Revenue Administrative Bulletin 1988-19

MICHIGAN DEPARTMENT OF TREASURY
REVENUE ADMINISTRATIVE BULLETIN 1988-19
Approved: May 27, 1988

INDIVIDUAL INCOME TAX--
TAXABILITY OF INCOME TO A BENEFICIARY OF A TRUST

RAB-88-19. This bulletin describes the Michigan Income Tax treatment of: (1) a resident and nonresident beneficiary of a resident or nonresident trust, and (2) the effect of the Tax Reform Act of 1986 amendment to Section 645 of the Internal Revenue Code of 1986 (IRC) with respect to the taxable year of trusts.

Federal Tax Treatment

Sections 652 and 662 of the IRC require that a beneficiary of a trust include in his or her gross income the amount of income required to be distributed by a trust, whether distributed or not, plus all other amounts that are properly paid, credited or required to be distributed for the tax year. The income of a trust that passes through to a beneficiary does not lose its identity and will have the same character in the hands of the beneficiary as in the hands of the trust, pursuant to the above-mentioned provisions.

For tax years beginning after December 31, 1986, Section 645 of the IRC requires that a trust shall adopt the calendar year as its taxable year. An estate is not affected by this law change. Therefore, a fiscal year trust must file two trust returns in 1987: (1) a fiscal year return for the tax year ending in 1987, and (2) a short-period return for the fiscal year period beginning in 1987 and ending December 31, 1987.

Beginning with the year of change, a beneficiary who receives a distribution from a trust that has filed a short-period return will experience a "bunching" of income. This bunched income may be spread ratably over a period of four tax years. In effect, a beneficiary will include one-fourth of the bunched income in his or her Federal adjusted gross income for 1987.

Michigan Income Tax Treatment of a Beneficiary of a Trust

Taxability of a Resident Beneficiary

A resident beneficiary who receives a distribution from a resident or nonresident trust is taxable on the distribution to the extent this income is includable in the resident beneficiary's "taxable income" as defined under the Michigan Income Tax Act [MCL 206.30(1)].

"Taxable income" is defined in MCL 206.30(1) in the case of a person other than a corporation, an estate, or trust as adjusted gross income as determined in the Internal Revenue Code subject to certain adjustments. A "person" includes, in addition to a resident or nonresident individual, a beneficiary of a trust pursuant to MCL 206.51(3)(b).

In accordance with the Michigan Income Tax Act, MCL 206.51(2), a tax is imposed on the income of a resident beneficiary to the extent this income is includable in adjusted gross income, as modified, subject to the applicable source and attribution provisions of Michigan's Income Tax Act.

Tax Credits for Resident Beneficiaries

A credit is allowed on a resident beneficiary's income tax return for all or a proportionate part of any tax paid by a trust on accumulations from a preceding tax year which would not have been payable if the trust had in fact made distributions to its beneficiaries. [MCL 206.51(5)].

The Act also allows a credit on the resident beneficiary's income tax return for tax imposed by another state of the United States or a political subdivision thereof, the District of Columbia, or a Canadian province under Michigan's Income Tax Act, MCL 206.255. The credit is limited to the lesser of: (1) the tax due to the other state, or (2) the portion of Michigan income tax that the income subject to tax in both states bears to total taxable income under the Department of Treasury Income Tax Rules, 1979 AC, R 206.16(1).

Taxability of a Nonresident Beneficiary of a Michigan Trust

A nonresident beneficiary's taxable income is computed in the same manner as in the case of a resident individual except as provided in the State's Income Tax Act, MCL 206.51(6). The taxable income of a nonresident beneficiary will not include income from a resident estate or trust, regardless of the source or attribution of the income.

Example: A nonresident has income from real estate located in Michigan. He is also a beneficiary of a Michigan trust that has interest and dividends as its source of income. The taxpayer will only be taxed on the income from the real property located in Michigan to the extent included in adjusted gross income. The trust income will be allocated to his or her state of domicile.

Taxability of a Nonresident Beneficiary of a Nonresident Trust

A nonresident beneficiary's taxable income is computed in the same manner as in the case of a resident individual, subject to the allocation and apportionment rules of the Michigan Income Tax Act. Although an exclusion is allowed on the Michigan income tax return for all income passed through to a nonresident beneficiary from a Michigan trust, there will be no exclusion of income to a nonresident beneficiary from a trust in another state if the income is allocable or apportionable to this State under the provisions of Chapter 3 of the Michigan Income Tax Act.

Michigan Income Tax Treatment of Trust Income Distributed
to a Beneficiary Under the Federal Transitional Rule

The taxable income of a beneficiary, as well as any other person who is required to file a return under the Michigan Income Tax Act, MCL 206.30(1), is defined as adjusted gross income as determined in the Internal Revenue Code subject to certain adjustments.

With exception to a distribution made to a nonresident beneficiary of a Michigan trust, a distribution of trust income to a resident or nonresident beneficiary is taxable to Michigan at the time the income is includable in adjusted gross income, subject to the allocation and apportionment rules.

Therefore, under the Federal transitional rule, a distribution received by a beneficiary because of the change in the trust's taxable fiscal year to a calendar taxable year will be ratably spread over a four-year period beginning with the year of the change. The tax due on the distribution is effectively deferred for Federal income tax purposes. This deferment also passes through to the beneficiary's Michigan income tax liability. In each taxable year, the character of the income and the domicile of the taxpayer will be examined to determine the taxability of the trust income.

Household Income

For purposes of computing a property tax credit, farmland preservation tax credit, or home heating credit, trust income deferred under the transitional rule of Section 645 of the Internal Revenue Code of 1986 is includable in household income only in the year the income is included in the taxpayer's Federal adjusted gross income.