A Paycheck As A Treasure Trove

 

I am looking at a case where the taxpayer was using Cesarini to argue her position.

COMMENT: Cesarini is one of my favorite tax decisions and a big reason this case caught my eye. The family purchased a piano at auction for $15. Seven years later – while cleaning the piano – they discovered approximately $4,500 in currency. The tax case addressed when the $4,500 was taxable – when they bought the piano, when they found the money, or some other date. It also introduced us to the “treasure trove” doctrine, addressing – not surprisingly – when finding a treasure is taxable.

COMMENT: $4,500 does not strike as that much money in 2025. Cesarini however was decided in 1964, when median U.S. household income was about $6,000. We probably would agree that finding 75% of your annual household income by fluke could be described as a treasure trove.

Let’s introduce Corri Fiege, who worked in Alaska for a U.S. subsidiary of an Australian corporation. She participated in a performance rights plan and was granted 60,000 unvested rights in parent company stock. The rights vested over three years, and she received 20,000 shares on each of July 31, 2011, 2012 and 2013.

There of course was tax involved. She had the company sell 1/3 of the stock and send the cash as federal tax withholding. She owed tax. She paid tax. There was no problem with these years.

In 2013 she received a fresh tranche of rights - 400,000 rights vesting over the four-years ending December 21, 2013, 2014, 2015 and 2016.

This time the grant was a handcuff. The parent company was in financial distress and was firing people left and right. However, they wanted to keep Corri - that is, until they let her go on November 24, 2014.

Vesting did not happen until December 21. She wasn’t going to make it.

But the company did something unexpected: it transferred 100,000 shares of stock into her Charles Schwab account. She assumed they made a mistake, and she was required by plan terms to report if there was a mistake. She called someone in Brisbane, Australia; that person had left. She called another in Houston, Texas. That person had left too. She gave up trying to report the matter to the company.

She received a W-2 showing an additional $75,660 from the stock.

But this time there was no selling 1/3 of the shares for tax withholding. She would be writing a check to Uncle Sam.

What to do?

She did not file a joint income tax return for 2014.

COMMENT: Worst. Possible. Decision.

This was easy picking for the IRS computers.

Off to Tax Court they went.

Corri and the IRS had two very different arguments.

She argued that the treasure trove doctrine applied.

Corri argued that the shares were transferred contrary to the performance rights plan, making the money subject to an ongoing claim by her employer under Alaska law.

I get it: she argued treasure trove because it would delay taxation until the taxpayer had undisputed possession.

This of course put a lot of pressure on her argument that she had disputed possession.

The IRS came from an altogether different angle.

·       Corri had an employment relationship.

·       She was compensated both in cash and property.

·       Under the tax Code, both cash and property are taxable.

·       The Code does have a specific provision (Section 83) for property transferred with restrictions on its further transfer or with a risk of forfeiture. This is what happened here. Corri was awarded rights, exercisable in the future. If she remained employed, the rights were exchangeable for actual shares, which she was free to keep or sell without further restriction. The rights were not taxable when awarded, as Corri had to remain employed until the exercise date. Once she reached that date, the restrictions came off and she had taxable compensation.

The IRS argument proved formidable against Corri. She had no further obligations to the company after she left. In addition, she was not required to refrain from acting (think a covenant not to compete). There was no risk of forfeiture from her acting or not acting. She was also free to sell or otherwise transfer the shares.

And it was there that she lost the argument of disputed possession. In Cesarini nobody knew who the cash had belonged to, and the matter of its possession had to be sorted out under state law. In this case all parties knew who the shares belonged to, and there remained nothing to be sorted out under Alaska law.

There was no treasure trove.

There was no delay.

The IRS won.

There are two things in this case that bother me. Neither are tax driven. I would describe them instead as common sense.

1. The Company had the right to overrule the terms of the performance rights plan and award shares even if plan terms were not met. To rephrase, the company was not allowed to remove a benefit already granted but it was allowed to grant a benefit an employee would otherwise not receive. I believe that is what happened here: Corri was a diligent and valued employee, and the company wanted to show appreciation, even if they had to release her.
2. If an employer gives me free money, why wouldn’t I pay tax? It seems to me that I am still better off than without the free money.

Our case this time was Corri Feige v Commissioner, T.C. Memo 2025-88.

Loan Warehousing And The Claim of Right

 

Tax returns are generally filed in one-year increments.

That raises an accounting question: what if the transaction being accounted for stretches over more than one year?

A variation is:

Set aside whether the whether the transaction resolved in the same period. Was there doubt as to a material fact affecting the transaction? If one were to redo the accounting knowing what one knows now, would there be a different answer?

This is the backdrop for the claim of right doctrine. Judge Brandeis referred to it in North American Oil Consolidated v Burnet (1932):

If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.”

You can immediately see a couple of requirements:

(1) The taxpayer is later required to return the money.

(2) The taxpayer, however, initially received the money without restriction upon its use.

If you are preparing a tax return and learn of the above, what do you do?

(1)  Amend the original tax return?

(2)  Deduct the repayment in the year of repayment?

It might not seem significant upon first hearing, but it can be. Here are two common ways it can be significant:

(1) The original year (that is, the year the income was reported) is closed under the statute of limitations.

(2) Tax rates have changed substantially between the years.

Congress finally passed a Code section codifying the claim of right doctrine in 1954:

26 U.S. Code § 1341 - Computation of tax where taxpayer restores substantial amount held under claim of right

(a) General rule If—

(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;

(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and

(3) the amount of such deduction exceeds $3,000,

then the tax imposed by this chapter for the taxable year shall be the lesser of the following:

(4) the tax for the taxable year computed with such deduction; or

(5) an amount equal to—

(A) the tax for the taxable year computed without such deduction, minus

(B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).

This is a rare find in the tax Code, as Congress actually expanded the claim of right to make it more taxpayer friendly. The Code still allows a deduction in the year of repayment, but it also allows a recalculation using the original year’s tax rates. If tax rates have decreased (overall or yours personally), the recalculation of the original year may be the better way to go.

Let’s look at Norwich Commercial Group v Commissioner.

Here is the first sentence of the decision:

P overreported more than $7 million in income on its 2007 through 2013 federal income tax returns."

Big number. It caught my attention.

Norwich was a residential mortgage loan originator. It engaged in warehouse lending, a term that may sound mysterious but is really not. Here is what warehousing means in a lending context: 

• Norwich (call it the warehouse) borrows money, likely on a line of credit, to start the transaction. 
• The warehouse lends the money to a customer (in this case, a home buyer) in exchange for a promissory note. 
• The warehouse sells the promissory note to an investor. The money received from the sale is (almost certainly) deposited with the lender the warehouse itself borrowed the money from. 
• The lender does its calculations: how much is owed, how much interest is due and other charges, if any. It subtracts this amount from the amount deposited. Whatever is leftover is returned to the warehouse as gross profit (in this context called: mortgage fee income).

If you think about it, this is an inventory accounting of sorts, except that the inventory is money lent.

So, Norwich was a warehouse.

Liberty was Norwich’s primary lender. There were others, but let’s sidestep as they are not necessary to understand the tax issue at play.

Norwich had to design an accounting procedure for its mortgage fee income. It did the following: 

• First, all mortgage deposits were posted to Mortgage Fee Income.
• Second, the amounts kept by Liberty reduced Mortgage Fee Income.
• Third, Norwich would adjust Mortgage Fee Income to whatever Liberty said it was.
• Fourth, the difference was assumed to be Unsold Mortgages.

I get it, but Norwich should backstop its critical accounts.

Let’s see:

(1)  Cash

a.     Well, that is easy to backstop with a bank statement.

(2)  Loan payable to Liberty.

a.     Again: easy. Liberty should be able to tell them that number.

(3)  Unsold Mortgages.

a.     Liberty cannot help Norwich here, as these have not entered Liberty’s accounting system. They are off the radar as far as Liberty is concerned.

We have identified the weak spot in the accounting, as Unsold Mortgages are just a subtraction. Best practice would involve keeping detail – more or less, as required – to have a reality check on the running balance.

In 2014 Norwich started using new accounting software.

It could not reconcile certain accounts.

COMMENT: This is my shocked face.

Norwich contacted Liberty, who in turn provided detail and balances to help with reconciliations. One of those numbers was collateral held by Liberty to secure the line of credit. The collateral included everything, including loans in process or otherwise but not yet sold by Norwich.

If that sounds a lot like Norwich’s Unsold Mortgages account, that is because it is.

Liberty’s number was significantly less than Norwich’s – by over $7 million. Mind you, all this stuff was collateral for the line of credit. If the actual Unsold Mortgages balance was substantially less than previously reported, Norwich might be undercollateralized. The term for this is “out of trust,” and it could also cause problems for Liberty on the regulator side.

BTW Liberty did not initially believe that Norwich was correct or that the situation was urgent. Norwich tried repeatedly to schedule meetings with Liberty. Liberty in turn delayed, expecting nothing to be amiss.

We will fast forward through the banking side of this.

Norwich filed its claim of right refund – for $7.5 million – on its 2014 tax return.

The IRS denied the refund entirely.

You know this went to Court.

And the arguments are easy to predict:

Norwich: We had an unrestricted right to that income in prior years. It was not until 2014 that we discovered otherwise. Under claim of right, 2014 is the proper year for the deduction.

IRS: Everything here is a loan. Norwich issued loans. Norwich borrowed on loans. When originated loans were sold, Norwich in turn paid back its loans. Everything that happened here circles around loans of one type or another. The claim of right has nothing to do with loans.

Both sides had a point.

Here is the Court:

This, the Commissioner focuses on the origin of the funds rather than the origin of the transaction ….”

I agree. The business activity required extensive use of loans, but the intended result of all the loans was to generate a profit, not to maintain a loan into perpetuity.

The Court noted that everybody - including Liberty - thought that Norwich was entitled to the money when Norwich received it.

The repayment was also deductible as an ordinary and necessary business expense and was not barred by another Code section.

2014 was also the correct year for the deduction. It was the year Norwich found the error, which discovery was memorialized in paperwork between Norwich and Liberty. Norwich agreed to either (1) provide more collateral or (2) pay down its line of credit with Liberty.

The Court did tweak some numbers, but overall Norwich prevailed in its claim of right refund request.

Our case this time was Norwich Commercial Group v Commissioner, T.C. Memo 2025-43.

Recurring Proposal For Estate Beneficiary’s Basis In An Asset

There is an ongoing proposal in estate taxation to require the use of carryover basis by an inheriting beneficiary.

I am not a fan.

There is no need to go into the grand cosmology of the proposal. My retort is simple: it will fail often enough to be an unviable substitute for the current system.

You might be surprised how difficult it can be sometimes to obtain routine tax reports. I have backed into a social security 1099 more times than I care to count.

And that 1099 is at best a few months old.

Let’s talk stocks.

Question: what should you do if you do not know your basis in a stock?

In the old days – when tax CPAs used to carve numbers into rock with a chisel – the rule of thumb was to use 50% of selling price as cost. There was some elegance to it: you and the IRS shared equally in any gain.

This issue lost much of its steam when Congress required brokers to track stock basis for their customers in 2011. Mutual funds came under the same rule the following year.

There is still some steam, though. One client comes immediately to mind.

How did it happen?

Easy: someone gifted him stock years ago.

So?  Find out when the stock was gifted and do a historical price search.

The family member who gifted the stock is deceased.

So? Does your client remember - approximately - when the gift happened?

When he was a boy.

All right, already. How much difference can it make?

The stock was Apple.

Then you have the following vapid observation:

Someone should have provided him with that information years ago.

The planet is crammed with should haves. Take a number and sit down, pal.

Do you know the default IRS position when you cannot prove your basis in a stock?

The IRS assumes zero basis. Your proceeds are 100% gain.

I can see the IRS position (it is not their responsibility to track your cost or basis), but that number is no better than the 50% many of us learned when we entered the profession.

You have something similar with real estate.

 Let’s look at the Smith case.

Sherman Darrell Smith (Smith) recently went before the Tax Court on a pro se basis.

COMMENT: We have spoken of pro se many times. It is commonly described as going to Tax Court without an attorney, but that is incorrect. It means going to Tax Court represented by someone not recognized to practice before the Tax Court. How does one become recognized? By passing an exam. Why would someone not take the exam? Perhaps Tax Court is but a fragment of their practice and the effort and cost to be expended thereon is inordinate for the benefits to be received. The practitioner can still represent you, but you would nonetheless be considered pro se.

Smith’s brother bought real property in 2002. There appears to have been a mortgage. His brother may or may not have lived there.

Apparently, this family follows an oral history tradition.

In 2011 Smith took over the mortgage.

The brother may or may not have continued to live there.

Several years later Smith’s brother conveyed an ownership interest to Smith.

The brother transferred a tenancy in common.

So?

A tenancy in common is when two or more people own a single property.

Thanks, Mr. Obvious. Again: so?

Ownership does not need to be equal.

Explain, Mr. O.

One cannot assume that the real estate was owned 50:50. It probably was but saying that there was a tenancy in common does not automatically mean the brothers owned the property equally.

Shouldn’t there be something in writing about this?

You now see the problem with an oral history tradition.

Can this get any worse?

Puhleeeze.

The property was first rented in 2017.

COMMENT: I suspect every accountant that has been through at least one tax course has heard the following:

The basis for depreciation when an asset is placed in service (meaning used for business or at least in a for-profit activity) is the lower of the property’s adjusted basis or fair market value at the time of conversion.

One could go on Zillow or similar websites and obtain an estimate of what the property is worth. One would compare that to basis and use the lower number for purposes of depreciation.

Here is the Court:

Petitioner used real estate valuation sources available in 2024 to estimate the rental property’s fair market value at the time of conversion.”

Sounds like the Court did not like Smith researching Zillow in 2024 for a number from 2017. Smith should have done this in 2017.

If only he had used someone who prepares taxes routinely: an accountant, maybe.

Let’s continue:

But even if we were to accept his estimate …, his claim to the deduction would fail because of the lack of proof on the rental property’s basis.”

The tenancy in common kneecapped the basis issue.

Zillow from 2024 kneecapped the fair market value issue.

Here is the Court:

Petitioner has failed to establish that the depreciation deduction here in dispute was calculated by taking into account the lesser of (1) the rental property’s fair market value or (2) his basis in the rental property.”

And …

That being so, he is not entitled to the depreciation deduction shown on his untimely 2018 federal tax return.”

Again, we can agree that zero is inarguably wrong.

But such is tax law.

And yes, the Court mentioned that Smith failed to timely file his 2018 tax return, which is how this mess started.

Here is the Court:

Given the many items agreed to between the parties, we suspect that if the return had been timely filed, then this case would not have materialized.”

Let’s go back to my diatribe.

How many years from purchase to Tax Court?

Fifteen years.

Let’s return to the estate tax proposal.

Allow for:

• Years if not decades
• Deaths of relevant parties
• Failure to create or maintain records, either by the parties in interest or by municipalities tasked with such matters
• Soap opera fact patterns

And there is why I object to cost carryover to a beneficiary.

Because I have to work with this. My classroom days are over.

And because – sooner or later – the IRS will bring this number back to zero. You know they will. It is chiseled in stone.

And that zero is zero improvement over the system we have now.

Our case this time was Smith v Commissioner, T.C. Memo 2025-24.

File A Return, Especially If You Have Carryovers

 

Please file a tax return when you have significant carryovers.

Let’s look at the Mosley case.

In 2003 Sonji Mosley bought four residential properties in North Carolina.

In 2007 she bought undeveloped land in South Carolina.

In 2009 all the properties were foreclosed.

On her 2009 return she reported approximately $20 grand of net rental expenses and a capital loss of approximately $182 grand.

On her 2014 return she claimed an (approximately) $17 thousand loss from one of the 2009 foreclosures.

On her 2015 return she claimed an (approximately) $28 thousand loss from one of the 2009 foreclosures.

On to n 2018.

It seemed an ordinary year. She worked for the city of Charlotte. She also broke two retirement accounts. The numbers were as follows: 

            Wages                                                $ 40,656

            Retirement plan distributions              $216,871

The retirement plan distributions were going to hurt as she was under 59 ½ years of age. There would be a 10% penalty for early distribution on top of ordinary income taxes.

Well, there would have been - had she filed a return.

The IRS prepared one for her. The IRS already had her W-2 and 1099s through computer matching, so they prepared something called a Substitute for Return (SFR). Taxes, penalties, and interest added to almost $60 grand. The implicit bias in the SFR is transparent: everything is taxable, nothing is deductible. The IRS wants you to see the SFR, clutch your chest and file an actual return.

To her credit, she did reply. She did not file a return, though; she replied with a letter.

COMMENT: She should have sent a return.

She explained that - yes – she should have filed a return, but the IRS was not giving her credit for prior year carryovers. If anything, she still had a credit with the IRS. She also requested the IRS to remove all penalties and interest.

COMMENT: She definitely should have sent a return.

The IRS could not understand her letter any more than you or I. They sent a Notice of Deficiency, also called a “NOD,” “SNOD,” or “90-day letter.” It is the ticket to Tax Court, as we have discussed before.

Off to Court they went.

Mosley next submitted four handwritten calculations to the IRS.

• The first showed a net operating loss (NOL) of $444,600 and a capital loss of $206,494, both originating in 2009.
• The second and third ones broke down those numbers between South and North Carolina.
• The fourth one was an updated calculation of her 2018 taxes. According to her numbers, she had a remaining NOL of $211,308 going into 2018. Since the total of her 2019 income was approximately $257 grand, she had very much separated the thorn from the stalk.

The IRS had questions. The tax impact of a foreclosure can be nonintuitive, but – in general – there are two tax pieces to a foreclosure:

(1)  The borrower may have income from the cancellation of income. That part makes sense: if the bank settles a $150,000 debt for $100 grand, one can see the $50 grand entering the conversation. Then follows a bramble of tax possibilities – one is insolvent, for example – which might further affect the final tax answer but which we will leave alone for this discussion.

(2)   Believe it or not, the foreclosure is also considered a sale of the property. There might be gain or loss, and the gain might be taxable (or not), and the loss might be deductible (or not). Again, we will avoid this bramble for this discussion.

The IRS looked at her calculations. She had calculated a 2009 NOL of $444,600 and $78,025 capital loss from her North Carolina properties. The IRS recalculated North Carolina and arrived at taxable gain of $55,575.

Not even close.

You can anticipate the skepticism the Tax Court brought to bear:

(1)  She did not file a 2009 return, yet she asserted that there were carryovers from 2009 that affected her 2018 return.

(2)  She reported the same transactions in 2009, 2014 and 2019.

(3)  The tax reporting for foreclosures can be complicated enough, but her situation was further complicated by involving rental properties. Rentals allow for depreciation, which would affect her basis in the property and thereby her gain or loss on the foreclosure of the property.

(4)  The IRS recalculations were brutal.

The Court pointed out the obvious: Mosley had to prove it. The Court did not necessarily want her to recreate the wheel, but it did want to see a wheel.

Here is the Court’s sniff at the net operating loss carryover:

It is apparent that the record is devoid of evidence to properly establish both the existence and the amount of petitioner’s NOLs in 2009.”

Here is the Court on the capital loss carryover:

“ … petitioner initially reported the foreclosure on the South Carolina land resulted in $182,343 of net long-term capital losses, and for each of 2009-17, she claimed $3,000 of that amount as a long-term capital loss deduction pursuant to section 1211(b). But on the 2015 return … petitioner also improperly claimed an ordinary loss deduction of 110,257 from the sale or exchange of the South Carolina land despite the foreclosure on that land in 2009. Thus, petitioner effectively double counted the loss …."

Mosley lost on every count, She owed tax, penalty, and interest.

And there is a lesson. If you have significant tax carryovers spilling over several years, you should file even if the result is no taxable income. The IRS wants to see the numbers play out. Get yourself in hot water and the Tax Court will want to see them play out also.

You might even catch mistakes, like double-counting things.

Our case this time was Mosely v Commissioner, T.C. Memo 2025-7.  

Section 643 and MSTs

 

I came across the following recently on LinkedIn:

 

The line of tax code that 99% of CPAs can’t understand for some reason.

And because they don’t understand this they make their clients tax planning convoluted and unnecessary.

26 U.S. Code § 643

(3) Capital gains and losses
Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c). 

Stop, just stop.

There is a lot of nonsense going around on social media concerning something called - among other things – a “nongrantor, irrevocable, complex, discretionary, spendthrift trust.”

I just call it a “643 trust.” It is probably unfair as Section 643 has its legitimate place in the Code, but I simply cannot repetitively spray multisyllabic spittle when referring to these.

They have many forms, but one thing is key: Section 643. I met last year with someone who was hawking these things but was unable to find a CPA with his elevated mastery of the tax Code.

Uh huh. Elevator is down the hall, pal.

Let’s walk through these trusts.

The tax Code has numerous sections. Go to Chapter 1 Subchapter J and you will find sections dealing with trusts. You will note that they all have numbers between 641 and 692.

Section 643 is between 641 and 692. We are in the right place.

Trust taxation is not the easiest thing to understand. There are weird concepts. Then there are uncommon terms, such as:

 

·       The grantor – the person who transfers assets to the trust.

·       The income beneficiary – the person entitled to income distributions.

·       The residuary beneficiary – the person entitled to the remainder of the trust when the income beneficiaries are done.

·        Irrevocable trust – a trust where the grantor cannot amend or end the trust after its creation.

·       Complex trust – a trust that can accumulate (that is, retain) its profit.

·       Trustee – the person managing trust assets for the benefit of trust beneficiaries. A trustee is required to act in the best interest of the beneficiaries.

·       Discretionary trust – a trust allowing a trustee the power to decide how and when to distribute assets (including income) to beneficiaries.

Believe it or not, there are also several definitions of income, such as:

 

·       Fiduciary accounting income – income as defined by the trust instrument and state law.

·       Distributable net income – the maximum income available to the trustee for distribution to beneficiaries.

·       Taxable income – income as defined by the tax Code.

And - yes - you can get different answers depending on which definition of income you are looking at.

Why is that?

One reason is possible tension between different beneficiary classes. Say that you create a trust for your son and daughter as income beneficiaries. Upon their death, the remaining trust assets (called corpus) goes to the grandkids, who are the residuary beneficiaries. Your kids may want something to be considered income, as they are entitled to income distributions. The grandkids may prefer something not be considered income, as that something would not be distributed and thereby remain in the trust until eventual distribution to them.

What are common friction points between income and residuary beneficiaries? Here are two repetitive ones: capital gains and depreciation.

For example, one may consider depreciation as a reserve to replace deteriorating physical assets. In that case, it makes sense to allocate depreciation to the residuary beneficiaries, as the assets will eventually go to them. Then again, accountants routinely include depreciation as a current period expense. In that case, depreciation should go to the income beneficiaries along with other current period expenses.

Back to our multisyllabic spittle trust (MST).

Look at Section 643(b):

    26 U.S. Code § 643 - Definitions applicable to subparts A, B, C, and D

(b) Income.

For purposes of this subpart and subparts B, C, and D, the term "income", when not preceded by the words "taxable", "distributable net", "undistributed net", or "gross", means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.  

What is this Section trying to do?

Looks like it is trying to define “income” and failing rather badly at it.

Look at the last sentence:

… which the fiduciary, acting in good faith, … shall not be considered income.”

Hmmmmm.

But read the first sentence:

… when not preceded by the words “taxable ….”

Seems to me that last sentence could be the solution to the Riemann Hypothesis and it would not matter once you put the word “taxable” in front of “income.”

Let’s move on to Section 643(a):

Distributable net income.

For purposes of this part, the term “distributable net means, with respect to any taxable year, the taxable income of the estate or trust computed with the following modifications —  

(3) Capital gains and losses         

Gains from the sale or exchange of capital assets shall be excluded to the extent that such gains are allocated to corpus and are not (A) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (B) paid, permanently set aside, or to be used for the purposes specified in section 642(c).  

(4) Extraordinary dividends and taxable stock dividends  

… there shall be excluded those items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, does not pay or credit to any beneficiary by reason of his determination that such dividends are allocable to corpus under the terms of the governing instrument and applicable local law.

I see the words “shall be excluded.”

I see the extraordinary dividends and taxable stock dividends from Section 643(b). And there is new wording about gains from the sale or exchange of capital assets. Is it possible …?

I also see the words “Distributable net income” at the top.

Let’s go back to our definitions of trust income.

Section 643(a) addresses distributable net income. Think of DNI as Mint Chocolate Chip.

Section 643(b) addresses taxable income. Think of TI as Cookies and Cream.

Mint Chocolate Chip is not Cookies and Cream.

Maybe capital gains are excludable from DNI. Maybe they are not. Either way, that conundrum has nothing to do with capital gains being excludable from taxable income.

The IRS is quite aware of the game being played.

Here is AM 2023-006:

 

One is dancing on the slippery beveled edge of a possible tax shelter.

Just leave these trusts alone. If I could make income nontaxable by running it through a string-a-bunch-of-words-together trust, I would have done so years ago. I might have even retired by now.