TikTok’s (Wrong) Tax Advice and How the Trust Tax Rules Really Work

My earlier post describing TikTok tax advice as to the magical workings of the “Non-Grantor Irrevocable Complex Discretionary Spendthrift Trust” (NGICDST) proved highly popular. The NGICDST is being marketed heavily on social media platforms and certain business websites. After the Internal Revenue Service (IRS) discovered the promotional material, the agency shut down any notion that the NGICDST can make taxable income somehow “disappear” by relying on a (very faulty) interpretation of Section 643 of the US Internal Revenue Code (Code).  My earlier post put it very simply – taxable income cannot, and does not, magically disappear with trusts.  Someone must always pay tax on it – be it the founder of the trust, the trust itself, and/or the trust beneficiaries.

Workings of the US Income Tax Rules for Trusts and their Beneficiaries

Some readers followed up with questions about how the US income tax rules actually work when it comes to the taxation of trusts and its beneficiaries. This is not a simple area of tax law, but as luck would have it one of my avid readers is renowned tax attorney, Richard LeVine who recently sent me an email precisely on this topic.  Richard’s correspondence set out in a simple fashion, the workings of the trust taxation rules to further refute the claimed magic of the NGICDST. The explanation was too good not to share and will enable readers to understand why the “TikTok” version is so very wrong.  Below follows Richard’s excellent summary (with permission and many thanks).

All references are to the Code:

• “Section 1 (e) imposes income tax on the taxable income of every trust.
• Section 61(a)(3) defines income to include income from all sources, including gains from dealing in property.
• Section 641(a)(1) states that the tax under Section 1 (e) applies to all income earned by a trust, including income which, in the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated.
• Section 651(a) allows a deduction to the trust for income distributed to a beneficiary.
• Section 651(b) limits the Section 651(a) deduction to the “distributable net income” of the trust (DNI).
• Section 652(a) taxes the beneficiary if they receive a distribution of DNI.
• Section 643(a)(3) allows a fiduciary to exclude capital gains from DNI.

Here are how all those rules fit together:

• Suppose a trust starts the year with $100 of cash, and during the year it received $100 of interest income and $100 of capital gain, and then distributes $200 to a beneficiary.
• If the trustee allocates the capital gain to DNI, then the trust’s DNI is $200.
  • The entire $200 distribution to the beneficiary is taxable to the beneficiary under Section 652.
  • The trust’s income for the year is then $0, because it has $200 of income and gets a $200 deduction under Section 651(a).
• If the trustee allocates the capital gain to corpus / principal, then the trust’s DNI is $100.
  • Only $100 of the distribution is taxable to the beneficiary, because there was only $100 of DNI.
  • The trust has taxable income of $100, because it has $200 of income and only gets a $100 deduction under Section 651(a) because the deduction is limited to DNI under Section 652(b).

So, by allocating capital gain between income and principal, the trustee can control whether the tax is paid by the beneficiary or by the trust. But the allocation of capital gain between income and principal does not reduce the total amount of income subject to tax. If the trust earned $200 of net income, someone is going to pay tax on $200. The only question is how much the beneficiary pays and how much the trust pays.

Or to put it another way, when you allocate capital gain to principal and not to income, you are not reducing the trust’s taxable income. What you are reducing is the maximum amount that the beneficiary has to pay tax on, but also reducing the maximum amount that the trust can deduct by making distributions. If the capital gain is not part of DNI, then the trust does not get a deduction for distributing those dollars. Without a distribution deduction, the trust remains taxable on the gain.

I know that this [Section] 643 argument [for NGICDSTs] is floating around all over….. It is simply wrong.”

Going Forward

Yep. As Richard says, it is simply wrong and should serve as a warning to taxpayers that there is no substitute for competent tax advice.

Taxpayers who have made the mistake and been duped into a NGICDST can amend their tax returns.  Getting good tax help before the IRS catches up is the best way forward.

Posted September 21, 2023

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