Life and Death Planning for Retirement Benefits

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Chapter 6: Leaving Retirement Benefits in Trust 325
income tax deduction is limited to the amount of the trust’s distributable net income or DNI, so
this is usually called the “DNI deduction.”
If the trust’s income resulting from retirement plan distributions can be passed out to the
individual beneficiaries of the trust as part of DNI, the income tax burden is shifted to the
individual beneficiaries, and overall income taxes will be lowered if those beneficiaries are in a
lower tax bracket than the trust. Unfortunately, the DNI deduction is not as simple as some
practitioners might wish.
First the good news: Retirement plan distributions received by a trust, like other items of
IRD, become part of the trust’s DNI. See definition of DNI at Reg.
Examples 6 and 9; and CCA 2006-44016. Accordingly, distributions of such IRD are eligible for
the DNI deduction when passed out to the trust beneficiary, and are includible in the beneficiary’s
income. Reg.
Even though IRD, like capital gain, is a form of gross income that is usually allocated to
“principal” for trust accounting purposes , IRD is not subject to the special rules that
limit a trustee’s ability to pass out capital gain as part of DNI. IRD goes straight into DNI just as
interest and other “ordinary income” items do. CCA 2006-44016. In contrast, capital gains are not
included in DNI (and accordingly cannot be passed through to the trust beneficiary) unless various
tests are met. Reg.
Now the bad news: The mere fact that a trustee receives a retirement plan distribution and
later makes a distribution to a trust beneficiary does not automatically mean that the distribution
to the beneficiary carries with it the gross income arising from the retirement plan distribution.
The trust might still be liable for the income tax on the retirement plan distribution it received. The
question is (in trust administration lingo) whether such distribution “carries out DNI.”
Here are the six hurdles the trustee must clear in order for the trust’s distribution of IRD to
carry out the income tax burden to the trust beneficiary as part of DNI:
A. Trust must authorize the distribution. The DNI deduction will not be available unless
the beneficiary is entitled to receive the money; thus, obtaining this deduction requires
attention at the trust drafting stage. See
B. Income must be required to be, or must actually be, distributed, in year received. The
DNI deduction is available only for gross income that either is required to be distributed,
or is actually distributed, to the individual beneficiary in the same taxable year it is received
by the trust (or within 65 days after the end of such taxable year, if the trustee elects under
to have such distribution treated as made during such taxable year).
Thus, in the case of discretionary distributions, the trustee must take action prior to
the deadline; if no one considers the problem until it is time to prepare the trust’s tax return,
it will be too late.
C. Allocation of DNI when separate share rule applies. If there are two or more
beneficiaries, and they have “substantially separate and independent shares,” a distribution
to one beneficiary will not carry out DNI that is allocated under the “separate share” rule
to a different beneficiary. See for how this rule applies to retirement
benefits.
D. Transfer of the plan does not carry out DNI. Though a distribution from a retirement
plan to a trust is IRD, and becomes part of DNI, the retirement plan itself, which is a “right