How Does a Trustee Equalize Trust Distributions and Tax Liability Among Beneficiaries?

ANSWER: CAREFULLY MAKING PRO RATA DISTRIBUTIONS, OF TAXABLE TRUST INCOME AND NON-TAXABLE PRINCIPAL, TO BENEFICIARIES FOR EQUAL TAX BASIS, IN THE SAME YEAR OF ANY AMOUNTS AVAILABLE.

The trustees often will pay one beneficiary who needs money right now, for any reason, and other beneficiaries later as they do not need money right now. That can occur for a period of time or even for years. That is based on thinking that any distribution is equal to another distribution. That often is a serious problem because the initial payments to the beneficiary who needs money right now may be paid out of non-taxable principal such as bank accounts not subject to tax (non-taxable principal) versus payment to other beneficiaries later from income that is taxable perhaps taxable interest earned on bank account or gains from a sale. That means that the initial beneficiary does not pay tax on its distribution as it came out of bank accounts not subject to tax and the later beneficiary does pay tax. That can result in a different tax burden as tax on a distribution reduces the value of the distribution. That can become a claim against the trustee necessitating legal fees paid by the beneficiaries to “right” this inequity, legal fees paid by the trustee to defend, time waiting in court for a decision, plus surcharges against the trustee and requests for fees or removal of a trustee for making a distribution decision that had a predictable detriment to a beneficiary who received taxable income versus principal. This can be how trusts start to spiral out of control and fees and costs reduce the amounts available. A trustee can work with a trust expert witness who is a tax attorney and tax preparer to make certain that the distributions and trust tax reporting to the beneficiaries remains equal and consistent with their interests in the trust or a specific asset that is sold.



Trustees may not realize this, but trust distributions should be timed in each calendar year so that tax consequences are predictable and do not advantage any beneficiary while it disadvantages another beneficiary (as it does in the above paragraph). There should be specific distributions based on proportionate shares in the assets sold and payment should be made to each beneficiary as it is received with each beneficiary being treated equally in proportion to their interest either in the trust or in the asset that is sold. Additionally, if a trustee is authorized to do so, a trustee should make discretionary distributions of income and principal to trust beneficiaries for health, maintenance, support, and education so that such distributions are made by year end and are also proportionate based on each beneficiary’s interest in the trust.

Importantly, once trustees make distributions for a few years, it is very difficult, potentially not possible, to correct distributions in prior years because the principal may have been distributed in such a manner that the differences in distributions are too large to be corrected. And probate courts are often willing to rule that differences in tax consequences will not be taken into account as the courts do not have the time or expertise to do so. There is law to the effect that tax consequences should be considered, and adjustments made, but it is not universally determined by judges to be applicable.

The trust expert witness, often a tax expert or a tax preparer, and Probate Courts are equipped to determine and equalize the tax consequences if sought either in advance or before they occur through distributions. Even after distributions at year-end there are possibilities to make certain the tax consequences are reflected properly in the trust tax returns.

SOURCES:
Cal Prob Code § 16003 - A trustee must act impartially in investing and managing trust property, considering the differing interests of the beneficiaries.

Cal Prob Code § 16000 - Trustees are required to administer trust according to its terms and, where the trust instrument is silent, according to the statutory provisions.

Uzyel v. Kadisha, 188 Cal. App. 4th 866 (2010) - Trustees must also act in good faith and with reasonable care, skill, and caution.

Klein v. Hughes, 133 Cal. App. 4th 121 (2005) - Adjustments should only be made when tax consequences are both inequitable and reliably calculable. See Dehgani-Fard and the FAQ’s below.

Cal Prob Code § 11642 - After-discovered assets are distributed according to the terms of the final distribution order.

Estate of Dehgani-Fard, 141 Cal. App. 4th 797 (2006) - The equitable principle requires that the burden of the tax accompanies the income and should be borne by the account into which the taxed item goes.

If you are searching for an experienced trust distribution and trust administration lawyer, to navigate the carefully timed trust administration process, Cheadle Law has specialized in trusts, estate planning, wills, tax related to a trust, tax deferral, and other trust related matters for over 30 years. Tucker Cheadle has been the administrator for several hundred trusts, some of which have large businesses and large portfolios of securities, and has the experience to optimize your trusts and the assets you place in them especially when related to the tax implications. Tucker Cheadle has been designated as an expert in civil court, family court, probate court, criminal court, and federal court. Contact Cheadle Law today at 949.553.1066 to set up a consultation to go over your specific needs.

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