by Laura Johnson, EA
Trusts can terminate for several reasons, for example:
- The term of the trust has lapsed
- Assets remaining in the trust are small and thus it is not economical to continue to administer them in trust form
- The purpose for which the trust was created is no longer relevant, for example by a minor child becoming an adult
At that point, the trustee has a decision to make. Assume that the trust assets are invested in stocks and mutual funds. Should she sell all of the holdings and make the distribution in cash or make an in-kind distribution of the trust assets? The choice is not obvious.
Cash or In Kind?
If the trust sells assets prior to distributing cash, the trust will realize capital gains (assuming of course that the assets have appreciated in value). If the cash is distributed to the beneficiaries in the same tax year, the capital gain will flow out to the beneficiaries. Along with a pile of cash the beneficiary will get the tax bill for the capital gains. This option is attractive for a few reasons:
- Easy to administer
- Gives beneficiaries the greatest flexibility with future investments
- Generates cash for taxes
Here is an example. Assume a trust with one beneficiary holds 10,000 shares of Stock X and wishes to terminate. The trust purchased Stock X for $60 per share. The current value of Stock X is $100 per share. The trust could sell Stock X and distribute $100,000 cash to the beneficiary. The trust would realize $40,000 of capital gain on the transaction, gain that would be passed through to the beneficiary. The beneficiary gets $100,000 and a tax bill. Or the trust could distribute the assets in kind. No capital gain would be recognized. The beneficiary gets 10,000 shares of Stock X worth $100,000 and no tax bill. The basis of the stock remains the same as it was in the trust, in this case $60,000.The advantage here is the beneficiary gets the assets but doesn’t have to pay tax on the distribution and can plan for any future sale with his advisors as he wishes.
What About Prior Year Losses?
However, what if the trust had capital loss carryovers from a prior year? In the final year of a trust, capital losses in excess of gains pass out to the beneficiaries and can be deducted by them, subject to the usual limits on capital losses. In that case, it might be more tax efficient to sell some of the trust’s appreciated stock at a gain to capture those losses currently.
A Special Election
Another option would be for the trustee to make an election under Code Section 643. This law allows a trust to distribute appreciated assets in kind while treating them as having been sold. This way, the trust would in fact distribute stock, but would reap the benefit of its prior losses. And the distributed stock would take a basis for the beneficiary equal to the value on the date of distribution. The election applies only to assets that have gone up in value, not to losses. Be wary though: the Section 643 election will apply to all trust property, not just a few cherry-picked stocks, so you can end up recognizing more gain than you bargained for.
At John Schachter + Associates, we help our clients plan for the trust distributions in a tax-efficient manner. Let us know if we can help you too!