Pass-Through Entities, Mandatory Income Trusts, and Allocation

Steven B. Gorin (Partner, Thompson Coburn LLP, St. Louis, Missouri) and Carol A. Cantrell (Tax Shareholder, Briggs & Veselka Co., Houston, Texas) have recently published their article entitled UPIA Amendment Clarifies Tax Allocation Between Income and Principal When Mandatory Income Trust Owns Pass-through Entity, Prob. & Prop., Jan./Feb. 200-9, at 24.

Here is the introduction to their article:

In the summer of 2008, the Uniform Law Commission amended section 505 of the Uniform Principal and Income Act (the “UPIA”). The amendment clarifies the ambiguity that existed regarding how the trustee of a mandatory income trust should allocate between income and principal the tax on taxable income from a pass-through entity owned by the trust. The article addresses the concerns underlying the changes and explains how amended section 505 operates. It also discusses other problems and planning suggestions when a trust owns a pass-through entity, especially one that fails to distribute all of its income.  These other concerns include complying with the prudent investor rule and qualifying the trust for the marital deduction. 
   

When a mandatory income trust holds an interest in a partnership or other pass-through entity, allocating the trust’s tax n the entity’s taxable income between income and principal is easier said than done. Before its amendment, section 505 was ambiguous. There were at least two interpretations among practitioners and academics. Trustees were often unaware of the problem. The most widely accepted interpretation was that of E. James Gamble, co-reporter of the UPIA. These two interpretations produced vastly different results, as this article illustrates below. To prevent litigation over the matter, the Uniform Law Commission amended section 505 to clarify that it carries out James Gamble’s intent.