Time Is Running Out to Use the 65 Day Rule
Generally, as calendar year taxpayers prepare to file their 2020 income tax returns during this 2021 filing season, there is not a lot of tax planning that one can do for the 2020 tax year as it has come and gone. There are, however, a few exceptions, such as the ability to make contributions to an individual retirement account or a health savings account during 2021 and to deduct such contribution for the 2020 tax year. Trustees of non-grantor trusts also have an opportunity to take actions during 2021 that may reduce the trust’s 2020 income tax liability. Such opportunity exists under IRC Section 663(b). IRC Section 663(b) allows a trustee to elect to treat distributions made during the first 65 days of the current tax year as distributions made during the immediately preceding tax year.
Trusts are subject to the same marginal tax rates as individuals. However, trusts reach the highest marginal rate at a much faster pace than individuals. For example, the highest marginal income tax rate for individuals and trusts for 2020 is 37%. An individual whose filing status is single does not reach this rate bracket until reaching taxable income of $518,400. Whereas, a trust reaches this rate bracket with taxable income of only $12,950. Also, individuals filing as single are not subject to the net investment income tax (“NIIT”) unless they have modified adjusted gross income (“MAGI”) in excess of $200,000. A trust is subject to the NIIT once it’s MAGI exceeds $12,950. Because of this difference, trust beneficiaries are more likely to be in a lower tax bracket than the trust. Where that is the case, income that is distributed to the trust beneficiaries and taxed to the beneficiaries instead of the trust will result in tax savings.
IRC Section 663(b) allows a trustee of a trust who is not required to distribute income (referred to as a complex trust) extra time to determine the trust’s taxable income for the prior tax year and if there may be any income tax savings by distributing that income to the trust’s beneficiaries. If a trustee determines that there are income tax savings to be realized by having the trust beneficiaries pay income tax on the income instead of the trust, the trustee may make distributions to the trust beneficiaries during the first 65 days of the current tax year and treat those distributions as distributions of income to the beneficiaries for the previous tax year. Accordingly, a trustee of a trust with a tax year ending Dec. 31, 2020 has until March 6, 2021 to make distributions that will be treated as distributions made during 2020.
The trustee must make the election on a timely filed (including extensions) Form 1041. Thus, a trustee currently has until at least April 15, 2021 to determine the trust’s 2020 taxable income and if the election should be made but must make any distributions to be eligible for the election by March 6. If it is ultimately determined that distributions made during the first 65 days of the current tax year exceed the amount needed to carry-out the trust’s taxable income for the prior tax year, the election may be made for only a portion of those distributions. The trustee should keep records as to what year a distribution applies. Also, the trustee must make sure that the distributions comply with the terms of the trust and are in the best interests of the beneficiary as income taxes are only one of many considerations in making that determination. Finally, it is recommended that you discuss these issues with a competent tax advisor before trying to implement the rules discussed herein.
Note that the 65-day rule under IRC Section 663(b) also applies to estates.