayer level. In the case of a group of affiliated corporations that file a consolidated return, it applies at the consolidated tax return filing level. A farming business, including agricultural and horticultural cooperatives, may elect not to be subject to this limitation if the business uses the alternative depreciation system to depreciate any property used in the farming business with a recovery period of 10 years or more. An electing real property trade or business may also elect out of the interest deduction limitation if the business also uses the alternative depreciation system to depreciate its property.

Business interest means any interest paid or accrued on indebtedness properly allocable to a trade or business. Any amount treated as interest for purposes of the Internal Revenue Code is interest for purposes of the proposal. Business interest income means the amount of interest includible in the gross income of the taxpayer for the taxable year which is properly allocable to a trade or business. Business interest does not include investment interest, and business interest income does not include investment income, within the meaning of Code Sec. 163(d).

By including business interest income in the limitation, the rule operates to limit the deduction for net interest expense to 30 percent of adjusted taxable income. That is, a deduction for business interest is permitted to the full extent of business interest income. To the extent that business interest exceeds business interest income, the deduction for the net interest expense is limited to 30 percent of adjusted taxable income.

Generally, adjusted taxable income means the taxable income of the taxpayer computed without regard to:

(1) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business (but see below for special rules for tax years beginning after 2017 and before 2022);

(2) any business interest or business interest income;

(3) the 23 percent deduction for certain pass-through income; and

(4) the amount of any net operating loss deduction.

However, under the Conference Bill, for taxable years beginning after December 31, 2017 and before January 1, 2022, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, or depletion. Additionally, because the Conference Bill repeals Code Sec. 199 effective December 31, 2017 (see discussion below), adjusted taxable income is computed without regard to such deduction.

The Conference Bill would authorize the IRS to provide other adjustments to the computation of adjusted taxable income.

Application to pass-through entities. In the case of any partnership, the limitation is applied at the partnership level. Any deduction for business interest is taken into account in determining the nonseparately stated taxable income or loss of the partnership. To prevent double counting, special rules are provided for the determination of the adjusted taxable income of each partner of the partnership. Similarly, to allow for additional interest deduction by a partner in the case of an excess amount of unused adjusted taxable income limitation of the partnership, special rules apply. Similar rules apply with respect to any S corporation and its shareholders.

Double counting rule. The adjusted taxable income of each partner (or shareholder, as the case may be) is determined without regard to such partner’s distributive share of the nonseparately stated income or loss of such partnership. In the absence of such a rule, the same dollars of adjusted taxable income of a partnership could generate additional interest deductions as the income is passed through to the partners .

Additional deduction limit. The limit on the amount allowed as a deduction for business interest is increased by a partner’s distributive share of the partnership’s excess taxable income. The excess taxable income with respect to any partnership is the amount which bears the same ratio to the partnership’s adjusted taxable income as the excess (if any) of 30 percent of the adjusted taxable income of the partnership over the amount (if any) by which the business interest of the partnership exceeds the business interest income of the partnership bears to 30 percent of the adjusted taxable income of the partnership. This allows a partner of a partnership to deduct additional interest expense the partner may have paid or incurred to the extent the partnership could have deducted more business interest. The Conference Bill requires that excess taxable income be allocated in the same manner as nonseparately stated income and loss.

Carryforward of disallowed business interest. The amount of any business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year. Business interest may be carried forward indefinitely. With respect to the limitation on deduction of interest by domestic corporations which are United States shareholders that are members of worldwide affiliated groups with excess domestic indebtedness, whichever rule imposes the lower limitation on the deduction of interest with respect to the taxable year (and therefore the greatest amount of interest to be carried forward) governs.

The trade or business of performing services as an employee is not treated as a trade or business for purposes of the limitation. As a result, for example, the wages of an employee are not counted in the adjusted taxable income of the taxpayer for purposes of determining the limitation.

The Conference Bill proposal would apply to taxable years beginning after December 31, 2017.

Repeal of Domestic Activities Production Deduction

Under the Conference Bill, the deduction in Code Sec. 199 for domestic production activities is repealed.

The Conference Bill provision applies to taxable years beginning after December 31, 2017.

Limitation on Deduction by Employers of Expenses for Fringe Benefits

The Conference Bill provides that no deduction is allowed with respect to –

(1) an activity generally considered to be entertainment, amusement or recreation;

(2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes; or

(3) a facility or portion thereof used in connection with any of the above items.

Thus, the proposal repeals the present-law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer’s trade or business (and the related rule applying a 50 percent limit to such deductions). The Conference Bill also disallows a deduction for expenses associated with providing any qualified transportation fringe to employees of the taxpayer, and except as necessary for ensuring the safety of an employee, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee’s residence and place of employment.

Taxpayers may still generally deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel). For amounts incurred and paid after December 31, 2017 and until December 31, 2025, the provision expands this 50 percent limitation to expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer. Such amounts incurred and paid after December 31, 2025 are not deductible.

The Conference Bill proposal generally applies to amounts paid or incurred after December 31, 2017. However, for expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer, amounts paid or incurred after December 31, 2025 are not deductible.

Repeal of Deduction for Local Lobbying Expenses

The Conference Bill disallows deductions for lobbying expenses with respect to legislation before local government bodies (including Indian tribal governments), effective for amounts paid or incurred on or after the date of enactment.

Limitation on Deduction Relating to FDIC Premiums

Under the Conference Bill, no deduction is allowed for the applicable percentage of any FDIC premium paid or incurred by certain large financial institutions. For taxpayers with total consolidated assets of $50 billion or more, the applicable percentage is 100 percent. Otherwise, the applicable percentage is the ratio of the excess of total consolidated assets over $10 billion to $40 billion. The proposal does not apply to taxpayers with total consolidated assets (as of the close of the taxable year) that do not exceed $10 billion. The provision applies to taxable years beginning after December 31, 2017.

Contributions to Capital

While the Conference Bill retains Code Sec. 118, a provision the House Bill had sought to repeal, it provides that the term “contributions to capital” does not include –

(1) any contribution in aid of construction or any other contribution as a customer or potential customer, and

(2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).

The Conference Report states that the conferees intend that, as modified, Code Sec. 118, which under current law provides that the gross income of a corporation does not include any contributions to capital, will continue to apply only to corporations.

The Conference Bill provision will apply to contributions made after the date of enactment. However, the provision will not apply to any contribution made after the date of enactment by a governmental entity pursuant to a master development plan that has been approved prior to such date by a governmental entity.

Tax Credits

The Conference Bill modifies the rehabilitation credit in Code Sec. 47.

Observation: While both the House Bill and the Senate Bill would have repealed the deduction in Code Sec. 196 for certain unused business credits, the repeal of that provision did not make it into the Conference Bill.

Change in Determination of Cost Basis of Specified Securities

The Conference Bill does not include a controversial provision in the Senate Bill which would have required that the cost of any specified security sold, exchanged, or otherwise disposed of on or after January 1, 2018, generally be determined on a first-in first-out basis except to the extent the average basis method is otherwise allowed (as in the case of stock of a regulated investment company). The Senate’s proposal had included several conforming amendments, including a rule restricting a broker’s basis reporting method to the first-in first-out method in the case of the sale of any stock for which the average basis method was not permitted.

Repeal of Rollover of Publicly Traded Securities Gain into Specialized Small Business Investment Companies

The Conference Bill repeals the election that could be made by a corporation or individual to roll over tax-free any capital gain realized on the sale of publicly-traded securities to the extent of the taxpayer’s cost of purchasing common stock or a partnership interest in a specialized small business investment company within 60 days of the sale. The amount of gain that an individual could elect to roll over under this provision for a taxable year was limited to (1) $50,000 or (2) $500,000 reduced by the gain previously excluded under this provision. For corporations, these limits were $250,000 and $1 million, respectively.

The Conference Bill provision would apply to sales after December 31, 2017.

Certain Self-Created Property Not Treated as a Capital Asset

The Conference Bill amends Code Sec. 1221(a)(3), resulting in the exclusion of a patent, invention, model or design (whether or not patented), and a secret formula or process which is held either by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) from the definition of a “capital asset.” Thus, gains or losses from the sale or exchange of a patent, invention, model or design (whether or not patented), or a secret formula or process which is held either by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) will not receive capital gain treatment.

The Conference Bill proposal would apply to dispositions after December 31, 2017.

Repeal of Technical Termination of Partnerships

The Conference Bill repeals the Code Sec. 708(b)(1)(B) rule providing for technical terminations of partnerships. The provision does not change the present-law rule of Code Sec. 708(b)(1)(A) that a partnership is considered as terminated if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership.

The Conference Bill provision would apply to partnership taxable years beginning after December 31, 2017

Recharacterization of Certain Gains in The Case of Partnership Profits Interests Held in Connection With Performance of Investment Services

The Conference Bill provides for a three-year holding period in the case of certain net long-term capital gain with respect to any applicable partnership interest held by the taxpayer. The Conference Bill clarifies the interaction of Code Sec. 83 with the provision’s three-year holding requirement, which applies notwithstanding the rules of Code Sec. 83 or any election in effect under Code Sec. 83(b). Under the provision, the fact that an individual may have included an amount in income upon acquisition of the applicable partnership interest, or that an individual may have made a Code Sec. 83(b) election with respect to an applicable partnership interest, does not change the three-year holding period requirement for long-term capital gain treatment with respect to the applicable partnership interest. Thus, the provision treats as short-term capital gain taxed at ordinary income rates the amount of the taxpayer’s net long-term capital gain with respect to an applicable partnership interest for the taxable year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies. In making this calculation, the provision takes account of long-term capital losses calculated as if a three-year holding period applies.

The Conference Bill provision would apply to tax years beginning after December 31, 2017.

Compensation and Benefits

Modification of Limitation on Excessive Employee Remuneration. The Conference Bill revises the definition of covered employee to include both the principal executive officer and the principal financial officer. Further, an individual is a covered employee if the individual holds one of these positions at any time during the taxable year. The proposal also defines as a covered employee the three (rather than four) most highly compensated officers for the taxable year (other than the principal executive officer or principal financial officer) who are required to be reported on the company’s proxy statement for the taxable year (or who would be required to be reported on such a statement for a company not required to make such a report to shareholders). The proposal would apply to tax years beginning after December 31, 2017. However, there is a transition rule which provides that the proposed changes do not apply to any remuneration under a written binding contract which was in effect on November 2, 2017, and which was not modified after this date in any material respect, and to which the right of the covered employee was no longer subject to a substantial risk of forfeiture on or before December 31, 2016.

Excise Tax on Excess Tax-Exempt Organization Executive Compensation . Under the Conference Bill, an employer is liable for an excise tax equal to 21 percent of the sum of the (1) remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a taxable year, and (2) any excess parachute payment (under a new definition for this purpose that relates solely to separation pay) paid by the applicable tax-exempt organization to a covered employee. Accordingly, the excise tax applies as a result of an excess parachute payment, even if the covered employee’s remuneration does not exceed $1 million. The proposal would apply to tax years beginning after December 31, 2017.

Treatment of Qualified Equity Grants. Under the Conference Bill, a qualified employee can elect to defer, for income tax purposes, the inclusion in income of the amount of income attributable to qualified stock transferred to the employee by the employer. An election to defer income inclusion (inclusion deferral election) with respect to qualified stock must be made no later than 30 days after the first time the employee’s right to the stock is substantially vested or is transferable, whichever occurs earlier. If an employee elects to defer income inclusion under the provision, the income must be included in the employee’s income for the taxable year that includes the earliest of (1) the first date the qualified stock becomes transferable, including, solely for this purpose, transferable to the employer; (2) the date the employee first becomes an excluded employee (as described below); (3) the first date on which any stock of the employer becomes readily tradable on an established securities market; (4) the date five years after the first date the employee’s right to the stock becomes substantially vested; or (5) the date on which the employee revokes her inclusion deferral election. Deferred income inclusion applies also for purposes of the employer’s deduction of the amount of income attributable to the qualified stock. The provision generally applies with respect to stock attributable to options exercised or RSUs settled after December 31, 2017.

Excise Tax on Stock Compensation in an Inversion Transaction. The Conference Bill increases the excise tax on stock compensation in an inversion transaction from 15 percent to 20 percent. The Conference Bill provision applies to corporations first becoming expatriated corporations after the date of enactment.

Partnerships

Tax Gain on the Sale of a Partnership Interest on a Look-through Basis. Under the Conference Bill, gain or loss from the sale or exchange of a partnership interest is effectively connected with a U.S. trade or business to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. The proposal requires that any gain or loss from the hypothetical asset sale by the partnership be allocated to interests in the partnership in the same manner as nonseparately stated income and loss.

The Conference Bill also requires the transferee of a partnership interest to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certifies that the transferor is not a nonresident alien individual or foreign corporation. If the transferee fails to withhold the correct amount, the partnership is required to deduct and withhold from distributions to the transferee partner an amount equal to the amount the transferee failed to withhold.

The Conference Bill provision treating gain or loss on sale of a partnership interest as effectively connected income is effective for sales, exchanges, and dispositions on or after November 27, 2017. The portion of the provision requiring withholding on sales or exchanges of partnership interests is effective for sales, exchanges, and dispositions after December 31, 2017.

Modification of the Definition of Substantial Built-in Loss on Transfers of a Partnership Interest. The Conference Bill modifies the definition of a substantial built-in loss for purposes of Code Sec. 743(d), affecting transfers of partnership interests. Under the proposal, in addition to the present-law definition, a substantial built-in loss also exists if the transferee would be allocated a net loss in excess of $250,000 upon a hypothetical disposition by the partnership of all partnership’s assets in a fully taxable transaction for cash equal to the assets’ fair market value, immediately after the transfer of the partnership interest.

Example: ABC Partnership has three taxable partners (partners A, B, and C). ABC has not made an election pursuant to Code Sec. 754. The partnership has two assets, one of which, Asset X, has a built-in gain of $1 million, while the other asset, Asset Y, has a built-in loss of $900,000. Pursuant to the ABC partnership agreement, any gain on sale or exchange of Asset X is specially allocated to partner A. The three partners share equally in all other partnership items, including in the built-in loss in Asset Y. In this case, each of partner B and partner C has a net built-in loss of $300,000 (one third of the loss attributable to asset Y) allocable to his partnership interest. Nevertheless, the partnership does not have an overall built-in loss, but a net built-in gain of $100,000 ($1 million minus $900,000). Partner C sells his partnership interest to another person, D, for $33,333. Under the Senate’s proposal, the test for a substantial built-in loss applies both at the partnership level and at the transferee partner level. If the partnership were to sell all its assets for cash at their fair market value immediately after the transfer to D, D would be allocated a loss of $300,000 (one third of the built-in loss of $900,000 in Asset Y). The partnership does not have a substantial built-in loss, but a substantial built-in loss exists under the partner-level test, and the partnership adjusts the basis of its assets accordingly with respect to D.

The Conference Bill proposal would apply to transfers of partnership interests after December 31, 2017.

Charitable Contributions and Foreign Taxes Taken into Account in Determining Limitation on Allowance of Partner’s Share of Loss. The Conference Bill modifies the basis limitation on partner losses to provide that a partner’s distributive share of items that are not deductible in computing the partnership’s taxable income, and not properly chargeable to capital account, are allowed only to the extent of the partner’s adjusted basis in its partnership interest at the end of the partnership taxable year in which the expenditure occurs. Thus, the basis limitation on partner losses applies to a partner’s distributive share of charitable contributions and foreign taxes. A partner’s distributive share of loss takes into account the partner’s distributive share of charitable contributions and foreign taxes for purposes of the basis limitation on partner losses. In the case of a charitable contribution of property whose fair market value exceeds its adjusted basis, the basis limitation on partner losses does not apply to the extent of the partner’s distributive share of such excess.

The Conference Bill proposal would apply to partnership taxable years beginning after December 31, 2017.

Amortization of Research and Experimental Expenditures

Under the Conference Bill, amounts defined as specified research or experimental expenditures are required to be capitalized and amortized ratably over a five-year period, beginning with the midpoint of the taxable year in which the specified research or experimental expenditures were paid or incurred. Specified research or experimental expenditures which are attributable to research that is conducted outside of the United States are required to be capitalized and amortized ratably over a period of 15 years, beginning with the midpoint of the taxable year in which such expenditures were paid or incurred. Specified research or experimental expenditures subject to capitalization include expenditures for software development. Specified research or experimental expenditures do not include expenditures for land or for depreciable or depletable property used in connection with the research or experimentation, but do include the depreciation and depletion allowances of such property. Also excluded are exploration expenditures incurred for ore or other minerals (including oil and gas).

This rule would be applied on a cutoff basis to research or experimental expenditures paid or incurred in taxable years beginning after December 31, 2025 (hence there is no adjustment under Code Sec. 481(a) for research or experimental expenditures paid or incurred in taxable years beginning before January 1, 2026).

The Conference Bill proposal would apply to amounts paid or incurred in taxable years beginning after December 31, 2025.

Employer Credit for Paid Family and Medical Leave

This Conference Bill allows eligible employers to claim a general business credit equal to 12.5 percent of the amount of wages paid to qualifying employees during any period in which such employees are on family and medical leave (FMLA) if the rate of payment under the program is 50 percent of the wages normally paid to an employee. The credit would be increased by 0.25 percentage points (but not above 25 percent) for each percentage point by which the rate of payment exceeds 50 percent.

The Conference Bill proposal would generally be effective for wages paid in taxable years beginning after December 31, 2017.

Modify Tax Treatment of Alaska Native Corporations and Settlement Trusts

The Conference Bill addresses the tax treatment of Alaska Native Corporations and settlement trusts in three separate but related sections. The first section would allow a Native Corporation to assign certain payments described in the Alaska Native Claims Settlement Act (ANCSA) to a Settlement Trust without having to recognize gross income from those payments, provided the assignment is in writing and the Native Corporation has not received the payment prior to assignment. The Settlement Trust is required to include the assigned payment in gross income when received. The second section allows a Native Corporation to elect annually to deduct contributions made to a Settlement Trust. The third section of the proposal requires any Native Corporation which has made an election to deduct contributions to a Settlement Trust as described above to furnish a statement to the Settlement Trust containing: (1) the total amount of contributions; (2) whether such contribution was in cash; (3) for non-cash contributions, the date that such property was acquired by the Native Corporation and the adjusted basis of such property on the contribution date; (4) the date on which each contribution was made to the Settlement Trust; and (5) such information as the Secretary determines is necessary for the accurate reporting of income relating to such contributions.

The Conference Bill proposal relating to the exclusion for ANCSA payments assigned to Settlement Trusts would be effective to taxable years beginning after December 31, 2016. The proposal relating to the reporting requirement would apply to taxable years beginning after December 31, 2016.

Expansion of Qualifying Beneficiaries of an Electing Small Business Trust (ESBT)

The Conference Bill allows a nonresident alien individual to be a potential current beneficiary of an ESBT. The proposal would take effect on January 1, 2018.

Charitable Contribution Deduction for ESBTs

The Conference Bill provides that the charitable contribution deduction of an ESBT is not determined by the rules generally applicable to trusts but rather by the rules applicable to individuals. Thus, the percentage limitations and carryforward provisions applicable to individuals apply to charitable contributions made by the portion of an ESBT holding S corporation stock.

The Conference Bill proposal would apply to taxable years beginning after December 31, 2017.

Deductibility of Penalties and Fines for Federal Income Tax Purposes

The Conference Bill denies deductibility for any otherwise deductible amount paid or incurred (whether by suit, agreement, or otherwise) to or at the direction of a government or specified nongovernmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law. An exception applies to payments that the taxpayer establishes are either restitution (including remediation of property) or amounts required to come into compliance with any law that was violated or involved in the investigation or inquiry, that are identified in the court order or settlement agreement as restitution, remediation, or required to come into compliance. In the case of any amount of restitution for failure to pay any tax and assessed as restitution under the Code, such restitution is deductible only to the extent it would have been allowed as a deduction if it had been timely paid. Restitution or included remediation of property does not include reimbursement of government investigative or litigation costs.

The proposal applies only where a government (or other entity treated in a manner similar to a government under the provision) is a complainant or investigator with respect to the violation or potential violation of any law. An exception also applies to any amount paid or incurred as taxes due.

The Conference Bill proposal would be effective for amounts paid or incurred after the date of enactment, except that it would not apply to amounts paid or incurred under any binding order or agreement entered into before such date. Such exception does not apply to an order or agreement requiring court approval unless the approval was obtained before such date.

Aircraft Management Services

The Conference Bill exempts certain payments related to the management of private aircraft from the excise taxes imposed on taxable transportation by air, effective for amounts paid after the date of enactment.

Qualified Opportunity Zones

The Conference Bill provides for the temporary deferral of inclusion in gross income for capital gains reinvested in a qualified opportunity fund and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund. The proposal allows for the designation of certain low-income community population census tracts as qualified opportunity zones, where low-income communities are defined in Code Sec. 45D(e). The designation of a population census tract as a qualified opportunity zone remains in effect for the period beginning on the date of the designation and ending at the close of the tenth calendar year beginning on or after the date of designation. The proposal would be effective on the date of enactment.

Expensing of Certain Costs of Replanting Citrus Plants Lost by Reason of Casualty

The Conference Bill modifies the special rule for costs incurred by persons other than the taxpayer in connection with replanting an edible crop for human consumption following loss or damage due to casualty. Under the proposal, with respect to replanting costs paid or incurred after the date of enactment, but no later than a date which is ten years after such date of enactment, for citrus plants lost or damaged due to casualty, such costs may also be deducted by a person other than the taxpayer if (1) the taxpayer has an equity interest of not less than 50 percent in the replanted citrus plants at all times during the taxable year in which the replanting costs are paid or incurred and such other person holds any part of the remaining equity interest, or (2) such other person acquires all of the taxpayer’s equity interest in the land on which the lost or damaged citrus plants were located at the time of such loss or damage, and the replanting is on such land.

Denial of Deduction for Settlements Subject to a Nondisclosure Agreement Paid in Connection with Sexual Harassment or Sexual Abuse

Under the Conference Bill, no deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement. The proposal is effective for amounts paid or incurred after the date of enactment.

Repeal of Tax Credit Bonds

The Conference Bill prospectively repeals authority to issue tax-credit bonds and direct-pay bonds. The provisions would apply to bonds issued after December 31, 2017.

  1. Foreign-Related Changes

Deduction for Foreign-Source Portion of Dividends Received by Domestic Corporations from Specified 10-Percent Owned Foreign Corporations

The Conference Bill provides for an exemption for certain foreign income. This exemption is provided for by means of a 100-percent deduction for the foreign-source portion of dividends received from specified 10-percent owned foreign corporations by domestic corporations that are United States shareholders of those foreign corporations within the meaning of Code Sec. 951(b) (referred to as “DRD”). The proposal would be effective for distributions made (and for purposes of determining a taxpayer’s foreign tax credit limitation under Code Sec. 904, deductions in taxable years beginning) after December 31, 2017.

Special Rules Relating to Sales or Transfers Involving Specified 10-Percent Owned Foreign Corporations

The Conference Bill provides that In the case of the sale or exchange by a domestic corporation of stock in a foreign corporation held for one year or more, any amount received by the domestic corporation which is treated as a dividend for purposes of Code Sec. 1248, is treated as a dividend for purposes of applying the provision.

Solely for the purpose of determining a loss, the Conference Bill provides that a domestic corporate shareholder’s adjusted basis in the stock of a specified 10-percent owned foreign corporation (as defined in this provision) is reduced by an amount equal to the portion of any dividend received with respect to such stock from such foreign corporation that was not taxed by reason of a dividends received deduction allowable under Code Sec. 245A in any taxable year of such domestic corporation. This rule applies in coordination with Code Sec. 1059, such that any reduction in basis required pursuant to this provision will be disregarded, to the extent the basis in the specified 10-percent owned foreign corporation’s stock has already been reduced pursuant to section 1059.

The Conference bill also provides that, if for any taxable year of a controlled foreign corporation (CFC) beginning after December 31, 2017, an amount is treated as a dividend under Code Sec. 964(e)(1) because of a sale or exchange by the CFC of stock in another foreign corporation held for a year or more, then: (1) the foreign-source portion of the dividend is treated as subpart F income of the selling CFC for purposes of Code Sec. 951(a)(1)(A), (2) a United States shareholder with respect to the selling CFC includes in gross income for the taxable year of the shareholder with or within the tax year of the CFC ends, an amount equal to the shareholder’s pro rata share (determined in the same manner as under Code Sec. 951(a)(2)) of the amount treated as subpart F income under (1), and (3) the deduction under Code Sec. 245A(a) is allowable to the U.S. shareholder with respect to the subpart F income included in gross income under (2) in the same manner as if the subpart F income were a dividend received by the shareholder from the selling CFC.

In the case of a sale or exchange by a CFC of stock in another corporation in a taxable year of the selling CFC beginning after December 31, 2017, to which this provision applies if gain were recognized, rules similar to Code Sec. 961(d) apply.

Code Sec. 367 is amended to provide that in connection with any exchange described in Code Secs. 332351354356, or 361, if a U.S. person transfers property used in the active conduct of a trade or business to a foreign corporation, such foreign corporation shall not, for purposes of determining the extent to which gain shall be recognized on such transfer, be considered to be a corporation.

Under the Conference Bill, if a domestic corporation transfers substantially all of the assets of a foreign branch (within the meaning of Code Sec. 367(a)(3)(C)) as in effect before the date of enactment of TCJA) to a specified 10-percent owned foreign corporation with respect to which it is a U.S. shareholder after the transfer, the domestic corporation includes in gross income an amount equal to the transferred loss amount, subject to certain limitations.

The Conference Bill provisions relating to sales or exchanges of stock would apply to sales or exchanges after December 31, 2017. The provision relating to reduction of basis in certain foreign stock for the purposes of determining a loss would be effective for distributions made after December 31, 2017. The provisions relating to transfer of loss amounts from foreign branches to certain foreign corporations and to the repeal of the active trade or business would be effective for transfers after December 31, 2017.

Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation

The Conference Bill generally requires that, for the last taxable year beginning before January 1, 2018, any U.S. shareholder of a controlled foreign corporation, as well as all foreign corporations (other than PFICs) in which a U.S. person owns a 10-percent voting interest, must include in income its pro rata share of the undistributed, non-previously-taxed post-1986 foreign earnings of the corporation (“mandatory inclusion”). A special rule permits deferral of the transition net tax liability for shareholders of a U.S. shareholder that is an S corporation. The Conference Bill provision would be effective for the last taxable year of a foreign corporation that begins before January 1, 2018, and with respect to U.S. shareholders, for the taxable years in which or with which such taxable years of the foreign corporations end.

Current Year Inclusion of Global Intangible Low-Taxed Income by U.S. Shareholders

Under the Conference Bill, a U.S. shareholder of any CFC must include in gross income for a taxable year its global intangible low-taxed income (GILTI) in a manner generally similar to inclusions of subpart F income. GILTI means, with respect to any U.S. shareholder for the shareholder’s taxable year, the excess (if any) of the shareholder’s net CFC tested income over the shareholder’s net deemed tangible income return. The shareholder’s net deemed tangible income return is an amount equal to 10 percent of the aggregate of the shareholder’s pro rata share of the qualified business asset investment (QBAI) of each CFC with respect to which it is a U.S. shareholder. The proposal would be effective for taxable years of foreign corporations beginning after December 31, 2017, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end.

Deduction for Foreign-Derived Intangible Income and Global Intangible Low-Taxed Income

The Conference Bill provides domestic corporations with reduced rates of U.S. tax on their foreign-derived intangible income (“FDII”) and global intangible low-taxed income (“GILTI”). GILTI is defined in new Code Sec. 951A, while a domestic corporation’s FDII is the portion of its intangible income, determined on a formulaic basis that is derived from serving foreign markets. For taxable years beginning after December 31, 2017, and before January 1, 2019, the effective tax rate on FDII is 21.875 percent and the effective U.S. tax rate on GILTI is 17.5 percent under the Senate amendment. For taxable years beginning after December 31, 2018, and before January 1, 2026, the effective tax rate on FDII is 12.5 percent and the effective U.S. tax rate on GILTI is 10 percent. For taxable years beginning after December 31, 2025, the effective tax rate on FDII is 15.625 percent and the effective U.S. tax rate on GILTI is 12.5 percent. The proposal would be effective for taxable years beginning after December 31, 2017.

Modifications of Subpart F Provisions

The Conference Bill would make the following modifications –

(1) eliminate the inclusion of foreign base company oil related income as a category of foreign base company income;

(2) repeal Code Sec. 955;

(3) amend the ownership attribution rules of Code Sec. 958(b);

(4) modify the definition of U.S. shareholder;

(5) eliminate the requirement that a corporation must be controlled for 30 days before subpart F inclusions apply;

(6) make permanent the exclusion from foreign personal holding company income for certain dividends, interest (including factoring income that is treated as equivalent to interest under Code Sec. 954(c)(1)(E)), rents, and royalties received or accrued by one CFC from a related CFC; and

(7) amend the requirement in subpart F that U.S. shareholders recognize income when earnings are repatriated in the form of increases in investment by a CFC in U.S. property to provide an exception for domestic corporations that are U.S. shareholders in the CFC either directly or through a domestic partnership.

Prevention of Base Erosion

The Conference Bill would make the following modifications –

(1) place limitations on income shifting through intangible property transfers;

(2) deny a deduction for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or by, or to, a hybrid entity;

(3) provide rules that surrogate foreign corporations are not eligible for reduced rate on dividends; and

(4) modify the tax rate on base erosion payments of taxpayers with substantial gross receipts.

Modifications Related to Foreign Tax Credit System

The Conference Bill would (1) repeal the Code Sec. 902 indirect foreign tax credits and provide for the determination of Code Sec. 960 credit on current year basis; (2) require foreign branch income to be allocated to a specific foreign tax credit basket; (3) accelerate the effective date of the worldwide interest allocation rules to apply to taxable years beginning after December 31, 2017, rather than to taxable years beginning after December 31, 2020; and (4) allocate and apportion gains, profits, and income from the sale or exchange of inventory property produced partly in, and partly outside, the United States on the basis of the location of production with respect to the property.

Inbound Provisions

Under the Conference Bill, an applicable taxpayer is required to pay a tax equal to the base erosion minimum tax amount for the taxable year. The base erosion minimum tax amount means, with respect to an applicable taxpayer for any taxable year, the excess of 10-percent of the modified taxable income of the taxpayer for the taxable year over an amount equal to the regular tax liability of the taxpayer for the taxable year reduced (but not below zero) by the excess (if any) of credits allowed under Chapter 1 against such regular tax liability over the sum of: (1) the credit allowed under Code Sec. 38 for the taxable year which is properly allocable to the research credit determined under Code Sec. 41(a), plus (2) the portion of the applicable Code Sec. 38 credits not in excess of 80 percent of the lesser of the amount of such credits or the base erosion minimum tax amount (determined without regard to this clause (2)). For taxable years beginning after December 31, 2025, two changes would be made, (i) the 10-percent provided for above would be changed to 12.5-percent, and (ii) the regular tax liability would be reduced by the aggregate amount of the credits allowed under Chapter 1 (and no other adjustment made).

Modification of Insurance Exception to the Passive Foreign Investment Company Rules

The Conference Bill modifies the requirements for a corporation the income of which is not included in passive income for purposes of the PFIC rules. The proposal replaces the test based on whether a corporation is predominantly engaged in an insurance business with a test based on the corporation’s insurance liabilities. The requirement that the foreign corporation would be subject to tax under subchapter L if it were a domestic corporation is retained.

Repeal of Fair Market Value of Interest Expense Apportionment

The Conference Bill prohibits members of a U.S. affiliated group from allocating interest expense on the basis of the fair market value of assets for purposes of Code Sec. 864(e). Instead, the members must allocate interest expense based on the adjusted tax basis of assets. The provision would be effective for taxable years beginning after December 31, 2017.

  1. Retirement Plan-Related Changes

Partial Repeal of Special Rule Permitting Recharacterization of IRA Contributions

The Conference Bill partially repeals the special rule that allows IRA contributions to one type of IRA (either traditional or Roth) to be recharacterized as a contribution to the other type of IRA. Under the provision, the special rule that allows a contribution to one type of IRA to be recharacterized as a contribution to the other type of IRA does not apply to a conversion contribution to a Roth IRA. Thus, recharacterization cannot be used to unwind a Roth conversion. However, recharacterization is still permitted with respect to other contributions. For example, an individual may make a contribution for a year to a Roth IRA and, before the due date for the individual’s income tax return for that year, recharacterize it as a contribution to a traditional IRA.

An individual may still make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA, but the provision precludes the individual from later unwinding the conversion through a recharacterization.

The provision is effective for taxable years beginning after December 31, 2017.

Extended Rollover Period for the Rollover of Plan Loan Offset Amounts in Certain Cases

Under the Conference Bill, the period during which a qualified plan loan offset amount may be contributed to an eligible retirement plan as a rollover contribution is extended from 60 days after the date of the offset to the due date (including extensions) for filing the federal income tax return for the taxable year in which the plan loan offset occurs, that is, the taxable year in which the amount is treated as distributed from the plan. Under the provision, a qualified plan loan offset amount is a plan loan offset amount that is treated as distributed from a qualified retirement plan, a Code Sec. 403(b)plan or a governmental Code Sec. 457(b) plan solely by reason of the termination of the plan or the failure to meet the repayment terms of the loan because of the employee’s separation from service, whether due to layoff, cessation of business, termination of employment, or otherwise. As under present law, a loan offset amount under the provision is the amount by which an employee’s account balance under the plan is reduced to repay a loan from the plan. The provision applies to taxable years beginning after December 31, 2017.

Length of Service Award Programs for Bona Fide Public Safety Volunteers

The Conference Bill increases the aggregate amount of length of service awards that may accrue for a bona fide volunteer with respect to any year of service to $6,000 and adjusts that amount to reflect changes in cost-of-living for years after the first year the provision is effective. In addition, under the provision, if the plan is a defined benefit plan, the limit applies to the actuarial present value of the aggregate amount of length of service awards accruing with respect to any year of service. Actuarial present value is to be calculated using reasonable actuarial assumptions and methods, assuming payment will be made under the most valuable form of payment under the plan with payment commencing at the later of the earliest age at which unreduced benefits are payable under the plan or the participant’s age at the time of the calculation. The provision is effective for taxable years beginning after December 31, 2017.

If you have any question or  want to discuss how the new Bill affect your situation please contact our office at once by calling (951) 234 5175 Ext 3. Accurate Accounting.

Tiebreaker and IRS Flip Flop

IRS Flip Flops on Earned Income Credit linked to Tiebreaker rules

IRS Changes Position on Claiming Childless EIC ( Earned Income Credit) Which means Amended Returns May be in Order

The IRS issued proposed regulations which reflect a change in the IRS’s position on the interaction of the Code Sec. 152(c)(4) tiebreaker rules, which goes into effect when two or more people can claim a child as a qualifying child for tax purposes, with the Code Sec. 32 earned income credit rules. Under the revised position, if an individual is not treated as a qualifying child of a taxpayer after applying the tiebreaker rules in Code Sec. 152(c)(4), then the individual will not prevent that taxpayer from qualifying for the childless earned income credit. REG-137604-07 (1/19/17).

Background

Under Code Sec. 32, a taxpayer may claim an earned income credit (EIC) if the taxpayer:

(1) has earned income,

(2) has adjusted gross income not in excess of certain limits,

(3) does not have more than a specified amount of investment income,

(4) is a U.S. citizen or resident for the entire year,

(5) does not file as married filing separately,

(6) has a valid social security number, and

(7) does not claim the foreign earned income exclusion or the foreign housing exclusion or deduction.

The credit is available to taxpayers with a qualifying child or qualifying children, as well as taxpayers without a qualifying child, although different sets of rules apply.

Sometimes an individual meets the tests to be a qualifying child of more than one person. However, only one of these persons can treat the child as a qualifying child for EIC and other child-related tax benefit purposes (such as the child tax credit and the credit for child and dependent care expenses). The other person(s) cannot claim any of these benefits based on the qualifying child. A tiebreaker rules in Code Sec. 152(c)(4) determine who, if anyone, can claim the EIC when an individual is a qualifying child of more than one person.

A taxpayer who does not have a qualifying child for the tax year, but who meets the general requirements to claim the EIC, can claim the “childless EIC” under Code Sec. 32(c)(1)(A) and (B) if the taxpayer (1) is age 25 through 64, or files jointly with someone who meets this age test; (2) lives in the U.S. for more than half the tax year; (3) cannot be claimed as a dependent on another taxpayer’s return for the year; and (4) is not a qualifying child of another taxpayer for the year.

Proposed Regulations

Last week, the IRS issued proposed regulations dealing with the dependency exemption deduction, the EIC, and the tiebreaker rules. In the preamble to the proposed regulations, the IRS noted a problem with the tiebreaker rules in Code Sec. 152(c)(4) that determine who is eligible for the EIC where an individual is the qualifying child of more than one person. The problem, the IRS said, can be illustrated by the following example. Two sisters, Betty and Carol, live together and each of them is a low-income taxpayer. Neither has a child and each may claim the childless EIC. Later, Betty has a child and Betty’s child meets the definition of a qualifying child for both Betty and Carol. However, under the tiebreaker rules of Code Sec. 152(c)(4), the child is treated as the qualifying child of Betty and Betty may claim the EIC as an eligible individual with a qualifying child.

Although there is no regulatory guidance on this issue, the IRS had taken the position in Publication 596, Earned Income Credit, that if someone meets the definition of a qualifying child for multiple individuals, including the taxpayer, but is not treated as the qualifying child of a particular individual under the tiebreaker rules, the taxpayer is precluded from claiming the childless EIC. Thus, under the current rule, Carol would not be allowed to claim the childless EIC.

The IRS said that allowing Carol to continue to claim the childless EIC after the child is born is both equitable and consistent with the purpose of Code Sec. 32 to assist working low-income taxpayers. As a result, Prop. Reg. Sec. 1.32-2(c)(3) provides that, if an individual is not treated as a qualifying child of a taxpayer after applying the tiebreaker rules of Code Sec. 152(c)(4), then the individual will not prevent that taxpayer from qualifying for the childless EIC.

Effective Date

Prop. Reg. 1.32-2(c)(3) is effective when finalized. However, taxpayers can apply the proposed regulations to any open tax years. Thus, if the proposed regulation applies to a taxpayer who had been denied the EIC as a result of the IRS’s previous interpretation of the EIC tiebreaker rules, an amended return may be filed to obtain a refund. Generally, under Code Sec. 6511(a), a claim for refund must be filed within three years of the date the return was filed or two years from the date the tax was paid, whichever is later. If the taxpayer was not required to file a return for the prior year, the claim for refund must be filed within two years of the date the tax to be refunded was paid.

Caution: The White House has issued a moratorium on the implementation of regulations with effective dates after January 20. As a result, it is unclear whether these regulations may be immediately applied.

21 Century Cure Act

21st Century Cures Act Allows Small Employers to Offer Health Reimbursement Arrangements

 

On December 13, 2016, President Obama signed into law the 21st Century Cures Act. The legislation had overwhelmingly bipartisan support, passing the House by a vote of 392-26 and passing the Senate by a vote of 94-5. The Cures Act, which pays for cancer research, mental health treatments, the fight against opioid abuse, also creates a new type of employer-provided health care coverage – qualified small employer health reimbursement arrangements. Previously, such plans did not meet the stringent requirements of the Affordable Care Act (ACA), otherwise known as “Obamacare,” and were subject to hefty penalties. Now, under the new law, small businesses can offer stand-alone health care reimbursement plans to their employees. H.R. 34 (12/13/2016).

 

Background

The Internal Revenue Code, the Employee Retirement Income Security Act of 1974 (ERISA), and the ACA, impose various requirements with respect to employer-sponsored health plans (i.e., group health plans). Under the ACA, employers with 50 or more full-time employees are required to provide health insurance to their employees. An employer is generally subject to an excise tax of $100 a day per employee (or $36,500 per employee for a full year) if it sponsors a group health plan that fails to meet any of the applicable requirements.

 

In Notice 2013-2 and Notice 2015-17, the IRS stated that employer payment plans such as health reimbursement arrangements (HRAs), health flexible spending arrangements (health FSAs), and certain other employer healthcare arrangements, including arrangements under which an employer reimburses an employee for some or all of the premium expenses incurred for an individual health insurance policy, generally fail to comply with the ACA rules. This effectively prevented small businesses from providing these types of health benefits to its employees, which in turn affected such businesses ability to provide benefits competitive with those of larger employers required to provide health insurance to their employees under the ACA.

 

Qualified Small Employer Health Reimbursement Arrangements

 

Section 18001 of the 21st Century Cures Act amends the Code, ERISA, and the ACA to exempt qualified small employer health reimbursement arrangements (QSEHRAs) from certain requirements that apply to group health plans. As a result, such plans can now be offered to employees of small businesses. A QSEHRA is defined as an arrangement offered by an employer that has fewer than 50 full-time employees and that does not offer group health plans to any of their employees. In order to qualify as a QSEHRA, the arrangement must:

 

(1) be provided on the same terms to all eligible employees of the employer;

 

(2) be funded solely by the employer without salary reduction contributions;

 

(3) provide, after an employee provides proof of insurance coverage, for the payment or reimbursement of medical expenses of the employee and family members; and

 

(4) limit annual payments and reimbursements to specified dollar amounts ($4,950 per year for individuals, and $10,000 for families).

 

QSEHRAs that meet these requirements are not considered group health plans and are exempt from the various requirements that apply to group health plans. An arrangement does not fail to be provided on the same terms to all eligible employees merely because employees’ permitted benefits vary with the price of a health insurance policy in the individual insurance market based on the ages of the employee and family members or the number of family members covered by the arrangement, provided that the variation is determined by reference to the same insurance policy for all eligible employees.

 

Coverage and payments under QSEHRAs are excluded from gross income, unless the employee does not have minimum essential health insurance coverage for the month in which the medical care was provided. Employers offering a QSEHRA must notify employees in advance regarding permitted benefits. Additional information reporting is required, including the reporting of benefit information on W-2 forms.

When Goodwill Merges With Basis: Cost to IRS $206 Million

expert-witness
Expert Witness Omission Cost

On October 31, 2016 a very interesting case  was decided  that cost IRS more than $206 Million . The crust of the issue was when does the Goodwill and Going Concerns, some of the most common intangible costs, become an inherent part of the basis. Section 1603 cases are always huge ticket cases and this one is no exception.

One other interesting outcome of the case is the fact that the Rules of Evidence and admissibility of testimony of the expert witness are extremely granular.  One small emission intentionally or otherwise can cost the party to the lawsuit lot of money, may be in this case the whole $206 Million to IRS.

Plaintiffs are the owners of six wind farm facilities in the Alta Wind Energy Center near Los Angeles, California. They commenced these actions on June 14, 2013, alleging that the Government underpaid them by over $206 million when it made a grant to them pursuant to Section 1603 of the American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, 123 Stat. 115 (“ARRA”). Congress passed the ARRA in the wake of the 2008 financial crisis to stimulate the United States economy. As part of this strategy, Section 1603 created a system whereby certain renewable energy facility owners became entitled to cash grants. Owners of “specified energy property” like Plaintiffs became entitled to grants equal to thirty percent of “the basis of such property.” Id. Sec. 1603(b)(1)- (2)(A).

And therein lies the dispute. Plaintiffs argue that “basis” means the purchase prices of their wind farm facilities, minus small allocations for ineligible property such as land and energy transmission lines. The Government maintains that basis really should be calculated from the value of each wind farm’s grant-eligible constituent parts and their respective development and construction costs, citing a myriad of factors that allegedly made the purchase prices an unfair measure of each wind farm’s value. To bolster its arguments, the Government maintains that the purchases were subject to Section 1060 of the Internal Revenue Code, which calls for the residual method of tax accounting. Using the residual method, the Government argues that a substantial portion of the wind farms’ purchase prices must be allocated to intangibles such as goodwill and going concern value.

The Court conducted a nine-day trial in this case from May 9 to May 23, 2016. At trial, the Court heard the testimony of eleven witnesses. Plaintiffs’ nine witnesses were, in the order presented: James Pagano, George Revock, James Spencer, Lance Markowitz, Damon Huplosky, Anthony Johnston, Donald Edward Settle, Dr. Edward Maydew, and Dr. Colin Blaydon. The Government’s witnesses were Ellen Neubauer and Judson Jaffe.

The Government sought to introduce expert testimony from Dr. John Parsons in the areas of economics, finance, and valuation. Parsons, Tr. 1889. Dr. Parsons is a Senior Lecturer at the Massachusetts Institute of Technology (“MIT”) Sloan School of Management, where he has worked since 2005. See Parsons Expert Report App’x 1, at 2. Previously, he worked at MIT in 1984-1990 as an Assistant Professor of Finance, before moving to the City University of New York, Baruch College in 1990-1993 as Associate Professor of Finance, and later to Columbia University, Graduate School of Business, in 1993-1995 as Visiting Associate Professor of Finance. From 1995-2005, Dr. Parsons worked for the consulting firm of Charles River Associates as Senior Associate, Principal, and Vice President. Id.

Dr. Parsons’ Curriculum Vitae lists forty-seven articles and publications that he authored or co-authored from 1985 to the present. Id. at 3-7. Rule 26(a)(2)(B)(iv) of the Court of Federal Claims (“RCFC”) requires an expert witness to list “all publications authored in the previous ten years.” On voir dire examination, Dr. Parsons confirmed that he had provided a complete listing, both at trial and in his earlier deposition, of all of his articles and publications-not only from the previous ten years, but also from 1985 to the present. Parsons, Tr. 1890-94.

Plaintiffs’ counsel also introduced Dr. Parsons’ March 10, 1997 expert report from another case, Babson-United Investment Advisors, Inc. v. Hulbert , No. 96 Civ. 11349-REK (D. Mass.). PX 804. Dr. Parsons included a list of his articles and publications in that report as well, pursuant to a requirement in the 1997 Federal Rules of Civil Procedure that an expert witness list “all publications authored by the witness within the preceding ten years.” Fed. R. Civ. P. 26(a)(2)(B) (1997); PX 807. The 1997 expert report contained a comparable listing of Dr. Parsons’ articles and publications for the period 1985-1995, which he confirmed was a complete list. Parsons, Tr. 1897-1908.

However, Dr. Parsons’ lists of articles both in this case and in Babson-United were not complete, as he attempted to conceal articles he wrote for Marxist and East German publications. Plaintiffs’ counsel confronted Dr. Parsons with the fact that his current Curriculum Vitae and his 1997 expert report in the Babson-United case omitted five published articles that he authored from 1986-1989.2 Dr. Parsons also was listed as an Editorial Board member of Science & Society in 1994-1995, see PX 810, and a contributing editor for the same publication from 1995 to 2010. See PX 810, 819. Science & Society touts itself as “A Journal of Marxist Thought and Analysis,” that is “the longest continuously published journal of Marxist scholarship in the world, in any language.” PX 809 at 1.

After Plaintiffs’ counsel revealed these glaring omissions in Dr. Parsons’ publication history, the Court had no choice but to exclude Dr. Parsons’ testimony. The Court found that Dr. Parsons failed to disclose his articles relating to Marxist and socialist economic thought, and thereby provided untruthful testimony under oath to the Court. It is reasonable to infer that when Dr. Parsons left academia in 1995 to join a private-sector consulting firm, he likely found it uncomfortable to have these articles associated with his name. The Court based its ruling to exclude Dr. Parsons’ testimony solely on the conclusion that he was untruthful under oath at trial and in his deposition, and not in any way on the substance of any articles he authored when he was a college professor. The Court simply could not rely on the substantive expert testimony of a witness who was untruthful in describing his background and qualifications. This outcome was especially dispositive here because Dr. Parsons’ untruthfulness related to his writing on economics topics, which was the area in which he was called to testify as an expert. As one court facing a similar situation noted:

The court cannot trust the word of an expert witness who would brazenly lie about her credentials and then further lie when caught. If she would lie about her academic credentials, there is no reason to believe that she would not provide erroneous and/or misleading valuation testimony if she believed it would benefit her client. The court, therefore, will not ascribe any weight to the evidence supplied by [this expert].

Contreras v. Sec’y of Health & Human Servs. , 121 Fed. Cl. 230, 240-41 (2015) (quoting In re WRT Energy Corp. , 282 B.R. 343, 371 (Bankr. W.D. La. 2011)).3

For these reasons, the Court excluded the expert testimony of Dr. Parsons. The Government did not identify any other experts on its pretrial list of witnesses, and therefore had no expert testimony to rebut Plaintiffs’ experts, Dr. Maydew and Dr. Blaydon, or to support the Government’s counterclaims. Therefore, the Government’s counterclaims fail for lack of evidence.

After weighing the evidence and applicable law, the Court finds in Plaintiffs’ favor. The Court holds that Plaintiffs’ basis in their wind farm facilities must be calculated according to the facilities’ purchase prices, minus reasonable allocations for land and other grant-ineligible property. Therefore, the Government underpaid Plaintiffs when it awarded them Section 1603 grants, and Plaintiffs are entitled to damages in amounts equal to the difference between the grants they received and the grants they were owed.

Findings of Fact

I. Developing Wind Power in the Tehachapi Region

This case centers on six of the wind farms that make up the Alta Wind Energy Center.4The Alta Wind Energy Center is the largest wind center in North America, and possibly in the world. Pagano, Tr. 50, 70-72. It is located in the Tehachapi Region, which is a hilly area west of the Mojave Desert about ninety miles north of Los Angeles. Pagano, Tr. 62; PX 10 at 8. The Tehachapi Region is uniquely suited to wind production. The Mojave Desert heats in the morning, which creates a thermal low pressure region. JX 12 at 13. Cool air then moves in from a high pressure region over the Pacific Ocean in the west. Id. ; DX 706 at 8-9. To get to the desert, this cooler air first must pass through the Tehachapi hills and valleys, and this effect generates substantial wind. Id. Moreover, the Tehachapi Region is at its windiest during the day-i.e. , during the time when people use the most energy. Pagano, Tr. 64-65, 72-73.

In short, if one were going to build a wind farm, this would be the ideal place to do it. Unsurprisingly, companies have been developing wind power facilities in the Tehachapi region since the early 1980s. PX 299 at 12 ¶ 14. By 2009, five percent of all wind power generation in the United States came from the Tehachapi Region. Id.

II. Developing and Constructing the Alta Wind Projects

Building and operating a wind farm requires many physical assets. For example, a wind farm requires turbines, foundations to support them, meteorological towers, roads, and interconnection and transmission equipment. See, e.g. , JX 67 at 11-12, 17; Markowitz, Tr. 927; Revock, Tr. 686. Beginning power production also requires navigating a maze of various contracts. For example, the wind farm must enter into a power purchase agreement (“PPA”) with a utility customer. See JX 67 at 11. It must also enter into transmission and interconnection agreements, which allow wind farms to access the wider electrical grid. See JX 67 at 11-12. Operation and maintenance contracts allow wind farm purchasers who do not intend to run the wind farms themselves to keep their purchased facilities running. See JX 67 at 11. Finally, shared facilities and wake impact agreements allow wind farms to share their resources and to offset a phenomenon known as “waking,” in which one wind farm blocks a certain amount of wind from another wind farm. JX 67 at 18. Naturally, wind farms also require adequate land, and their owners may acquire land outright or lease it from other owners.

The Alta Wind projects at the center of this lawsuit were developed in two stages. In the first stage, Oak Creek Energy Systems (“Oak Creek”) began the development process and partnered with Allco Wind Energy Management Pty. Ltd. (“Allco”) to finance the projects’ development. Stip. ¶ 5; 5 JX 1 at 7. In the second stage, Terra-Gen Power LLC (“Terra-Gen”) acquired the projects from Allco, completed developing and constructing them, and sold the finished products to Plaintiffs. Stip. ¶ 6. The finished product, the Alta Wind Energy Center, is made up of eleven wind farm facilities. See PX 221. These facilities are numbered sequentially from Alta I through Alta XI. Id. Altas I through VI are the subject of this lawsuit. The Energy Center was divided into eleven facilities essentially to facilitate their construction, sale, and development. Pagano, Tr. 96, 396. Still, an observer would not be able to tell where one facility ended and another began. Pagano, Tr. 82-83.

A. Oak Creek and Allco Begin Development and Construction

In December 2006, Southern California Edison (“SCE”) and a subsidiary of Oak Creek and Allco entered into a Master Power Purchase and Wind Project Development Agreement (the “Master PPA”). See JX 6. The Master PPA provided that the Oak Creek/Allco subsidiary would develop multiple wind facilities totaling an aggregate capacity between 1,500 and 1,550 Megawatts, with all of that output to be sold to SCE for a period of roughly 24 years. In return, SCE agreed to enter into a separate long-term PPA to purchase all electricity generated by each of these facilities, with the price to be set in accordance with a formula set forth in the Master PPA. JX 6 at 15, JX 12 at 26; Pagano, Tr. 388-90. The parties amended the Master PPA four times. See JX 9; JX 10; JX 21; JX 23.

Oak Creek and Allco completed development work on the promised wind facilities, but did not actually begin construction. See Pagano, Tr. 86. Specifically, by June 2008, they had (1) completed environmental studies; (2) secured key transmission and interconnection queue requests in the Tehachapi Renewable Transmission Project (a project designed to generate more electricity to customers in Southern California, see JX 12 at 18); (3) secured land rights; (4) begun the permitting process; (5) completed site analysis for turbines and other major equipment; (6) purchased GE turbines and executed turbine-related contracts; (7) constructed meteorological towers and collected wind data; and (8) secured the Master PPA with SCE. JX 12 at 10-26, JX 6; Stip. ¶ 15.

B. Terra-Gen Acquires Allco’s Assets

In July 2008, Terra-Gen acquired Allco’s U.S. wind energy business, including the Tehachapi Projects, for approximately $394 million. Stip. ¶ 6. In the transaction, Terra-Gen acquired development rights, transmission rights, some leased land, some land in fee simple, and an unrelated wind facility (Alite). Pagano, Tr. 119-21, 130; JX 14 at 17-39. Most of the land rights Terra-Gen acquired were unperfected; Allco had secured an option to lease the land, with the lease itself to be negotiated later. Pagano, Tr. 86-90, 457; JX 14 at 29-36; PX 223.

When Terra-Gen purchased Allco’s assets, it engaged Duff & Phelps (“Duff”), an appraisal firm, to perform an appraisal of all of these assets in July 2008. Stip. ¶¶ 9-13. Duff’s first appraisal report describes Duff’s estimation of the fair market value of the identifiable tangible and intangible assets acquired by Terra-Gen for the purpose of allocating the purchase price among the acquired assets. Stip. ¶ 9; JX 32; Pagano, Tr. 120. Duff allocated approximately $36 million of the $394 million purchase price to the Alite wind farm, $1.5 million dollars to land owned by Allco, as well as other assets. JX 32 at 7; Huplosky, Tr. 1136. Duff estimated that the remaining $350 million pertained to the Tehachapi Projects. Of that amount, $68 million of the purchase price reflected payments that Terra-Gen had made for GE turbines that would be used in what later became Alta I. JX 32 at 35; Huplosky, Tr. 1137-38. The remaining $282 million reflected the acquisition of certain rights and intangible assets for the Tehachapi Projects. JX 32 at 35. Duff determined that $272 million of this amount reflected the value of the development rights Terra-Gen had acquired from Allco (valued at $195 million) and power transmission rights (valued at $77 million). Stip. ¶¶ 11, 12; JX 32 at 45. Duff allocated both of these intangible asset values solely across Altas I through XI. See Stip. ¶ 14.

C. Terra-Gen Finishes Developing and Constructing the Alta Wind Energy Center

Even though Oak Creek and Allco had made valuable progress on developing what eventually became the Alta Wind Energy Center, much work remained to be done when Terra-Gen took over the project. Terra-Gen had to secure required permits, negotiate and enter into turbine and construction contracts, execute interconnection and crossings agreements, obtain additional land rights, obtain construction financing, and oversee and implement the actual construction of the Alta Wind Energy Center. Pagano, Tr. 110-15. Terra-Gen did all of these things, at a total cost of over $4 billion for the entire Alta Wind Energy Center (of which over $2 billion related to costs associated with Altas I through VI). See Pagano, Tr. 78-79; 115-16, 121. Terra-Gen developed the Energy Center at great risk, as it would have lost its entire $394 million investment if it had failed to obtain necessary real estate, permits, or other development requirements. See Pagano, Tr. 103- 04.

Several factors outside Terra-Gen’s control also increased the value of Altas I-VI during their development. First, California instituted and then increased its Renewable Portfolio Standards, which dictated that utilities were required to purchase a certain percentage of their electricity from renewable sources. Pagano, Tr. 73-74. Second, Section 1603 was passed during this development period. The grants available under the Section 1603 program were much more valuable than the preexisting tax credits that would have applied to the Alta projects. SeeHuplosky, Tr. 1192. Finally, SCE built the transmission lines that would carry power from the Alta projects. Pagano, Tr. 113-14.

D. Terra-Gen Sells Altas I-VI to Plaintiffs

After Terra-Gen had invested the necessary resources into the Alta projects, it began the process of selling them. Terra-Gen would have preferred to keep and continue to develop the Alta projects, but Section 1603 made this approach impractical. See Pagano, Tr. 157, 166. Under Section 1603, “pass-thru” entities are not eligible for cash grants if any “holder of an equity or profits interest” in the pass-thru entity is a nonprofit organization. ARRA Sec. 1603(g)(4). During the period relevant to this case, Terra-Gen was a pass-thru entity owned by ArcLight Capital and Global Infrastructure Partners, each of which had a small percentage of non-profit owners. Pagano, Tr. 53-54; 157, 166. Therefore, Terra-Gen could not take advantage of the Section 1603 cash grant program itself. Terra-Gen even sought a legislative solution to this problem, but to no avail. Pagano, Tr. 156-60; PX 1; PX 2. Terra-Gen could have established a C corporation blocker entity between itself and each individual Alta entity to become eligible for a Section 1603 grant, but this approach would have imposed a costly double layer of income taxation. Pagano, Tr. 161. Terra-Gen therefore decided to sell the Alta projects. It sold Alta VI in an outright sale, and sold Altas I-V in sale-leaseback transactions. Pagano, Tr. 166-67, 186.

The weight of the evidence demonstrates that all of the Alta I-VI transactions were negotiated by sophisticated parties at arm’s length. Specifically, Citibank, N.A. (“Citi”) and Google, Inc. negotiated the Alta II-V transactions, General Electric Capital Corporation (“GE”) and Union Bank of California (through UnionBanCal Corporation) (“UBOC”) negotiated the Alta I transaction, and Everpower Wind Holdings, Inc. (“EverPower”) negotiated the sale of Alta VI (all parties negotiated with Terra-Gen). The testimony at trial cumulatively showed that these parties extensively negotiated to achieve the best possible purchase prices.

1. Sale-Leaseback of Altas II-V

First, Terra-Gen sold Altas II-V to Citi and additional investors after an initial bidding process in a series of transactions that lasted from December 2010 to June 2011. See Stip. ¶¶ 18-21; Revock, Tr. 740, 771-72, 774. To facilitate the purchase transactions, Citi and Terra-Gen created multiple trusts (which are Plaintiffs in this case), each of which acquired an undivided percentage interest in the applicable Alta project. JX 225; JX 286; JX 344; JX 402.

Citi and Terra-Gen then individually closed all four project transactions, with Citi divesting some or all of its interest in each individual phase to other potential investors, either by recruiting a co-investor before closing (as with Google) or divesting its interest in an owner-lessor entity after closing. Revock, Tr. 740-41, 773-74, 707; PX 13. The agreements also leased Altas II-V back to Terra-Gen. Essentially, this meant that Terra-Gen would continue to operate Altas II-V while paying a steady income stream to Plaintiffs. This income stream was generated by the wind farms as integrated facilities, and reflected benefits derived from use of each entire wind farm. Revock, Tr. 735, 785. As Mr. Revock testified on behalf of Citi, the parties used a computer program to generate a leaseback transaction that optimized Plaintiffs’ income from the leaseback and met Terra-Gen’s objectives. Revock, Tr. 746, 747. In total, the purchase prices that Plaintiffs paid Terra-Gen in the Alta II-V transactions were (approximately): $440.25 million for Alta II, $444.5 million for Alta III, $288.8 million for Alta IV, and $488 million for Alta V. See Stip. ¶¶ 18-21; JX 225; JX 286; JX 344; JX 402. These purchase prices reflect only property that the parties deemed eligible for grants under Section 1603; the parties exchanged grant-ineligible property in separate agreements. SeeHuplosky, Tr. 1114; JX 225; JX 286; JX 344; JX 402.

2. Sale-Leaseback of Alta I

In December 2010, Terra-Gen closed a similar sale-leaseback transaction for Alta I. GE and UBOC formed a consortium to participate as equal co-investors in the sale-leaseback. Markowitz Tr. 925-27. To accomplish the deal, GE and UBOC formed trusts that became the owner-lessors in the leaseback (as with Altas II-V, these trusts are Plaintiffs in this case). Stip. ¶ 17. The overall transaction created a structure whereby Terra-Gen continued to operate Alta I, and Plaintiffs received an income stream from the cash flows Alta I generated. Markowitz, Tr. 989-90. The overall purchase price for Alta I was $560 million. Stip. ¶ 17; JX 212. In contrast to the sale-leaseback transactions of Altas II-V, the Alta I transaction conveyed both grant-eligible and ineligible property. JX 212.

3. Outright Sale of Alta VI

EverPower bought Alta VI from Terra-Gen in 2012 for $439.388 million. Mr. Spencer, on behalf of EverPower, testified that the purchase price reflected the fact that Alta VI was a complete facility with all of its necessary contracts and was capable of generating income. Spencer, Tr. 850. EverPower also acquired some project land free of charge in the transaction. Spencer, Tr. 895-97. Terra-Gen also required EverPower to change the name of Alta VI to “Mustang Hills.” Huplosky, Tr. 1211. The parties changed the name because they hoped Treasury would not lower the claimed Section 1603 grant amount for Alta VI (as Treasury had for the other Alta facilities). Id.

4. Section 1603 Indemnities

The parties to the Alta I-VI transactions also included indemnity provisions in their transactions. With the indemnities, Terra-Gen agreed to accept the risk that the Government would not pay the full amount Plaintiffs would claim under Section 1603, using the purchase price as basis. Specifically, the Alta II-V transactions provided that Terra-Gen would take the financial risk of any difference between the payments requested using the purchase price as the basis (as Plaintiffs argue basis should be calculated in this case) and any actual reduced payment, up to a certain amount. Revock, Tr. 723-24. In the Alta I transaction, Terra-Gen went even further: it agreed to indemnify the purchasers for any difference between the Government’s actual grant and a purchase price-basis grant with no upper limit on Terra-Gen’s liability. See, e.g. , JX 223. The Alta VI indemnity essentially guaranteed that EverPower would receive $87 million, regardless of the Government’s Section 1603 award (with any grant amount in excess of $87 million payable to Terra-Gen). See Spencer, Tr. 886. Thus, the Alta I-VI deals allowed Plaintiffs to apply for a Section 1603 grant using their purchase price as a basis, but protected them to a certain extent from any reduced grant award.

III. Plaintiffs’ Applications for Section 1603 Grants are Denied

A. Terra-Gen Creates and KPMG Certifies Purchase Price Allocations

Before Plaintiffs submitted Section 1603 applications, Terra-Gen first prepared cost schedules for the Alta projects that broke down the total development and construction costs into various components, including property that was eligible for a Section 1603 grant and property that was not. Huplosky, Tr. 1041-50, 1052-53. Terra-Gen “capitalized” the indirect costs into the hard assets-meaning that the indirect cost effectively becomes part of the hard asset. Huplosky, Tr. 1046-48. In some instances, indirect costs were entirely eligible-for instance, if they were associated with only eligible assets, such as permits for the wind turbines. Huplosky, Tr. 1049. In other instances, indirect costs were entirely ineligible, such as costs related solely to electricity transmission. Id. Finally, some indirect costs, like interest during construction, related to the entire Facility and were thus partially eligible and partially ineligible. Such indirect costs were apportioned pro rata among all of the direct costs. To illustrate, if the Facility’s eligible direct costs were twice as high as the Facility’s ineligible direct costs, then the indirect costs were spread among the direct cost items using the same 2:1 ratio. Huplosky, Tr. 1049-50. KPMG approved this method of allocating indirect costs. Huplosky, Tr. 1051, 1094.

Treasury required companies applying for a Section 1603 grant to provide an opinion from an independent auditor validating the claimed grant-eligible costs. Plaintiffs retained KPMG to examine, and prepare an opinion validating, Plaintiffs’ claimed eligible costs. Johnston, Tr. 1215-16. Terra-Gen and KPMG first evaluated the costs incurred by Terra-Gen to construct each component of the facility, and determined which of these costs were eligible and which were ineligible. Huplosky, Tr. 1038; see also JX 168 at 1-5. Terra-Gen relied on Treasury’s Section 1603 Guidance to determine what costs were eligible, and, in accordance with that guidance, classified as eligible the items that were necessary to create electricity, and classified as ineligible items that were not. Huplosky, Tr. 1041-44. Members of KPMG’s Fixed Assets team then reviewed these determinations. Johnston, Tr. 1229-30, 1282; Huplosky, Tr. 1044.

In addition to classifying costs as eligible or ineligible, KPMG also confirmed that the costs had actually been incurred, a process referred to as “vouching” the costs. Huplosky, Tr. 1202, 1282. KPMG vouched eighty percent or more of the construction costs for each Alta Wind lawsuit facility. Johnston, Tr. 1220, 1226-29; JX 86 at 3. Based on this vouching work, KPMG verified “that management’s assertion of the eligible cost basis” for each Facility with respect to Terra-Gen’s construction costs “is accurately stated.” Johnston, Tr. 1227-29.

Terra-Gen then prepared cost schedules that set forth Plaintiffs’ claimed allocations of the purchase price to eligible and ineligible property. Huplosky, Tr. 1079-80. Thus, for Altas I and VI, Plaintiffs submitted applications for Section 1603 grants that multiplied the percentage of construction costs that Terra-Gen deemed eligible for Section 1603 grants by the purchase price. Huplosky, Tr. 1080, 1117. Plaintiffs’ analysis deemed 93.1 percent of Alta I to be eligible property under Section 1603. Huplosky, Tr. 1080, 1100. Similarly, Plaintiffs deemed 96.9 percent of Alta VI to be eligible for a Section 1603 grant. See Huplosky, Tr. 1117-19. Terra-Gen performed no allocation for Altas II-V because those transactions were structured such that no ineligible property was transferred. In addition to certifying that Terra-Gen’s breakdown of the construction costs for the Alta Wind Lawsuit Facilities into eligible and ineligible components was reasonably stated, KPMG also issued a certification regarding the amount of the purchase price for each Alta Wind Lawsuit Facility that was eligible for a cash grant under Section 1603, using the pro rata methodology. These certifications are sometimes known as fair market value (or “FMV”) certifications. See Johnston, Tr. 1223; JX 194.

Plaintiffs’ expert, Dr. Maydew, testified that this allocation method was reasonable. Maydew, Tr. 1411-14, 1415-16; PX 326 at 27-28 ¶¶ 2-4. He also testified that at least three of the “Big 4” accounting firms have approved and used the pro rata allocation method to determine the basis of eligible property at wind power facilities. Maydew, Tr. 1418-19. Mr. Settle’s testimony further showed that both the industry and the National Renewable Energy Laboratory (“NREL”) accept, as a “rule of thumb,” that generally ninety-five percent of the construction costs of a wind farm are eligible. Settle, Tr. 1305- 06. Indeed, Mr. Settle noted that NREL “tested” this ninety-five-percent ratio “early on multiple projects and determined that a good representation is five percent nonqualifying, ninety-five percent eligible out of total project costs.” Settle, Tr. 1309-10, 1314. Thus, the 93.1 percent and 96.9 percent allocations for Altas I and VI would be within the range of this “rule of thumb.”

B. Plaintiffs Apply for Section 1603 Grants

Each Plaintiff timely applied to Treasury for a cash grant equal to thirty percent of the purchase-price basis of its eligible property. JX 195; Stip. ¶¶ 36-37. Treasury had entered into an interagency agreement with NREL, which performed a review of cash grant applications and completed an “application checklist” for each Plaintiff application. These application checklists confirmed that Plaintiffs had satisfied all statutory requirements to receive Section 1603 grants. Settle, Tr. 1306-07; PX 205; PX 132. Instead of paying Plaintiffs cash grants equal to thirty percent of their purchase price basis, the Government paid cash grants equal to thirty percent of Terra-Gen’s construction and development costs for each facility. See JX 196; Pagano, Tr. 418; see also Jaffe, Tr. 2014 (noting that all of the Alta awards were based on the schedule provided by Terra-Gen summarizing Terra-Gen’s construction and development costs). Therefore, Plaintiffs now seek reimbursement of the difference between the Government’s reduced grant award and a grant reward that is thirty percent of their claimed purchase price basis (after applicable allocations for ineligible property).

Discussion

ARRA Section 1603 allows owners of “specified energy property” to apply for grants. ARRA Sec. 1603(a). Wind facilities are one type of specified energy property, Id. Sec. 1603(d)(1); 28 U.S.C. Sec. 45(d)(1), and the parties do not dispute that Altas I-VI are wind facilities that qualify for grants under Section 1603. Section 1603 incorporates the definitions in Section 48 of the Internal Revenue Code (“IRC”), see Sec. 1603(h), which defines “qualified property” as “tangible property . . . used as an integral part” of grant-eligible facilities. 26 U.S.C. Sec. 48(a)(5)(D). Treasury guidance for the Section 1603 program excludes as qualified property “electrical transmission equipment, such as transmission lines and towers, or any equipment beyond the electrical transmission stage, such as transformers and distribution lines.” JX 126 at 11-12. Grants under Section 1603 therefore are calculated by taking thirty percent of the owner’s basis in this qualified property. See ARRA Sec. 1603(b)(2)(A).

The question in this suit has always been what the basis of Altas I-VI is. If the Court were to follow the Government’s approach in awarding the Section 1603 grants, basis would mean the development and construction costs of each Alta facility-i.e. , a grant predicated on the “cost method” of tax valuation. See Def. Post-Trial Br. at 111, Dkt. No. 118. Plaintiffs’ approach, on the other hand, would mean that the Alta Wind facilities’ purchase prices, minus reasonable allocations for ineligible property under Section 1603, would be used to calculate basis. See Pl. Post-Trial Br. at 40, Dkt. No. 158.

I. Plaintiffs’ Purchase Prices Determine Their Basis for Section 1603 Grants

Basis, as defined in the IRC, is the cost of property to its owner. See 26 U.S.C. Sec. 1012(a).6 Therefore, if someone built a wind farm facility, his development and construction costs would be his basis in the facility because this is what the cost of the facility is to him. Conversely, a buyer’s basis in a wind farm facility he purchases generally would be the facility’s purchase price, as this is the cost of the facility to the buyer. See Solitron Devices, Inc., v. Comm’r , 80 T.C. 1, 23 (1983), aff’d , 744 F.2d 95 (11th Cir. 1984) (“One of the verities of tax law is that the cost basis of property is equal to the amount of cash paid for such property.”).

There are exceptions to the general rule that purchase price determines basis, and the Government argues that several of them apply here. Essentially, the Government argues that the purchase prices cannot be Plaintiffs’ basis in the wind farm facilities because they do not capture the fair market value of the tangible property that is eligible for Section 1603 grants. The Government first points to the fact that the purchase prices included ineligible property to show that the fair market value of the eligible property is not ascertainable from the purchase prices. Next, the Government argues that Section 1060 of the IRC, and its accompanying “residual method” of tax valuation, applies because intangible goodwill or going concern value was included in the purchase prices. Finally, the Government argues that the purchase prices cannot serve as Plaintiffs’ basis because (a) the transactions were not “conducted at arm’s-length by two economically self-interested parties;” and (b) the transactions were “based upon ‘peculiar circumstances’ which influence[d] the purchaser to agree to a price in excess of the property’s fair market value.” Lemmen v. Comm’r , 77 T.C. 1326, 1348 (1981) (quoting Bixby v. Comm’r , 58 T.C. 757, 776 (1972)). The Court will address each of the Government’s arguments in turn.

A. Section 1060 of the IRC Does Not Apply to the Transactions

Both parties agree that the price Plaintiffs paid for Altas I-VI was higher than the mere cost of developing and assembling the facilities. Therefore, the question is whether some of this additional value constitutes goodwill or going concern value. If it does, then Section 1060 applies, and the parties would have to use the “residual method” promulgated under Section 338(b)(5) of the IRC to value the grant-eligible assets. The residual method allocates value on a waterfall basis among several categories of tangible and intangible assets, and the Government argues that much of the value in the Alta I-VI transactions would be allocated to ineligible intangibles (such as goodwill or going concern value) if the residual method applied.

Section 1060 applies to “applicable asset acquisitions.” 26 U.S.C. Sec. 1060(a). An applicable asset acquisition “means any transfer . . . of assets which constitute a trade or business, and with respect to which the transferee’s basis in such assets is determined wholly by reference to the consideration paid for such assets.” Id. Sec. 1060(c). The Treasury promulgated regulations that further elaborate on the circumstances in which assets constitute a trade or business. See 26 C.F.R. Sec. 1.1060-1(b)(2). Under that Regulation, assets constitute a trade or business within the meaning of Section 1060 if their “character is such that goodwill or going concern value could under any circumstances attach to such [assets].” Id. Sec. 1.1060-1(b)(2)(i)(B).7 “Goodwill is the value of a trade or business attributable to the expectancy of continued customer patronage.” Id. Sec. 1.1060-1(b)(2)(ii). “Going concern value is the additional value that attaches to property because of its existence as an integral part of an ongoing business activity.” Id. It “includes the value attributable to the ability of a trade or business . . . to continue functioning or generating income without interruption notwithstanding a change in ownership.” Id. Going concern value “also includes the value that is attributable to the immediate use or availability of an acquired trade or business . . . .” Id. To determine whether goodwill or going concern value could attach to a group of assets, “all the facts and circumstances surrounding the transaction are taken into account,” including:

(A) The presence of any intangible assets . . . ;

(B) The existence of an excess of the total consideration over the aggregate book value of the tangible and intangible assets purchased (other than goodwill and going concern value) as shown in the financial accounting books and records of the purchaser; and

(C) Related transactions, including lease agreements, licenses, or other similar agreements between the purchaser and seller . . . in connection with the transfer.

Id. Sec. 1.1060-1(b)(2)(iii).

There is a structural problem that becomes apparent when one tries to parse this Treasury Regulation. First, in subsection 1.1060-1(b)(2)(ii), the Regulation sets out specific definitions for goodwill and going concern value, which are presented as two distinct (if related) terms. Further, the definitions for goodwill and going concern value appear largely to incorporate the terms’ common law meanings. See, e.g. , Newark Morning Ledger Co. v. United States , 507 U.S. 546, 555 (1993) (citing “the shorthand description of good-will as ‘the expectancy of continued patronage'”) (citation omitted); UFE, Inc. v. Comm’r , 92 T.C. 1314, 1323 (1989) (“Going concern value is manifested in the business’ ability to resume business activity without interruption and to continue generating sales after an acquisition.”) (citing Computing & Software Inc. v. Comm’r , 64 T.C. 223, 235 (1975)).

In the next subsection, however, the Regulation enumerates situations in which both of these two concepts “could apply.” So, if one were to read the categories in subsection 1.1060-1(b)(2)(iii) as mandatory triggers for finding that either goodwill or going concern value could apply, then the definitions in the previous subsection-and, indeed, the body of case law that gave rise to them-would be meaningless. It is hard to believe the Treasury intended such a drastic result, particularly given the Regulation’s phrasing: “Factors to be considered include . . . .” 26 C.F.R. Sec. 1.1060-1(b)(2)(iii) (emphasis added). Therefore, it is more appropriate to view subsection 1.1060-1(b)(2)(iii) as a non-exhaustive list of factors that may mean goodwill or going concern value could apply. The Court must consider these factors along with the totality of the circumstances in the Alta transactions. As shown below, the Court finds that other factors are dispositive here.

1. No Goodwill Value Could Attach to the Alta Facilities

As noted above, goodwill is the “expectancy of continued patronage.” Newark Morning Ledger , 507 U.S. at 555. This is “a useful label with which to identify the total of all the imponderable qualities that attract customers to the business.” Id. (citation omitted); see also Lorvic Holdings, Inc. v. Comm’r , T.C. Mem. 1998-281, 1998 WL 437287, at *7 (1998) (“[G]oodwill is the aggregate value of the relationships and reputation developed by a business with its present and potential customers and associates over a period of time.”). Thus, goodwill is not a free-floating residual category to which one must allocate any value attached to a group of assets that exceeds the development and construction costs of those assets. Rather, goodwill is a distinct concept that represents the value a business acquires from its ability to attract and maintain customer relationships over time.

The Court is aware of authority that appears at first blush to contradict this view. See, e.g. , Coast Fed. Bank, FSB v. United States , 323 F.3d 1035, 1039 (Fed. Cir. 2003) (“Goodwill, an intangible asset, is the excess of cost over the fair value of the identifiable net assets acquired.”) (citation omitted); Deseret Mgmt. Corp. v. United States , 112 Fed. Cl. 438, 449 (2013) (same). However, this “residual goodwill” approach would completely eclipse authority and Treasury regulations that attach different and distinct meanings to goodwill and going concern value. If goodwill is all value over the fair value of identifiable assets, then going concern value is squeezed out as a concept. Furthermore, the IRS has found that Newark Morning Ledger “had the effect of rendering irrelevant the early depreciation cases in so far as they used the term ‘goodwill and going concern value’ as shorthand for any intangible that was nondepreciable.” IRS Tech. Adv. Mem. 0907024 (Feb. 13, 2009). Therefore, a more internally consistent approach differentiates between the goodwill and going concern value, and gives unique meaning to each. See UFE , 92 T.C. at 1323 (“While courts have blurred these distinctions between goodwill and going concern value, they are different conceptually.”).

With that definition in mind, there are a few Alta Wind-specific factors that deserve consideration here. When sold, Altas I-VI (1) were not yet operational, (2) had lined up only one long-term customer (SCE) to buy the entirety of their electricity output for the foreseeable future, and (3) were not capable of taking on any other customers. Thus, any “expectancy of continued patronage” would have to come from an expectancy that the Alta facilities would keep doing business with SCE, their sole customer.

It is true that goodwill may attach even where one customer purchases all of a business’s output “for a long series of years.” See Pfleghar Hardware Specialty Co. v. Blair , 30 F.2d 614, 617 & n.9 (2d Cir. 1929). Still, the fact that the Alta facilities-unlike the business in Pfleghar -were not yet operational when purchased is dispositive here. At the time of sale, SCE and Altas I-VI had not yet begun performing under the PPAs. After a period of performance under the contract during which the facilities were kept in good working order and SCE continued buying electricity, goodwill might accumulate in the form of an expectation that the parties would not breach the PPAs, or that the parties might renew the PPAs-i.e. , that Altas I-VI would keep “attracting” SCE’s business. This would be the “expectancy of continued patronage” to which the cases refer. Because both parties had not yet begun performance under the PPAs at the time of purchase, however, this expectancy could not have existed at that time, so goodwill could not have attached. See, e.g. , J & M Turner, Inc. v. Applied Bolting Tech. Prods., Inc. , No. CIV. A. 95-2179, 1998 WL 47379, at *11 (E.D. Pa. Jan. 30, 1998), aff’d , 173 F.3d 421 (3d Cir. 1998) (citing “cases that hold that goodwill cannot be fairly calculated for a business that is just starting up and has no record of earnings or profits”).

The Government’s argument that the location of Altas I-VI adds goodwill also fails. It is undisputed that the Alta facilities’ location added value to the wind farm facilities. However, the value of an asset’s permanent location is part of the basis of the asset itself, and is not goodwill or any other separate intangible asset. See, e.g. , IRS Tech. Adv. Mem. 9317001, 1993 WL 134598 (Apr. 30, 1993) (finding that a transponder’s physical location “is reflected in its value, and cannot be separated from the transponder itself”). Any other approach would not make sense, as it would mean that property values in places like New York City would be made up largely of goodwill as a separate intangible asset. Plaintiffs’ expert, Dr. Maydew, confirmed that this is not standard practice. See Maydew, Tr. 1450- 51, 1453. Therefore, no goodwill could have attached at the time of the Alta transactions.

2. No Going Concern Value Could Attach to the Alta Facilities

Going concern value, while related conceptually to goodwill, is a distinct form of value. See United States v. Cornish , 348 F.2d 175, 184 (9th Cir. 1965); UFE , 92 T.C. at 1323. Essentially, going concern value is the “special value inherent in a functioning established plant continuing to operate, to do business, and to earn money, with its staff and personnel.” Miami Val. Broad. Corp. v. United States , 499 F.2d 677, 682 (Ct. Cl. 1974). It “is manifested in the business’ ability to resume business activity without interruption and to continue generating sales after an acquisition.” UFE , 92 T.C. at 1323.

Here, there was no “functioning established plant” at any of the Alta facilities at the time of the Alta I-VI transactions. Altas I-VI were fully developed and constructed when Terra-Gen sold them, but they were not yet operational; therefore, they were not “established.” As noted above, performance under the PPAs had not yet begun, so there were no cash flows that would continue to be generated after an acquisition-these cash flows, at the time of the transactions, were prospective only. In short, there was no going concern value at time of the Alta transactions because there was not yet a going concern.

Because the Court finds that neither goodwill nor going concern value could have attached to Altas I-VI at the time of the transactions, the transactions were not “applicable asset acquisitions” within the meaning of Section 1060. Therefore, Section 1060 and its accompanying residual method do not apply to the transactions.

B. Altas I-VI had Turn-Key Value

Obviously, Altas I-VI had additional value over their development and construction costs because they were ready-to-use wind farm facilities located in the windy Tehachapi Region, not just collections of turbines lying on the ground somewhere. This is the real sticking point in this case. The Government argues that this value is goodwill or going concern value, but those labels do not capture the situation of Altas I-VI, as shown above. Rather, Altas I-VI had “turn-key” value because they were ready-to-use wind farm facilities.

Ready-built facilities may have value over and above the sum of their construction and development costs. Part of this value is turn-key value, which essentially describes value a facility has when it is ready for immediate use after purchase. Here, Miami Valley is instructive. In that case, the plaintiffs bought new radio station facilities that had already been “tested and coordinated.” 499 F.2d at 680. The court held that those facilities had turn-key value because they were ready for operation at the time of purchase, noting:

[F]air market value would take into account the fact that this buyer received (and was entitled under its contract to receive) a put-together plant in good all-round working shape, not a congeries of uncoordinated physical assets liable as not to fail to work as a unit. The ‘turnkey’ product was worth more than the sum of the untested and uncoordinated parts, even though they were all constructed and installed in place. Normally a buyer would pay an increment for such an assurance that the plant and equipment would all work together without need of costly and time-consuming adjustments and coordination.

499 F.2d at 680. It is important to note that turn-key value is not the same thing as “going concern” value. In a turn-key transaction, the buyer is not purchasing an operating business; rather, he is purchasing a put-together facility that is ready for operation. See id. at 681-82. This distinction is important because turn-key value, unlike going concern value or goodwill, is considered part of the tangible assets in a transaction rather than a separate intangible asset. See, e.g. , IRS Tech. Adv. Mem. 0907024, 2009 WL 356169 (“[C]ase law supports a conclusion that it is appropriate to value interrelated assets in the aggregate and that the synergistic value of a collection of assets is attributable to those assets rather than a conceptually distinguishable goodwill or going concern value element.”).

Altas I-VI were ready-to-operate wind farm facilities at the time of purchase. Terra-Gen had completed the necessary development and permitting work before the purchase. Therefore, the wind farm facilities had turn-key value, and their tangible assets were more valuable than they would have been if the wind farm facilities were not ready to operate. This value was part of the fair market value of Altas I-VI.

C. No “Peculiar Circumstances” Counsel Against Using the Purchase Prices as Basis

Even when Section 1060 does not apply to a transaction, the Tax Court historically has looked to other measures of a property’s fair market value if evidence shows that a “transaction [was] not conducted at arm’s-length by two economically self-interested parties or where a transaction is based upon ‘peculiar circumstances’ which influence the purchaser to agree to a price in excess of the property’s fair market value.” Lemmen , 77 T.C. at 1348 (quoting Bixby , 58 T.C. at 776). The Court finds this approach sensible. At bottom, “peculiar circumstances” exist if the parties appear to be unduly manipulating the purchase price by entering into separate agreements at or near the time of purchase, causing the purchase price to be highly inflated. For example, in Lemmen , the parties agreed to transfer herds of cattle. Id. at 1348. In addition to the herd purchase contracts, the parties also entered into several “maintenance contracts” at the time of purchase. Id. The transactions, taken together, were peculiar because the herd purchase prices were “highly inflated above the market value of the animals,” while the maintenance contracts had below-market prices. Id. at 1348-49. This was especially true because the seller was selling “managed breeding herds to investors,” so maintenance was an integral part of the transaction. Id. at 1349.

Further, it is important to note that the Court should disregard the purchase price as basis only if the evidence shows that peculiar circumstances have highly inflated the purchase price. For example, in Lemmen , the herd’s price had been inflated by nearly 500 percent. Id. at 1348. In another case, the evidence failed to prove “that the facts stand for anything other than an elaborate tax-avoidance scheme.” Bixby , 58 T.C. at 777.

As stated above, the Court finds that all of the Alta transactions occurred at arm’s length between sophisticated and self-interested parties. Therefore, the only question remaining is whether any peculiar circumstances were present in the Alta transactions that highly inflated the Alta facilities’ purchase prices. The Government argues that there were such peculiar circumstances, citing the sale-leaseback transactions for Altas I-V, several side-agreements between the parties to the transactions, and Terra-Gen’s agreements to indemnify Plaintiffs’ Section 1603 payments.

1. The Sale-Leaseback Transactions did not Create Peculiar Circumstances

The parties to the Alta I-V transactions entered into sale-leaseback transactions in which Terra-Gen sold its facilities to Plaintiffs but immediately leased the facilities in order to operate them itself. See Findings of Fact, supra Point II.D.1-2. The structure of the sale-leaseback transactions does not mean that these transactions created peculiar circumstances. A sale-leaseback is “a commercially acceptable device which affords significant advantages to both purchaser-lessor and seller-lessee.” In re San Francisco Indus. Park, Inc. , 307 F. Supp. 271, 276 (N.D. Cal. 1969). Indeed, the guidance for the Section 1603 grant program explicitly envisioned sale-leaseback structures. See JX 0126.009.

Therefore, to create peculiar circumstances, there must be some indication that the parties to the transactions adjusted various aspects of the sale and leaseback prices in order to highly inflate the purchase prices, as in Lemmen . The Government did not present evidence at trial to show that this occurred. The purchase prices paid for Altas I-V, which were sold in sale-leaseback transactions, were essentially the same on a per-kilowatt basis (after adjusting for differences in electrical generating capacity). Furthermore, they were essentially the same on a per-kilowatt basis as the prices paid for the outright purchase of Alta VI (Mustang Hills). Blaydon, Tr. 1596-97, 1601; Pagano, Tr. 173-76; PX 281. Moreover, all six of those purchase prices were essentially the same on a per-kilowatt basis as the purchase prices paid for two Alta Wind Energy Center facilities that are not involved in this litigation. Those two non-lawsuit facilities (Altas VIII and IX) were the subject of outright-purchase transactions in January and November 2012, respectively, by unrelated third parties. PX 299 at 33 ¶ 57; PX 154.

Other factors also show that the leasebacks did not fundamentally alter the Alta I-V transactions. First, the Alta II-V leasebacks were negotiated after Citi and Terra-Gen had separately agreed on a per-kilowatt purchase price. For example, Mr. Revock testified that “the value [sale price] is determined separately in advance of running the lease profile” in these sale-leaseback transactions. Revock, Tr. 809-10. Further, in the Alta I transaction, a competing bidder-Brookfield Renewable Power, Inc.-made a last-minute bid for an outright purchase of Alta I that was less than two percent lower than the price UBOC and GE eventually paid. SeePagano, Tr. 325-26; see also PX 299 at 27. Moreover, all of the Alta I-V sale-leaseback transactions closely tracked an independent analysis of the Alta facilities’ fair market values by DAI Management Consultants that did not take the leaseback transactions into account. See JX 112 at 13 (Alta I appraisal); JX 59 at 12 (Alta II appraisal); JX 62 at 12 (Alta III appraisal); JX 60 at 12 (Alta IV appraisal); JX 61 at 12 (Alta V appraisal). In sum, the evidence demonstrates that the leaseback portion of the sale-leaseback transactions did not highly inflate the purchase prices for Altas I-V.8

The rent prepayments in the sale-leaseback transactions also did not create peculiar circumstances. The purpose of such prepayments was merely to reduce the periodic rent payments due under the lease agreements, as this helps ensure that the project cash-flows will be enough to cover Terra-Gen’s rent payments to Plaintiffs. See Pagano, Tr. 527. Lowering the periodic rent payments through an up-front prepayment gives the lessee some breathing room in case, for example, the wind does not blow as strongly in a particular month. Again, there is simply no evidence that these prepayments inflated the purchase price in any way. Therefore, because the weight of the evidence demonstrates that the facilities sold in sale-leaseback transactions had similar capacity-adjusted prices-per-kilowatt, the sale-leasebacks did not create peculiar circumstances.

2. The Various Side-Agreements Between Terra-Gen and Plaintiffs did not Create Peculiar Circumstances

The Government points to land agreements and indemnification for certain financial obligations such as “wake payments” to show that the Alta I-VI transactions contained peculiar circumstances. However, there is nothing in the agreements to which the Government refers that would lead to a “highly inflated” purchase price for the Alta facilities. See Lemmen , 77 T.C. at 1348.

First, Terra-Gen obligated itself during the construction and development phase to make wake payments from Alta VI to the other Alta facilities. These wake payments compensated facilities that were downwind of Alta VI for the disruption in wind-flow that Alta VI caused. In other words, facilities downwind of Alta VI could not generate as much electricity because they were in Alta VI’s wake. Terra-Gen itself-not Alta VI-therefore took on the obligation to make wake payments to the downwind facilities because it was the developer of all six facilities. See Pagano, Tr. 414; 534-35; Spencer, Tr. 911. Because Terra-Gen took on this responsibility, it did not pass the obligation to make wake payments on to Plaintiffs when it sold Alta VI, so it did not effectively refund part of the purchase price by making these wake payments on Plaintiffs’ behalf. Therefore, the wake payments cannot be construed as a peculiar circumstance that inflated the purchase price.

Second, it is undisputed that Terra-Gen conveyed some fee land to Plaintiffs at no charge, and that it also transferred leased land to Plaintiffs as part of the Alta transactions. However, Plaintiffs have accounted for the fee land in their Section 1603 allocation. As shown below, the Court finds this allocation for land to be reasonable. Because Plaintiffs acknowledge that the land’s value cannot be part of their basis in Altas I-VI, there is no reason to believe that Plaintiffs are attempting to highly inflate their basis by including ineligible fee land value.

Further, the evidence shows that the lease terms on the leased land that Plaintiffs acquired during the Alta transactions were not more favorable than other similar leases during the same time period. See Pagano, Tr. 408-09. Terra-Gen did not own all of the land in the Alta projects; rather, it had an obligation to make royalty payments to certain landowners based on the output of each wind farm facility. It transferred this obligation to Plaintiffs. If the royalty rates due under the land lease agreements were better than market rates at the time of the Alta transactions, then Plaintiffs would have gained a benefit when they acquired the leases. Because the weighted average of these royalty rates was 5.37 percent and other Terra-Gen leases had royalty rates of about five percent, however, these royalty rates were worse than market rate and could not have added value to the Alta facilities. See id ; Maydew, Tr. 1466. While the Government takes issue with Plaintiffs’ evidence on this point (for example, Mr. Pagano’s reliance on a “weighted average” for all of the facilities) it cannot point to evidence that favorable leases “highly inflated” the value of the Alta transactions.

In sum, no evidence demonstrates that the value of wake payments or grant-ineligible land highly inflated the Alta I-VI purchase prices. Therefore, these agreements do not constitute peculiar circumstances.

3. The Section 1603 Indemnities did not Create Peculiar Circumstances

Terra-Gen indemnified Plaintiffs for the difference between their claimed Section 1603 grant amounts and lower grant amounts they might receive. Still, this is not a peculiar circumstance. One of the reasons Terra-Gen sold, and Plaintiffs bought, the Alta facilities was the existence of the Section 1603 cash grant program. Both Terra-Gen and Plaintiffs believed the facilities to be worth as much as they would be worth had the Government awarded a Section 1603 grant using the purchase price as basis. Nothing about this enhanced value estimate is peculiar; rather, “[w]hen examining a transaction, the reality that the tax laws affect the shape of most business transactions cannot be ignored.” Tanner v. Comm’r , T.C. Mem. 1992-235, 1992 WL 79077 (April 21, 1992) (citing Frank Lyon Co. v. United States , 435 U.S. 561, 576-80 (1978)). Further, the weight of the evidence confirmed that similar tax-related indemnities are common in complex commercial transactions like this one. For example, Mr. Revock testified that tax indemnities were in every lease agreement he worked on. Revock, Tr. 724. Thus, the indemnities simply confirmed the fair market value of the facilities once expected grant amounts were taken into account, and did not give rise to peculiar circumstances.

D. Plaintiffs’ Pro-Rata Allocations are Reasonable

In the absence of peculiar circumstances that highly inflated the Alta I-VI purchase prices, the Court looks to these purchase prices to determine basis for purposes of Section 1603. See Solitron Devices , 80 T.C. at 23. Section 1603’s divisions between grant-eligible and grant-ineligible property, however, mean that part of the purchase price cannot be counted as basis in the transactions that transferred both eligible and ineligible property: those involving Altas I and VI. To solve this problem, Plaintiffs used a pro-rata allocation method in which they (1) noted the percentage of construction and development costs that applied to eligible property, and (2) applied that percentage to Altas I and VI’s purchase prices to determine the eligible basis for those facilities.9 The Government objects to this allocation method, but did not present evidence at trial to show that it was unreasonable. Instead, the Government challenges the sufficiency of Plaintiffs’ evidence underlying the allocations.

Courts allow pro-rata allocations where they are necessary to determine the percentage of a purchase price that should be allocated to a particular asset. For example, in Washington Mutual, Inc. v. United States , 996 F. Supp. 2d 1095 (W.D. Wash. 2014), the court faced an analogous situation. It held that, “[i]n transactions where one lump-sum purchase price is paid for a conglomeration of assets . . . the cost of each asset must be determined by apportioning the purchase price among the assets according to each asset’s relative fair market value at the time of the acquisition.” Id. at 1104 (citing Bixby , 58 T.C. at 785; see also Victor Meat Co. v. Comm’r , 52 T.C. 929, 931 (1969) (“[W]hen a taxpayer buys a mixed aggregate of assets for a lump sum, an allocation of the purchase price will be made to the separate items upon the relative value of each item to the value of the whole.”).

Plaintiffs appear to have made such an allocation here for Altas I and VI (the transactions in which the parties conveyed both eligible and ineligible property). Their auditor, KPMG, prepared certifications of the fair market value of eligible and ineligible property in Altas I-VI. See JX 194. After the Treasury awarded reduced Section 1603 grants, KPMG reviewed its work and recertified its allocations. See Johnston, Tr. 1252- 54, PX 120. For Alta I, KMPG found that 93.1 percent of total construction costs related to grant-eligible assets, so Plaintiffs claimed 93.1 percent of the purchase price as the basis for Alta I. Huplosky, Tr. 1095-1100. For Alta VI, 96.9 percent of construction costs related to grant-eligible assets, so Plaintiffs claimed this percentage of the Alta VI purchase price as basis. See Huplosky, Tr. 1117-19. These two values appear reasonable, particularly because Mr. Settle testified that both the industry and NREL use a “rule of thumb” that treats ninety-five percent of wind farm construction costs as grant-eligible. Settle, Tr. 1305-06. This rule of thumb indicates that it is reasonable to allocate ninety-five percent of a purchase price to eligible property.

Plaintiffs’ expert witnesses also endorsed KPMG’s allocations. Dr. Maydew testified to the reasonableness of KPMG’s pro-rata allocation work. See Maydew, Tr. 1411-16; PX 326 at 27-28 ¶¶ 2-4; PX 329 at 6-7 ¶¶ 6-7. Dr. Blaydon also testified that the pro rata methodology is a “common rule that is generally used in this industry.” Blaydon, Tr. 1605-07, 1719-20; PX 299 at 86-87 ¶ 167.

Further, Plaintiffs’ analysis takes into account the value of the fee land conveyed in the Alta transactions free of charge. This value is just over $4 million, which is about two-tenths of one percent of the total Alta I-VI purchase price. Blaydon, Tr. 1625; PX 219; PX 218; PX 299 at 92-93 ¶¶ 180-82. The Court finds that the value attributed to land-which is essentially de minimis, given its value compared to the overall value of the Alta transactions-is reasonable, and that Dr. Blaydon properly deducted this value in performing his damages calculations. SeeBlaydon, Tr. 1625-26.

The Government argues that the KPMG allocation documents and related testimony are inadmissible as expert testimony under Rules 701 and 702 of the Federal Rules of Evidence. See Def. Post-Trial Br. at 96-98, Dkt. No. 163. However, the Government did not object on these grounds at trial, so this objection is waived. See Fed. R. Evid. 103(a)(1) (noting that objections to admission of evidence must be timely); Commercial Contractors, Inc. v. United States , 154 F.3d 1357, 1367 (Fed. Cir. 1998) (“CCI argues first that the . . . declarations are hearsay, and that the court erroneously admitted them into evidence . . . . CCI waived that argument, however, by not objecting to the admission of the declarations on that ground at trial.”). Additionally, the Government’s objection to the KMPG allocation documents is waived because the Government moved these documents into evidence as joint exhibits. See Ronickher, Tr. 10 (moving KPMG documents into evidence as joint exhibits); Ohler v. United States , 529 U.S. 753, 755-56 (2000) (“[A] party introducing evidence cannot complain on appeal that the evidence was erroneously admitted).

The Government further argues that Plaintiffs’ allocation fails to account for the PPAs, which it maintains are intangible, ineligible property. The Government argues that PPAs must be classified as “customer-based intangibles” within the meaning of 26 U.S.C. Sec. 197(d)(2)(A)(iii). However, the Court finds Plaintiffs’ treatment of the PPAs more persuasive. Plaintiffs’ approach treats the PPAs like land leases. A land lease is not considered a separate asset from the underlying land, even if the land lease terms are better than market. See Schubert v. Comm’r, 33 T.C. 1048, 1053 (1960), aff’d , 286 F.2d 573 (4th Cir. 1961). As with land leases-which relate only to the specific parcel of land leased-the PPAs each relate only to their specific wind farm facilities and are not transferable or assignable. Maydew, Tr. 1439; Pagano, Tr. 393-94; PX 326 at 19 ¶ 1c. Dr. Maydew found that these characteristics mean the PPAs may not be viewed as separate assets from their underlying facilities from a tax accounting perspective. Maydew, Tr. 1438; PX 326 at 18 ¶ 1. Therefore, the close nexus between the wind farm facilities and their respective PPAs means that the PPAs cannot be viewed as separate intangible assets.10

Many of the Government’s arguments essentially boil down to an attack on the logic behind any pro-rata allocation method Plaintiffs could possibly use in this case. However, because the Court finds that the purchase price is the best measure of the Alta facilities’ fair market value (and, therefore, basis), a pro-rata allocation method appears on the evidence to be the most reasonable solution to the problem Section 1603 presents. Under Section 1603, the value of certain property is ineligible as basis for a grant. In the real world, this grant-ineligible property is hopelessly intertwined with grant-eligible property. Having both types of property in one place makes a wind farm valuable as a wind farm generating cash flows, and not just as a disjointed collection of random assets. See PX 328 at 20 ¶ 40. Therefore, any pro-rata allocation method will necessarily involve extrapolation based on the construction and development costs of the grant-eligible property under Section 1603, and the Court finds Plaintiffs’ allocations to be reasonable.

II. Plaintiffs are Entitled to Damages

In sum, the Court finds that applying the Government’s preferred valuation approach, which would value the Alta facilities solely based on their construction and development costs, improperly excludes value from Plaintiffs’ basis in these facilities in a way that is not supported under Section 1603 or the IRC. If Congress had intended some other definition of “basis” to apply in situations like this, then it should have said so when it drafted the statute. In the absence of such guidance, the Court finds that Plaintiffs have calculated the basis of their wind farm assets in the least imperfect way possible.

The Court finds that the Government should have used Plaintiffs’ purchase prices, subject to reasonable allocations in the cases of Altas I and VI (and with de minimis deductions for land conveyed in fee simple), as basis in calculating Plaintiffs’ grants under Section 1603. Therefore, the Court awards Plaintiffs damages in amounts equal to the shortfall between the grant amounts to which Plaintiffs were entitled and the amounts the Government awarded. In total, the Court awards Plaintiffs damages of $206,833,364. The following table shows the damages each Plaintiff is awarded:

Plaintiff            Basis of                      Cash Grant to         Cash Grant          Damages

                           Eligible                  Which Plaintiff            Paid by              Awarded

                           Property                  was Entitled                Treasury

Alta I Owner       $130,300,750       $39,090,225       $29,974,983      $9,115,242

Lessor C

Alta I Owner       $130,300,750       $39,090,225       $29,974,983      $9,115,242

Lessor D

Alta II Owner      $110,043,250       $33,012,975       $22,791,621     $10,221,354

Lessor A

Alta II Owner      $110,043,250       $33,012,975       $22,791,621     $10,221,354

Lessor B

Alta II Owner       $88,034,600       $26,410,380       $18,233,297      $8,177,083

Lessor C

Alta II Owner       $66,025,950       $19,807,785       $13,674,973      $6,132,812

Lessor D

Alta II Owner       $66,025,950       $19,807,785       $13,674,973      $6,132,812

Lessor E

Alta III Owner     $110,993,750       $33,298,125       $23,093,966     $10,204,159

Lessor A

Alta III Owner     $110,993,750       $33,298,125       $23,093,966     $10,204,159

Lessor B

Alta III Owner     $110,993,750       $33,298,125       $23,093,966     $10,204,159

Lessor C

Alta III Owner     $110,993,750       $33,298,125       $23,093,966     $10,204,159

Lessor D

Alta IV Owner       $72,058,000       $21,617,400       $15,482,478      $6,134,922

Lessor A

Alta IV Owner       $72,058,000       $21,617,400       $15,482,478      $6,134,922

Lessor B

Alta IV Owner       $72,058,000       $21,617,400       $15,482,478      $6,134,922

Lessor C

Alta IV Owner       $72,058,000       $21,617,400       $15,482,478      $6,134,922

Lessor D

Alta V Owner       $121,860,750       $36,558,225       $25,649,674     $10,908,551

Lessor A

Alta V Owner       $121,860,750       $36,558,225       $25,649,674     $10,908,551

Lessor B

Alta V Owner       $121,860,750       $36,558,225       $25,649,674     $10,908,551

Lessor C

Alta V Owner       $121,860,750       $36,558,225       $25,649,674     $10,908,551

Lessor D

Mustang Hills      $418,774,000      $125,632,200       $86,905,263     $38,726,937

CONCLUSION

The Clerk is directed to enter final judgment against the Government in the amount of $206,833,364. Pursuant to RCFC 54(d), the Court awards reasonable costs to Plaintiffs.

IT IS SO ORDERED.

s/Thomas C. Wheeler

THOMAS C. WHEELER

Judge

Footnotes

1 The Court issued this decision under seal on October 24, 2016, and invited the parties to submit proposed redactions of any proprietary, confidential, or other protected information on or before October 31, 2016. Neither party proposed any redactions. Thus, the Court reissues the opinion in full. Additionally, the Court has corrected three typographical and citation-related errors.

2 These articles are: (1) Bubble, Bubble, How Much Trouble? Financial Markets, Capitalist Development and Capitalist Crises , 52 Sci. & Soc’y 260-89 (Fall 1988), PX 808; (2) Forms of GDR Economic Cooperation With the Nonsocialist World , 29 Ass’n of Comp. Econ. Stud. 7-37 (Summer 1987), PX 813; (3) Plan and Market in the Marxist Imagination: Changing of the Guard Among GDR Economists , 17 German Pol. and Soc’y 39-49 (Summer 1989 Special Issue on “The GDR at Forty”), PX 812; (4) Which Road to Oz? New Thinking in East Germany About the World Economy and the Course of Socialism ,) Working Paper No. 2045-88, Leopold Classic Library (Jan. 1989), PX 818; and (5) Credit Contracts in the GDR: Decentralized Investment Decisions in a Planned Economy , 20 Econ. of Planning 28-51 (1986), PX 817.

3 There is ample precedent for the trial court to exclude the testimony of an expert witness deemed not credible. See, e.g. , Contreras , 121 Fed. Cl. 230, 240-41 (2015) (finding expert witness who perjured himself as to his qualifications should have been excluded); In re Unisys Savings Plan Litig. , 173 F.3d 145, 156-57 (3d Cir. 1999) (excluding expert who provided testimony on voir dire inconsistent with his deposition testimony as unreliable).

4 These six wind farms will be referred to herein as “Alta I” through “Alta VI.” As noted below, Alta VI was renamed “Mustang Hills.”

5 References to “Stip. ¶ __” are to the parties’ April 15, 2016 joint Stipulation of Facts (Dkt. No. 115).

6 Ms. Neubauer, the Section 1603 Program Director, agreed that concepts such as “cost basis” “come from the Internal Revenue Code.” Neubauer, Tr. 1771-72, 1777-78.

7 Assets also constitute a trade or business if “[t]he use of such assets would constitute an active trade or business under section 355” of the IRC. Id. Sec. 1.1060-1(b)(2)(i)(A). The Government does not make any substantive argument that Altas I-VI constitute an active trade or business under Section 355.

8 Although the Government elicited testimony in which certain witnesses acknowledged that it was possible to manipulate the leaseback and sale prices, no witness testified that Plaintiffs and Terra-Gen had actually used these techniques to inflate the purchase prices.

9 Plaintiffs used the same allocation approach when they purchased Altas II-V from Terra-Gen. See Revock, Tr. 729. The difference between these transactions is that Plaintiffs purchased only the eligible property from Terra-Gen in the Alta II-V transactions. Because the Court finds Plaintiffs’ allocations to be reasonable, the Court also agrees that only eligible property was transferred in the Alta II-V purchases.

10 The Government also argues that transmission agreements associated with the Alta facilities are intangible and thus ineligible. See Def. Post-Trial Br. at 64-65, Dkt. No. 163. However, Plaintiffs treated these agreements as part of the (ineligible) transmission lines for allocation purposes. See Huplosky, Tr. 1073-75. Therefore, the point appears to be moot.

 

Relief from missing IRA rollover deadline

irarolloverHere is a relief from missing the IRA rollover deadline. Believe me it is a big relief. Many times clients walk in with the situation when they have requested the distribution from IRA account, before calling me, and hope to roll that over into another retirement vehicle. And they did not for any number of reasons. What a painful situation for me as well as for the clients. This new procedure that IRS just released provides a relief and I mean a Big Relief. It is effective 08/24/16. The IRS has provided a self-certification procedure that allows taxpayers to claim eligibility for a waiver of the 60-day rollover requirement under Code Sections 402(c)(3) and 408(d)(3). A plan administrator or an IRA trustee can rely on such certification in accepting and reporting receipt of a rollover contribution. The new procedure is effective as of August 24, 2016. Rev. Proc. 2016-47.

Background

Code Secs. 402(c)(3) and 408(d)(3) allow a taxpayer to roll over, tax free, a distribution from a qualified plan or IRA into an eligible retirement plan. Generally, the individual must make the rollover contribution by the 60th day after the day the individual receives the distribution. Similar rules apply to Code Sec. 403(a) annuity plans, Code Sec. 403(b) tax sheltered annuities, and Code Sec. 457 eligible governmental plans.

The IRS may waive the 60-day requirement where the failure to do so would be against equity or good conscience, such as in the event of a casualty, disaster, or other event beyond the individual’s reasonable control. Rev. Proc. 2003-16 provides for automatic approval for a waiver of the 60-day rollover requirement in certain circumstances in which a rollover is not made timely due to an error on the part of a financial institution. Taxpayers who do not qualify for an automatic waiver can apply for a waiver by submitting a request for a private letter ruling under the procedures outlined in Rev. Proc. 2016-4. If a taxpayer requests a waiver and the IRS grants it, the taxpayer typically has 60 days from the issuance of the letter ruling to complete the rollover.

Without a waiver, amounts not rolled over within the 60-day period do not qualify for tax-free rollover treatment and the taxpayer must treat them as a taxable distribution from the plan or IRA.

New Self-Certification Procedure

In Rev. Proc. 2016-47, the IRS has introduced a procedure for taxpayers to make a written certification to a plan administrator or an IRA trustee receiving a contribution that the contribution is eligible for a waiver of the 60-day rollover requirement. Taxpayers can make this certification by using the model letter in the appendix to the revenue procedure on a word-for-word basis or by using a letter that is substantially similar in all material respects.

Practice Tip: Taxpayers are not required to submit a copy of the certification to the IRS following the rollover or with their returns, but are advised to retain a copy to be made available to the IRS if requested on audit.

Rev. Proc. 2016-47 states that self-certification is not a waiver by the IRS of the 60-day rollover requirement, but provides that a taxpayer may report the contribution as a valid rollover. The IRS, in the course of an examination, can still consider whether a taxpayer’s contribution meets the requirements for a waiver. For example, the IRS might determine that the requirements for a waiver were not met because of a material misstatement in the self-certification, or that the reason the taxpayer claimed for missing the 60-day deadline did not actually prevent him or her from timely completing the rollover.

For purposes of accepting and reporting a rollover contribution into a plan or IRA, a plan administrator or IRA trustee can rely on a taxpayer’s self-certification in determining whether the taxpayer has satisfied the conditions for a waiver of the 60-day rollover requirement.

Caution: The IRS stated that it intends to modify the instructions to Form 5498, IRA Contribution Information, to require an IRA trustee that accepts a rollover contribution after the 60-day deadline to report that the contribution was accepted after the 60-day deadline. Because the IRS can challenge a taxpayer’s treatment of the self-certified rollover during an audit, requesting an IRS waiver of the rollover through a PLR may still make sense, depending on the taxpayer’s situation.

Conditions for Making a Self-Certification
In order to make a self-certification, Rev. Proc. 2016-47 requires the taxpayer to have missed the 60-day deadline because of his or her inability to complete a rollover due to one or more of the following reasons:

(1) An error was committed by the financial institution receiving the contribution or making the distribution to which the contribution relates;

(2) The distribution, having been made in the form of a check, was misplaced and never cashed;

(3) The distribution was deposited into and remained in an account that the taxpayer mistakenly thought was an eligible retirement plan;

(4) The taxpayer’s principal residence was severely damaged;

(5) A member of the taxpayer’s family died;

(6) The taxpayer or a member of the taxpayer’s family was seriously ill;

(7) The taxpayer was incarcerated;

(8) Restrictions were imposed by a foreign country;

(9) A postal error occurred;

(10) The distribution was made on account of a levy under Code Sec. 6331 and the proceeds of the levy have been returned to the taxpayer; or

(11) The party making the distribution to which the rollover relates delayed providing information that the receiving plan or IRA required to complete the rollover despite the taxpayer’s reasonable efforts to obtain the information.

Rev. Proc. 2016-47 also requires that the contribution be made to the plan or IRA as soon as possible once the reason or reasons described above no longer prevent the taxpayer from making the contribution. This requirement is satisfied if the contribution is made within 30 days after the taxpayer is able to do so. In addition, the IRS must not have previously denied a taxpayer’s waiver request with respect to a rollover of all or part of the distribution to which the contribution relates.

Effective Date
Rev. Proc. 2016-47 is effective on August 24, 2016.

 

UPIA

UNIFORM PRINCIPAL AND INCOME ACT
(Last Amended or Revised in 2008)

Drafted by the

NATIONAL CONFERENCE OF COMMISSIONERS ON UNIFORM STATE LAWS

and by it

APPROVED AND RECOMMENDED FOR ENACTMENT IN ALL THE STATES

at its

ANNUAL CONFERENCE
MEETING IN ITS ONE-HUNDRED-AND-SIXTH YEAR IN SACRAMENTO, CALIFORNIA
JULY 25 B AUGUST 1, 1997

WITH PREFATORY NOTE AND COMMENTS

COPYRIGHT 8 2003
By
NATIONAL CONFERENCE OF COMMISSIONERS ON UNIFORM STATE LAWS

February 9, 2009

DRAFTING COMMITTEE ON UNIFORM PRINCIPAL AND INCOME ACT
The Committee that acted for the National Conference of Commissioners on Uniform State
Laws in preparing the Uniform Principal and Income Act was as follows:

MATTHEW S. RAE, JR., 37th Floor, 777 S. Figueroa Street, Los Angeles, CA 90017, Chair
FRANK W. DAYKIN, 4745 Giles Way, Carson City, NV 89704
JOANNE B. HUELSMAN, Room 510, 119 Martin Luther King, Madison, WI 53703
L. S. JERRY KURTZ, JR., 1050 Beech Lane, Anchorage, AK 99501
EDWARD F. LOWRY, JR., Suite 1120, 2901 N. Central Avenue, Phoenix, AZ 85012
ROBERT A. STEIN, American Bar Association, 750 N. Lake Shore Drive, Chicago, IL 60611
HARRY M. WALSH, Office of Revisor of Statutes, 700 State Office Building, St. Paul, MN 55155
JOEL C. DOBRIS, University of California at Davis, School of Law, King Hall, Davis, CA 95616, Co-Reporter
E. JAMES GAMBLE, Suite 1300, 525 N. Woodward Avenue, Bloomfield Hills, MI 48304,
Co-Reporter

EX OFFICIO
BION M. GREGORY, Office of Legislative Counsel, State Capitol, Suite 3021, Sacramento, CA 95814-4996, President
JOHN H. LANGBEIN, Yale Law School, P.O. Box 208215, New Haven, CT 06520,
Chair, Division D

EXECUTIVE DIRECTOR
FRED H. MILLER, University of Oklahoma, College of Law, 300 Timberdell Road, Norman, OK 73019, Executive Director
WILLIAM J. PIERCE, 1505 Roxbury Road, Ann Arbor, MI 48104, Executive Director Emeritus

DRAFTING COMMITTEE ON 2008 AMENDMENTS TO UNIFORM PRINCIPAL AND INCOME ACT
The Committee appointed by and representing the National Conference of
Commissioners on Uniform State Laws in drafting these amendments consists of the following individuals:

SUZANNE BROWN WALSH, P.O. Box 271820, West Hartford, CT 06127, Chair
TURNEY P. BERRY, 2700 PNC Plaza, Louisville, KY 40202
DAVID M. ENGLISH, University of Missouri-Columbia School of Law, Missouri Ave. & Conley Ave., Columbia, MO 65211
STANLEY C. KENT, 90 S. Cascade Ave., Suite 1210, Colorado Springs, CO 80903
MATTHEW S. RAE, JR., 600 John St., Manhattan Beach, CA 90266

EX OFFICIO

MARTHA LEE WALTERS, Oregon Supreme Court, 1163 State St., Salem, OR 97301-2563,
President

AMERICAN BAR ASSOCIATION ADVISOR

STEVEN B. GORIN, 20 Saint Alfred Rd., St. Louis, MO 63132-4130, ABA Advisor

EXECUTIVE DIRECTOR

JOHN A. SEBERT, 111 N. Wabash Ave., Suite 1010, Chicago, IL 60602, Executive Director

Copies of this Act may be obtained from: NATIONAL CONFERENCE OF COMMISSIONERS
ON UNIFORM STATE LAWS
111 N. Wabash Ave., Suite 1010
Chicago, Illinois 60602 (312) 450-6600 www.nccusl.org

TABLE OF CONTENTS

PREFATORY NOTE ……………………………………………………………………………………………………….. 1

[ARTICLE] 1
DEFINITIONS AND FIDUCIARY DUTIES
SECTION 101. SHORT TITLE ………………………………………………………………………………………. ….5
SECTION 102. DEFINITIONS ……………………………………………………………………………………….. ..5
SECTION 103. FIDUCIARY DUTIES; GENERAL PRINCIPLES…………………………………………… 7
SECTION 104. TRUSTEE’S POWER TO ADJUST ……………………………………………………………… 9
SECTION 105. JUDICIAL CONTROL OF DISCRETIONARY POWER………………………………… 18

[ARTICLE] 2
DECEDENT’S ESTATE OR TERMINATING INCOME INTEREST
SECTION 201. DETERMINATION AND DISTRIBUTION OF NET INCOME …………………….. 24
SECTION 202. DISTRIBUTION TO RESIDUARY AND REMAINDER
BENEFICIARIES …………………………………………………………………………………………………………. 28

[ARTICLE] 3
APPORTIONMENT AT BEGINNING AND END OF INCOME INTEREST
SECTION 301. WHEN RIGHT TO INCOME BEGINS AND ENDS …………………………………….. 30
SECTION 302. APPORTIONMENT OF RECEIPTS AND

DISBURSEMENTS WHEN DECEDENT DIES OR INCOME INTEREST BEGINS ………………. 31
SECTION 303. APPORTIONMENT WHEN INCOME INTEREST ENDS …………………………… 32

[ARTICLE] 4
ALLOCATION OF RECEIPTS DURING ADMINISTRATION OF TRUST

[PART 1
RECEIPTS FROM ENTITIES] SECTION 401. CHARACTER OF RECEIPTS …………………………………………………………………… 35
SECTION 402. DISTRIBUTION FROM TRUST OR ESTATE ……………………………………………. 37
SECTION 403. BUSINESS AND OTHER ACTIVITIES CONDUCTED BY TRUSTEE ………….. 38

[PART 2
RECEIPTS NOT NORMALLY APPORTIONED] SECTION 404. PRINCIPAL RECEIPTS……………………………………………………………………………. 40
SECTION 405. RENTAL PROPERTY……………………………………………………………………………….. 41
SECTION 406. OBLIGATION TO PAY MONEY ……………………………………………………………….. 41
SECTION 407. INSURANCE POLICIES AND SIMILAR CONTRACTS ………………………………. 43

[PART 3
RECEIPTS NORMALLY APPORTIONED] SECTION 408. INSUBSTANTIAL ALLOCATIONS NOT REQUIRED …………………………………. 43
SECTION 409. DEFERRED COMPENSATION, ANNUITIES, AND SIMILAR
PAYMENTS ………………………………………………………………………………………………………………….. 44
SECTION 410. LIQUIDATING ASSET ……………………………………………………………………………. 50
SECTION 411. MINERALS, WATER, AND OTHER NATURAL RESOURCES …………………….. 51
SECTION 412. TIMBER………………………………………………………………………………………………….. 53
SECTION 413. PROPERTY NOT PRODUCTIVE OF INCOME …………………………………………… 54
SECTION 414. DERIVATIVES AND OPTIONS…………………………………………………………………. 56
SECTION 415. ASSET-BACKED SECURITIES ………………………………………………………………… 58

[ARTICLE] 5
ALLOCATION OF DISBURSEMENTS DURING ADMINISTRATION OF TRUST
SECTION 501. DISBURSEMENTS FROM INCOME………………………………………………………… 60
SECTION 502. DISBURSEMENTS FROM PRINCIPAL …………………………………………………….. 61
SECTION 503. TRANSFERS FROM INCOME TO PRINCIPAL FOR DEPRECIATION ……….. 63
SECTION 504. TRANSFERS FROM INCOME TO REIMBURSE PRINCIPAL …………………….. 64
SECTION 505. INCOME TAXES …………………………………………………………………………………… 65
SECTION 506. ADJUSTMENTS BETWEEN PRINCIPAL AND INCOME BECAUSE
OF TAXES……………………………………………………………………………………………………………………. 68

[ARTICLE] 6
MISCELLANEOUS PROVISIONS
SECTION 601. UNIFORMITY OF APPLICATION AND CONSTRUCTION …………………………. 71
SECTION 602. SEVERABILITY CLAUSE…………………………………………………………………………. 71
SECTION 603. REPEAL…………………………………………………………………………………………………. 71
SECTION 604. EFFECTIVE DATE ………………………………………………………………………………….. 71
SECTION 605. APPLICATION OF [ACT] TO EXISTING TRUSTS AND ESTATES ……………… 71
SECTION 606. TRANSITIONAL MATTERS…………………………………………………………………….. 71

PREFATORY NOTE

This revision of the 1931 Uniform Principal and Income Act and the 1962 Revised
Uniform Principal and Income Act has two purposes.

One purpose is to revise the 1931 and the 1962 Acts. Revision is needed to support the now widespread use of the revocable living trust as a will substitute, to change the rules in those Acts that experience has shown need to be changed, and to establish new rules to cover situations not provided for in the old Acts, including rules that apply to financial instruments invented since 1962.

The other purpose is to provide a means for implementing the transition to an investment regime based on principles embodied in the Uniform Prudent Investor Act, especially the principle of investing for total return rather than a certain level of “income” as traditionally perceived in terms of interest, dividends, and rents.

Revision of the 1931 and 1962 Acts

The prior Acts and this revision of those Acts deal with four questions affecting the rights of beneficiaries:

(1) How is income earned during the probate of an estate to be distributed to trusts and to persons who receive outright bequests of specific property, pecuniary gifts, and the residue?

(2) When an income interest in a trust begins (i.e., when a person who creates the trust dies or when she transfers property to a trust during life), what property is principal that will eventually go to the remainder beneficiaries and what is income?

(3) When an income interest ends, who gets the income that has been received but not distributed, or that is due but not yet collected, or that has accrued but is not yet due?

(4) After an income interest begins and before it ends, how should its receipts and disbursements be allocated to or between principal and income?

Changes in the traditional sections are of three types: new rules that deal with situations not covered by the prior Acts, clarification of provisions in the 1962 Act, and changes to rules in the prior Acts.

New rules. Issues addressed by some of the more significant new rules include:

(1) The application of the probate administration rules to revocable living trusts after the settlor’s death and to other terminating trusts. Articles 2 and 3.

(2) The payment of interest or some other amount on the delayed payment of an outright pecuniary gift that is made pursuant to a trust agreement instead of a will when the agreement or state law does not provide for such a payment. Section 201(3).

(3) The allocation of net income from partnership interests acquired by the trustee other than from a decedent (the old Acts deal only with partnership interests acquired from a decedent). Section 401.

(4) An “unincorporated entity” concept has been introduced to deal with businesses operated by a trustee, including farming and livestock operations, and investment activities in rental real estate, natural resources, timber, and derivatives. Section 403.

(5) The allocation of receipts from discount obligations such as zero-coupon bonds. Section 406(b).

(6) The allocation of net income from harvesting and selling timber between principal and income. Section 412.

(7) The allocation between principal and income of receipts from derivatives, options, and asset-backed securities. Sections 414 and 415.

(8) Disbursements made because of environmental laws. Section 502(a)(7).

(9) Income tax obligations resulting from the ownership of S corporation stock and interests in partnerships. Section 505.

(10) The power to make adjustments between principal and income to correct inequities caused by tax elections or peculiarities in the way the fiduciary income tax rules apply. Section
506.

Clarifications and changes in existing rules. A number of matters provided for in the prior Acts have been changed or clarified in this revision, including the following:

(1) An income beneficiary’s estate will be entitled to receive only net income actually received by a trust before the beneficiary’s death and not items of accrued income. Section 303.

(2) Income from a partnership is based on actual distributions from the partnership, in the same manner as corporate distributions. Section 401.

(3) Distributions from corporations and partnerships that exceed 20% of the entity’s gross assets will be principal whether or not intended by the entity to be a partial liquidation. Section 401(d)(2).
409.

(4) Deferred compensation is dealt with in greater detail in a separate section. Section

(5) The 1962 Act rule for “property subject to depletion,” (patents, copyrights, royalties, and the like), which provides that a trustee may allocate up to 5% of the asset’s inventory value to income and the balance to principal, has been replaced by a rule that allocates 90% of the amounts received to principal and the balance to income. Section 410.

(6) The percentage used to allocate amounts received from oil and gas has been changed B 90% of those receipts are allocated to principal and the balance to income. Section
411.

(7) The unproductive property rule has been eliminated for trusts other than marital deduction trusts. Section 413.

(8) Charging depreciation against income is no longer mandatory, and is left to the discretion of the trustee. Section 503.

Coordination with the Uniform Prudent Investor Act

The law of trust investment has been modernized. See Uniform Prudent Investor Act (1994); Restatement (Third) of Trusts: Prudent Investor Rule (1992) (hereinafter Restatement of Trusts 3d: Prudent Investor Rule). Now it is time to update the principal and income allocation rules so the two bodies of doctrine can work well together. This revision deals conservatively with the tension between modern investment theory and traditional income allocation. The starting point is to use the traditional system. If prudent investing of all the assets in a trust viewed as a portfolio and traditional allocation effectuate the intent of the settlor, then nothing need be done. The Act, however, helps the trustee who has made a prudent, modern portfolio- based investment decision that has the initial effect of skewing return from all the assets under management, viewed as a portfolio, as between income and principal beneficiaries. The Act gives that trustee a power to reallocate the portfolio return suitably. To leave a trustee constrained by the traditional system would inhibit the trustee’s ability to fully implement modern portfolio theory.

As to modern investing see, e.g., the Preface to, terms of, and Comments to the Uniform Prudent Investor Act (1994); the discussion and reporter’s note by Edward C. Halbach, Jr. in Restatement of Trusts 3d: Prudent Investor Rule; John H. Langbein, The Uniform Prudent Investor Act and the Future of Trust Investing, 81 Iowa L. Rev. 641 (1996); Bevis Longstreth, Modern Investment Management and the Prudent Man Rule (1986); John H. Langbein &
Richard A. Posner, The Revolution in Trust Investment Law, 62 A.B.A.J. 887 (1976); and Jeffrey N. Gordon, The Puzzling Persistence of the Constrained Prudent Man Rule, 62 N.Y.U. L. Rev. 52 (1987). See also R.A. Brearly, An Introduction to Risk and Return from Common Stocks (2d ed.
1983); Jonathan R. Macey, An Introduction to Modern Financial Theory (2d ed. 1998). As to the need for principal and income reform see, e.g., Joel C. Dobris, Real Return, Modern Portfolio Theory and College, University and Foundation Decisions on Annual Spending From Endowments: A Visit to the World of Spending Rules, 28 Real Prop., Prob., & Tr. J. 49 (1993); Joel C. Dobris, The Probate World at the End of the Century: Is a New Principal and Income Act in Your Future?, 28 Real Prop., Prob., & Tr. J. 393 (1993); and Kenneth L. Hirsch, Inflation and

the Law of Trusts, 18 Real Prop., Prob., & Tr. J. 601 (1983). See also, Jerold I. Horn, The Prudent Investor Rule B Impact on Drafting and Administration of Trusts, 20 ACTEC Notes 26 (Summer 1994).

UNIFORM PRINCIPAL AND INCOME ACT
[ARTICLE] 1

DEFINITIONS AND FIDUCIARY DUTIES

SECTION 101. SHORT TITLE. This [Act] may be cited as the Uniform Principal and

Income Act.

SECTION 102. DEFINITIONS. In this [Act]:

(1) “Accounting period” means a calendar year unless another 12-month period is selected by a fiduciary. The term includes a portion of a calendar year or other 12-month period that begins when an income interest begins or ends when an income interest ends.
(2) “Beneficiary” includes, in the case of a decedent’s estate, an heir [, legatee,] and devisee and, in the case of a trust, an income beneficiary and a remainder beneficiary.
(3) “Fiduciary” means a personal representative or a trustee. The term includes an executor, administrator, successor personal representative, special administrator, and a person performing substantially the same function.
(4) “Income” means money or property that a fiduciary receives as current return from a principal asset. The term includes a portion of receipts from a sale, exchange, or liquidation of a principal asset, to the extent provided in [Article] 4.
(5) “Income beneficiary” means a person to whom net income of a trust is or may be payable.
(6) “Income interest” means the right of an income beneficiary to receive all or part of net income, whether the terms of the trust require it to be distributed or authorize it to be distributed in the trustee’s discretion.

(7) “Mandatory income interest” means the right of an income beneficiary to receive net income that the terms of the trust require the fiduciary to distribute.
(8) “Net income” means the total receipts allocated to income during an accounting period minus the disbursements made from income during the period, plus or minus transfers under this [Act] to or from income during the period.
(9) “Person” means an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint venture, government; governmental subdivision, agency, or instrumentality; public corporation, or any other legal or commercial entity.
(10) “Principal” means property held in trust for distribution to a remainder beneficiary when the trust terminates.
(11) “Remainder beneficiary” means a person entitled to receive principal when an income interest ends.
(12) “Terms of a trust” means the manifestation of the intent of a settlor or decedent with respect to the trust, expressed in a manner that admits of its proof in a judicial proceeding, whether by written or spoken words or by conduct.
(13) “Trustee” includes an original, additional, or successor trustee, whether or not appointed or confirmed by a court.
Comment

“Income beneficiary.” The definitions of income beneficiary (Section 102(5)) and income interest (Section 102(6)) cover both mandatory and discretionary beneficiaries and interests. There are no definitions for “discretionary income beneficiary” or “discretionary income interest” because those terms are not used in the Act.

Inventory value. There is no definition for inventory value in this Act because the provisions in which that term was used in the 1962 Act have either been eliminated (in the case of the underproductive property provision) or changed in a way that eliminates the need for the term (in the case of bonds and other money obligations, property subject to depletion, and the method for determining entitlement to income distributed from a probate estate).

“Net income.” The reference to “transfers under this Act to or from income” means transfers made under Sections 104(a), 412(b), 502(b), 503(b), 504(a), and 506.

“Terms of a trust.” This term was chosen in preference to “terms of the trust
instrument” (the phrase used in the 1962 Act) to make it clear that the Act applies to oral trusts as well as those whose terms are expressed in written documents. The definition is based on the Restatement (Second) of Trusts ‘ 4 (1959) and the Restatement (Third) of Trusts ‘ 4 (Tent. Draft No. 1, 1996). Constructional preferences or rules would also apply, if necessary, to determine
the terms of the trust.

SECTION 103. FIDUCIARY DUTIES; GENERAL PRINCIPLES.

(a) In allocating receipts and disbursements to or between principal and income, and with respect to any matter within the scope of [Articles] 2 and 3, a fiduciary:
(1) shall administer a trust or estate in accordance with the terms of the trust or the will, even if there is a different provision in this [Act];
(2) may administer a trust or estate by the exercise of a discretionary power of administration given to the fiduciary by the terms of the trust or the will, even if the exercise of the power produces a result different from a result required or permitted by this [Act];
(3) shall administer a trust or estate in accordance with this [Act] if the terms of the trust or the will do not contain a different provision or do not give the fiduciary a discretionary power of administration; and
(4) shall add a receipt or charge a disbursement to principal to the extent that the terms of the trust and this [Act] do not provide a rule for allocating the receipt or disbursement to or between principal and income.
(b) In exercising the power to adjust under Section 104(a) or a discretionary power of administration regarding a matter within the scope of this [Act], whether granted by the terms of a trust, a will, or this [Act], a fiduciary shall administer a trust or estate impartially, based on

what is fair and reasonable to all of the beneficiaries, except to the extent that the terms of the trust or the will clearly manifest an intention that the fiduciary shall or may favor one or more of the beneficiaries. A determination in accordance with this [Act] is presumed to be fair and reasonable to all of the beneficiaries.
Comment

Prior Act. The rule in Section 2(a) of the 1962 Act is restated in Section 103(a), without changing its substance, to emphasize that the Act contains only default rules and that provisions in the terms of the trust are paramount. However, Section 2(a) of the 1962 Act applies only to the allocation of receipts and disbursements to or between principal and income. In this Act, the
first sentence of Section 103(a) states that it also applies to matters within the scope of Articles 2 and 3. Section 103(a)(2) incorporates the rule in Section 2(b) of the 1962 Act that a
discretionary allocation made by the trustee that is contrary to a rule in the Act should not give rise to an inference of imprudence or partiality by the trustee.

The Act deletes the language that appears at the end of 1962 Act Section 2(a)(3) B “and in view of the manner in which men of ordinary prudence, discretion and judgment would act in the management of their affairs” – because persons of ordinary prudence, discretion and judgment, acting in the management of their own affairs do not normally think in terms of the interests of successive beneficiaries. If there is an analogy to an individual’s decision-making process, it is probably the individual’s decision to spend or to save, but this is not a useful guideline for trust administration. No case has been found in which a court has relied on the “prudent man” rule of the 1962 Act.

Fiduciary discretion. The general rule is that if a discretionary power is conferred upon a trustee, the exercise of that power is not subject to control by a court except to prevent an
abuse of discretion. Restatement (Second) of Trusts ‘ 187. The situations in which a court will control the exercise of a trustee’s discretion are discussed in the comments to ‘ 187. See also id.
‘ 233 Comment p.

Questions for which there is no provision. Section 103(a)(4) allocates receipts and disbursements to principal when there is no provision for a different allocation in the terms of the trust, the will, or the Act. This may occur because money is received from a financial instrument not available at the present time (inflation-indexed bonds might have fallen into this category
had they been announced after this Act was approved by the Commissioners on Uniform State Laws) or because a transaction is of a type or occurs in a manner not anticipated by the Drafting Committee for this Act or the drafter of the trust instrument.

Allocating to principal a disbursement for which there is no provision in the Act or the terms of the trust preserves the income beneficiary’s level of income in the year it is allocated to principal, but thereafter will reduce the amount of income produced by the principal. Allocating to principal a receipt for which there is no provision will increase the income received by the

income beneficiary in subsequent years, and will eventually, upon termination of the trust, also favor the remainder beneficiary. Allocating these items to principal implements the rule that requires a trustee to administer the trust impartially, based on what is fair and reasonable to both income and remainder beneficiaries. However, if the trustee decides that an adjustment between principal and income is needed to enable the trustee to comply with Section 103(b), after considering the return from the portfolio as a whole, the trustee may make an appropriate adjustment under Section 104(a).

Duty of impartiality. Whenever there are two or more beneficiaries, a trustee is under a duty to deal impartially with them. Restatement of Trusts 3d: Prudent Investor Rule ‘ 183 (1992). This rule applies whether the beneficiaries’ interests in the trust are concurrent or successive. If the terms of the trust give the trustee discretion to favor one beneficiary over another, a court will not control the exercise of such discretion except to prevent the trustee from abusing it. Id. ‘ 183, Comment a. “The precise meaning of the trustee’s duty of impartiality and the balancing of competing interests and objectives inevitably are matters of judgment and interpretation. Thus, the duty and balancing are affected by the purposes, terms, distribution requirements, and other circumstances of the trust, not only at the outset but as they may change from time to time.” Id. ‘ 232, Comment c.

The terms of a trust may provide that the trustee, or an accountant engaged by the trustee, or a committee of persons who may be family members or business associates, shall have the power to determine what is income and what is principal. If the terms of a trust provide that this Act specifically or principal and income legislation in general does not apply to the trust but fail to provide a rule to deal with a matter provided for in this Act, the trustee has an implied grant of discretion to decide the question. Section 103(b) provides that the rule of impartiality applies in the exercise of such a discretionary power to the extent that the terms of the trust do not provide that one or more of the beneficiaries are to be favored. The fact that a person is named an
income beneficiary or a remainder beneficiary is not by itself an indication of partiality for that beneficiary.

SECTION 104. TRUSTEE’S POWER TO ADJUST.

(a) A trustee may adjust between principal and income to the extent the trustee considers necessary if the trustee invests and manages trust assets as a prudent investor, the terms of the trust describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income, and the trustee determines, after applying the rules in Section 103(a), that the trustee is unable to comply with Section 103(b).
(b) In deciding whether and to what extent to exercise the power conferred by subsection

(a), a trustee shall consider all factors relevant to the trust and its beneficiaries, including the

following factors to the extent they are relevant:

(1) the nature, purpose, and expected duration of the trust; (2) the intent of the settlor;
(3) the identity and circumstances of the beneficiaries;

(4) the needs for liquidity, regularity of income, and preservation and appreciation of capital;
(5) the assets held in the trust; the extent to which they consist of financial assets, interests in closely held enterprises, tangible and intangible personal property, or real property; the extent to which an asset is used by a beneficiary; and whether an asset was purchased by the trustee or received from the settlor;
(6) the net amount allocated to income under the other sections of this [Act] and the increase or decrease in the value of the principal assets, which the trustee may estimate as to assets for which market values are not readily available;
(7) whether and to what extent the terms of the trust give the trustee the power to invade principal or accumulate income or prohibit the trustee from invading principal or accumulating income, and the extent to which the trustee has exercised a power from time to time to invade principal or accumulate income;
(8) the actual and anticipated effect of economic conditions on principal and income and effects of inflation and deflation; and
(9) the anticipated tax consequences of an adjustment. (c) A trustee may not make an adjustment:
(1) that diminishes the income interest in a trust that requires all of the income to be paid at least annually to a spouse and for which an estate tax or gift tax marital deduction

would be allowed, in whole or in part, if the trustee did not have the power to make the adjustment;
(2) that reduces the actuarial value of the income interest in a trust to which a person transfers property with the intent to qualify for a gift tax exclusion;
(3) that changes the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust assets;
(4) from any amount that is permanently set aside for charitable purposes under a will or the terms of a trust unless both income and principal are so set aside;
(5) if possessing or exercising the power to make an adjustment causes an individual to be treated as the owner of all or part of the trust for income tax purposes, and the individual would not be treated as the owner if the trustee did not possess the power to make an adjustment;
(6) if possessing or exercising the power to make an adjustment causes all or part of the trust assets to be included for estate tax purposes in the estate of an individual who has the power to remove a trustee or appoint a trustee, or both, and the assets would not be included in the estate of the individual if the trustee did not possess the power to make an adjustment;
(7) if the trustee is a beneficiary of the trust; or

(8) if the trustee is not a beneficiary, but the adjustment would benefit the trustee directly or indirectly.
(d) If subsection (c)(5), (6), (7), or (8) applies to a trustee and there is more than one trustee, a cotrustee to whom the provision does not apply may make the adjustment unless the exercise of the power by the remaining trustee or trustees is not permitted by the terms of the trust.

(e) A trustee may release the entire power conferred by subsection (a) or may release only the power to adjust from income to principal or the power to adjust from principal to income if the trustee is uncertain about whether possessing or exercising the power will cause a result described in subsection (c)(1) through (6) or (c)(8) or if the trustee determines that possessing or exercising the power will or may deprive the trust of a tax benefit or impose a tax burden not described in subsection (c). The release may be permanent or for a specified period, including a period measured by the life of an individual.
(f) Terms of a trust that limit the power of a trustee to make an adjustment between principal and income do not affect the application of this section unless it is clear from the terms of the trust that the terms are intended to deny the trustee the power of adjustment conferred by subsection (a).
Comment

Purpose and Scope of Provision. The purpose of Section 104 is to enable a trustee to select investments using the standards of a prudent investor without having to realize a particular portion of the portfolio’s total return in the form of traditional trust accounting income such as interest, dividends, and rents. Section 104(a) authorizes a trustee to make adjustments between principal and income if three conditions are met: (1) the trustee must be managing the trust assets under the prudent investor rule; (2) the terms of the trust must express the income beneficiary’s distribution rights in terms of the right to receive “income” in the sense of traditional trust accounting income; and (3) the trustee must determine, after applying the rules in Section 103(a), that he is unable to comply with Section 103(b). In deciding whether and to what extent to exercise the power to adjust, the trustee is required to consider the factors described in Section
104(b), but the trustee may not make an adjustment in circumstances described in Section
104(c).

Section 104 does not empower a trustee to increase or decrease the degree of beneficial enjoyment to which a beneficiary is entitled under the terms of the trust; rather, it authorizes the trustee to make adjustments between principal and income that may be necessary if the income component of a portfolio’s total return is too small or too large because of investment decisions made by the trustee under the prudent investor rule. The paramount consideration in applying Section 104(a) is the requirement in Section 103(b) that “a fiduciary must administer a trust or estate impartially, based on what is fair and reasonable to all of the beneficiaries, except to the extent that the terms of the trust or the will clearly manifest an intention that the fiduciary shall or may favor one or more of the beneficiaries.” The power to adjust is subject to control by the

court to prevent an abuse of discretion. Restatement (Second) of Trusts ‘ 187 (1959). See also id. ” 183, 232, 233, Comment p (1959).

Section 104 will be important for trusts that are irrevocable when a State adopts the prudent investor rule by statute or judicial approval of the rule in Restatement of Trusts 3d: Prudent Investor Rule. Wills and trust instruments executed after the rule is adopted can be drafted to describe a beneficiary’s distribution rights in terms that do not depend upon the amount of trust accounting income, but to the extent that drafters of trust documents continue to describe an income beneficiary’s distribution rights by referring to trust accounting income, Section 104 will be an important tool in trust administration.

Three conditions to the exercise of the power to adjust. The first of the three conditions that must be met before a trustee can exercise the power to adjust – that the trustee invest and manage trust assets as a prudent investor – is expressed in this Act by language derived from the Uniform Prudent Investor Act, but the condition will be met whether the prudent investor rule applies because the Uniform Act or other prudent investor legislation has been enacted, the prudent investor rule has been approved by the courts, or the terms of the trust require it. Even if a State’s legislature or courts have not formally adopted the rule, the Restatement establishes the prudent investor rule as an authoritative interpretation of the common law prudent man rule, referring to the prudent investor rule as a “modest reformulation of the Harvard College dictum and the basic rule of prior Restatements.” Restatement of Trusts
3d: Prudent Investor Rule, Introduction, at 5. As a result, there is a basis for concluding that the first condition is satisfied in virtually all States except those in which a trustee is permitted to invest only in assets set forth in a statutory “legal list.”

The second condition will be met when the terms of the trust require all of the “income” to be distributed at regular intervals; or when the terms of the trust require a trustee to distribute all of the income, but permit the trustee to decide how much to distribute to each member of a class of beneficiaries; or when the terms of a trust provide that the beneficiary shall receive the greater of the trust accounting income and a fixed dollar amount (an annuity), or of trust accounting income and a fractional share of the value of the trust assets (a unitrust amount). If the trust authorizes the trustee in its discretion to distribute the trust’s income to the beneficiary or to accumulate some or all of the income, the condition will be met because the terms of the trust do not permit the trustee to distribute more than the trust accounting income.

To meet the third condition, the trustee must first meet the requirements of Section
103(a), i.e., she must apply the terms of the trust, decide whether to exercise the discretionary powers given to the trustee under the terms of the trust, and must apply the provisions of the Act if the terms of the trust do not contain a different provision or give the trustee discretion.
Second, the trustee must determine the extent to which the terms of the trust clearly manifest an intention by the settlor that the trustee may or must favor one or more of the beneficiaries. To
the extent that the terms of the trust do not require partiality, the trustee must conclude that she is unable to comply with the duty to administer the trust impartially. To the extent that the terms of the trust do require or permit the trustee to favor the income beneficiary or the remainder beneficiary, the trustee must conclude that she is unable to achieve the degree of partiality required or permitted. If the trustee comes to either conclusion – that she is unable to administer

the trust impartially or that she is unable to achieve the degree of partiality required or permitted – she may exercise the power to adjust under Section 104(a).

Impartiality and productivity of income. The duty of impartiality between income and remainder beneficiaries is linked to the trustee’s duty to make the portfolio productive of trust accounting income whenever the distribution requirements are expressed in terms of distributing the trust’s “income.” The 1962 Act implies that the duty to produce income applies on an asset by asset basis because the right of an income beneficiary to receive “delayed income” from the sale proceeds of underproductive property under Section 12 of that Act arises if “any part of principal … has not produced an average net income of a least 1% per year of its inventory value
for more than a year … .” Under the prudent investor rule, “[t]o whatever extent a requirement of income productivity exists, … the requirement applies not investment by investment but to the portfolio as a whole.” Restatement of Trusts 3d: Prudent Investor Rule ‘ 227, Comment i, at 34. The power to adjust under Section 104(a) is also to be exercised by considering net income from the portfolio as a whole and not investment by investment. Section 413(b) of this Act eliminates the underproductive property rule in all cases other than trusts for which a marital deduction is allowed; the rule applies to a marital deduction trust if the trust’s assets “consist substantially of property that does not provide the spouse with sufficient income from or use of the trust assets
…” – in other words, the section applies by reference to the portfolio as a whole.

While the purpose of the power to adjust in Section 104(a) is to eliminate the need for a trustee who operates under the prudent investor rule to be concerned about the income component of the portfolio’s total return, the trustee must still determine the extent to which a distribution must be made to an income beneficiary and the adequacy of the portfolio’s liquidity as a whole to make that distribution.

For a discussion of investment considerations involving specific investments and techniques under the prudent investor rule, see Restatement of Trusts 3d: Prudent Investor Rule
‘ 227, Comments k-p.

Factors to consider in exercising the power to adjust. Section 104(b) requires a trustee to consider factors relevant to the trust and its beneficiaries in deciding whether and to what extent the power to adjust should be exercised. Section 2(c) of the Uniform Prudent Investor Act sets forth circumstances that a trustee is to consider in investing and managing trust assets. The circumstances in Section 2(c) of the Uniform Prudent Investor Act are the source of the factors in paragraphs (3) through (6) and (8) of Section 104(b) (modified where necessary to adapt them to the purposes of this Act) so that, to the extent possible, comparable factors will apply to investment decisions and decisions involving the power to adjust. If a trustee who is operating under the prudent investor rule decides that the portfolio should be composed of financial assets whose total return will result primarily from capital appreciation rather than dividends, interest, and rents, the trustee can decide at the same time the extent to which an adjustment from principal to income may be necessary under Section 104. On the other hand, if a trustee decides that the risk and return objectives for the trust are best achieved by a portfolio whose total return includes interest and dividend income that is sufficient to provide the income beneficiary with the beneficial interest to which the beneficiary is entitled under the terms of the trust, the trustee can decide that it is unnecessary to exercise the power to adjust.

Assets received from the settlor. Section 3 of the Uniform Prudent Investor Act provides that “[a] trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.” The special circumstances may include the wish to retain a family business, the benefit derived from deferring liquidation of the asset in order to defer payment of income taxes, or the anticipated capital appreciation from retaining an asset such as undeveloped real estate for a long period. To the extent the trustee retains assets received from the settlor because of special circumstances that overcome the duty to diversify, the trustee may take these circumstances into account in determining whether and to what extent the power to adjust should be exercised to change the results produced by other provisions of this Act that apply to the retained assets. See Section 104(b)(5); Uniform Prudent Investor Act ‘ 3, Comment, 7B U.L.A.
18, at 25-26 (Supp. 1997); Restatement of Trusts 3d: Prudent Investor Rule ‘ 229 and Comments
a-e.

Limitations on the power to adjust. The purpose of subsections (c)(1) through (4) is to preserve tax benefits that may have been an important purpose for creating the trust. Subsections (c)(5), (6), and (8) deny the power to adjust in the circumstances described in those subsections
in order to prevent adverse tax consequences, and subsection (c)(7) denies the power to adjust to any beneficiary, whether or not possession of the power may have adverse tax consequences.

Under subsection (c)(1), a trustee cannot make an adjustment that diminishes the income interest in a trust that requires all of the income to be paid at least annually to a spouse and for which an estate tax or gift tax marital deduction is allowed; but this subsection does not prevent the trustee from making an adjustment that increases the amount of income paid from a marital deduction trust to the spouse. Subsection (c)(1) applies to a trust that qualifies for the marital deduction because the spouse has a general power of appointment over the trust, but it applies to a qualified terminable interest property (QTIP) trust only if and to the extent that the fiduciary
makes the election required to obtain the tax deduction. Subsection (c)(1) does not apply to a so- called “estate” trust. This type of trust qualifies for the marital deduction because the terms of
the trust require the principal and undistributed income to be paid to the surviving spouse’s estate when the spouse dies; it is not necessary for the terms of an estate trust to require the income to
be distributed annually. Reg. ‘ 20.2056(c)-2(b)(1)(iii).

Subsection (c)(3) applies to annuity trusts and unitrusts with no charitable beneficiaries as well as to trusts with charitable income or remainder beneficiaries; its purpose is to make it clear that a beneficiary’s right to receive a fixed annuity or a fixed fraction of the value of a trust’s assets is not subject to adjustment under Section 104(a). Subsection (c)(3) does not apply to any additional amount to which the beneficiary may be entitled that is expressed in terms of a right to receive income from the trust. For example, if a beneficiary is to receive a fixed annuity or the trust’s income, whichever is greater, subsection (c)(3) does not prevent a trustee from making an adjustment under Section 104(a) in determining the amount of the trust’s income.

If subsection (c)(5), (6), (7), or (8), prevents a trustee from exercising the power to adjust, subsection (d) permits a cotrustee who is not subject to the provision to exercise the power
unless the terms of the trust do not permit the cotrustee to do so.

Release of the power to adjust. Section 104(e) permits a trustee to release all or part of the power to adjust in circumstances in which the possession or exercise of the power might deprive the trust of a tax benefit or impose a tax burden. For example, if possessing the power would diminish the actuarial value of the income interest in a trust for which the income beneficiary’s estate may be eligible to claim a credit for property previously taxed if the beneficiary dies within ten years after the death of the person creating the trust, the trustee is permitted under subsection (e) to release just the power to adjust from income to principal.

Trust terms that limit a power to adjust. Section 104(f) applies to trust provisions that limit a trustee’s power to adjust. Since the power is intended to enable trustees to employ the prudent investor rule without being constrained by traditional principal and income rules, an instrument executed before the adoption of this Act whose terms describe the amount that may or must be distributed to a beneficiary by referring to the trust’s income or that prohibit the invasion of principal or that prohibit equitable adjustments in general should not be construed as forbidding the use of the power to adjust under Section 104(a) if the need for adjustment arises because the trustee is operating under the prudent investor rule. Instruments containing such provisions that are executed after the adoption of this Act should specifically refer to the power
to adjust if the settlor intends to forbid its use. See generally, Joel C. Dobris, Limits on the
Doctrine of Equitable Adjustment in Sophisticated Postmortem Tax Planning, 66 Iowa L. Rev.
273 (1981).

Examples. The following examples illustrate the application of Section 104:

Example (1) B T is the successor trustee of a trust that provides income to A for life, remainder to B. T has received from the prior trustee a portfolio of financial assets invested 20% in stocks and 80% in bonds. Following the prudent investor rule, T determines that a strategy of investing the portfolio 50% in stocks and 50% in bonds has risk and return objectives that are reasonably suited to the trust, but T also determines that adopting this approach will cause the trust to receive a smaller amount of dividend and interest income. After considering the factors in Section 104(b), T may transfer cash from principal to income to the extent T considers it necessary to increase the amount distributed to the income beneficiary.

Example (2) B T is the trustee of a trust that requires the income to be paid to the settlor’s son C for life, remainder to C’s daughter D. In a period of very high inflation, T
purchases bonds that pay double-digit interest and determines that a portion of the interest, which is allocated to income under Section 406 of this Act, is a return of capital. In consideration of the loss of value of principal due to inflation and other factors that T considers relevant, T may transfer part of the interest to principal.

Example (3) B T is the trustee of a trust that requires the income to be paid to the settlor’s sister E for life, remainder to charity F. E is a retired schoolteacher who is single and has no children. E’s income from her social security, pension, and savings exceeds the
amount required to provide for her accustomed standard of living. The terms of the trust permit T to invade principal to provide for E’s health and to support her in her

accustomed manner of living, but do not otherwise indicate that T should favor E or F. Applying the prudent investor rule, T determines that the trust assets should be invested entirely in growth stocks that produce very little dividend income. Even though it is not necessary to invade principal to maintain E’s accustomed standard of living, she is entitled to receive from the trust the degree of beneficial enjoyment normally accorded a person who is the sole income beneficiary of a trust, and T may transfer cash from principal to income to provide her with that degree of enjoyment.

Example (4) B T is the trustee of a trust that is governed by the law of State X. The trust became irrevocable before State X adopted the prudent investor rule. The terms of the trust require all of the income to be paid to G for life, remainder to H, and also give T the power to invade principal for the benefit of G for “dire emergencies only.” The terms of the trust limit the aggregate amount that T can distribute to G from principal during G’s life to 6% of the trust’s value at its inception. The trust’s portfolio is invested initially
50% in stocks and 50% in bonds, but after State X adopts the prudent investor rule T determines that, to achieve suitable risk and return objectives for the trust, the assets should be invested 90% in stocks and 10% in bonds. This change increases the total return from the portfolio and decreases the dividend and interest income. Thereafter, even though G does not experience a dire emergency, T may exercise the power to adjust under Section 104(a) to the extent that T determines that the adjustment is from only the capital appreciation resulting from the change in the portfolio’s asset allocation. If T is unable to determine the extent to which capital appreciation resulted from the change in asset allocation or is unable to maintain adequate records to determine the extent to which principal distributions to G for dire emergencies do not exceed the 6% limitation, T may not exercise the power to adjust. See Joel C. Dobris, Limits on the Doctrine of Equitable Adjustment in Sophisticated Postmortem Tax Planning, 66 Iowa L. Rev. 273 (1981).

Example (5) B T is the trustee of a trust for the settlor’s child. The trust owns a diversified portfolio of marketable financial assets with a value of $600,000, and is also the sole beneficiary of the settlor’s IRA, which holds a diversified portfolio of marketable financial assets with a value of $900,000. The trust receives a distribution from the IRA that is the minimum amount required to be distributed under the Internal Revenue Code, and T allocates 10% of the distribution to income under Section 409(c) of this Act. The total return on the IRA’s assets exceeds the amount distributed to the trust, and the value of the IRA at the end of the year is more than its value at the beginning of the year. Relevant factors that T may consider in determining whether to exercise the power to adjust and the extent to which an adjustment should be made to comply with Section
103(b) include the total return from all of the trust’s assets, those owned directly as well
as its interest in the IRA, the extent to which the trust will be subject to income tax on the portion of the IRA distribution that is allocated to principal, and the extent to which the income beneficiary will be subject to income tax on the amount that T distributes to the income beneficiary.

Example (6) B T is the trustee of a trust whose portfolio includes a large parcel of undeveloped real estate. T pays real property taxes on the undeveloped parcel from

income each year pursuant to Section 501(3). After considering the return from the trust’s portfolio as a whole and other relevant factors described in Section 104(b), T may exercise the power to adjust under Section 104(a) to transfer cash from principal to income in order to distribute to the income beneficiary an amount that T considers necessary to comply with Section 103(b).

Example (7) B T is the trustee of a trust whose portfolio includes an interest in a mutual fund that is sponsored by T. As the manager of the mutual fund, T charges the fund a management fee that reduces the amount available to distribute to the trust by $2,000. If the fee had been paid directly by the trust, one-half of the fee would have been paid from income under Section 501(1) and the other one-half would have been paid from principal under Section 502(a)(1). After considering the total return from the portfolio as a whole and other relevant factors described in Section 104(b), T may exercise its power to adjust under Section 104(a) by transferring $1,000, or half of the trust’s proportionate share of the fee, from principal to income.

SECTION 105. JUDICIAL CONTROL OF DISCRETIONARY POWER.

(a) The court may not order a fiduciary to change a decision to exercise or not to exercise a discretionary power conferred by this [Act] unless it determines that the decision was an abuse of the fiduciary’s discretion. A fiduciary’s decision is not an abuse of discretion merely because the court would have exercised the power in a different manner or would not have exercised the power.
(b) The decisions to which subsection (a) applies include:

(1) a decision under Section 104(a) as to whether and to what extent an amount should be transferred from principal to income or from income to principal.
(2) a decision regarding the factors that are relevant to the trust and its beneficiaries, the extent to which the factors are relevant, and the weight, if any, to be given to those factors, in deciding whether and to what extent to exercise the discretionary power conferred by Section 104(a).
(c) If the court determines that a fiduciary has abused the fiduciary’s discretion, the court may place the income and remainder beneficiaries in the positions they would have occupied if

the discretion had not been abused, according to the following rules:

(1) To the extent that the abuse of discretion has resulted in no distribution to a beneficiary or in a distribution that is too small, the court shall order the fiduciary to distribute from the trust to the beneficiary an amount that the court determines will restore the beneficiary, in whole or in part, to the beneficiary’s appropriate position.
(2) To the extent that the abuse of discretion has resulted in a distribution to a beneficiary which is too large, the court shall place the beneficiaries, the trust, or both, in whole or in part, in their appropriate positions by ordering the fiduciary to withhold an amount from one or more future distributions to the beneficiary who received the distribution that was too large or ordering that beneficiary to return some or all of the distribution to the trust.
(3) To the extent that the court is unable, after applying paragraphs (1) and (2), to place the beneficiaries, the trust, or both, in the positions they would have occupied if the discretion had not been abused, the court may order the fiduciary to pay an appropriate amount from its own funds to one or more of the beneficiaries or the trust or both.
(d) Upon [petition] by the fiduciary, the court having jurisdiction over a trust or estate shall determine whether a proposed exercise or nonexercise by the fiduciary of a discretionary power conferred by this [Act] will result in an abuse of the fiduciary’s discretion. If the petition describes the proposed exercise or nonexercise of the power and contains sufficient information to inform the beneficiaries of the reasons for the proposal, the facts upon which the fiduciary relies, and an explanation of how the income and remainder beneficiaries will be affected by the proposed exercise or nonexercise of the power, a beneficiary who challenges the proposed exercise or nonexercise has the burden of establishing that it will result in an abuse of discretion.
Comment

General. All of the discretionary powers in the 1997 Act are subject to the normal rules that govern a fiduciary’s exercise of discretion. Section 105 codifies those rules for purposes of the Act so that they will be readily apparent and accessible to fiduciaries, beneficiaries, their counsel and the courts if and when questions concerning such powers arise.

Section 105 also makes clear that the normal rules governing the exercise of a fiduciary’s powers apply to the discretionary power to adjust conferred upon a trustee by Section 104(a). Discretionary provisions authorizing trustees to determine what is income and what is principal have been used in governing instruments for years; Section 2 of the 1931 Uniform Principal and Income Act recognized that practice by providing that “the person establishing the principal may himself direct the manner of ascertainment of income and principal…or grant discretion to the trustee or other person to do so….” Section 103(a)(2) also recognizes the power of a settlor to grant such discretion to the trustee. Section 105 applies to a discretionary power granted by the terms of a trust or a will as well as the power to adjust in Section 104(a).

Power to Adjust. The exercise of the power to adjust is governed by a trustee’s duty of impartiality, which requires the trustee to strike an appropriate balance between the interests of the income and remainder beneficiaries. Section 103(b) expresses this duty by requiring the trustee to “administer a trust or estate impartially, based on what is fair and reasonable to all of the beneficiaries, except to the extent that the terms of the trust or the will clearly manifest an intention that the fiduciary shall or may favor one or more of the beneficiaries.” Because this involves the exercise of judgment in circumstances rarely capable of perfect resolution, trustees are not expected to achieve perfection; they are, however, required to make conscious decisions in good faith and with proper motives.

In seeking the proper balance between the interests of the beneficiaries in matters involving principal and income, a trustee’s traditional approach has been to determine the settlor’s objectives from the terms of the trust, gather the information needed to ascertain the financial circumstances of the beneficiaries, determine the extent to which the settlor’s objectives can be achieved with the resources available in the trust, and then allocate the trust’s
assets between stocks and fixed-income securities in a way that will produce a particular level or range of income for the income beneficiary. The key element in this process has been to determine the appropriate level or range of income for the income beneficiary, and that will continue to be the key element in deciding whether and to what extent to exercise the discretionary power conferred by Section 104(a). If it becomes necessary for a court to determine whether an abuse of the discretionary power to adjust between principal and income has occurred, the criteria should be the same as those that courts have used in the past to determine whether a trustee has abused its discretion in allocating the trust’s assets between stocks and fixed-income securities.

A fiduciary has broad latitude in choosing the methods and criteria to use in deciding whether and to what extent to exercise the power to adjust in order to achieve impartiality between income beneficiaries and remainder beneficiaries or the degree of partiality for one or the other that is provided for by the terms of the trust or the will. For example, in deciding what the appropriate level or range of income should be for the income beneficiary and whether to exercise the power, a trustee may use the methods employed prior to the adoption of the 1997

Act in deciding how to allocate trust assets between stocks and fixed-income securities; or may consider the amount that would be distributed each year based on a percentage of the portfolio’s value at the beginning or end of an accounting period, or the average portfolio value for several accounting periods, in a manner similar to a unitrust, and may select a percentage that the trustee believes is appropriate for this purpose and use the same percentage or different percentages in subsequent years. The trustee may also use hypothetical portfolios of marketable securities to determine an appropriate level or range of income within which a distribution might fall.

An adjustment may be made prospectively at the beginning of an accounting period, based on a projected return or range of returns for a trust’s portfolio, or retrospectively after the fiduciary knows the total realized or unrealized return for the period; and instead of an annual adjustment, the trustee may distribute a fixed dollar amount for several years, in a manner similar to an annuity, and may change the fixed dollar amount periodically. No inference of abuse is to be drawn if a fiduciary uses different methods or criteria for the same trust from time to time, or uses different methods or criteria for different trusts for the same accounting period.

While a trustee must consider the portfolio as a whole in deciding whether and to what extent to exercise the power to adjust, a trustee may apply different criteria in considering the portion of the portfolio that is composed of marketable securities and the portion whose market value cannot be determined readily, and may take into account a beneficiary’s use or possession of a trust asset.

Under the prudent investor rule, a trustee is to incur costs that are appropriate and reasonable in relation to the assets and the purposes of the trust, and the same consideration applies in determining whether and to what extent to exercise the power to adjust. In making investment decisions under the prudent investor rule, the trustee will have considered the purposes, terms, distribution requirements, and other circumstances of the trust for the purpose of adopting an overall investment strategy having risk and return objectives reasonably suited to the trust. A trustee is not required to duplicate that work for principal and income purposes, and
in many cases the decision about whether and to what extent to exercise the power to adjust may be made at the same time as the investment decisions. To help achieve the objective of reasonable investment costs, a trustee may also adopt policies that apply to all trusts or to individual trusts or classes of trusts, based on their size or other criteria, stating whether and under what circumstances the power to adjust will be exercised and the method of making adjustments; no inference of abuse is to be drawn if a trustee adopts such policies.

General rule. The first sentence of Section 105(a) is from Restatement (Second) of Trusts ‘ 187 and Restatement (Third) of Trusts (Tentative Draft No. 2, 1999) ‘ 50(1). The second sentence of Section 105(a) derives from Comment e to ‘ 187 of the Second Restatement and Comment b to ‘ 50 of the Third Restatement.

The reference in Section 105(a) to a fiduciary’s decision to exercise or not to exercise a discretionary power underscores a fundamental precept, which is that a fiduciary has a duty to make a conscious decision about exercising or not exercising a discretionary power. Comment b to ‘ 50 of the Third Restatement states:

[A] court will intervene where the exercise of a power is left to the judgment of a trustee who improperly fails to exercise that judgment. Thus, even where a trustee has discretion whether or not to make any payments to a particular beneficiary, the court will interpose if the trustee, arbitrarily or without knowledge of or inquiry into relevant circumstances, fails to exercise the discretion.

Section 105(b) makes clear that the rule of subsection (a) applies not only to the power conferred by Section 104(a) but also to the evaluation process required by Section 104(b) in deciding whether and to what extent to exercise the power to adjust. Under Section 104(b), a trustee is to consider all of the factors that are relevant to the trust and its beneficiaries, including, to the extent the trustee determines they are relevant, the nine factors enumerated in Section 104(b). Section 104(b) derives from Section 2(c) of the Uniform Prudent Investor Act, which lists eight circumstances that a trustee shall consider, to the extent they are relevant, in investing and managing assets. The trustee’s decisions about what factors are relevant for purposes of Section 104(b) and the weight to be accorded each of the relevant factors are part of
the discretionary decision-making process. As such, these decisions are not subject to change for the purpose of changing the trustee’s ultimate decision unless the court determines that there has been an abuse of discretion in determining the relevancy and weight of these factors.

Remedy. The exercise or nonexercise of a discretionary power under the Act normally affects the amount or timing of a distribution to the income or remainder beneficiaries. The primary remedy under Section 105(c) for abuse of discretion is the restoration of the beneficiaries and the trust to the positions they would have occupied if the abuse had not occurred. It draws on a basic principle of restitution that if a person pays money to someone who is not intended to receive it (and in a case to which this Act applies, not intended by the settlor to receive it in the absence of an abuse of discretion by the trustee), that person is entitled to restitution on the ground that the payee would be unjustly enriched if he were permitted to retain the payment. See Restatement of Restitution ‘ 22 (1937). The objective is to accomplish the restoration initially by making adjustments between the beneficiaries and the trust to the extent possible; to the extent that restoration is not possible by such adjustments, a court may order the trustee to pay an amount to one or more of the beneficiaries, the trust, or both the beneficiaries and the trust. If the court determines that it is not possible in the circumstances to restore them to their appropriate positions, the court may provide other remedies appropriate to the circumstances. The approach of Section 105(c) is supported by Comment b to ‘ 50 of the Third Restatement of Trusts:

When judicial intervention is required, a court may direct the trustee to make or refrain from making certain payments; issue instructions to clarify the standards or guidelines applicable to the exercise of the power; or rescind the trustee’s payment decisions, usually directing the trustee to recover amounts improperly distributed and holding the trustee liable for failure or inability to do so….

Advance determinations. Section 105(d) employs the familiar remedy of the trustee’s petition to the court for instructions. It requires the court to determine, upon a petition by the fiduciary, whether a proposed exercise or nonexercise of a discretionary power by the fiduciary of a power conferred by the Act would be an abuse of discretion under the general rule of

Section 105(a). If the petition contains the information prescribed in the second sentence of subsection (d), the proposed action or inaction is presumed not to result in an abuse, and a beneficiary who challenges the proposal must establish that it will.

Subsection (d) is intended to provide a fiduciary the opportunity to obtain an assurance of finality in a judicial proceeding before proceeding with a proposed exercise or nonexercise of a discretionary power. Its purpose is not, however, to have the court instruct the fiduciary how to exercise the discretion.

A fiduciary may also obtain the consent of the beneficiaries to a proposed act or an omission to act, and a beneficiary cannot hold the fiduciary liable for that act or omission unless:

(a) the beneficiary was under an incapacity at the time of such consent or of such act or omission; or

(b) the beneficiary, when he gave his consent, did not know of his rights and of the material facts which the trustee knew or should have known and which the trustee did not reasonably believe that the beneficiary knew; or

(c) the consent of the beneficiary was induced by improper conduct of the trustee.

Restatement (Second) of Trusts ‘ 216.

If there are many beneficiaries, including some who are incapacitated or unascertained, the fiduciary may prefer the greater assurance of finality provided by a judicial proceeding that will bind all persons who have an interest in the trust.

[ARTICLE] 2

DECEDENT’S ESTATE OR TERMINATING INCOME INTEREST
SECTION 201. DETERMINATION AND DISTRIBUTION OF NET INCOME. After a decedent dies, in the case of an estate, or after an income interest in a trust ends, the following rules apply:
(1) A fiduciary of an estate or of a terminating income interest shall determine the amount of net income and net principal receipts received from property specifically given to a beneficiary under the rules in [Articles] 3 through 5 which apply to trustees and the rules in paragraph (5). The fiduciary shall distribute the net income and net principal receipts to the beneficiary who is to receive the specific property.
(2) A fiduciary shall determine the remaining net income of a decedent’s estate or a terminating income interest under the rules in [Articles] 3 through 5 which apply to trustees and by:
(A) including in net income all income from property used to discharge liabilities; (B) paying from income or principal, in the fiduciary’s discretion, fees of
attorneys, accountants, and fiduciaries; court costs and other expenses of administration; and interest on death taxes, but the fiduciary may pay those expenses from income of property
passing to a trust for which the fiduciary claims an estate tax marital or charitable deduction only to the extent that the payment of those expenses from income will not cause the reduction or loss of the deduction; and
(C) paying from principal all other disbursements made or incurred in connection with the settlement of a decedent’s estate or the winding up of a terminating income interest,

including debts, funeral expenses, disposition of remains, family allowances, and death taxes and related penalties that are apportioned to the estate or terminating income interest by the will, the terms of the trust, or applicable law.
(3) A fiduciary shall distribute to a beneficiary who receives a pecuniary amount outright the interest or any other amount provided by the will, the terms of the trust, or applicable law from net income determined under paragraph (2) or from principal to the extent that net income
is insufficient. If a beneficiary is to receive a pecuniary amount outright from a trust after an income interest ends and no interest or other amount is provided for by the terms of the trust or applicable law, the fiduciary shall distribute the interest or other amount to which the beneficiary would be entitled under applicable law if the pecuniary amount were required to be paid under a will.
(4) A fiduciary shall distribute the net income remaining after distributions required by paragraph (3) in the manner described in Section 202 to all other beneficiaries, including a beneficiary who receives a pecuniary amount in trust, even if the beneficiary holds an unqualified power to withdraw assets from the trust or other presently exercisable general power of appointment over the trust.
(5) A fiduciary may not reduce principal or income receipts from property described in paragraph (1) because of a payment described in Section 501 or 502 to the extent that the will, the terms of the trust, or applicable law requires the fiduciary to make the payment from assets other than the property or to the extent that the fiduciary recovers or expects to recover the payment from a third party. The net income and principal receipts from the property are determined by including all of the amounts the fiduciary receives or pays with respect to the property, whether those amounts accrued or became due before, on, or after the date of a

decedent’s death or an income interest’s terminating event, and by making a reasonable provision for amounts that the fiduciary believes the estate or terminating income interest may become obligated to pay after the property is distributed.
Comment

Terminating income interests and successive income interests. A trust that provides for a single income beneficiary and an outright distribution of the remainder ends when the income interest ends. A more complex trust may have a number of income interests, either concurrent or successive, and the trust will not necessarily end when one of the income interests ends. For that reason, the Act speaks in terms of income interests ending and beginning rather than trusts ending and beginning. When an income interest in a trust ends, the trustee’s powers continue during the winding up period required to complete its administration. A terminating income interest is one that has ended but whose administration is not complete.

If two or more people are given the right to receive specified percentages or fractions of the income from a trust concurrently and one of the concurrent interests ends, e.g., when a beneficiary dies, the beneficiary’s income interest ends but the trust does not. Similarly, when a trust with only one income beneficiary ends upon the beneficiary’s death, the trust instrument may provide that part or all of the trust assets shall continue in trust for another income beneficiary. While it is common to think and speak of this (and even to characterize it in a trust instrument) as a “new” trust, it is a continuation of the original trust for a remainder beneficiary who has an income interest in the trust assets instead of the right to receive them outright. For purposes of this Act, this is a successive income interest in the same trust. The fact that a trust may or may not end when an income interest ends is not significant for purposes of this Act.

If the assets that are subject to a terminating income interest pass to another trust because the income beneficiary exercises a general power of appointment over the trust assets, the recipient trust would be a new trust; and if they pass to another trust because the beneficiary exercises a nongeneral power of appointment over the trust assets, the recipient trust might be a new trust in some States (see 5A Austin W. Scott & William F. Fratcher, The Law of Trusts
‘ 640, at 483 (4th ed. 1989)); but for purposes of this Act a new trust created in these circumstances is also a successive income interest.

Gift of a pecuniary amount. Section 201(3) and (4) provide different rules for an outright gift of a pecuniary amount and a gift in trust of a pecuniary amount; this is the same approach used in Section 5(b)(2) of the 1962 Act.

Interest on pecuniary amounts. Section 201(3) provides that the beneficiary of an outright pecuniary amount is to receive the interest or other amount provided by applicable law if there is no provision in the will or the terms of the trust. Many States have no applicable law that provides for interest or some other amount to be paid on an outright pecuniary gift under an inter vivos trust; this section provides that in such a case the interest or other amount to be paid shall be the same as the interest or other amount required to be paid on testamentary pecuniary

gifts. This provision is intended to accord gifts under inter vivos instruments the same treatment as testamentary gifts. The various state authorities that provide for the amount that a beneficiary of an outright pecuniary amount is entitled to receive are collected in Richard B. Covey, Marital Deduction and Credit Shelter Dispositions and the Use of Formula Provisions, App. B (4th ed.
1997).

Administration expenses and interest on death taxes. Under Section 201(2)(B) a fiduciary may pay administration expenses and interest on death taxes from either income or principal. An advantage of permitting the fiduciary to choose the source of the payment is that,
if the fiduciary’s decision is consistent with the decision to deduct these expenses for income tax purposes or estate tax purposes, it eliminates the need to adjust between principal and income that may arise when, for example, an expense that is paid from principal is deducted for income tax purposes or an expense that is paid from income is deducted for estate tax purposes.

The United States Supreme Court has considered the question of whether an estate tax marital deduction or charitable deduction should be reduced when administration expenses are paid from income produced by property passing in trust for a surviving spouse or for charity and deducted for income tax purposes. The Court rejected the IRS position that administration expenses properly paid from income under the terms of the trust or state law must reduce the amount of a marital or charitable transfer, and held that the value of the transferred property is not reduced for estate tax purposes unless the administration expenses are material in light of the
income the trust corpus could have been expected to generate. Commissioner v. Estate of Otis C. Hubert, 117 S.Ct. 1124 (1997). The provision in Section 201(2)(B) permits a fiduciary to pay
and deduct administration expenses from income only to the extent that it will not cause the reduction or loss of an estate tax marital or charitable contributions deduction, which means that the limit on the amount payable from income will be established eventually by Treasury Regulations.

Interest on estate taxes. The IRS agrees that interest on estate and inheritance taxes may be deducted for income tax purposes without having to reduce the estate tax deduction for amounts passing to a charity or surviving spouse, whether the interest is paid from principal or income. Rev. Rul. 93-48, 93-2 C.B. 270. For estates of persons who died before 1998, a fiduciary may not want to deduct for income tax purposes interest on estate tax that is deferred under Section 6166 or 6163 because deducting that interest for estate tax purposes may produce more beneficial results, especially if the estate has little or no income or the income tax bracket is significantly lower than the estate tax bracket. For estates of persons who die after 1997, no estate tax or income tax deduction will be allowed for interest paid on estate tax that is deferred under Section 6166. However, interest on estate tax deferred under Section 6163 will continue to be deductible for both purposes, and interest on estate tax deficiencies will continue to be deductible for estate tax purposes if an election under Section 6166 is not in effect.

Under the 1962 Act, Section 13(c)(5) charges interest on estate and inheritance taxes to principal. The 1931 Act has no provision. Section 501(3) of this Act provides that, except to the extent provided in Section 201(2)(B) or (C), all interest must be paid from income.

SECTION 202. DISTRIBUTION TO RESIDUARY AND REMAINDER BENEFICIARIES.
(a) Each beneficiary described in Section 201(4) is entitled to receive a portion of the net income equal to the beneficiary’s fractional interest in undistributed principal assets, using
values as of the distribution date. If a fiduciary makes more than one distribution of assets to beneficiaries to whom this section applies, each beneficiary, including one who does not receive part of the distribution, is entitled, as of each distribution date, to the net income the fiduciary has received after the date of death or terminating event or earlier distribution date but has not distributed as of the current distribution date.
(b) In determining a beneficiary’s share of net income, the following rules apply:

(1) The beneficiary is entitled to receive a portion of the net income equal to the beneficiary’s fractional interest in the undistributed principal assets immediately before the distribution date, including assets that later may be sold to meet principal obligations.
(2) The beneficiary’s fractional interest in the undistributed principal assets must be calculated without regard to property specifically given to a beneficiary and property required to pay pecuniary amounts not in trust.
(3) The beneficiary’s fractional interest in the undistributed principal assets must be calculated on the basis of the aggregate value of those assets as of the distribution date without reducing the value by any unpaid principal obligation.
(4) The distribution date for purposes of this section may be the date as of which the fiduciary calculates the value of the assets if that date is reasonably near the date on which assets are actually distributed.
(c) If a fiduciary does not distribute all of the collected but undistributed net income to

each person as of a distribution date, the fiduciary shall maintain appropriate records showing the interest of each beneficiary in that net income.
(d) A fiduciary may apply the rules in this section, to the extent that the fiduciary considers it appropriate, to net gain or loss realized after the date of death or terminating event or earlier distribution date from the disposition of a principal asset if this section applies to the income from the asset.
Comment

Relationship to prior Acts. Section 202 retains the concept in Section 5(b)(2) of the
1962 Act that the residuary legatees of estates are to receive net income earned during the period of administration on the basis of their proportionate interests in the undistributed assets when distributions are made. It changes the basis for determining their proportionate interests by using asset values as of a date reasonably near the time of distribution instead of inventory values; it extends the application of these rules to distributions from terminating trusts; and it extends
these rules to gain or loss realized from the disposition of assets during administration, an omission in the 1962 Act that has been noted by several commentators. See, e.g., Richard B. Covey, Marital Deduction and Credit Shelter Dispositions and the Use of Formula Provisions 91 (4th ed. 1998); Thomas H. Cantrill, Fractional or Percentage Residuary Bequests: Allocation of Postmortem Income, Gain and Unrealized Appreciation, 10 Prob. Notes 322, 327 (1985).

[ARTICLE] 3

APPORTIONMENT AT BEGINNING AND END OF INCOME INTEREST
SECTION 301. WHEN RIGHT TO INCOME BEGINS AND ENDS.

(a) An income beneficiary is entitled to net income from the date on which the income interest begins. An income interest begins on the date specified in the terms of the trust or, if no date is specified, on the date an asset becomes subject to a trust or successive income interest.
(b) An asset becomes subject to a trust:

(1) on the date it is transferred to the trust in the case of an asset that is transferred to a trust during the transferor’s life;
(2) on the date of a testator’s death in the case of an asset that becomes subject to a trust by reason of a will, even if there is an intervening period of administration of the testator’s estate; or
(3) on the date of an individual’s death in the case of an asset that is transferred to a fiduciary by a third party because of the individual’s death.
(c) An asset becomes subject to a successive income interest on the day after the preceding income interest ends, as determined under subsection (d), even if there is an intervening period of administration to wind up the preceding income interest.
(d) An income interest ends on the day before an income beneficiary dies or another terminating event occurs, or on the last day of a period during which there is no beneficiary to whom a trustee may distribute income.
Comment

Period during which there is no beneficiary. The purpose of the second part of subsection (d) is to provide that, at the end of a period during which there is no beneficiary to

whom a trustee may distribute income, the trustee must apply the same apportionment rules that apply when a mandatory income interest ends. This provision would apply, for example, if a settlor creates a trust for grandchildren before any grandchildren are born. When the first grandchild is born, the period preceding the date of birth is treated as having ended, followed by a successive income interest, and the apportionment rules in Sections 302 and 303 apply accordingly if the terms of the trust do not contain different provisions.

SECTION 302. APPORTIONMENT OF RECEIPTS AND DISBURSEMENTS WHEN DECEDENT DIES OR INCOME INTEREST BEGINS.
(a) A trustee shall allocate an income receipt or disbursement other than one to which Section 201(1) applies to principal if its due date occurs before a decedent dies in the case of an estate or before an income interest begins in the case of a trust or successive income interest.
(b) A trustee shall allocate an income receipt or disbursement to income if its due date occurs on or after the date on which a decedent dies or an income interest begins and it is a periodic due date. An income receipt or disbursement must be treated as accruing from day to day if its due date is not periodic or it has no due date. The portion of the receipt or disbursement accruing before the date on which a decedent dies or an income interest begins must be allocated to principal and the balance must be allocated to income.
(c) An item of income or an obligation is due on the date the payer is required to make a payment. If a payment date is not stated, there is no due date for the purposes of this [Act]. Distributions to shareholders or other owners from an entity to which Section 401 applies are deemed to be due on the date fixed by the entity for determining who is entitled to receive the distribution or, if no date is fixed, on the declaration date for the distribution. A due date is periodic for receipts or disbursements that must be paid at regular intervals under a lease or an obligation to pay interest or if an entity customarily makes distributions at regular intervals.
Comment

Prior Acts. Professor Bogert stated that “Section 4 of the [1962] Act makes a change with respect to the apportionment of the income of trust property not due until after the trust began but which accrued in part before the commencement of the trust. It treats such income as to be credited entirely to the income account in the case of a living trust, but to be apportioned between capital and income in the case of a testamentary trust. The [1931] Act apportions such income in the case of both types of trusts, except in the case of corporate dividends.” George G. Bogert, The Revised Uniform Principal and Income Act, 38 Notre Dame Law. 50, 52 (1962). The 1962 Act also provides that an asset passing to an inter vivos trust by a bequest in the settlor’s will is governed by the rule that applies to a testamentary trust, so that different rules apply to assets passing to an inter vivos trust depending upon whether they were transferred to the trust during the settlor’s life or by his will.

Having several different rules that apply to similar transactions is confusing. In order to simplify administration, Section 302 applies the same rule to inter vivos trusts (revocable and irrevocable), testamentary trusts, and assets that become subject to an inter vivos trust by a testamentary bequest.

Periodic payments. Under Section 302, a periodic payment is principal if it is due but unpaid before a decedent dies or before an asset becomes subject to a trust, but the next payment is allocated entirely to income and is not apportioned. Thus, periodic receipts such as rents, dividends, interest, and annuities, and disbursements such as the interest portion of a mortgage payment, are not apportioned. This is the original common law rule. Edwin A. Howes, Jr., The American Law Relating to Income and Principal 70 (1905). In trusts in which a surviving
spouse is dependent upon a regular flow of cash from the decedent’s securities portfolio, this rule will help to maintain payments to the spouse at the same level as before the settlor’s death.
Under the 1962 Act, the pre-death portion of the first periodic payment due after death is apportioned to principal in the case of a testamentary trust or securities bequeathed by will to an inter vivos trust.

Nonperiodic payments. Under the second sentence of Section 302(b), interest on an obligation that does not provide a due date for the interest payment, such as interest on an
income tax refund, would be apportioned to principal to the extent it accrues before a person dies or an income interest begins unless the obligation is specifically given to a devisee or remainder beneficiary, in which case all of the accrued interest passes under Section 201(1) to the person who receives the obligation. The same rule applies to interest on an obligation that has a due
date but does not provide for periodic payments. If there is no stated interest on the obligation, such as a zero coupon bond, and the proceeds from the obligation are received more than one year after it is purchased or acquired by the trustee, the entire amount received is principal under Section 406.

SECTION 303. APPORTIONMENT WHEN INCOME INTEREST ENDS.

(a) In this section, “undistributed income” means net income received before the date on which an income interest ends. The term does not include an item of income or expense that is

due or accrued or net income that has been added or is required to be added to principal under the terms of the trust.
(b) When a mandatory income interest ends, the trustee shall pay to a mandatory income beneficiary who survives that date, or the estate of a deceased mandatory income beneficiary whose death causes the interest to end, the beneficiary’s share of the undistributed income that is not disposed of under the terms of the trust unless the beneficiary has an unqualified power to revoke more than five percent of the trust immediately before the income interest ends. In the latter case, the undistributed income from the portion of the trust that may be revoked must be added to principal.
(c) When a trustee’s obligation to pay a fixed annuity or a fixed fraction of the value of the trust’s assets ends, the trustee shall prorate the final payment if and to the extent required by applicable law to accomplish a purpose of the trust or its settlor relating to income, gift, estate, or other tax requirements.
Comment

Prior Acts. Both the 1931 Act (Section 4) and the 1962 Act (Section 4(d)) provide that a deceased income beneficiary’s estate is entitled to the undistributed income. The Drafting Committee concluded that this is probably not what most settlors would want, and that, with respect to undistributed income, most settlors would favor the income beneficiary first, the remainder beneficiaries second, and the income beneficiary’s heirs last, if at all. However, it decided not to eliminate this provision to avoid causing disputes about whether the trustee
should have distributed collected cash before the income beneficiary died.

Accrued periodic payments. Under the prior Acts, an income beneficiary or his estate is entitled to receive a portion of any payments, other than dividends, that are due or that have accrued when the income interest terminates. The last sentence of subsection (a) changes that rule by providing that such items are not included in undistributed income. The items affected include periodic payments of interest, rent, and dividends, as well as items of income that accrue over a longer period of time; the rule also applies to expenses that are due or accrued.

Example B accrued periodic payments. The rules in Section 302 and Section 303 work in the following manner: Assume that a periodic payment of rent that is due on July 20 has not been paid when an income interest ends on July 30; the successive income interest begins on

July 31, and the rent payment that was due on July 20 is paid on August 3. Under Section
302(a), the July 20 payment is added to the principal of the successive income interest when received. Under Section 302(b), the entire periodic payment of rent that is due on August 20 is income when received by the successive income interest. Under Section 303, neither the income beneficiary of the terminated income interest nor the beneficiary’s estate is entitled to any part of either the July 20 or the August 20 payments because neither one was received before the income interest ended on July 30. The same principles apply to expenses of the trust.

Beneficiary with an unqualified power to revoke. The requirement in subsection (b) to pay undistributed income to a mandatory income beneficiary or her estate does not apply to the extent the beneficiary has an unqualified power to revoke more than five percent of the trust immediately before the income interest ends. Without this exception, subsection (b) would apply to a revocable living trust whose settlor is the mandatory income beneficiary during her lifetime, even if her will provides that all of the assets in the probate estate are to be distributed to the
trust.

If a trust permits the beneficiary to withdraw all or a part of the trust principal after attaining a specified age and the beneficiary attains that age but fails to withdraw all of the principal that she is permitted to withdraw, a trustee is not required to pay her or her estate the undistributed income attributable to the portion of the principal that she left in the trust. The assumption underlying this rule is that the beneficiary has either provided for the disposition of the trust assets (including the undistributed income) by exercising a power of appointment that she has been given or has not withdrawn the assets because she is willing to have the principal and undistributed income be distributed under the terms of the trust. If the beneficiary has the power to withdraw 25% of the trust principal, the trustee must pay to her or her estate the undistributed income from the 75% that she cannot withdraw.

[ARTICLE] 4

ALLOCATION OF RECEIPTS DURING ADMINISTRATION OF TRUST
[PART 1

RECEIPTS FROM ENTITIES]

SECTION 401. CHARACTER OF RECEIPTS.

(a) In this section, “entity” means a corporation, partnership, limited liability company, regulated investment company, real estate investment trust, common trust fund, or any other organization in which a trustee has an interest other than a trust or estate to which Section 402 applies, a business or activity to which Section 403 applies, or an asset-backed security to which Section 415 applies.
(b) Except as otherwise provided in this section, a trustee shall allocate to income money received from an entity.
(c) A trustee shall allocate the following receipts from an entity to principal: (1) property other than money;
(2) money received in one distribution or a series of related distributions in exchange for part or all of a trust’s interest in the entity;
(3) money received in total or partial liquidation of the entity; and

(4) money received from an entity that is a regulated investment company or a real estate investment trust if the money distributed is a capital gain dividend for federal income tax purposes.
(d) Money is received in partial liquidation:

(1) to the extent that the entity, at or near the time of a distribution, indicates that

it is a distribution in partial liquidation; or

(2) if the total amount of money and property received in a distribution or series of related distributions is greater than 20 percent of the entity’s gross assets, as shown by the entity’s year-end financial statements immediately preceding the initial receipt.
(e) Money is not received in partial liquidation, nor may it be taken into account under subsection (d)(2), to the extent that it does not exceed the amount of income tax that a trustee or beneficiary must pay on taxable income of the entity that distributes the money.
(f) A trustee may rely upon a statement made by an entity about the source or character of a distribution if the statement is made at or near the time of distribution by the entity’s board of directors or other person or group of persons authorized to exercise powers to pay money or transfer property comparable to those of a corporation’s board of directors.
Comment

Entities to which Section 401 applies. The reference to partnerships in Section 401(a) is intended to include all forms of partnerships, including limited partnerships, limited liability partnerships, and variants that have slightly different names and characteristics from State to State. The section does not apply, however, to receipts from an interest in property that a trust owns as a tenant in common with one or more co-owners, nor would it apply to an interest in a joint venture if, under applicable law, the trust’s interest is regarded as that of a tenant in common.

Capital gain dividends. Under the Internal Revenue Code and the Income Tax Regulations, a “capital gain dividend” from a mutual fund or real estate investment trust is the excess of the fund’s or trust’s net long-term capital gain over its net short-term capital loss. As a result, a capital gain dividend does not include any net short-term capital gain, and cash received by a trust because of a net short-term capital gain is income under this Act.

Reinvested dividends. If a trustee elects (or continues an election made by its predecessor) to reinvest dividends in shares of stock of a distributing corporation or fund, whether evidenced by new certificates or entries on the books of the distributing entity, the new shares would be principal. Making or continuing such an election would be equivalent to deciding under Section 104 to transfer income to principal in order to comply with Section
103(b). However, if the trustee makes or continues the election for a reason other than to comply with Section 103(b), e.g., to make an investment without incurring brokerage commissions, the trustee should transfer cash from principal to income in an amount equal to the reinvested

dividends.

Distribution of property. The 1962 Act describes a number of types of property that would be principal if distributed by a corporation. This becomes unwieldy in a section that applies to both corporations and all other entities. By stating that principal includes the distribution of any property other than money, Section 401 embraces all of the items enumerated in Section 6 of the 1962 Act as well as any other form of nonmonetary distribution not specifically mentioned in that Act.

Partial liquidations. Under subsection (d)(1), any distribution designated by the entity as a partial liquidating distribution is principal regardless of the percentage of total assets that it represents. If a distribution exceeds 20% of the entity’s gross assets, the entire distribution is a partial liquidation under subsection (d)(2) whether or not the entity describes it as a partial liquidation. In determining whether a distribution is greater than 20% of the gross assets, the portion of the distribution that does not exceed the amount of income tax that the trustee or a beneficiary must pay on the entity’s taxable income is ignored.

Other large distributions. A cash distribution may be quite large (for example, more than 10% but not more than 20% of the entity’s gross assets) and have characteristics that suggest it should be treated as principal rather than income. For example, an entity may have received cash from a source other than the conduct of its normal business operations because it sold an investment asset; or because it sold a business asset other than one held for sale to customers in the normal course of its business and did not replace it; or it borrowed a large sum of money and secured the repayment of the loan with a substantial asset; or a principal source of its cash was from assets such as mineral interests, 90% of which would have been allocated to principal if the trust had owned the assets directly. In such a case the trustee, after considering the total return from the portfolio as a whole and the income component of that return, may decide to exercise the power under Section 104(a) to make an adjustment between income and principal, subject to the limitations in Section 104(c).

SECTION 402. DISTRIBUTION FROM TRUST OR ESTATE. A trustee shall allocate to income an amount received as a distribution of income from a trust or an estate in which the trust has an interest other than a purchased interest, and shall allocate to principal an amount received as a distribution of principal from such a trust or estate. If a trustee purchases an interest in a trust that is an investment entity, or a decedent or donor transfers an interest in such a trust to a trustee, Section 401 or 415 applies to a receipt from the trust.
Comment

Terms of the distributing trust or estate. Under Section 103(a), a trustee is to allocate

receipts in accordance with the terms of the recipient trust or, if there is no provision, in accordance with this Act. However, in determining whether a distribution from another trust or an estate is income or principal, the trustee should also determine what the terms of the distributing trust or estate say about the distribution B for example, whether they direct that the distribution, even though made from the income of the distributing trust or estate, is to be added to principal of the recipient trust. Such a provision should override the terms of this Act, but if the terms of the recipient trust contain a provision requiring such a distribution to be allocated to income, the trustee may have to obtain a judicial resolution of the conflict between the terms of the two documents.

Investment trusts. An investment entity to which the second sentence of this section applies includes a mutual fund, a common trust fund, a business trust or other entity organized as a trust for the purpose of receiving capital contributed by investors, investing that capital, and managing investment assets, including asset-backed security arrangements to which Section 415 applies. See John H. Langbein, The Secret Life of the Trust: The Trust as an Instrument of Commerce, 107 Yale L.J. 165 (1997).

SECTION 403. BUSINESS AND OTHER ACTIVITIES CONDUCTED BY TRUSTEE.
(a) If a trustee who conducts a business or other activity determines that it is in the best interest of all the beneficiaries to account separately for the business or activity instead of accounting for it as part of the trust’s general accounting records, the trustee may maintain separate accounting records for its transactions, whether or not its assets are segregated from other trust assets.
(b) A trustee who accounts separately for a business or other activity may determine the extent to which its net cash receipts must be retained for working capital, the acquisition or replacement of fixed assets, and other reasonably foreseeable needs of the business or activity, and the extent to which the remaining net cash receipts are accounted for as principal or income in the trust’s general accounting records. If a trustee sells assets of the business or other activity, other than in the ordinary course of the business or activity, the trustee shall account for the net amount received as principal in the trust’s general accounting records to the extent the trustee

determines that the amount received is no longer required in the conduct of the business.

(c) Activities for which a trustee may maintain separate accounting records include: (1) retail, manufacturing, service, and other traditional business activities;
(2) farming;

(3) raising and selling livestock and other animals; (4) management of rental properties;
(5) extraction of minerals and other natural resources; (6) timber operations; and
(7) activities to which Section 414 applies.

Comment

Purpose and scope. The provisions in Section 403 are intended to give greater
flexibility to a trustee who operates a business or other activity in proprietorship form rather than in a wholly-owned corporation (or, where permitted by state law, a single-member limited liability company), and to facilitate the trustee’s ability to decide the extent to which the net receipts from the activity should be allocated to income, just as the board of directors of a corporation owned entirely by the trust would decide the amount of the annual dividend to be paid to the trust. It permits a trustee to account for farming or livestock operations, rental properties, oil and gas properties, timber operations, and activities in derivatives and options as though they were held by a separate entity. It is not intended, however, to permit a trustee to account separately for a traditional securities portfolio to avoid the provisions of this Act that apply to such securities.

Section 403 permits the trustee to account separately for each business or activity for which the trustee determines separate accounting is appropriate. A trustee with a computerized accounting system may account for these activities in a “subtrust”; an individual trustee may continue to use the business and record-keeping methods employed by the decedent or transferor who may have conducted the business under an assumed name. The intent of this section is to give the trustee broad authority to select business record-keeping methods that best suit the activity in which the trustee is engaged.

If a fiduciary liquidates a sole proprietorship or other activity to which Section 403 applies, the proceeds would be added to principal, even though derived from the liquidation of accounts receivable, because the proceeds would no longer be needed in the conduct of the business. If the liquidation occurs during probate or during an income interest’s winding up period, none of the proceeds would be income for purposes of Section 201.

Separate accounts. A trustee may or may not maintain separate bank accounts for business activities that are accounted for under Section 403. A professional trustee may decide not to maintain separate bank accounts, but an individual trustee, especially one who has continued a decedent’s business practices, may continue the same banking arrangements that were used during the decedent’s lifetime. In either case, the trustee is authorized to decide to what extent cash is to be retained as part of the business assets and to what extent it is to be transferred to the trust’s general accounts, either as income or principal.

[PART 2

RECEIPTS NOT NORMALLY APPORTIONED]

SECTION 404. PRINCIPAL RECEIPTS. A trustee shall allocate to principal: (1) to the extent not allocated to income under this [Act], assets received from a
transferor during the transferor’s lifetime, a decedent’s estate, a trust with a terminating income interest, or a payer under a contract naming the trust or its trustee as beneficiary;
(2) money or other property received from the sale, exchange, liquidation, or change in form of a principal asset, including realized profit, subject to this [article];
(3) amounts recovered from third parties to reimburse the trust because of disbursements described in Section 502(a)(7) or for other reasons to the extent not based on the loss of income;
(4) proceeds of property taken by eminent domain, but a separate award made for the loss of income with respect to an accounting period during which a current income beneficiary had a mandatory income interest is income;
(5) net income received in an accounting period during which there is no beneficiary to whom a trustee may or must distribute income; and
(6) other receipts as provided in [Part 3].

Comment

Eminent domain awards. Even though the award in an eminent domain proceeding may include an amount for the loss of future rent on a lease, if that amount is not separately

stated the entire award is principal. The rule is the same in the 1931 and 1962 Acts.

SECTION 405. RENTAL PROPERTY. To the extent that a trustee accounts for receipts from rental property pursuant to this section, the trustee shall allocate to income an amount received as rent of real or personal property, including an amount received for cancellation or renewal of a lease. An amount received as a refundable deposit, including a security deposit or a deposit that is to be applied as rent for future periods, must be added to principal and held subject to the terms of the lease and is not available for distribution to a beneficiary until the trustee’s contractual obligations have been satisfied with respect to that amount.
Comment

Application of Section 403. This section applies to the extent that the trustee does not account separately under Section 403 for the management of rental properties owned by the trust.

Receipts that are capital in nature. A portion of the payment under a lease may be a reimbursement of principal expenditures for improvements to the leased property that is characterized as rent for purposes of invoking contractual or statutory remedies for nonpayment. If the trustee is accounting for rental income under Section 405, a transfer from income to reimburse principal may be appropriate under Section 504 to the extent that some of the “rent” is really a reimbursement for improvements. This set of facts could also be a relevant factor for a trustee to consider under Section 104(b) in deciding whether and to what extent to make an adjustment between principal and income under Section 104(a) after considering the return from the portfolio as a whole.

SECTION 406. OBLIGATION TO PAY MONEY.

(a) An amount received as interest, whether determined at a fixed, variable, or floating rate, on an obligation to pay money to the trustee, including an amount received as consideration for prepaying principal, must be allocated to income without any provision for amortization of premium.

(b) A trustee shall allocate to principal an amount received from the sale, redemption, or other disposition of an obligation to pay money to the trustee more than one year after it is purchased or acquired by the trustee, including an obligation whose purchase price or value when it is acquired is less than its value at maturity. If the obligation matures within one year
after it is purchased or acquired by the trustee, an amount received in excess of its purchase price or its value when acquired by the trust must be allocated to income.
(c) This section does not apply to an obligation to which Section 409, 410, 411, 412,

414, or 415 applies.

Comment

Variable or floating interest rates. The reference in subsection (a) to variable or floating interest rate obligations is intended to clarify that, even though an obligation’s interest rate may change from time to time based upon changes in an index or other market indicator, an obligation to pay money containing a variable or floating rate provision is subject to this section and is not to be treated as a derivative financial instrument under Section 414.

Discount obligations. Subsection (b) applies to all obligations acquired at a discount, including short-term obligations such as U.S. Treasury Bills, long-term obligations such as U.S. Savings Bonds, zero-coupon bonds, and discount bonds that pay interest during part, but not all, of the period before maturity. Under subsection (b), the entire increase in value of these obligations is principal when the trustee receives the proceeds from the disposition unless the obligation, when acquired, has a maturity of less than one year. In order to have one rule that applies to all discount obligations, the Act eliminates the provision in the 1962 Act for the payment from principal of an amount equal to the increase in the value of U.S. Series E bonds. The provision for bonds that mature within one year after acquisition by the trustee is derived from the Illinois act. 760 ILCS 15/8 (1996).

Subsection (b) also applies to inflation-indexed bonds – any increase in principal due to inflation after issuance is principal upon redemption if the bond matures more than one year after the trustee acquires it; if it matures within one year, all of the increase, including any attributable to an inflation adjustment, is income.

Effect of Section 104. In deciding whether and to what extent to exercise the power to adjust between principal and income granted by Section 104(a), a relevant factor for the trustee to consider is the effect on the portfolio as a whole of having a portion of the assets invested in bonds that do not pay interest currently.

SECTION 407. INSURANCE POLICIES AND SIMILAR CONTRACTS.

(a) Except as otherwise provided in subsection (b), a trustee shall allocate to principal the proceeds of a life insurance policy or other contract in which the trust or its trustee is named as beneficiary, including a contract that insures the trust or its trustee against loss for damage to, destruction of, or loss of title to a trust asset. The trustee shall allocate dividends on an insurance policy to income if the premiums on the policy are paid from income, and to principal if the premiums are paid from principal.
(b) A trustee shall allocate to income proceeds of a contract that insures the trustee against loss of occupancy or other use by an income beneficiary, loss of income, or, subject to Section 403, loss of profits from a business.
(c) This section does not apply to a contract to which Section 409 applies.
[PART 3

RECEIPTS NORMALLY APPORTIONED]

SECTION 408. INSUBSTANTIAL ALLOCATIONS NOT REQUIRED. If a trustee determines that an allocation between principal and income required by Section 409, 410, 411,
412, or 415 is insubstantial, the trustee may allocate the entire amount to principal unless one of the circumstances described in Section 104(c) applies to the allocation. This power may be exercised by a cotrustee in the circumstances described in Section 104(d) and may be released for the reasons and in the manner described in Section 104(e). An allocation is presumed to be insubstantial if:
(1) the amount of the allocation would increase or decrease net income in an accounting period, as determined before the allocation, by less than 10 percent; or

(2) the value of the asset producing the receipt for which the allocation would be made is less than 10 percent of the total value of the trust’s assets at the beginning of the accounting period.
Comment

This section is intended to relieve a trustee from making relatively small allocations while preserving the trustee’s right to do so if an allocation is large in terms of absolute dollars.

For example, assume that a trust’s assets, which include a working interest in an oil well, have a value of $1,000,000; the net income from the assets other than the working interest is
$40,000; and the net receipts from the working interest are $400. The trustee may allocate all of the net receipts from the working interest to principal instead of allocating 10%, or $40, to income under Section 411. If the net receipts from the working interest are $35,000, so that the amount allocated to income under Section 411 would be $3,500, the trustee may decide that this amount is sufficiently significant to the income beneficiary that the allocation provided for by Section 411 should be made, even though the trustee is still permitted under Section 408 to allocate all of the net receipts to principal because the $3,500 would increase the net income of
$40,000, as determined before making an allocation under Section 411, by less than 10%. Section 408 will also relieve a trustee from having to allocate net receipts from the sale of trees in a small woodlot between principal and income.

While the allocation to principal of small amounts under this section should not be a cause for concern for tax purposes, allocations are not permitted under this section in circumstances described in Section 104(c) to eliminate claims that the power in this section has adverse tax consequences.

SECTION 409. DEFERRED COMPENSATION, ANNUITIES, AND SIMILAR PAYMENTS.
(a) In this section, “payment”:

(1) “Payment” means a payment that a trustee may receive over a fixed number of years or during the life of one or more individuals because of services rendered or property transferred to the payer in exchange for future payments. The term includes a payment made in money or property from the payer’s general assets or from a separate fund created by the payer, including:. For purposes of subsections (d), (e), (f), and (g), the term also includes any payment

from any separate fund, regardless of the reason for the payment.

(2) “Separate fund” includes a private or commercial annuity, an individual retirement account, and a pension, profit-sharing, stock-bonus, or stock-ownership plan.
(b) To the extent that a payment is characterized as interest, or a dividend, or a payment made in lieu of interest or a dividend, a trustee shall allocate it the payment to income. The trustee shall allocate to principal the balance of the payment and any other payment received in the same accounting period that is not characterized as interest, a dividend, or an equivalent payment.
(c) If no part of a payment is characterized as interest, a dividend, or an equivalent payment, and all or part of the payment is required to be made, a trustee shall allocate to income
10 percent of the part that is required to be made during the accounting period and the balance to principal. If no part of a payment is required to be made or the payment received is the entire amount to which the trustee is entitled, the trustee shall allocate the entire payment to principal. For purposes of this subsection, a payment is not “required to be made” to the extent that it is made because the trustee exercises a right of withdrawal.
(d) If, to obtain an estate tax marital deduction for a trust, a trustee must allocate more of

a payment to income than provided for by this section, the trustee shall allocate to income the

additional amount necessary to obtain the marital deduction. Except as otherwise provided in

subsection (e), subsections (f) and (g) apply, and subsections (b) and (c) do not apply, in

determining the allocation of a payment made from a separate fund to:

(1) a trust to which an election to qualify for a marital deduction under Section

2056(b)(7) of the Internal Revenue Code of 1986 [, as amended] [, 26 U.S.C. Section 2056(b)(7)] [, as amended], has been made; or

(2) a trust that qualifies for the marital deduction under Section 2056(b)(5) of the

Internal Revenue Code of 1986 [, as amended] [, 26 U.S.C. Section 2056(b)(5)] [, as amended].

(e) Subsections (d), (f), and (g) do not apply if and to the extent that the series of

payments would, without the application of subsection (d), qualify for the marital deduction

under Section 2056(b)(7)(C) of the Internal Revenue Code of 1986 [, as amended] [, 26 U.S.C.

Section 2056(b)(7)(C)] [, as amended].

(f) A trustee shall determine the internal income of each separate fund for the accounting

period as if the separate fund were a trust subject to this [act]. Upon request of the surviving

spouse, the trustee shall demand that the person administering the separate fund distribute the

internal income to the trust. The trustee shall allocate a payment from the separate fund to

income to the extent of the internal income of the separate fund and distribute that amount to the

surviving spouse. The trustee shall allocate the balance of the payment to principal. Upon

request of the surviving spouse, the trustee shall allocate principal to income to the extent the

internal income of the separate fund exceeds payments made from the separate fund to the trust

during the accounting period.

(g) If a trustee cannot determine the internal income of a separate fund but can determine

the value of the separate fund, the internal income of the separate fund is deemed to equal [insert

number at least three percent and not more than five percent] of the fund’s value, according to

the most recent statement of value preceding the beginning of the accounting period. If the

trustee can determine neither the internal income of the separate fund nor the fund’s value, the

internal income of the fund is deemed to equal the product of the interest rate and the present

value of the expected future payments, as determined under Section 7520 of the Internal

Revenue Code of 1986 [, as amended] [, 26 U.S.C. Section 7520] [, as amended], for the month

preceding the accounting period for which the computation is made.

(e)(h) This section does not apply to payments a payment to which Section 410 applies.

Comment

Scope. Section 409 applies to amounts received under contractual arrangements that provide for payments to a third party beneficiary as a result of services rendered or property transferred to the payer. While the right to receive such payments is a liquidating asset of the kind described in Section 410 (i.e., “an asset whose value will diminish or terminate because the asset is expected to produce receipts for a period of limited duration”), these payment rights are covered separately in Section 409 because of their special characteristics.

Section 409 applies to receipts from all forms of annuities and deferred compensation arrangements, whether the payment will be received by the trust in a lump sum or in installments over a period of years. It applies to bonuses that may be received over two or three years and payments that may last for much longer periods, including payments from an individual retirement account (IRA), deferred compensation plan (whether qualified or not qualified for special federal income tax treatment), and insurance renewal commissions. It applies to a retirement plan to which the settlor has made contributions, just as it applies to an annuity policy that the settlor may have purchased individually, and it applies to variable annuities, deferred annuities, annuities issued by commercial insurance companies, and “private annuities” arising from the sale of property to another individual or entity in exchange for payments that are to be made for the life of one or more individuals. The section applies whether the payments begin when the payment right becomes subject to the trust or are deferred until a future date, and it applies whether payments are made in cash or in kind, such as employer stock (in-kind payments usually will be made in a single distribution that will be allocated to principal under the second sentence of subsection (c)).

The 1962 Act. Under Section 12 of the 1962 Act, receipts from “rights to receive payments on a contract for deferred compensation” are allocated to income each year in an amount “not in excess of 5% per year” of the property’s inventory value. While “not in excess of
5%” suggests that the annual allocation may range from zero to 5% of the inventory value, in practice the rule is usually treated as prescribing a 5% allocation. The inventory value is usually the present value of all the future payments, and since the inventory value is determined as of the date on which the payment right becomes subject to the trust, the inventory value, and thus the amount of the annual income allocation, depends significantly on the applicable interest rate on the decedent’s date of death. That rate may be much higher or lower than the average long-term interest rate. The amount determined under the 5% formula tends to become fixed and remain unchanged even though the amount received by the trust increases or decreases.

Allocations Under Section 409(b). Section 409(b) applies to plans whose terms characterize payments made under the plan as dividends, interest, or payments in lieu of dividends or interest. For example, some deferred compensation plans that hold debt obligations or stock of the plan’s sponsor in an account for future delivery to the person rendering the services provide for the annual payment to that person of dividends received on the stock or

interest received on the debt obligations. Other plans provide that the account of the person rendering the services shall be credited with “phantom” shares of stock and require an annual payment that is equivalent to the dividends that would be received on that number of shares if they were actually issued; or a plan may entitle the person rendering the services to receive a fixed dollar amount in the future and provide for the annual payment of interest on the deferred amount during the period prior to its payment. Under Section 409(b), payments of dividends, interest or payments in lieu of dividends or interest under plans of this type are allocated to income; all other payments received under these plans are allocated to principal.

Section 409(b) does not apply to an IRA or an arrangement with payment provisions similar to an IRA. IRAs and similar arrangements are subject to the provisions in Section
409(c).

Allocations Under Section 409(c). The focus of Section 409, for purposes of allocating payments received by a trust to or between principal and income, is on the payment right rather than on assets that may be held in a fund from which the payments are made. Thus, if an IRA holds a portfolio of marketable stocks and bonds, the amount received by the IRA as dividends and interest is not taken into account in determining the principal and income allocation except to the extent that the Internal Revenue Service may require them to be taken into account when the payment is received by a trust that qualifies for the estate tax marital deduction (a situation
that is provided for in Section 409(d)). An IRA is subject to federal income tax rules that require payments to begin by a particular date and be made over a specific number of years or a period measured by the lives of one or more persons. The payment right of a trust that is named as a beneficiary of an IRA is not a right to receive particular items that are paid to the IRA, but is instead the right to receive an amount determined by dividing the value of the IRA by the remaining number of years in the payment period. This payment right is similar to the right to receive a unitrust amount, which is normally expressed as an amount equal to a percentage of the value of the unitrust assets without regard to dividends or interest that may be received by the unitrust.

An amount received from an IRA or a plan with a payment provision similar to that of an
IRA is allocated under Section 409(c), which differentiates between payments that are required to be made and all other payments. To the extent that a payment is required to be made (either under federal income tax rules or, in the case of a plan that is not subject to those rules, under the terms of the plan), 10% of the amount received is allocated to income and the balance is
allocated to principal. All other payments are allocated to principal because they represent a change in the form of a principal asset; Section 409 follows the rule in Section 404(2), which provides that money or property received from a change in the form of a principal asset be allocated to principal.

Section 409(c) produces an allocation to income that is similar to the allocation under the
1962 Act formula if the annual payments are the same throughout the payment period, and it is simpler to administer. The amount allocated to income under Section 409 is not dependent upon the interest rate that is used for valuation purposes when the decedent dies, and if the payments received by the trust increase or decrease from year to year because the fund from which the payment is made increases or decreases in value, the amount allocated to income will also

increase or decrease.

Marital deduction requirements. When an IRA is payable to a QTIP marital deduction trust, the IRS treats the IRA as separate terminable interest property and requires that a QTIP election be made for it. In order to qualify for QTIP treatment, an IRS ruling states that all of the IRA’s income must be distributed annually to the QTIP marital deduction trust and then must be allocated to trust income for distribution to the spouse. Rev. Rul. 89-89, 1989-2 C.B. 231. If an allocation to income under this Act of 10% of the required distribution from the IRA does not meet the requirement that all of the IRA’s income be distributed from the trust to the spouse, the provision in subsection (d) requires the trustee to make a larger allocation to income to the extent necessary to qualify for the marital deduction. The requirement of Rev. Rul. 89-89 should also be satisfied if the IRA beneficiary designation permits the spouse to require the trustee to withdraw the necessary amount from the IRA and distribute it to her, even though the spouse never actually requires the trustee to do so. If such a provision is in the beneficiary designation, a distribution under subsection (d) should not be necessary.

Marital deduction requirements. When an IRA or other retirement arrangement (a “plan”) is payable to a marital deduction trust, the IRS treats the plan as a separate property interest that itself must qualify for the marital deduction. IRS Revenue Ruling 2006-26 said that, as written, Section 409 does not cause a trust to qualify for the IRS’ safe harbors. Revenue Ruling 2006-26 was limited in scope to certain situations involving IRAs and defined contribution retirement plans. Without necessarily agreeing with the IRS’ position in that ruling, the revision to this section is designed to satisfy the IRS’ safe harbor and to address concerns
that might be raised for similar assets. No IRS pronouncements have addressed the scope of Code § 2056(b)(7)(C).

Subsection (f) requires the trustee to demand certain distributions if the surviving spouse so requests. The safe harbor of Revenue Ruling 2006-26 requires that the surviving spouse be separately entitled to demand the fund’s income (without regard to the income from the trust’s other assets) and the income from the other assets (without regard to the fund’s income). In any event, the surviving spouse is not required to demand that the trustee distribute all of the fund’s income from the fund or from other trust assets. Treas. Reg. § 20.2056(b)-5(f)(8).

Subsection (f) also recognizes that the trustee might not control the payments that the trustee receives and provides a remedy to the surviving spouse if the distributions under subsection (d)(1) are insufficient.

Subsection (g) addresses situations where, due to lack of information provided by the fund’s administrator, the trustee is unable to determine the fund’s actual income. The bracketed language is the range approved for unitrust payments by Treas. Reg. § 1.643(b)-1. In determining the value for purposes of applying the unitrust percentage, the trustee would seek to obtain the value of the assets as of the most recent statement of value immediately preceding the beginning of the year. For example, suppose a trust’s accounting period is January 1 through December 31. If a retirement plan administrator furnishes information annually each
September 30 and declines to provide information as of December 31, then the trustee may rely
on the September 30 value to determine the distribution for the following year. For funds whose

values are not readily available, subsection (g) relies on Code section 7520 valuation methods because many funds described in Section 409 are annuities, and one consistent set of valuation principles should apply whether or not the fund is, in fact, an annuity.

Application of Section 104. Section 104(a) of this Act gives a trustee who is acting under the prudent investor rule the power to adjust from principal to income if, considering the portfolio as a whole and not just receipts from deferred compensation, the trustee determines that an adjustment is necessary. See Example (5) in the Comment following Section 104.

SECTION 410. LIQUIDATING ASSET.

(a) In this section, “liquidating asset” means an asset whose value will diminish or terminate because the asset is expected to produce receipts for a period of limited duration. The term includes a leasehold, patent, copyright, royalty right, and right to receive payments during a period of more than one year under an arrangement that does not provide for the payment of interest on the unpaid balance. The term does not include a payment subject to Section 409, resources subject to Section 411, timber subject to Section 412, an activity subject to Section
414, an asset subject to Section 415, or any asset for which the trustee establishes a reserve for depreciation under Section 503.
(b) A trustee shall allocate to income 10 percent of the receipts from a liquidating asset and the balance to principal.
Comment

Prior Acts. Section 11 of the 1962 Act allocates receipts from “property subject to depletion” to income in an amount “not in excess of 5%” of the asset’s inventory value. The
1931 Act has a similar 5% rule that applies when the trustee is under a duty to change the form of the investment. The 5% rule imposes on a trust the obligation to pay a fixed annuity to the income beneficiary until the asset is exhausted. Under both the 1931 and 1962 Acts the balance of each year’s receipts is added to principal. A fixed payment can produce unfair results. The remainder beneficiary receives all of the receipts from unexpected growth in the asset, e.g., if royalties on a patent or copyright increase significantly. Conversely, if the receipts diminish more rapidly than expected, most of the amount received by the trust will be allocated to income
and little to principal. Moreover, if the annual payments remain the same for the life of the asset, the amount allocated to principal will usually be less than the original inventory value. For these reasons, Section 410 abandons the annuity approach under the 5% rule.

Lottery payments. The reference in subsection (a) to rights to receive payments under an arrangement that does not provide for the payment of interest includes state lottery prizes and similar fixed amounts payable over time that are not deferred compensation arrangements covered by Section 409.

SECTION 411. MINERALS, WATER, AND OTHER NATURAL RESOURCES.

(a) To the extent that a trustee accounts for receipts from an interest in minerals or other natural resources pursuant to this section, the trustee shall allocate them as follows:
(1) If received as nominal delay rental or nominal annual rent on a lease, a receipt must be allocated to income.
(2) If received from a production payment, a receipt must be allocated to income if and to the extent that the agreement creating the production payment provides a factor for interest or its equivalent. The balance must be allocated to principal.
(3) If an amount received as a royalty, shut-in-well payment, take-or-pay payment, bonus, or delay rental is more than nominal, 90 percent must be allocated to principal and the balance to income.
(4) If an amount is received from a working interest or any other interest not provided for in paragraph (1), (2), or (3), 90 percent of the net amount received must be allocated to principal and the balance to income.
(b) An amount received on account of an interest in water that is renewable must be allocated to income. If the water is not renewable, 90 percent of the amount must be allocated to principal and the balance to income.
(c) This [Act] applies whether or not a decedent or donor was extracting minerals, water, or other natural resources before the interest became subject to the trust.
(d) If a trust owns an interest in minerals, water, or other natural resources on [the

effective date of this [Act]], the trustee may allocate receipts from the interest as provided in this [Act] or in the manner used by the trustee before [the effective date of this [Act]]. If the trust acquires an interest in minerals, water, or other natural resources after [the effective date of this [Act]], the trustee shall allocate receipts from the interest as provided in this [Act].
Comment

Prior Acts. The 1962 Act allocates to principal as a depletion allowance, 27-1/2% of the gross receipts, but not more than 50% of the net receipts after paying expenses. The Internal Revenue Code no longer provides for a 27-1/2% depletion allowance, although the major
oil-producing States have retained the 27-1/2% provision in their principal and income acts
(Texas amended its Act in 1993, but did not change the depletion provision). Section 9 of the
1931 Act allocates all of the net proceeds received as consideration for the “permanent severance of natural resources from the lands” to principal.

Section 411 allocates 90% of the net receipts to principal and 10% to income. A
depletion provision that is tied to past or present Code provisions is undesirable because it causes a large portion of the oil and gas receipts to be paid out as income. As wells are depleted, the amount received by the income beneficiary falls drastically. Allocating a larger portion of the receipts to principal enables the trustee to acquire other income producing assets that will continue to produce income when the mineral reserves are exhausted.

Application of Sections 403 and 408. This section applies to the extent that the trustee does not account separately for receipts from minerals and other natural resources under Section
403 or allocate all of the receipts to principal under Section 408.

Open mine doctrine. The purpose of Section 411(c) is to abolish the “open mine doctrine” as it may apply to the rights of an income beneficiary and a remainder beneficiary in receipts from the production of minerals from land owned or leased by a trust. Instead, such receipts are to be allocated to or between principal and income in accordance with the provisions of this Act. For a discussion of the open mine doctrine, see generally 3A Austin W. Scott & William F. Fratcher, The Law of Trusts ‘ 239.3 (4th ed. 1988), and Nutter v. Stockton, 626 P.2d
861 (Okla. 1981).

Effective date provision. Section 9(b) of the 1962 Act provides that the natural resources provision does not apply to property interests held by the trust on the effective date of the Act, which reflects concerns about the constitutionality of applying a retroactive administrative provision to interests in real estate, based on the opinion in the Oklahoma case of Franklin v. Margay Oil Corporation, 153 P.2d 486, 501 (Okla. 1944). Section 411(d) permits a trustee to use either the method provided for in this Act or the method used before the Act takes effect. Lawyers in jurisdictions other than Oklahoma may conclude that retroactivity is not a problem as to property situated in their States, and this provision permits trustees to decide, based on advice from counsel in States whose law may be different from that of Oklahoma,

whether they may apply this provision retroactively if they conclude that to do so is in the best interests of the beneficiaries.

If the property is in a State other than the State where the trust is administered, the trustee must be aware that the law of the property’s situs may control this question. The outcome turns on a variety of questions: whether the terms of the trust specify that the law of a State other than the situs of the property shall govern the administration of the trust, and whether the courts will follow the terms of the trust; whether the trust’s asset is the land itself or a leasehold interest in the land (as it frequently is with oil and gas property); whether a leasehold interest or its
proceeds should be classified as real property or personal property, and if as personal property, whether applicable state law treats it as a movable or an immovable for conflict of laws purposes. See 5A Austin W. Scott & William F. Fratcher, The Law of Trusts ” 648, at 531,
533-534; ‘ 657, at 600 (4th ed. 1989).

SECTION 412. TIMBER.

(a) To the extent that a trustee accounts for receipts from the sale of timber and related products pursuant to this section, the trustee shall allocate the net receipts:
(1) to income to the extent that the amount of timber removed from the land does not exceed the rate of growth of the timber during the accounting periods in which a beneficiary has a mandatory income interest;
(2) to principal to the extent that the amount of timber removed from the land exceeds the rate of growth of the timber or the net receipts are from the sale of standing timber;
(3) to or between income and principal if the net receipts are from the lease of timberland or from a contract to cut timber from land owned by a trust, by determining the amount of timber removed from the land under the lease or contract and applying the rules in paragraphs (1) and (2); or
(4) to principal to the extent that advance payments, bonuses, and other payments are not allocated pursuant to paragraph (1), (2), or (3).
(b) In determining net receipts to be allocated pursuant to subsection (a), a trustee shall deduct and transfer to principal a reasonable amount for depletion.

(c) This [Act] applies whether or not a decedent or transferor was harvesting timber from the property before it became subject to the trust.
(d) If a trust owns an interest in timberland on [the effective date of this [Act]], the trustee may allocate net receipts from the sale of timber and related products as provided in this [Act] or in the manner used by the trustee before [the effective date of this [Act]]. If the trust acquires an interest in timberland after [the effective date of this [Act]], the trustee shall allocate net receipts from the sale of timber and related products as provided in this [Act].
Comment

Scope of section. The rules in Section 412 are intended to apply to net receipts from the sale of trees and by-products from harvesting and processing trees without regard to the kind of trees that are cut or whether the trees are cut before or after a particular number of years of growth. The rules apply to the sale of trees that are expected to produce lumber for building purposes, trees sold as pulpwood, and Christmas and other ornamental trees. Subsection (a) applies to net receipts from property owned by the trustee and property leased by the trustee.
The Act is not intended to prevent a tenant in possession of the property from using wood that he cuts on the property for personal, noncommercial purposes, such as a Christmas tree, firewood, mending old fences or building new fences, or making repairs to structures on the property.

Under subsection (a), the amount of net receipts allocated to income depends upon whether the amount of timber removed is more or less than the rate of growth. The method of determining the amount of timber removed and the rate of growth is up to the trustee, based on methods customarily used for the kind of timber involved.

Application of Sections 403 and 408. This section applies to the extent that the trustee does not account separately for net receipts from the sale of timber and related products under Section 403 or allocate all of the receipts to principal under Section 408. The option to account for net receipts separately under Section 403 takes into consideration the possibility that timber harvesting operations may have been conducted before the timber property became subject to the trust, and that it may make sense to continue using accounting methods previously established
for the property. It also permits a trustee to use customary accounting practices for timber operations even if no harvesting occurred on the property before it became subject to the trust.

SECTION 413. PROPERTY NOT PRODUCTIVE OF INCOME.

(a) If a marital deduction is allowed for all or part of a trust whose assets consist substantially of property that does not provide the spouse with sufficient income from or use of

the trust assets, and if the amounts that the trustee transfers from principal to income under Section 104 and distributes to the spouse from principal pursuant to the terms of the trust are insufficient to provide the spouse with the beneficial enjoyment required to obtain the marital deduction, the spouse may require the trustee to make property productive of income, convert property within a reasonable time, or exercise the power conferred by Section 104(a). The trustee may decide which action or combination of actions to take.
(b) In cases not governed by subsection (a), proceeds from the sale or other disposition of an asset are principal without regard to the amount of income the asset produces during any accounting period.
Comment

Prior Acts’ Conflict with Uniform Prudent Investor Act. Section 2(b) of the Uniform Prudent Investor Act provides that “[a] trustee’s investment and management decisions respecting individual assets must be evaluated not in isolation but in the context of the trust
portfolio as a whole … .” The underproductive property provisions in Section 12 of the 1962 Act and Section 11 of the 1931 Act give the income beneficiary a right to receive a portion of the proceeds from the sale of underproductive property as “delayed income.” In each Act the provision applies on an asset by asset basis and not by taking into consideration the trust
portfolio as a whole, which conflicts with the basic precept in Section 2(b) of the Prudent Investor Act. Moreover, in determining the amount of delayed income, the prior Acts do not permit a trustee to take into account the extent to which the trustee may have distributed principal to the income beneficiary, under principal invasion provisions in the terms of the trust, to compensate for insufficient income from the unproductive asset. Under Section 104(b)(7) of this Act, a trustee must consider prior distributions of principal to the income beneficiary in
deciding whether and to what extent to exercise the power to adjust conferred by Section 104(a).

Duty to make property productive of income. In order to implement the Uniform Prudent Investor Act, this Act abolishes the right to receive delayed income from the sale proceeds of an asset that produces little or no income, but it does not alter existing state law regarding the income beneficiary’s right to compel the trustee to make property productive of income. As the law continues to develop in this area, the duty to make property productive of current income in a particular situation should be determined by taking into consideration the performance of the portfolio as a whole and the extent to which a trustee makes principal distributions to the income beneficiary under the terms of the trust and adjustments between principal and income under Section 104 of this Act.

Trusts for which the value of the right to receive income is important for tax reasons may

be affected by Reg. ‘ 1.7520-3(b)(2)(v) Example (1), ‘ 20.7520-3(b)(2)(v) Examples (1) and (2), and ‘ 25.7520-3(b)(2)(v) Examples (1) and (2), which provide that if the income beneficiary
does not have the right to compel the trustee to make the property productive, the income interest is considered unproductive and may not be valued actuarially under those sections.

Marital deduction trusts. Subsection (a) draws on language in Reg.
‘ 20.2056(b)-5(f)(4) and (5) to enable a trust for a spouse to qualify for a marital deduction if applicable state law is unclear about the spouse’s right to compel the trustee to make property productive of income. The trustee should also consider the application of Section 104 of this Act and the provisions of Restatement of Trusts 3d: Prudent Investor Rule ‘ 240, at 186, app. ‘ 240, at 252 (1992). Example (6) in the Comment to Section 104 describes a situation involving the payment from income of carrying charges on unproductive real estate in which Section 104 may apply.

Once the two conditions have occurred – insufficient beneficial enjoyment from the property and the spouse’s demand that the trustee take action under this section – the trustee must act; but instead of the formulaic approach of the 1962 Act, which is triggered only if the trustee sells the property, this Act permits the trustee to decide whether to make the property productive of income, convert it, transfer funds from principal to income, or to take some combination of those actions. The trustee may rely on the power conferred by Section 104(a) to adjust from principal to income if the trustee decides that it is not feasible or appropriate to make the
property productive of income or to convert the property. Given the purpose of Section 413, the power under Section 104(a) would be exercised to transfer principal to income and not to transfer income to principal.

Section 413 does not apply to a so-called “estate” trust, which will qualify for the marital deduction, even though the income may be accumulated for a term of years or for the life of the surviving spouse, if the terms of the trust require the principal and undistributed income to be paid to the surviving spouse’s estate when the spouse dies. Reg. ‘ 20.2056(c)-2(b)(1)(iii).

SECTION 414. DERIVATIVES AND OPTIONS.

(a) In this section, “derivative” means a contract or financial instrument or a combination of contracts and financial instruments which gives a trust the right or obligation to participate in some or all changes in the price of a tangible or intangible asset or group of assets, or changes in a rate, an index of prices or rates, or other market indicator for an asset or a group of assets.
(b) To the extent that a trustee does not account under Section 403 for transactions in derivatives, the trustee shall allocate to principal receipts from and disbursements made in

connection with those transactions.

(c) If a trustee grants an option to buy property from the trust, whether or not the trust owns the property when the option is granted, grants an option that permits another person to sell property to the trust, or acquires an option to buy property for the trust or an option to sell an asset owned by the trust, and the trustee or other owner of the asset is required to deliver the
asset if the option is exercised, an amount received for granting the option must be allocated to principal. An amount paid to acquire the option must be paid from principal. A gain or loss realized upon the exercise of an option, including an option granted to a settlor of the trust for services rendered, must be allocated to principal.
Comment

Scope and application. It is difficult to predict how frequently and to what extent trustees will invest directly in derivative financial instruments rather than participating indirectly through investment entities that may utilize these instruments in varying degrees. If the trust participates in derivatives indirectly through an entity, an amount received from the entity will be allocated under Section 401 and not Section 414. If a trustee invests directly in derivatives to a significant extent, the expectation is that receipts and disbursements related to derivatives will be accounted for under Section 403; if a trustee chooses not to account under Section 403, Section
414(b) provides the default rule. Certain types of option transactions in which trustees may engage are dealt with in subsection (c) to distinguish those transactions from ones involving options that are embedded in derivative financial instruments.

Definition of “derivative.” “Derivative” is a difficult term to define because new derivatives are invented daily as dealers tailor their terms to achieve specific financial objectives for particular clients. Since derivatives are typically contract-based, a derivative can probably be devised for almost any set of objectives if another party can be found who is willing to assume
the obligations required to meet those objectives.

The most comprehensive definition of derivative is in the Exposure Draft of a Proposed Statement of Financial Accounting Standards titled “Accounting for Derivative and Similar Financial Instruments and for Hedging Activities,” which was released by the Financial Accounting Standards Board (FASB) on June 20, 1996 (No. 162-B). The definition in Section
414(a) is derived in part from the FASB definition. The purpose of the definition in subsection (a) is to implement the substantive rule in subsection (b) that provides for all receipts and disbursements to be allocated to principal to the extent the trustee elects not to account for transactions in derivatives under Section 403. As a result, it is much shorter than the FASB definition, which serves much more ambitious objectives.

A derivative is frequently described as including futures, forwards, swaps and options, terms that also require definition, and the definition in this Act avoids these terms. FASB used the same approach, explaining in paragraph 65 of the Exposure Draft:

The definition of derivative financial instrument in this Statement includes those financial instruments generally considered to be derivatives, such as forwards, futures, swaps, options, and similar instruments. The Board considered defining a derivative financial instrument by merely referencing those commonly understood instruments, similar to paragraph
5 of Statement 119, which says that “… a derivative financial instrument is a futures, forward, swap, or option contract, or other financial instrument with similar characteristics.” However, the continued development of financial markets and innovative financial instruments could ultimately render a definition based on examples inadequate and obsolete. The Board, therefore, decided to base the definition of a derivative financial instrument on a description of the
common characteristics of those instruments in order to accommodate the accounting for newly developed derivatives. (Footnote omitted.)

Marking to market. A gain or loss that occurs because the trustee marks securities to market or to another value during an accounting period is not a transaction in a derivative financial instrument that is income or principal under the Act – only cash receipts and disbursements, and the receipt of property in exchange for a principal asset, affect a trust’s principal and income accounts.

Receipt of property other than cash. If a trustee receives property other than cash upon the settlement of a derivatives transaction, that property would be principal under Section
404(2).

Options. Options to which subsection (c) applies include an option to purchase real estate owned by the trustee and a put option purchased by a trustee to guard against a drop in value of a large block of marketable stock that must be liquidated to pay estate taxes. Subsection (c) would also apply to a continuing and regular practice of selling call options on securities owned by the trust if the terms of the option require delivery of the securities. It does not apply
if the consideration received or given for the option is something other than cash or property, such as cross-options granted in a buy-sell agreement between owners of an entity.

SECTION 415. ASSET-BACKED SECURITIES.

(a) In this section, “asset-backed security” means an asset whose value is based upon the right it gives the owner to receive distributions from the proceeds of financial assets that provide collateral for the security. The term includes an asset that gives the owner the right to receive from the collateral financial assets only the interest or other current return or only the proceeds

other than interest or current return. The term does not include an asset to which Section 401 or

409 applies.

(b) If a trust receives a payment from interest or other current return and from other proceeds of the collateral financial assets, the trustee shall allocate to income the portion of the payment which the payer identifies as being from interest or other current return and shall allocate the balance of the payment to principal.
(c) If a trust receives one or more payments in exchange for the trust’s entire interest in an asset-backed security in one accounting period, the trustee shall allocate the payments to principal. If a payment is one of a series of payments that will result in the liquidation of the trust’s interest in the security over more than one accounting period, the trustee shall allocate 10 percent of the payment to income and the balance to principal.
Comment

Scope of section. Typical asset-backed securities include arrangements in which debt obligations such as real estate mortgages, credit card receivables and auto loans are acquired by an investment trust and interests in the trust are sold to investors. The source for payments to an investor is the money received from principal and interest payments on the underlying debt. An asset-backed security includes an “interest only” or a “principal only” security that permits the investor to receive only the interest payments received from the bonds, mortgages or other assets that are the collateral for the asset-backed security, or only the principal payments made on those collateral assets. An asset-backed security also includes a security that permits the investor to participate in either the capital appreciation of an underlying security or in the interest or dividend return from such a security, such as the “Primes” and “Scores” issued by Americus Trust. An asset-backed security does not include an interest in a corporation, partnership, or an investment trust described in the Comment to Section 402, whose assets consist significantly or entirely of investment assets. Receipts from an instrument that do not come within the scope of this section or any other section of the Act would be allocated entirely to principal under the rule in Section 103(a)(4), and the trustee may then consider whether and to what extent to exercise
the power to adjust in Section 104, taking into account the return from the portfolio as whole and other relevant factors.

[ARTICLE] 5

ALLOCATION OF DISBURSEMENTS DURING ADMINISTRATION OF TRUST
SECTION 501. DISBURSEMENTS FROM INCOME. A trustee shall make the following disbursements from income to the extent that they are not disbursements to which Section 201(2)(B) or (C) applies:
(1) one-half of the regular compensation of the trustee and of any person providing investment advisory or custodial services to the trustee;
(2) one-half of all expenses for accountings, judicial proceedings, or other matters that involve both the income and remainder interests;
(3) all of the other ordinary expenses incurred in connection with the administration, management, or preservation of trust property and the distribution of income, including interest, ordinary repairs, regularly recurring taxes assessed against principal, and expenses of a proceeding or other matter that concerns primarily the income interest; and
(4) recurring premiums on insurance covering the loss of a principal asset or the loss of income from or use of the asset.
Comment

Trustee fees. The regular compensation of a trustee or the trustee’s agent includes compensation based on a percentage of either principal or income or both.

Insurance premiums. The reference in paragraph (4) to “recurring” premiums is intended to distinguish premiums paid annually for fire insurance from premiums on title insurance, each of which covers the loss of a principal asset. Title insurance premiums would be a principal disbursement under Section 502(a)(5).

Regularly recurring taxes. The reference to “regularly recurring taxes assessed against principal” includes all taxes regularly imposed on real property and tangible and intangible personal property.

SECTION 502. DISBURSEMENTS FROM PRINCIPAL.

(a) A trustee shall make the following disbursements from principal:

(1) the remaining one-half of the disbursements described in Section 501(1) and

(2);

(2) all of the trustee’s compensation calculated on principal as a fee for acceptance, distribution, or termination, and disbursements made to prepare property for sale;
(3) payments on the principal of a trust debt;

(4) expenses of a proceeding that concerns primarily principal, including a proceeding to construe the trust or to protect the trust or its property;
(5) premiums paid on a policy of insurance not described in Section 501(4) of which the trust is the owner and beneficiary;
(6) estate, inheritance, and other transfer taxes, including penalties, apportioned to the trust; and
(7) disbursements related to environmental matters, including reclamation, assessing environmental conditions, remedying and removing environmental contamination, monitoring remedial activities and the release of substances, preventing future releases of substances, collecting amounts from persons liable or potentially liable for the costs of those activities, penalties imposed under environmental laws or regulations and other payments made to comply with those laws or regulations, statutory or common law claims by third parties, and defending claims based on environmental matters.
(b) If a principal asset is encumbered with an obligation that requires income from that asset to be paid directly to the creditor, the trustee shall transfer from principal to income an amount equal to the income paid to the creditor in reduction of the principal balance of the

obligation.

Comment

Environmental expenses. All environmental expenses are payable from principal, subject to the power of the trustee to transfer funds to principal from income under Section 504. However, the Drafting Committee decided that it was not necessary to broaden this provision to cover other expenditures made under compulsion of governmental authority. See generally the annotation at 43 A.L.R.4th 1012 (Duty as Between Life Tenant and Remainderman with Respect to Cost of Improvements or Repairs Made Under Compulsion of Governmental Authority).

Environmental expenses paid by a trust are to be paid from principal under Section
502(a)(7) on the assumption that they will usually be extraordinary in nature. Environmental expenses might be paid from income if the trustee is carrying on a business that uses or sells toxic substances, in which case environmental cleanup costs would be a normal cost of doing business and would be accounted for under Section 403. In accounting under that Section, environmental costs will be a factor in determining how much of the net receipts from the business is trust income. Paying all other environmental expenses from principal is consistent with this Act’s approach regarding receipts – when a receipt is not clearly a current return on a principal asset, it should be added to principal because over time both the income and remainder beneficiaries benefit from this treatment. Here, allocating payments required by environmental laws to principal imposes the detriment of those payments over time on both the income and remainder beneficiaries.

Under Sections 504(a) and 504(b)(5), a trustee who makes or expects to make a principal disbursement for an environmental expense described in Section 502(a)(7) is authorized to transfer an appropriate amount from income to principal to reimburse principal for
disbursements made or to provide a reserve for future principal disbursements.

The first part of Section 502(a)(7) is based upon the definition of an “environmental remediation trust” in Treas. Reg. ‘ 301.7701-4(e)(as amended in 1996). This is not because the Act applies to an environmental remediation trust, but because the definition is a useful and thoroughly vetted description of the kinds of expenses that a trustee owning contaminated property might incur. Expenses incurred to comply with environmental laws include the cost of environmental consultants, administrative proceedings and burdens of every kind imposed as the result of an administrative or judicial proceeding, even though the burden is not formally characterized as a penalty.

Title proceedings. Disbursements that are made to protect a trust’s property, referred to in Section 502(a)(4), include an “action to assure title” that is mentioned in Section 13(c)(2) of the 1962 Act.

Insurance premiums. Insurance premiums referred to in Section 502(a)(5) include title insurance premiums. They also include premiums on life insurance policies owned by the trust, which represent the trust’s periodic investment in the insurance policy. There is no provision in the 1962 Act for life insurance premiums.
(a)(6).

Taxes. Generation-skipping transfer taxes are payable from principal under subsection

SECTION 503. TRANSFERS FROM INCOME TO PRINCIPAL FOR DEPRECIATION.
(a) In this section, “depreciation” means a reduction in value due to wear, tear, decay, corrosion, or gradual obsolescence of a fixed asset having a useful life of more than one year.
(b) A trustee may transfer to principal a reasonable amount of the net cash receipts from

a principal asset that is subject to depreciation, but may not transfer any amount for depreciation: (1) of that portion of real property used or available for use by a beneficiary as a
residence or of tangible personal property held or made available for the personal use or enjoyment of a beneficiary;
(2) during the administration of a decedent’s estate; or

(3) under this section if the trustee is accounting under Section 403 for the business or activity in which the asset is used.
(c) An amount transferred to principal need not be held as a separate fund.

Comment

Prior Acts. The 1931 Act has no provision for depreciation. Section 13(a)(2) of the
1962 Act provides that a charge shall be made against income for “… a reasonable allowance for depreciation on property subject to depreciation under generally accepted accounting principles
… .” That provision has been resisted by many trustees, who do not provide for any depreciation for a variety of reasons. One reason relied upon is that a charge for depreciation is not needed to protect the remainder beneficiaries if the value of the land is increasing; another is that generally accepted accounting principles may not require depreciation to be taken if the property is not
part of a business. The Drafting Committee concluded that the decision to provide for depreciation should be discretionary with the trustee. The power to transfer funds from income to principal that is granted by this section is a discretionary power of administration referred to in Section 103(b), and in exercising the power a trustee must comply with Section 103(b).

One purpose served by transferring cash from income to principal for depreciation is to

provide funds to pay the principal of an indebtedness secured by the depreciable property. Section 504(b)(4) permits the trustee to transfer additional cash from income to principal for this purpose to the extent that the amount transferred from income to principal for depreciation is less than the amount of the principal payments.

SECTION 504. TRANSFERS FROM INCOME TO REIMBURSE PRINCIPAL.

(a) If a trustee makes or expects to make a principal disbursement described in this section, the trustee may transfer an appropriate amount from income to principal in one or more accounting periods to reimburse principal or to provide a reserve for future principal disbursements.
(b) Principal disbursements to which subsection (a) applies include the following, but only to the extent that the trustee has not been and does not expect to be reimbursed by a third party:
(1) an amount chargeable to income but paid from principal because it is unusually large, including extraordinary repairs;
(2) a capital improvement to a principal asset, whether in the form of changes to an existing asset or the construction of a new asset, including special assessments;
(3) disbursements made to prepare property for rental, including tenant allowances, leasehold improvements, and broker’s commissions;
(4) periodic payments on an obligation secured by a principal asset to the extent that the amount transferred from income to principal for depreciation is less than the periodic payments; and
(5) disbursements described in Section 502(a)(7).

(c) If the asset whose ownership gives rise to the disbursements becomes subject to a successive income interest after an income interest ends, a trustee may continue to transfer

amounts from income to principal as provided in subsection (a).

Comment

Prior Acts. The sources of Section 504 are Section 13(b) of the 1962 Act, which permits a trustee to “regularize distributions,” if charges against income are unusually large, by using “reserves or other reasonable means” to withhold sums from income distributions; Section
13(c)(3) of the 1962 Act, which authorizes a trustee to establish an allowance for depreciation out of income if principal is used for extraordinary repairs, capital improvements and special assessments; and Section 12(3) of the 1931 Act, which permits the trustee to spread income expenses of unusual amount “throughout a series of years.” Section 504 contains a more detailed enumeration of the circumstances in which this authority may be used, and includes in subsection (b)(4) the express authority to use income to make principal payments on a mortgage if the depreciation charge against income is less than the principal payments on the mortgage.

SECTION 505. INCOME TAXES.

(a) A tax required to be paid by a trustee based on receipts allocated to income must be paid from income.
(b) A tax required to be paid by a trustee based on receipts allocated to principal must be paid from principal, even if the tax is called an income tax by the taxing authority.
(c) A tax required to be paid by a trustee on the trust’s share of an entity’s taxable income must be paid proportionately:
(1) from income to the extent that receipts from the entity are allocated only to

income; and

(2) from principal to the extent that:

(A) receipts from the entity are allocated only to principal; and

(B) the trust’s share of the entity’s taxable income exceeds the total

receipts described in paragraphs (1) and (2)(A).

(3) proportionately from principal and income to the extent that receipts from the

entity are allocated to both income and principal; and

(4) from principal to the extent that the tax exceeds the total receipts from the

entity.

(d) For purposes of this section, receipts allocated to principal or income must be

reduced by the amount distributed to a beneficiary from principal or income for which the trust

receives a deduction in calculating the tax. After applying subsections (a) through (c), the

trustee shall adjust income or principal receipts to the extent that the trust’s taxes are reduced

because the trust receives a deduction for payments made to a beneficiary.

Comment

Electing Small Business Trusts. An Electing Small Business Trust (ESBT) is a creature created by Congress in the Small Business Job Protection Act of 1996 (P.L. 104-188). For years beginning after 1996, an ESBT may qualify as an S corporation stockholder even if the trustee does not distribute all of the trust’s income annually to its beneficiaries. The portion of an ESBT that consists of the S corporation stock is treated as a separate trust for tax purposes (but not for trust accounting purposes), and the S corporation income is taxed directly to that portion of the trust even if some or all of that income is distributed to the beneficiaries.

A trust normally receives a deduction for distributions it makes to its beneficiaries. Subsection (d) takes into account the possibility that an ESBT may not receive a deduction for trust accounting income that is distributed to the beneficiaries. Only limited guidance has been issued by the Internal Revenue Service, and it is too early to anticipate all of the technical questions that may arise, but the powers granted to a trustee in Sections 506 and 104 to make adjustments are probably sufficient to enable a trustee to correct inequities that may arise because of technical problems.

Taxes on Undistributed Entity Taxable Income. When a trust owns an interest in a pass-through entity, such as a partnership or S corporation, it must report its share of the entity’s taxable income regardless of how much the entity distributes to the trust. Whether the entity distributes more or less than the trust’s tax on its share of the entity’s taxable income, the trust must pay the taxes and allocate them between income and principal.

Subsection (c) requires the trust to pay the taxes on its share of an entity’s taxable income from income or principal receipts to the extent that receipts from the entity are allocable to each. This assures the trust a source of cash to pay some or all of the taxes on its share of the entity’s taxable income. Subsection 505(d) recognizes that, except in the case of an Electing Small Business Trust (ESBT), a trust normally receives a deduction for amounts distributed to a beneficiary. Accordingly, subsection 505(d) requires the trust to increase receipts payable to a beneficiary as determined under subsection (c) to the extent the trust’s taxes are reduced by distributing those receipts to the beneficiary.

Because the trust’s taxes and amounts distributed to a beneficiary are interrelated, the trust may be required to apply a formula to determine the correct amount payable to a beneficiary. This formula should take into account that each time a distribution is made to a beneficiary, the trust taxes are reduced and amounts distributable to a beneficiary are increased. The formula assures that after deducting distributions to a beneficiary, the trust has enough to satisfy its taxes on its share of the entity’s taxable income as reduced by distributions to beneficiaries.

Example (1) – Trust T receives a Schedule K-1 from Partnership P reflecting taxable income of $1 million. Partnership P distributes $100,000 to T, which allocates the receipts to income. Both Trust T and income Beneficiary B are in the 35 percent tax bracket.
Trust T’s tax on $1 million of taxable income is $350,000. Under Subsection (c) T’s tax must be paid from income receipts because receipts from the entity are allocated only to income. Therefore, T must apply the entire $100,000 of income receipts to pay its tax. In this case, Beneficiary B receives nothing.

Example (2) – Trust T receives a Schedule K-1 from Partnership P reflecting taxable income of $1 million. Partnership P distributes $500,000 to T, which allocates the receipts to income. Both Trust T and income Beneficiary B are in the 35 percent tax bracket.
Trust T’s tax on $1 million of taxable income is $350,000. Under Subsection (c), T’s tax must be paid from income receipts because receipts from P are allocated only to income. Therefore, T uses $350,000 of the $500,000 to pay its taxes and distributes the remaining $150,000 to B. The
$150,000 payment to B reduces T’s taxes by $52,500, which it must pay to B. But the $52,500 further reduces T’s taxes by $18,375, which it also must pay to B. In fact, each time T makes a distribution to B, its taxes are further reduced, causing another payment to be due B.

Alternatively, T can apply the following algebraic formula to determine the amount
payable to B:

D = (C-R*K)/(1-R)

D = Distribution to income beneficiary C = Cash paid by the entity to the trust R = tax rate on income
K = entity’s K-1 taxable income

Applying the formula to Example (2) above, Trust T must pay $230,769 to B so that after deducting the payment, T has exactly enough to pay its tax on the remaining taxable income from P.

Taxable Income per K-1 1,000,000
Payment to beneficiary 230,7691
Trust Taxable Income $ 769,231
35 percent tax 269,231
Partnership Distribution $ 500,000
Fiduciary’s Tax Liability (269,231)
Payable to the Beneficiary $ 230,769

In addition, B will report $230,769 on his or her own personal income tax return, paying taxes of $80,769. Because Trust T withheld $269,231 to pay its taxes and B paid $80,769 taxes of its own, B bore the entire $350,000 tax burden on the $1 million of entity taxable income, including the $500,000 that the entity retained that presumably increased the value of the trust’s investment entity.

If a trustee determines that it is appropriate to so, it should consider exercising the discretion granted in UPIA section 506 to adjust between income and principal. Alternatively, the trustee may exercise the power to adjust under UPIA section 104 to the extent it is available and appropriate under the circumstances, including whether a future distribution from the entity that would be allocated to principal should be reallocated to income because the income beneficiary already bore the burden of taxes on the reinvested income. In exercising the power, the trust should consider the impact that future distributions will have on any current adjustments.

SECTION 506. ADJUSTMENTS BETWEEN PRINCIPAL AND INCOME BECAUSE OF TAXES.
(a) A fiduciary may make adjustments between principal and income to offset the shifting of economic interests or tax benefits between income beneficiaries and remainder beneficiaries which arise from:
(1) elections and decisions, other than those described in subsection (b), that the fiduciary makes from time to time regarding tax matters;
(2) an income tax or any other tax that is imposed upon the fiduciary or a

1 D = (C-R*K)/(1-R) = (500,000 – 350,000)/(1 – .35) = $230,769. (D is the amount payable to the income beneficiary, K is the entity’s K-1 taxable income, R is the trust ordinary tax rate, and C is the cash distributed by the entity).

beneficiary as a result of a transaction involving or a distribution from the estate or trust; or

(3) the ownership by an estate or trust of an interest in an entity whose taxable income, whether or not distributed, is includable in the taxable income of the estate, trust, or a beneficiary.
(b) If the amount of an estate tax marital deduction or charitable contribution deduction is reduced because a fiduciary deducts an amount paid from principal for income tax purposes instead of deducting it for estate tax purposes, and as a result estate taxes paid from principal are increased and income taxes paid by an estate, trust, or beneficiary are decreased, each estate, trust, or beneficiary that benefits from the decrease in income tax shall reimburse the principal from which the increase in estate tax is paid. The total reimbursement must equal the increase in the estate tax to the extent that the principal used to pay the increase would have qualified for a marital deduction or charitable contribution deduction but for the payment. The proportionate share of the reimbursement for each estate, trust, or beneficiary whose income taxes are reduced must be the same as its proportionate share of the total decrease in income tax. An estate or trust shall reimburse principal from income.
Comment

Discretionary adjustments. Section 506(a) permits the fiduciary to make adjustments between income and principal because of tax law provisions. It would permit discretionary adjustments in situations like these: (1) A fiduciary elects to deduct administration expenses that are paid from principal on an income tax return instead of on the estate tax return; (2) a distribution of a principal asset to a trust or other beneficiary causes the taxable income of an estate or trust to be carried out to the distributee and relieves the persons who receive the income of any obligation to pay income tax on the income; or (3) a trustee realizes a capital gain on the sale of a principal asset and pays a large state income tax on the gain, but under applicable
federal income tax rules the trustee may not deduct the state income tax payment from the capital gain in calculating the trust’s federal capital gain tax, and the income beneficiary receives the benefit of the deduction for state income tax paid on the capital gain. See generally Joel C. Dobris, Limits on the Doctrine of Equitable Adjustment in Sophisticated Postmortem Tax Planning, 66 Iowa L. Rev. 273 (1981).

Section 506(a)(3) applies to a qualified Subchapter S trust (QSST) whose income beneficiary is required to include a pro rata share of the S corporation’s taxable income in his return. If the QSST does not receive a cash distribution from the corporation that is large enough to cover the income beneficiary’s tax liability, the trustee may distribute additional cash from principal to the income beneficiary. In this case the retention of cash by the corporation benefits the trust principal. This situation could occur if the corporation’s taxable income includes capital gain from the sale of a business asset and the sale proceeds are reinvested in the business instead of being distributed to shareholders.

Mandatory adjustment. Subsection (b) provides for a mandatory adjustment from income to principal to the extent needed to preserve an estate tax marital deduction or charitable contributions deduction. It is derived from New York’s EPTL ‘ 11-1.2(A), which requires principal to be reimbursed by those who benefit when a fiduciary elects to deduct administration expenses on an income tax return instead of the estate tax return. Unlike the New York provision, subsection (b) limits a mandatory reimbursement to cases in which a marital
deduction or a charitable contributions deduction is reduced by the payment of additional estate taxes because of the fiduciary’s income tax election. It is intended to preserve the result reached in Estate of Britenstool v. Commissioner, 46 T.C. 711 (1966), in which the Tax Court held that a reimbursement required by the predecessor of EPTL ‘ 11-1.2(A) resulted in the estate receiving the same charitable contributions deduction it would have received if the administration
expenses had been deducted for estate tax purposes instead of for income tax purposes. Because a fiduciary will elect to deduct administration expenses for income tax purposes only when the income tax reduction exceeds the estate tax reduction, the effect of this adjustment is that the principal is placed in the same position it would have occupied if the fiduciary had deducted the expenses for estate tax purposes, but the income beneficiaries receive an additional benefit. For example, if the income tax benefit from the deduction is $30,000 and the estate tax benefit would have been $20,000, principal will be reimbursed $20,000 and the net benefit to the income beneficiaries will be $10,000.

Irrevocable grantor trusts. Under Sections 671-679 of the Internal Revenue Code (the “grantor trust” provisions), a person who creates an irrevocable trust for the benefit of another person may be subject to tax on the trust’s income or capital gains, or both, even though the settlor is not entitled to receive any income or principal from the trust. Because this is now a well-known tax result, many trusts have been created to produce this result, but there are also trusts that are unintentionally subject to this rule. The Act does not require or authorize a trustee to distribute funds from the trust to the settlor in these cases because it is difficult to establish a rule that applies only to trusts where this tax result is unintended and does not apply to trusts where the tax result is intended. Settlors who intend this tax result rarely state it as an objective in the terms of the trust, but instead rely on the operation of the tax law to produce the desired
result. As a result it may not be possible to determine from the terms of the trust if the result was intentional or unintentional. If the drafter of such a trust wants the trustee to have the authority
to distribute principal or income to the settlor to reimburse the settlor for taxes paid on the trust’s income or capital gains, such a provision should be placed in the terms of the trust. In some situations the Internal Revenue Service may require that such a provision be placed in the terms of the trust as a condition to issuing a private letter ruling.

[ARTICLE] 6

MISCELLANEOUS PROVISIONS
SECTION 601. UNIFORMITY OF APPLICATION AND CONSTRUCTION. In applying and construing this Uniform Act, consideration must be given to the need to promote uniformity of the law with respect to its subject matter among States that enact it.
SECTION 602. SEVERABILITY CLAUSE. If any provision of this [Act] or its application to any person or circumstance is held invalid, the invalidity does not affect other provisions or applications of this [Act] which can be given effect without the invalid provision or application, and to this end the provisions of this [Act] are severable.
SECTION 603. REPEAL. The following acts and parts of acts are repealed: (1) ………………………………….
(2) ………………………………….. (3) ………………………………….
SECTION 604. EFFECTIVE DATE. This [Act] takes effect on ……………

SECTION 605. APPLICATION OF [ACT] TO EXISTING TRUSTS AND ESTATES. This [Act] applies to every trust or decedent’s estate existing on [the effective date of this [Act]] except as otherwise expressly provided in the will or terms of the trust or in this [Act].
ALTERNATIVE A

SECTION 606. TRANSITIONAL MATTERS. Section 409, as amended by this

[amendment], applies to a trust described in Section 409(d) on and after the following dates:

(1) If the trust is not funded as of [the effective date of this [amendment]], the date of the

decedent’s death.

(2) If the trust is initially funded in the calendar year beginning January 1, [insert

year in which this [amendment] takes effect], the date of the decedent’s death.

(3) If the trust is not described in paragraph (1) or (2), January 1, [insert year in

which this [amendment] takes effect].

ALTERNATIVE B

SECTION 606. TRANSITIONAL MATTERS. Section 409 applies to a trust

described in Section 409(d) on and after the following dates:

(1) If the trust is not funded as of [the effective date of this [act]], the date of the

decedent’s death.

(2) If the trust is initially funded in the calendar year beginning January 1, [insert

year in which this [act] takes effect], the date of the decedent’s death.

(3) If the trust is not described in paragraph (1) or (2), January 1, [insert year in

which this [act] takes effect].

END OF ALTERNATIVES

Legislative Note: Use Alternative A if your state has already enacted the Uniform Principal and Income Act. Use Alternative B if your state has not enacted the Uniform Principal and Income Act.

If your state has not adopted the Uniform Principal and Income Act, use the text of Sections 409 and 505, as amended by these amendments, instead of the text of the previous version of those Sections.

Startup Cost

Startup

Every entrepreneur knows what Startup Cost is. When a new Startup business gets underway, taxes are the last thing in mind of the entrepreneur. However sometimes the Startup expenses are sizable. If proper capitalization is not followed upon then the client stands a chance of losing sizable deduction. Also hurrying in deducting these expenses can also result in an audit as it happened in the following case. Always remember the simple truth – Startup expenses are not deductible until-well the business actually starts. Here is how Ms. Tizard learn it the hard way.  The astute reader should pick up the tax filing tips in how to handle this situation without jeopardizing the deduction.

Background

Julie Tizard is a veteran of the U.S. Air Force (USAF) and an accomplished aviator. During a span of nearly 12 years in active duty, she rose through the USAF ranks and was assigned to various positions of increasing responsibility including instructor pilot, flight commander, commander of an in-flight refueling aircraft, and wing flying safety officer. In 1990, Tizard accepted a position as a full-time commercial airline pilot at United Airlines (United) and left active military duty for the USAF Reserves. She continued her service in the USAF Reserves until she retired in 2009, and continues to serve as a captain for United.

Under current FAA rules, Tizard is required to retire as a commercial airline pilot at age 65. In anticipation of that day, she researched ways that she might continue to earn income after her retirement, and eventually decided to purchase a military training aircraft and start an aviation business in Arizona. Tizard concluded that a Slingsby T-67C “Firefly” military training aircraft (Firefly) would allow her to provide a variety of aviation services.

In 2010, Tizard traveled around the country looking for a suitable Firefly to purchase. She found what she was looking for at an aircraft museum in Florida and in October 2010, she purchased the Firefly for $52,000. While negotiating the purchase of the aircraft, the seller expressed interest in hiring Tizard to provide aerial land surveys. However, she was never actually hired to provide such services.

After purchasing the aircraft, Tizard filed articles of organization for Tizard Aviation, LLC with the state of Arizona. She drafted a business plan that stated her company would begin operations by offering aerial land surveys, flight charters, and aviation photography services to the general public in central Arizona and professional aviation and aeronautical safety consulting services for corporate, airline, and general aviation needs. She planned to eventually expand operations to include specialized flight training for general aviation pilots. Once the aircraft was delivered, Tizard took an acquaintance who she considered a potential client for what she characterized as an “incentive orientation flight,” but she did not charge for the flight and no ongoing business relationship developed.

Tizard filed a Form 1040 for 2010, reporting wages of $154,218 that she earned at United. She attached to her tax return a Schedule C reporting that Tizard Aviation, L.L.C. had no gross receipts and expenses totaling $13,295. After examining her returns for that year, the IRS denied deductions for the losses for the aviation business.

Analysis

Code Sec. 195(a) provides the general rule that no current deduction is allowed for startup or pre-opening expenses prior to the tax year in which an active trade or business begins. However, under Code Sec. 195(b), taxpayers can elect to deduct up to $5,000 of start-up expenses once the activity becomes an active trade or business, and may deduct any remaining expenditures rat-ably over the following 180 months. Start-up expenses generally include expenses paid or incurred in connection with:

(1) investigating the creation or acquisition of an active trade or business;

(2) creating an active trade or business; or

(3) any other activity engaged in for profit or for the production of income in anticipation of such activity becoming an active trade or business.

Although the Tax Court was persuaded that Tizard fully intended to enter into an aviation business for profit, and found she committed substantial time and money to that endeavor in 2010, it determined that her activities had not ripened into an active trade or business in 2010. Thus, the court disallowed the losses that she claimed in respect of her aviation activity.

The court noted that by acquiring the Firefly, arranging to have it delivered to Arizona, drafting a business plan, and filing articles of organization for Tizard Aviation, LLC, Tizard had taken the initial steps to beginning her aviation business. However, the court observed, she did nothing in 2010 to formally advertise to the general public (either by way of print or electronic media) that Tizard Aviation, LLC was open for business. Nor did she describe and promote the various services the business would offer to its clients. The court noted that her informal efforts to promote the business’ services, her optimism that the person who sold her the Firefly might become a paying client, and the complimentary flight that she provided to her acquaintance was not evidence that the business was actually functioning and performing the activities for which it was organized. The court found that in 2010, Tizard Aviation, LLC had no clients, no contracts for aviation services, and no gross receipts.

Higher Education Expense, Deductible ?

When you can deduct Higher Degree Expenses
When you can deduct Higher Education Expense

There are tax benefits of Higher Education-with limitation of course. This is an excellent case to clarify issues surrounding the destructibility of the higher education expenses.

Background

Alex Kopaigora began working for Marriott International Corp. in 2002 as an accounting manager. In June 2006, Kopaigora accepted a position as senior assistant controller for the Marriott hotel in Los Angeles International Airport (Marriott LAX), where he was responsible for managing a team of employees, reviewing employee performances annually, participating in hiring activities, and training employees. Kopaigora’s duties included preparing financial reports, creating budgets, analyzing financial data, producing forecasts to enable reaction to business changes, and monitoring different departments’ performances. Additionally, Kopaigora conducted audits, prepared an accounting of taxes, prepared financial reports according to generally accepted accounting principles (GAAP), enforced internal controls, reconciled balance sheets, and ensured compliance with reporting requirements.

In July 2010, Kopaigora enrolled in the executive master of business administration (EMBA) degree program at Brigham Young University (BYU) in Utah in order to improve his leadership skills in corporate finance and management. Kopaigora worked at Marriott LAX on the weekdays and traveled to Salt Lake City every other weekend to attend classes at BYU. In April 2011, while Kopaigora was still working towards his EMBA degree, his employment with Marriott was terminated. Despite this setback, he continued to pursue his EMBA degree at BYU and looked for full-time employment within the corporate finance and accounting field as a controller, assistant controller, senior manager, vice president, or director.

Kopaigora graduated from the EMBA degree program in August 2012 and, in September, he was hired as vice president of finance of a small financing company. As vice president, Kopaigora was responsible for overseeing department managers, managing and leading a team of employees, supervising employees in daily issues of accounting, cash, risk, and business operations, and participating in hiring and training. Additionally, Kopaigora was responsible for auditing, accounting for taxes, setting up monthly reporting according to GAAP, and enforcing internal controls.

On his 2011 joint return, Kopaigora claimed an $18,879 deduction for his EMBA degree expenses, which included charges for his EMBA tuition, airfare between California and Utah, meals, and mileage. Following an examination, the IRS disallowed these deductions.

Analysis

Code Sec. 162 requires a taxpayer to be presently engaged in a trade or business in order for education expenses to be deductible. Reg. Sec. 1.162-5(b) disallows a deduction for education expenses for: (1) education required to meet the minimum requirements of a taxpayer’s trade or business, or (2) a program of study leading to the qualification of a taxpayer in a new trade or business. If the taxpayer can show that neither of the disqualifying factors applies, Reg. Sec. 1.162-5(a)(1) provides that the taxpayer can deduct the education expenses if the education maintains or improves skills required by the taxpayer in his or her employment or other trade or business.

Before the Tax Court, Kopaigora argued that he was entitled to deductions for his education expenses because he was established in the business of corporate finance and management before beginning his pursuit of an EMBA degree, he continued to be established in this business during his temporary unemployment, and his EMBA degree did not qualify him for a new trade or business. The IRS argued that Kopaigora did not carry on his trade or business through the 2011 tax year because he was unemployed for an indefinite period, the EMBA degree was a general degree that did not maintain or improve specific skills required for his employment, and the degree qualified him for a new trade or business.

The Tax Court determined that the facts supported Kopaigora’s argument, and held that the expenses he incurred to obtain his EMBA degree were deductible as unreimbursed employee expenses under Code Sec 162. When Kopaigora enrolled in the EMBA degree program, the court said, he was a well-established finance and accounting business manager at Marriott LAX. The court noted that he managed the hotel’s financial operations and auditing departments, he was responsible for large groups of employees from various backgrounds and specializations, and he made sure the hotel’s business practices were in compliance with GAAP. When his employment was abruptly terminated, the court found, he continued to take courses at BYU that improved his managerial and leadership skills – skills that were appropriate and helpful to his position as a business manager. The courses Kopaigora chose to fulfill his degree requirements, the court said, did not qualify him for a new trade or business because he was not qualified to perform new tasks or activities with the conferral of his degree. Instead, the court stated, Kopaigora chose courses in a line of study that he was familiar with – management and finance. The court determined that even though Kopaigora took a few courses that were outside that scope, those courses by themselves could not have prepared him to enter a new trade or business.

In addition, the court noted that Kopaigora’s unemployment did not prevent him from continuing his trade or business as a finance and accounting business manager for purposes of Code Sec. 162. The court found that after Kopaigora’s employment at Marriott LAX was terminated, he actively sought employment within the corporate finance and accounting field for the remainder of his time at BYU, and his active job search paid off. Although Kopaigora was hired after he graduated, the court found nothing in the record suggesting that the degree was a prerequisite for the job.

“Paper Loss” from Rental ? Must Read This

rentalIt is so tempting to claim those rental “paper loss” on the tax return that I almost always have to put a fight with my clients-specially the Real Estate Professionals.

At times I had to refuse to sign on the return or even let the client go somewhere else.

Two recent tax cases highlight the challenges taxpayers may face when attempting to use the real estate professional exception to the passive loss rules to deduct rental losses.

In one, the Ninth Circuit affirmed a district court and held that Code Sec. 469(c)(7) does not automatically render a real estate professional’s rental losses nonpassive and deductible where the taxpayer did not materially participate in the real estate endeavors.

In the other, the Tax Court found that, because of her credible testimony and the substantial amount of money and time devoted to each rental property, a taxpayer met the material participation requirements in Reg. Sec. 1.469-5T(a)(7) and could deduct her rental losses. Gragg v. U.S., 2016 PTC 288 (9th Cir. 2016); Hailstock v. Comm’r, T.C. Memo. 2016-146.

Passive Activity Loss Limitation Rules in summary.

In general, Code Sec. 469 disallows passive activity losses. Code Sec. 469(c)(1) defines a passive activity as any activity involving a trade or business in which the taxpayer does not materially participate. Under Code Sec. 469(c)(2), rental activities are per se passive activities.

Code Sec. 469(c)(7) provides an exception to the rule in Code Sec. 469(c)(2), however, for taxpayers in real property businesses. Under that exception, Code Sec. 469(c)(2) does not apply to any rental real estate activity if more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. In the case of a joint return, these requirements are satisfied if and only if either spouse separately satisfies such requirements. Generally, each interest of the taxpayer in rental real estate is treated as a separate activity unless the taxpayer makes an election under Code Sec. 469(c)(7)(A) to treat all interests in rental real estate as one activity.

Code Sec. 469(h) provides that a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial.

Gragg v. U.S.

In 2006 and 2007, Delores Gragg worked as a licensed real estate agent for a real estate brokerage firm. During those year, Delores and her husband owned two real estate rental properties. The Graggs’ rental properties incurred losses and, on joint returns for 2006 and 2007, the couple deducted those losses from their taxable income. The IRS disallowed the losses on the basis that, because the Graggs did not materially participate in the rental properties, the losses were passive activity losses that could only offset passive activity income. The couple took their case to a district court, arguing that Delores’s full-time occupation as a real estate professional generally relieved her and her husband from having to show material participation in their rental real estate activities before deducting losses from those activities against their income.

The key question for the district court was whether, under Code Sec. 469(c) and related regulations, the Graggs had to establish their material participation in their rental real estate activities separate and apart from Mrs. Gragg’s undisputed material participation in her profession as a real estate agent. The district court concluded that they did have to establish material participation and, because they had not proven they materially participated in their rental activities, the court disallowed their rental loss deductions.

On appeal, the Graggs argued that Code Sec. 469(c)(7) automatically renders a real estate professional’s rental losses nonpassive and deductible, regardless of material participation. On the other hand, the IRS argued that Code Sec. 469(c)(7) merely removes Code Sec. 469(c)(2)’s per se bar on treating rental losses as passive.

The Ninth Circuit agreed with the IRS, saying that the text of the statute did not support the Gragg’s interpretation. The effect of the Code Sec. 469(c)(7) exception, the court said, is merely that the per se bar in Code Sec. 469(c)(2) does not apply. If the per se rental bar does not apply, the court concluded, then the general Code Sec. 469(c)(1) rule does apply and a rental activity is passive unless the taxpayer materially participates. Further, the court stated, regulations implementing Code Sec. 469 reinforce this interpretation. Reg. Sec. 1.469-9(c)(1), the court noted, provides that a taxpayer who qualifies as a real estate professional can treat rental losses as nonpassive, but only so long as the taxpayer materially participates. That regulation, the court said, does not conform with the Graggs’ understanding that the Code Sec. 469(c)(7) exception excuses real estate professionals from the material participation requirement.

Hailstock v. Comm’r

Sometime in 2004, Beth Hailstock left her government job and went into the real estate business full-time. Between 2003 and 2008, Hailstock purchased numerous properties using an inheritance, savings, two lines of credit, and credit cards. She rented and incurred expenses in relation to some of the properties; she sold some of the properties within one year of acquisition (without renting); and she held some of the properties for investment (without renting).

From 2005 to 2009, Hailstock devoted substantial time and effort to her real estate endeavors and did not work elsewhere. She spent well over 40 hours per week carrying on her real estate business. Hailstock’s duties included checking messages for work orders, purchasing materials and cleaning supplies, supervising workers doing rehabilitation work, meeting with and conducting background checks on prospective tenants, executing leases, handling complaints regarding existing tenants, searching for new properties to purchase, taking real estate classes, and collecting rent payments from tenants.

In October of 2011, the IRS received from Hailstock a Form 1040 for each of the tax years 2005, 2006, 2007, 2008, and 2009. On each return, Hailstock listed her occupation as “Real Estate Professional.” She reported all of her real estate activities (i.e., renting, investing, and selling) on Schedules C, Profit or Loss From Business. The IRS audited her 2005-2009 tax returns and, in the course of the audit, Hailstock provided the IRS with reconstructed Forms 1040 for 2005-2009. Attached to the reconstructed returns were Schedules E, which reported rents and expenses pertaining to Hailstock’s rental properties.

The IRS used documents and records obtained from various financial institutions to perform a bank deposits analysis for Hailstock and determined Hailstock’s income for 2005-2009. The IRS’s bank deposits analysis discovered large discrepancies between the amounts deposited into Hailstock’s bank accounts and the amounts of rental income that she reported on Schedules E of her reconstructed returns. The IRS issued Hailstock notices of deficiencies for 2005-2009. Among other things, the IRS concluded that Hailstock had unreported rental income and that some of her rental losses were not deductible.

At trial, after Hailstock offered explanations for specific unidentified deposits in the IRS’s bank deposits analysis, the court found that Hailstock had unreported rental income in an amount less than that determined by the IRS. With respect to whether Hailstock could deduct all her rental losses, the court first looked to whether Hailstock’s losses were limited by the passive activity loss rules. The court had to determine if Hailstock materially participated in her real property trades or businesses. In assessing material participation, the court rejected Hailstock’s assertion that she made the election in Code Sec. 469(c)(7)(A) to treat all her real estate activities as one activity, saying that a taxpayer’s intention of aggregating properties without a proper election is insufficient. The court noted that there must have been an affirmative declaration by the Hailstock and there was not. Simply listing multiple properties on a Schedule E is insufficient, the court said.

However, the court concluded that, of the various tests for determining material participation, Hailstock satisfied the facts and circumstances test in Reg. Sec. 1.469-5T(a)(7) because of her credible testimony and the substantial amount of money and time devoted to each rental property. Although the court cautioned Hailstock to construct contemporaneous time logs for her future real estate endeavors, it found her detailed and credible testimony to be a reasonable means of proof that she materially participated in her real estate endeavors and could deduct most of her rental losses. The court did disallow losses relating to a property for which Hailstock reported minimal amounts of rental income 2005 and 2006 and no rental income for 2007-2009 and which the City of Cincinnati found to be in violation of housing codes. According to the court, this supported the IRS’s contention that the property was not an active rental property.