IRS TO WAIVE PENALTIES FOR CERTAIN ESTIMATED TAX PAYMENTS BY ESTATES AND TRUSTS AND ESTATES.

Notice 87-32

This notice provides guidance, in the form of questions and answers, with respect to sections 1403 and 1404 of the Tax Reform Act of 1986 (the Act), which extended section 6654 of the Internal Revenue Code, relating to payments of estimated tax, to trusts and certain estates. In addition, this notice advises fiduciaries of the circumstances in which the Internal Revenue Service will waive penalties for underpayment of estimated tax installments due before July 1, 1987.

The Internal Revenue Service expects to issue regulations under section 6654 regarding estimated tax payments by trusts and estates. Until further guidance is published, taxpayers may rely upon the guidance provided by these questions and answers to determine the estimated tax liability of trusts and certain estates. No inference should be drawn, however, regarding issues not addressed in this notice which may be suggested by a particular question and answer or as to why certain questions, and not others, are included.

Q-1: How do the rules in section 6654 of the Code, relating to payments of estimated tax, apply to trusts and estates?

A-1: Section 1404(a) of the Act amended section 6654 of the Code for taxable years beginning after December 31, 1986, to provide for an addition to tax to be paid by (1) any estate with respect to any taxable year ending 2 or more years after the date of the decedent's death, and (2) any trust, that fails to pay estimated tax under the rules that apply to individuals. Therefore, trusts and estates subject to the provisions of section 6654 must compute and pay required installments of estimated tax.

The amount of any installment of estimated tax required to be paid is the lowest of the amounts computed under three alternatives provided in section 6654(d), referred to below as the current year alternative, the prior year alternative, and the annualized income alternative, unless one of the exceptions in section 6654(e) applies.

Section 6654(d)(1)(A) provides that the amount of each required installment of estimated tax is 25 percent of the required annual payment. Section 6654(d)(1)(B) provides that the "required annual payment" is the lesser of (i) 90 percent of the tax shown on the return for the year (or if no return is filed, 90 percent of the tax for such year) (current year alternative), or (ii) 100 percent of the tax shown on the return for the preceding taxable year (prior year alternative). Accordingly, under the current year alternative, the taxpayer must pay 22.5 percent of the tax shown on the return (or 22.5 percent of the tax if no return is filed) by the due date of the installment. The prior year alternative requires the payment of 25 percent of the tax shown on the trust's or estate's return for the preceding year by the due date of the installment. The prior year alternative, however, generally cannot be used if (1) the preceding taxable year was not a 12-month period, or (2) the trust or estate did not file a return for the preceding taxable year. See A-5 of this notice for a special rule applicable to trusts that have short taxable years in 1987.

Under the third alternative, provided by section 6654(d)(2), the amount of the required installment is the "annualized income installment" (annualized income alternative). Section 6654(d)(2)(B) defines the "annualized income installment" as the excess, if any, of the "applicable percentage," as determined in section 6654(d)(2)(c)(ii), of the tax for the taxable year computed by placing on an annualized basis the trust's or estate's taxable income and alternative minimum taxable income for the months in the taxable year ending before the due date of the installment, over the aggregate amount of any prior required installments for the taxable year. For this purpose, the applicable percentage for full taxable years is determined in accordance with the following table:

      Installment Number                    Applicable Percentage

Section 6654(e) provides three exceptions to the penalty for underpayment of estimated tax. First, under section 6654(e)(1), no addition to tax is due if the tax shown on the return (or if no return is filed, the tax), reduced by the credit allowed under section 31 for taxes withheld, is less than $500. Second, no addition to tax is imposed for any taxable year if (1) the preceding taxable year was a 12-month period, and (2) the trust or estate did not have any liability for tax for the preceding taxable year. Finally, section 6654(e)(3) provides the Internal Revenue Service with the discretion to waive the addition to tax in certain unusual circumstances. See A-2 of this notice for the availability of a waiver of the addition to tax with respect to installments of estimated tax of trusts and estates due before July 1, 1987.

Q-2: Under what circumstances will the Internal Revenue Service waive the addition to tax for underpayment of estimated tax by trusts and estates?

A-2: The requirement that trusts and certain estates pay estimated taxes is new for 1987 and the Act made substantial other changes to the Code that affect trusts and estates. For these reasons, the Service will waive the penalty attributable to the underpayment of estimated tax for trusts and estates using either the current year alternative or annualized income alternative to compute required installments of estimated tax due before July 1, 1987, provided that the trustee or executor makes a good faith effort accurately to determine the amount of the required installment and makes a timely payment of the amount so determined.

Further, trusts and estates will not be required to take into account alternative minimum taxable income, if any, for purposes of making estimated tax payments until guidance is provided under section 59(c) of the Code.

Q-3: What are the due dates for the estimated tax payments of a trust or estate that has a short taxable year?

A-3: A trust or estate that has a short taxable year (that is, a period of less than 12 months) must pay installments of estimated tax on or before (1) the fifteenth day of the fourth month of such taxable year, (2) the fifteenth day of the sixth month of such taxable year, (3) the fifteenth day of the ninth month of such taxable year, and (4) the fifteenth day of the first month of the succeeding taxable year. The payments due in the sixth and/or ninth month of the short taxable year (but not the payment due on the fifteenth day of the first month of the succeeding taxable year) are not required to be paid if the short taxable year ended during or prior to such sixth and/or ninth months. The following chart provides the due dates of estimated tax payment for trusts or estates that have short taxable years:

 Short taxable   1st payment   2nd payment   3rd payment   Final pay-

Q-4: How does a trust or estate making estimated payments for a short taxable year compute the amount of the required annual payment under the prior year alternative?

A-4: A trust or estate may compute its required annual payment for a short year under the prior year alternative, by multiplying the tax shown on the return for the preceding taxable year by the number of months in the short taxable year, and dividing the resulting amount by 12.

Q-5: Will a trust with a short taxable year in 1987 be allowed to determine its estimated tax for 1988 under the prior year alternative, even though its preceding taxable year was less than 12 months?

A-5: Use of the prior year alternative is generally denied to taxpayers when the prior year is a period of less than 12 months. However, if "the preceding taxable year" referred to in Section 6654(d)(1)(B)(ii) was a short taxable year in 1987, the trust will be permitted to use the prior year alternative and the tax shown on the return for such preceding short year shall be increased by dividing it by the number of months in the short taxable year and multiplying the resulting amount by 12, provided that the short taxable year was preceded by a taxable year of twelve months.

Q-6: For purposes of the prior year alternative and the current year alternative, what percent of the required annual payment must a trust or estate pay in each required installment payment made with respect to a short taxable year?

A-6: When a trust or estate makes payments with respect to a short taxable year, the percent of the required annual payment which must be paid at each installment will vary depending on the number of required installments (as determined in A-3 of this notice). The percentages are as follows:

      Number of required                 Percent of required

A-7: When a trust or estate has a short taxable year the applicable percentage will vary depending on the number of required installments. If it is determined under A-3 of this notice that four installments are required, the applicable percentage is determined as set forth in A-1 of this notice. If less than four installments are required, the applicable percentage for purposes of section 6654(d)(2) is determined as follows:

         In the case of 3                        The applicable

A-8: The trustee may take into account the distribution deduction under section 651(a) of the Code, regardless of whether income is distributed during such period. The amount of the deduction, however, may not exceed the distributable net income of the trust for the months preceding the month in which the installment is due. Thus, a simple trust as defined in section 651 does not pay estimated tax with respect to income as defined in section 643(b). Similarly, a trustee or executor may take into account a portion of the distribution deduction under section 661(a)(1) for the months preceding the month in which the installment is due (regardless of whether income is distributed during such period) under the rules described below.

In case of an estate or trust that is required to distribute a specific dollar amount of income each year, the amount of the distribution deduction under section 661(a)(1) that must be taken into account for the months preceding the month in which the installment is due is the greater of (i) the amount of such income actually distributed during the months of the taxable year that precede the month in which the installment is due; or (ii) the specific dollar amount of income which must be distributed currently multiplied by a fraction, the numerator of which is the number of calendar months in the taxable year that precede the month in which the installment is due and the denominator of which is the total number of calendar months in the year.

For example, assume trust T, a calendar year trust, earned $10,000 of interest income from January 1 through March 31, 1987. T is required to distribute $10,000 of income to the sole beneficiary, B, each year. T did not distribute any income to B during this period. The trustee is allowed to take into account a distribution deduction of $2,500 in the first quarter, ($10,000 (income required to be distributed currently) x 3/12).

In the case of a trust or estate that is required to distribute a certain percentage of income each year, the amount of the distribution deduction that must be taken into account for the months preceding the month in which the installment is due is the income earned by the trust during such period multiplied by the percentage of income which must be distributed currently. To illustrate, assume the same facts as in the previous example except that the trustee of T is required to distribute currently to B one-half of trust accounting income, rather than $10,000 of trust accounting income. In this case, the distribution deduction for the first quarter would be $5,000 ($10,000 (trust accounting income from January 1 through March 31) x 50 percent (percentage of income which must be distributed currently)).

The trustee or executor may take into account the deduction for discretionary distributions under section 661(a)(2), however, only to the extent that distributions have been paid or credited during the months of the taxable year that precede the month in which the installment is due. For the required installment due in the fifteenth day of the first month of the succeeding taxable year, the trustee or executor also may take into account distributions made within sixty- five days of the end of the year that are considered to have been paid or credited on the last day of the year. The amount of the deduction that may be taken into account under section 661(a)(2), however, may not exceed the amount of distributable net income of the trust or estate during the applicable period. In summary, a complex trust or estate is generally required to pay estimated tax with respect to income that is neither required to be distributed in the current year nor actually paid or credited to a beneficiary prior to the month in which the installment payment is due.

Q-9: How is the annualized taxable income of a trust or estate calculated for purposes of determining the amount of the required installment under the annualized income alternative?

A-9: Taxable income is annualized by:

(1) Multiplying the taxable income of the trust or estate (computed without taking into account the deduction allowed under section 642(b)) for the calendar months in the taxable year that precede the month in which the installment is due by a fraction, the numerator of which is the total number of calendar months in the taxable year and the denominator of which is the number of calender months in the taxable year that precede the month in which the installment is due, and

(2) Subtracting the deduction allowed to the trust or estate under section 642(b).

The annualized income alternative can be illustrated by the following example. Assume trust W, a complex trust with a calendar year, earned $15,000 of interest income for the period January 1, 1987, through March 31, 1987. W made no other expenditures during this period. Under the terms of the trust, one-third of the income is required to be distributed currently to the sole beneficiary, B, and the remaining income is to be allocated to corpus. W does not make any distributions to B before March 31, 1987. For purposes of computing the required installment under the annualized income alternative, W is allowed a distribution deduction of $5,000 (the amount of income earned ($15,000) multiplied by the percentage of income which must be distributed currently (33 percent)). Thus, W has taxable income of $10,000. The annualized taxable income of T is determined as follows:

 Taxable income for the period

A-10: As required by section 443(b)(3) of the Code and section 1.443-1(b)(1)(v) of the Income Tax Regulations, in computing annualized taxable income of the short year resulting from a change from a fiscal year to a calendar year, the deduction allowed under section 642(b) must be reduced by multiplying it by a fraction, the numerator of which is the number of months in the short taxable year and the denominator of which is 12.

Q-11: How is trust taxable income for an installment period determined if the trust is a participant in a common trust fund (CTF)?

A-11: Section 584 of the Code and section 1.584-2(a) of the Income Tax Regulations provide that each participant in a common trust fund (CTF) is required to include in taxable income, for the taxable year within which or with which the taxable year of the CTF ends, its proportionate share of all gains, losses, and ordinary income or loss, whether or not distributed or distributable. In determining the taxable income of a trust that is a CTF participant for the months in the taxable year of the participating trust preceding the month in which any installment of estimated tax is due, a participating trust shall take into account the trust's share of items from the CTF described in section 584(c) (whether distributed or not) for the CTF's taxable year ending with or within the participating trust's taxable year, to the extent such income is attributable to months in such CTF's taxable year that preceded the month in the participating trust's taxable year in which the installment is due.

EXAMPLE (1). Trust A, whose taxable year is a calendar year, is a member of CF, a common trust fund, whose taxable year ends on June 30. Trust A must take into account, in determining its taxable income for the installment due on April 15, 1987, its share of all items of CF set forth in section 584(c) for the period July 1, 1986, through March 31, 1987, whether or not such items are distributed or distributable. For the installment due on June 15, 1987, the trust must take into account such amounts for the period July 1, 1986, to May 31, 1987; and for installments due on September 15, 1987, and January 15, 1988, the trust must take into account such amounts for the entire CF's entire taxable year, July 1, 1986, through June 30, 1987, but no amounts with respect to CF's taxable year ending June 30, 1988.

EXAMPLE (2). Trust A, whose taxable year is a calendar year, is a member of CF, a common trust fund, whose taxable year ends on January 31, 1987. Trust A must take into account, in determining its taxable income for the installment due on April 15, 1987, its share of all items set forth in section 584(c) for CF's taxable year beginning February 1, 1986, ending on January 31, 1987, whether or not such items were distributed or distributable. For installments due on June 15, 1987, September 15, 1987 and January 15, 1988, the trust must take into account such amounts for the CF's entire taxable year, February 1, 1986, through January 31, 1987, but no amounts with respect to CF's taxable year ending on January 31, 1988.

EXAMPLE (3). Trust A, whose taxable year is a calendar year, is a member of CF, a common trust fund, whose taxable year is a calendar year. Trust A must take into account, in determining its taxable income for the installment due on April 15, 1987, all items set forth in section 584(c) for the period January 1, 1987, through March 31, 1987, whether or not such items are distributed or distributable. For the installment due on June 15, 1987, the trust must take into account such amounts for the period January 1, 1987, to May 31, 1987; for the installment due on September 15, 1987, the trust must take into account such amounts for the period January 1, 1987, through August 31, 1987, and for the installment due on January 15, 1988, the trust must take into account such amounts for CF's entire taxable year.

Q-12: If a trustee elects under section 643(g) of the Code to treat a portion of an estimated tax payment as a payment made by a beneficiary, is such portion treated as a distribution that carries out distributable net income from the trust?

A-12: Section 643(g) of the Code provides that a trustee of a trust may elect to treat any portion of a payment of estimated tax made by such trust for any taxable year of the trust as a payment made by a beneficiary of such trust on January 15 of the following taxable year. The amount subject to this election shall be treated as a distribution that carries out distributable net income to the beneficiary on the last day of the taxable year of the trust with respect to which the payment was made by the trust. Accordingly, the trust is eligible for a section 661 deduction, if it makes a valid election under section 643(g).

Q-13: Are foreign trusts required to (1) adopt a calendar taxable year and (2) make estimated tax payments?

A-13: Yes. Section 645(a) of the Code provides that "the taxable year of any trust shall be the calendar year." Therefore any foreign trust subject to the provisions of the Internal Revenue Code must adopt a calendar year as its taxable year unless such trust meets the requirements of section 645(b), which provides an exception for trusts exempt from tax and charitable trusts.

In addition, section 6654(1) provides that "any trust" is subject to "an addition to the tax" if it fails to pay the appropriate amount of estimated income tax. Therefore, any foreign trust subject to federal income tax is required to make estimated taxpayments under section 6654.