Section 664 of the Internal Revenue Code includes the rules for income paid from trusts that are tax exempt under the section. These rules are the so-called four-tier accounting system.
 
This system lays out the basic rules for how distributions to the taxable beneficiaries of a tax-exempt asset diversification trust or a charitable remainder trust are taxed. (These types of trusts are governed by section 664 of the tax code.)
 
The Four Tiers
When a qualified §664 trust makes a distribution to a lead beneficiary, that distribution must be characterized for tax purposes using a tiered system. The code describes the tiers as follows:[1]
 
Amounts distributed [to a lead beneficiary] shall be considered as having the following characteristics in the hands of a beneficiary to whom is paid the annuity described in subsection (d)(1)(A) or the payment described in subsection (d)(2)(A):
 
(1) First, as amounts of income (other than gains, and amounts treated as gains, from the sale or other disposition of capital assets) includible in gross income to the extent of such income of the trust for the year and such undistributed income of the trust for prior years;
 
(2) Second, as a capital gain to the extent of the capital gain of the trust for the year and the undistributed capital gain of the trust for prior years;
 
(3) Third, as other income to the extent of such income of the trust for the year and such undistributed income of the trust for prior years; and
 
(4) Fourth, as a distribution of trust corpus.
 
For purposes of this section, the trust shall determine the amount of its undistributed capital gain on a cumulative net basis.
 
“Worst-in, First-out”
The basic rule-of-thumb for understanding the taxation of distributions from a §664 trust is “worst-in, first-out.”
 
The “worst” refers to the highest rate of tax. So, for example, ordinary income is taxed at the highest marginal rates. Long term capital gains are taxed at lower marginal rates. Tax-exempt income[2] (in most cases) will be the third tier, and the fourth tier, the “least worst” type of distribution, is return of principal (which may also be called corpus or basis).
 
Tier 1: Ordinary Income
The most common forms of ordinary income in a §664 trust will generally include interest, dividends, rents, and other forms of income that would normally be taxed at ordinary income tax rates if received by an individual.
 
Note that some types of ordinary income, such as many forms of business income, can not or should not be earned in a §664 trust because such income might constitute “unrelated business income.” See below for a discussion of unrelated business income.
 
Each trust must keep track of all four categories. Distributions must be made in the order, tier 1 to tier 4.
 
So, for example, as long as a trust has any tier 1 income on its books, that tier 1 income will be considered to be distributed when cash is distributed.
 
We provide examples below.
 
Tier 2: Capital Gains
The majority of §664 trusts are funded with appreciated capital assets. Typically, the trust then sells such assets, recognizing long term capital gains. Those capital gains go into the “tier 2” income account.

Tier 3: Tax-Exempt Income
Tier 3 income is tax-exempt income. In typical cases, a trust is unlikely to ever be in a position to distribute tax-exempt income.

If a trust is funded with a low-basis capital asset, and the trust sells the asset, that trust will have the entire amount of the capital gain in the tier 2 account.

For example, suppose a grantor owns $1 million of stock with a basis of $100,000, and contributes it to a §664 trust. When the trust sells the stock, the trust puts (for accounting purposes, there is no separate physical account) the $900,000 gain into the tier 2 account, and the $100,000 of basis into the tier 4 account.

Suppose that the trust has a payout rate of 5%, and further suppose that the entire $1 million is invested into tax-exempt bonds that yield exactly 5%. And just for simplicity, assume that the fair market value of the bond portfolio remains at exactly $1 million.

In the first year, the trust will earn $50,000 of tax exempt, tier 3, income. However, the distribution will be deemed to come from the $900,000 of tier 2 income, because of the “worst in, first out” principle. In the second year the same thing will happen.

In this example, the trust will earn $50,000 of tier 3, tax-exempt, income each year, but will distribute $50,000 of tier 2 (long term capital gain) income for as long as there is income remaining in the tier 2 account.

By our assumptions, it will take 18 years to distribute all the tier 2 income.

Only after that, in year 19, will the distributions be considered to come from tier 3, tax-exempt, income.

As you can see, the other likely way a trust can get to the point where it will distribute tax-exempt income is when the trust is initially funded with cash or high-basis assets.

Tier 4: Corpus, Basis, or Return of Principal
The code refers to tier 4 as “corpus.” Other names for the same concept are basis, or trust principal. This tier accounts for the original contributions to the trust, or other receipts that are not considered income for tax purposes. Distributions from tier 4 will not have tax consequences to the recipient because they are not taxable.[3]

If you’d like to see an example of how this would look in an actual case with a table that contains numbers, please click this link. 

For more information, call (703) 437-9720 and ask for Connor, or email [email protected]

---

[1] IRC §664(b)

[2] Exceptions may include muni-bonds purchased at a discount, muni-bonds that pay interest subject to the alternative minimum tax, the fact that certain “tax-exempt” income can push recipients into higher tax brackets for Medicare and/or cause their social security benefits to be taxed, or the fact that some muni-bonds are issued as taxable bonds.

[3] Given the complexity of the US income tax, it cannot be said with certainty that a tier 4 distribution could never have a tax consequence.