Introduction

In the world of fiduciary accounting and non-grantor trust taxation, few sections of the Internal Revenue Code are more misunderstood than §643(a)(3) and §643(b). These two provisions govern the critical distinction between “income” for tax purposes and “income” under the terms of the trust or state fiduciary accounting rules. This distinction forms the foundation for how distributions are taxed, how income is reported, and how trusts maintain compliance.

Yet, promoters of certain trust schemes often misinterpret or misapply these provisions, claiming that §643 allows a trust to "reclassify" all income as non-taxable or to shelter income under false accounting methods. This article will dispel those myths, explain how §643 actually works, and show how it fits into a legitimate trust tax strategy for private irrevocable non-grantor trusts.

Income in Trusts: A Two-Tiered System

Before we can understand §643, we must recognize that trusts deal with two overlapping but distinct definitions of income:

1. Accounting Income (Fiduciary Income):
   This is income as defined by the trust document or by local law, typically based on the Uniform Principal and Income Act (UPIA). It determines how income is allocated between the income beneficiary and the principal (or remainder) beneficiary.

2. Taxable Income (IRC):
   This is income as defined by the Internal Revenue Code, used to calculate the trust’s income tax on Form 1041. The IRS uses its own rules, not the trust instrument, to determine what constitutes gross income, deductions, and Distributable Net Income (DNI).

The discrepancy between fiduciary income and taxable income often creates planning opportunities—but also risks—if misunderstood or abused.

IRC §643(a): Defining Distributable Net Income (DNI)

IRC §643(a) defines Distributable Net Income (DNI)—the key concept in determining how much of a trust’s income is taxable to beneficiaries when distributed, and how much the trust can deduct when making distributions.

643(a)(3) specifically states that:

“Gains from the sale or exchange of capital assets shall be excluded from distributable net income except to the extent that such gains are (A) allocated to income under the terms of the governing instrument or local law, (B) paid, credited, or required to be distributed to any beneficiary during the taxable year, or (C) paid, permanently set aside, or to be used for charitable purposes.”

In plain terms:

• Capital gains are generally not included in DNI, meaning they are taxed to the trust unless an exception applies.

• But if the trust instrument or trustee accounting policy allows those gains to be treated as income and distributed, they can flow through to the beneficiaries and be taxed at their level.

This is a major area of strategic planning—capital gains allocation—which must be supported by the trust language and administered with consistency and intent.

IRC §643(b): Fiduciary “Income”

IRC §643(b) defines “income” for fiduciary accounting purposes:

“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.”

So, when a trust refers to “income” in its terms—such as “distribute all income to my daughter”—what counts as “income” is not defined by the IRS, but by the trust’s own language and the applicable state law (usually the state’s version of UPIA).

This fiduciary income might include:

• Interest

• Dividends

• Rent

• Ordinary business income

…but not necessarily capital gains, unless allocated to income by the trust or trustee policy. The difference between accounting income and taxable income can create a mismatch in how distributions are taxed.

Let’s consider three increasingly advanced scenarios showing how a private irrevocable, complex, non-grantor trust can apply IRC §643(a)(3) and §643(b) to manage capital gains taxably, allocate distributions, and—most importantly—retain and reinvest income while legally lowering tax exposure.

Baseline Facts

A trust earns the following in the current tax year:

• $50,000 in rental income (Schedule E)

• $10,000 in qualified dividends (Schedule B)

• $100,000 in long-term capital gains from stock sales (Schedule D)

Total Gross Income: $160,000

Scenario 1: Capital Gains Allocable to Principal (Default Case)

Trust language:
“Capital gains shall be allocated to principal and not treated as income.”

Distributions made:
Trustee distributes $60,000 to the beneficiaries.

How §643(b) and §643(a)(3) Apply:

• Under §643(b), only the $50,000 rental + $10,000 dividend = $60,000 qualifies as fiduciary accounting income.

• Under §643(a)(3), capital gains not allocated to income or distributed are excluded from DNI.

Tax Impact:

• The $60,000 distribution is considered DNI and is taxable to the beneficiaries (reported on their K-1s).

• The $100,000 in capital gains, being excluded from DNI, is taxable to the trust at compressed rates (likely paying ~$36,500 in federal income tax at 37%).

Result:

• Trust retains capital gains but pays a heavy tax.

• Beneficiaries receive distributions, but no tax advantage is gained.

Scenario 2: Capital Gains Allocable to Income by Trustee Discretion

Trust language:
“Capital gains may be allocated to income in the trustee’s sole discretion.”

Distributions made:
Trustee allocates $50,000 of capital gains to income and distributes it to beneficiaries, along with $60,000 of regular income.

How §643(b) and §643(a)(3) Apply:

• The trust now includes the $50,000 capital gain in fiduciary income (per the discretionary clause).

• Under §643(a)(3)(A), the allocated gain is now part of DNI.

• The trustee distributes $110,000 total ($60k ordinary income + $50k gains), all treated as DNI.

Tax Impact:

• The entire $110,000 is deductible to the trust and taxable to the beneficiaries.

• The remaining $50,000 in capital gains stays in the trust and is taxed at 37% = $18,500.

Result:

• Total tax liability is spread across beneficiaries (who may have lower brackets).

• The trust pays tax only on the portion of retained gains.

• Savings compared to Scenario 1: ~$18,000–$22,000, depending on beneficiary tax brackets.

Note: This is a lawful, advanced strategy using §643(a)(3) discretion, backed by trustee resolution and trust instrument.

Scenario 3: Capital Gains Retained, Reinvested, and Depreciated (Advanced Trust Strategy)

Trust language:
Same as Scenario 2: “Capital gains may be allocated to income or principal at trustee’s discretion.”

Distributions made:
Trustee retains the entire $100,000 capital gain in the trust and does not allocate it to income—it remains excluded from DNI.

What happens next?
The trustee uses the $100,000 retained capital gains to purchase depreciable property (e.g., a rental duplex, or business equipment).

How §643(a)(3) and §643(b) Apply:

• Since the gains are not allocated to income or distributed, they are excluded from DNI and taxed to the trust under §643(a)(3).

• However, the trust uses the taxed capital gain to purchase a trust-owned asset, which becomes eligible for depreciation under IRC §167 and §168.

Let’s assume:

• The trust purchases $100,000 of qualifying equipment with a 5-year MACRS depreciation schedule.

• In Year 1, it elects 100% bonus depreciation (if applicable), or claims $20,000 straight-line depreciation.

Tax Impact:

• The trust initially pays $36,500 in tax on the $100k gain.

• In the same or following years, the trust deducts $20,000/year from gross income via depreciation.

• The trust reduces future taxable income, potentially generating $7,400/year in tax savings over 5 years (assuming 37% rate).

Even better:

• If the property qualifies for bonus depreciation or §179 expensing, the trust may offset the same-year tax bill nearly dollar-for-dollar.

• This allows immediate reinvestment AND tax deferral/offset, turning a “taxed” gain into a deductible capital reinvestment.

Trustee Resolution Required:

To comply, the trustee must:

• Issue a formal resolution choosing to allocate the gain to principal;

• Record the capital reinvestment as a trust-level expense or addition to basis;

• Elect depreciation methods in alignment with IRS regulations (Form 4562 if applicable);

• Reflect this clearly in trust accounting and 1041 filings.

Summary of Scenarios:

Why This Matters in Contract Trust Planning

Private irrevocable contract trusts allow you to:

• Pre-authorize capital gain treatment with custom provisions,

• Empower trustees to allocate and reinvest gains based on economic substance,

• Combine tax strategies with depreciation, charitable deductions, or capital interest issuance,

• Build long-term compliance and audit protection by using clear accounting logic.

A boilerplate trust won’t give you this flexibility—but a carefully crafted contract trust can

Misuse and Myths: §643 Does Not Eliminate Tax

Some promoters claim that IRC §643(b) allows a trust to “define income however it wants” and thereby eliminate tax by calling everything corpus or principal. This is false and potentially abusive.

IRS rules are clear:

• Fiduciary income definitions govern internal trust accounting—but the IRS still taxes economic income.

• A trustee cannot simply declare rental income as “principal” and avoid tax. The trust must report all income under IRC rules.

• Misusing §643(b) to hide income from taxation can trigger reclassification, penalties, or even criminal charges if done willfully.

The substance over form doctrine still applies: calling income “principal” in your accounting doesn't make it disappear from IRS reporting.

Strategic and Lawful Uses of §643(a)(3)

1. Allocating Capital Gains to Income for Tax-Efficient Distribution

By default, capital gains are not included in DNI (and therefore are taxed to the trust). However, §643(a)(3) allows a trust to include capital gains in DNI if:

• The governing instrument or trust document authorizes allocation of gains to income, or

• Local law allows it, and

• The trustee elects and documents such an allocation consistently and non-abusively.

In a properly structured contract trust, the trust agreement can be custom-written to grant this flexibility, giving the trustee power to treat some or all capital gains as distributable to beneficiaries.

This strategy is useful when:

• Beneficiaries are in lower income tax brackets than the trust (which hits 37% at ~$15,000 of income).

• The trust wishes to avoid accumulating income (to reduce 1041 liabilities or NIIT exposure).

• There’s a capital event (e.g., a property sale or stock liquidation) and the trustee wants to share the tax burden with multiple beneficiaries.

Result: The trust takes a deduction for the distributed capital gains, the beneficiaries report the income on their K-1s, and the family unit may realize a lower aggregate tax bill.

2. Retaining Capital Gains and Paying at the Trust Level

Alternatively, a trust may choose not to allocate capital gains to income. When this happens:

• The gains are not part of DNI under §643(a)(3).

• They are taxable to the trust and not passed to beneficiaries, even if distributions are made.

This strategy is helpful when:

• Beneficiaries are already in high brackets, and the trust prefers to centralize taxation.

• The trustee wants to control liquidity, keeping funds in trust without triggering tax burdens on beneficiaries.

• The trust intends to reinvest or reserve capital for future distributions or asset purchases.

In contract trusts, this is made even more effective by drafting the trust to classify capital gains as corpus and specifying that they will be retained unless a resolution provides otherwise. This allows tailored reinvestment strategies without unnecessary tax passthrough.

Note: The trust must be prepared to pay tax at compressed rates (likely 37%) on those retained gains. Trustees should weigh this cost against the estate or reinvestment objectives.

3. Using Capital Gains for Charitable Set-Asides (IRC §642(c))

A sophisticated and lawful strategy involves directing capital gains toward charitable purposes. If the trust:

• Authorizes charitable contributions in the trust declaration,

• And the trustee allocates a portion of gross income, including capital gains, to a qualified charitable purpose (e.g., funding a 508(c)(1)(A) trust, a religious ministry, or another §170(c) organization),

Then under IRC §642(c), the trust may deduct the contributed amount against gross income, effectively eliminating taxable income.

This method:

• Removes the capital gains from DNI,

• Removes the gains from trust-level taxation,

• Fulfills philanthropic or religious purposes of the trust.

Contract trusts can be structured from the beginning with a dual-purpose provision—e.g., holding both family assets and assets earmarked for charitable reinvestment—especially when paired with a valid tax-exempt organization. This is lawful when properly segregated and documented.

The IRS supports this use case when:

• The donation is properly documented,

• The charity is real (not a sham entity),

• The transfer is complete, and

• The funds are used exclusively for charitable purposes (see Rev. Rul. 75-38; Regs. §1.642(c)-1).

4. Including Capital Gains in DNI via Custom Drafting and IRS Guidance

Under Treas. Reg. §1.643(a)-3(b), a trust may consistently include capital gains in DNI if:

• The trust instrument permits it, and

• The trustee’s allocation policy is reasonable, consistent, and reflected in the trust’s administration.

Contract trusts offer a unique advantage here: they are often custom-drafted from scratch, unlike boilerplate statutory trusts. This allows drafters to embed the precise language that meets IRS standards for capital gains inclusion.

For example, a contract trust may:

• Specify that “capital gains from sale of real or intangible property may be allocated to income in the trustee’s discretion, and included in distributable net income”.

• Grant the trustee power to elect capital gain treatment by resolution, allowing case-by-case tax optimization.

Important caveat: The trustee must not use this power arbitrarily to manipulate tax results (e.g., only including gains in DNI when it's convenient). IRS examiners look for consistent application, trust language backing, and compliance with Regs. §1.643(a)-3.

Why Contract Trusts Offer Greater Planning Precision

In contrast to statutory trusts with rigid templates or filing requirements, private irrevocable contract trusts afford much greater drafting precision and internal autonomy, making them especially effective at leveraging §643(a)(3):

• Their language is not constrained by pre-written boilerplate—they can be written to empower fiduciary discretion within tax law boundaries.

• Trustees often have broader flexibility to issue resolutions on how to allocate gains, without conflicting with institutional policies.

• With careful design, they can integrate IRS-approved planning models—such as gain allocation, charitable layering, and reinvestment—all while preserving asset protection and fiduciary integrity.

In all of these strategies, documentation, resolutions, and accounting integrity are key.

Conclusion: What §643 Really Means for Private Trusts

IRC §§643(a)(3) and 643(b) are not loopholes—they are technical guardrails governing how trust distributions are tracked, reported, and taxed. For legitimate private, non-grantor trusts, understanding these rules unlocks powerful and lawful tools for fiduciary accounting and tax planning. Misapplying them, however, opens the door to penalties and IRS scrutiny.

Used properly, these sections allow trustees to:

• Exercise discretion in capital gains allocation

• Plan distributions based on DNI mechanics

• Manage income tax exposure between trust and beneficiaries

• Reinforce their role as fiduciaries, not tax shelters

The IRS expects trustees to follow both trust law and tax law—not to manipulate one against the other. By respecting the boundaries of §643, and using them as intended, trustees can navigate income reporting with accuracy, strategic foresight, and full legal compliance.

Key IRS Authorities:

• IRC §643(a)(3) – Capital gains exclusion from DNI

• IRC §643(b) – Fiduciary definition of “income”

• Treas. Reg. §1.643(a)-3 – Detailed guidance on capital gains and DNI

• IRS Form 1041 Instructions – Income reporting and capital gain allocations

• Uniform Principal and Income Act (UPIA) – Governs state fiduciary accounting rules