The 65-Day Rule for Trusts & Estates
Under Internal Revenue Code (IRC) Code §663(b), also known as the 65-day rule, trusts and estates may elect to make distributions up to 65 days after the end of the taxable year and treat them as made during the previous year. This rule applies to complex trusts where the trustee has discretion to make distributions to the beneficiaries. Simple trusts, where net income is required to be distributed to beneficiaries yearly, do not qualify. Grantor trusts, where the income attributable to the trust is reported on the grantor’s personal income tax return, also do not qualify.
The election is made annually on the trust's or estate’s tax return. On the 2023 Form 1041, the election was made by marking the box on Page 3, “Other Information” Section, Line 6. Once made for the year, the election is irrevocable.
The trust or estate must distribute the income within 65 days of the start of the new year to utilize the election. The beneficiaries would receive a K-1 from the trust or estate and report this income on their individual tax return. The trust or estate would get a deduction for the distribution, effectively reducing its taxable income while increasing the taxable income of the beneficiaries.
Tax Arbitrage via 65-Day Distributions
The income tax advantage of making the 65-day distribution election comes into play when the trust or estate is expected to be in a higher tax bracket than the beneficiaries. The trust and estate tax bracket is more compressed than the bracket for individuals. For the 2023 tax year, trusts and estates reach the maximum tax rate of 37% at just $14,451 of taxable income. In comparison, individuals who file single do not reach the maximum 37% tax rate until their income is more than $578,125. Moreover, trusts and estates must pay net investment income tax (NIIT) at a rate of 3.8% on their investment income more than $14,450, while NIIT does not kick in for single individuals until their modified adjusted gross income exceeds $200,000.
With these bracket and threshold discrepancies, it’s easy to see how it could be advantageous to move taxable income from a trust or estate to an individual beneficiary. Below is an example to prove this out.
Example
Will, a single taxpayer under age 65, is the sole beneficiary of a complex trust. Under the trust agreement, the trustee is allowed to make distributions to the beneficiary as they see fit. At the end of 2023, the trust received $100,000 in interest income. There was not enough time to make distributions during the year, so the trustee is considering making a 65-day distribution election. The trust had no other deductions. Will’s personal income, all of which being ordinary investment income for purposes of this exercise, also amounted to $100,000. He takes the standard deduction.
| Without 65-Day Distribution | |||
|---|---|---|---|
| Income Tax | NIIT | Total Tax | |
| Will | 14,266 | - | 14,266 |
| Trust | 35,108 | 3,247 | 38,355 |
| 49,374 | 3,247 | 52,621 | |
| With 65-Day Distribution | |||
|---|---|---|---|
| Income Tax | NIIT | Total Tax | |
| Will | 38,400 | - | 38,400 |
| Trust | - | - | - |
| 38,400 | - | 38,400 | |
Making the 65-day distribution election and distributing all distributable net income (DNI) from the trust to Will would result in a total tax savings of $14,221.
Additional Considerations
In addition to federal tax obligations, there are state tax implications to take into account. If there is a situation in which the trust or estate has no state filing requirement, but the beneficiary is a resident of a state with a higher tax rate, that could tip the scales on whether it would be advantageous from a tax perspective to make the election.
There are also non-financial aspects to consider before making the election, such as whether the beneficiaries are capable of managing the money that would be distributed to them.
Final Thoughts
Although making the 65-day distribution election is a relatively simple task, it may result in significant tax savings. Forvis Mazars Private Client is ready to assist you with this and other tax-savings strategies. If you have any questions on the 65-day distribution election, please reach out to one of our professionals.
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