In trust taxation, the timing of distributions can significantly influence tax outcomes, particularly for complex trusts. The “65-day rule” is a key provision that allows trustees to optimize tax planning. This rule enables trustees of complex trusts to treat distributions made within the first 65 days of a new tax year as if they were made on the last day of the prior tax year. This election can shift taxable income from the trust to its beneficiaries, potentially resulting in significant tax savings.
Key planning insight: The deadline to take advantage of the 65-day rule for the 2024 tax year is March 6, 2025.
Understanding the 65-Day Rule
Unlike simple trusts, complex trusts are not required to distribute all their income annually. As a result, income retained within the trust is subject to trust income tax rates, which are notably compressed. For example, in 2024, trusts reach the highest federal income tax bracket of 37% at just $15,200 of taxable income, compared to $731,201 for married couples filing jointly. This compressed rate structure makes income shifting particularly advantageous.
The 65-day rule can reduce taxable income by allowing the trust to claim a distribution deduction for the previous year. Simultaneously, the distributed income becomes taxable to the beneficiaries, who may be in lower tax brackets, leading to potential tax savings.
Implementing the Election
To apply the 65-day rule, trustees must make a formal election by the trust’s tax return due date (including extensions) for the year in which the distributions are treated as having been made. This election is made on Form 1041 by checking the appropriate box or attaching a statement. Proper documentation for this election is crucial, and the distributions must be executed within the specified 65-day window.
Strategic Considerations
While the 65-day rule offers a valuable tax planning opportunity, trustees should carefully evaluate the following factors before making the election:
- Beneficiary Tax Brackets: Determine whether shifting income to beneficiaries will result in overall tax savings by assessing their tax brackets. For example, distributing income to a beneficiary in the 12% or 24% bracket may offer significant savings compared to trust-level taxation.
- Trust Objectives: Ensure that distributions align with the trust’s terms and the grantor’s intentions.
- Beneficiary Needs: Distributing income may have implications beyond tax considerations. Ensure you understand the financial needs and circumstances of beneficiaries.
- State Taxes: Some states do not follow the federal 65-day rule. Massachusetts does not follow this rule. This means that any distributions made within the first 65 days of 2025 that are treated as 2024 income for federal purposes will still be considered accumulated income for Massachusetts and taxed at the trust level.
However, non-Massachusetts source income for a vested nonresident beneficiary is not taxed at the trust level and can be deducted on the Massachusetts Fiduciary Income Tax return. Additionally, any distributions made within the first 65 days of 2025 will be treated as tax-free in 2024 for Massachusetts purposes.
Is this election right for your Trust?
The 65-day rule is a powerful tool for trustees to manage trusts’ and beneficiaries’ tax liabilities effectively. By carefully planning distributions within the 65-day window and making the appropriate election, trustees can optimize tax outcomes while aligning with the trust’s objectives and the beneficiaries’ best interests.
If you are considering this election, reach out to our team today. The deadline to take advantage of the 65-day rule for the 2024 tax year is March 6, 2025.