How to Use the 65-Day Rule for Trust Distributions
Explore timing considerations for trustees using the 65-day rule to strategically manage a trust's annual tax liability after the year has closed.
The 65-day rule is a tax planning tool that allows a trust or estate to make a distribution to a beneficiary within the first 65 days of a new year and treat that payment as if it were made in the preceding tax year. This gives the trustee or executor flexibility to manage the entity’s tax obligations after the year has closed but before the tax return is filed, based on final financial numbers.
Purpose and Eligibility for the 65-Day Rule
The purpose of the 65-day rule, authorized by Internal Revenue Code Section 663, is to manage the income tax liability of a trust or estate. Trusts and estates are taxed on income they do not distribute to beneficiaries. These entities face compressed tax brackets, and their income can be taxed at the highest marginal rate of 37% once it exceeds $15,650.
This structure incentivizes distributing income to beneficiaries, who are often in lower tax brackets, effectively shifting the tax burden. This is done through Distributable Net Income (DNI), which is the pool of taxable income a trust can pass to beneficiaries. When a trust distributes assets up to its DNI amount, it receives an income deduction, and the beneficiary reports that income on their personal return.
The rule allows a trustee to calculate the exact DNI after the year has ended and make a timed distribution to lower the trust’s taxable income. This can also help avoid the 3.8% Net Investment Income Tax, which applies to undistributed income in certain trusts. Distributing more income can reduce the trust’s exposure to this additional tax.
Eligibility for this election is limited to executors of estates and trustees of complex trusts. A complex trust is one that is not required to distribute all of its income annually and can therefore accumulate it. In contrast, a simple trust, which must distribute all its income each year, is not eligible for the 65-day rule because it has no accumulated income to manage.
Key Information for Making the Election
After calculating the final Distributable Net Income (DNI) for the prior tax year, the trustee must decide on the specific dollar amount to distribute. The amount chosen for the election cannot exceed the greater of the trust’s accounting income or its DNI for the year. This limitation ensures the distribution is tied to the income earned by the trust during that period.
The payment must be made to the beneficiary within 65 days of the beginning of the trust’s new tax year. For a calendar-year trust, this means a distribution for the 2024 tax year must be completed by March 6, 2025. This is a strict deadline for the payment and is separate from the tax filing deadline.
The trustee must keep records documenting that the distribution was made within this window to substantiate the election if questioned by the IRS. The trustee should also inform the beneficiary that the distribution is made under this rule and is considered income for the prior tax year.
How to Make the Election
The election is formally made on the trust’s annual income tax return, Form 1041, U.S. Income Tax Return for Estates and Trusts. To make the election, the trustee or executor must check the designated box for Question 6 on Page 2 of the form. This question asks if the estate or complex trust is making the election, and checking the box formally notifies the IRS of this choice.
The deadline for the distribution is different from the deadline for the election. While the payment must be made within 65 days of the year’s start, the election is made when Form 1041 is filed. The filing deadline for Form 1041 is the 15th day of the fourth month after the tax year ends, which can be extended.
Once the Form 1041 with the checked box is filed, the election is irrevocable for that tax year. The trustee cannot later change their mind and re-characterize the distribution as belonging to the current year.
After making the election, the trust must issue a Schedule K-1 to the beneficiary who received the funds. This form will report the distribution as part of the beneficiary’s share of income for the prior tax year, consistent with the election. The beneficiary then uses this document to accurately report the income on their personal income tax return.