CPAs & ADVISORS FIDUCIARY TAX COMPLIANCE. Kevin G. Horn, CPA. experience ideas //

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1 CPAs & ADVISORS experience ideas // FIDUCIARY TAX COMPLIANCE Kevin G. Horn, CPA

2 PRESENTATION AGENDA General Terminology Types of Trusts Reporting for Grantor Trust Ficuciary Accounting Rules Reporting for a non-grantor Trust Types of Income and additions to principal Types of deductions Estates and how they differ from trusts Revocable trusts and elections available to the estate Section 645 IRD and DRD Passive Activities 2 // experience ideas

3 GENERAL TERMINOLOGY Grantor (Settlor or Trustor) Irrevocable Trust Revocable Trust Beneficiary Income Beneficiary Remainder Beneficiary Fiduciary Income Tax Return (Form 1041) Distributable Net Income (DNI) Trust Accounting Income (TAI) Taxable Income Principal (Corpus) 3 // experience ideas

4 TYPES OF TRUSTS Grantor Simple Complex Charitable 4 // experience ideas

5 CLASSIFYING THE TRUSTS Trust Grantor Non - Grantor Simple Complex 5 // experience ideas

6 CHARACTERISTICS OF A GRANTOR TRUST Grantor (or person other than the grantor) retains substantial power over the trust. Statutory definitions Income, deductions, and credits are reported on the grantor s annual income tax return. Tax Return Filing Options No tax return is required. Reasons to file Form 1041 Separate Tax Identification Number Avoid matching notices Respect trust for estate purposes 1099 option 6 // experience ideas

7 GRANTOR TRUST TAX RETURNS 7 // experience ideas

8 GRANTOR TRUST TAX RETURNS 8 // experience ideas

9 K-1 DISCLOSURE ON GRANTOR LETTER 9 // experience ideas

10 General Fiduciary Accounting Rules 10 // experience ideas

11 WHO IS THE BENEFICIARY? Income beneficiaries Receive the income produced by the trust corpus (principal). Remainder beneficiaries Receive the corpus of the trust when the trust is terminated. 11 // experience ideas

12 TYPES OF INCOME Taxable versus Nontaxable Taxable Dividends from corporate stock Interest on corporate and United States bonds Rents Capital gains Nontaxable Municipal bond interest 12 // experience ideas

13 TRUST ACCOUNTING INCOME ILLUSTRATION 13 // experience ideas

14 TRUST ACCOUNTING INCOME ILLUSTRATION 14 // experience ideas

15 TRUST ACCOUNTING INCOME ILLUSTRATION 15 // experience ideas

16 EXAMPLE #1 INCOME VERSUS PRINCIPAL The ABC Trust had the following income and expenses for Complete the allocation between income and principal. Received taxable interest income of $10,000 Received municipal interest income of $10,000 Received Qualified Dividends of $20,000 Paid investment fees of $8,000 Paid trustee fees of $4,000 Sold investments resulting in a capital gain of $30,000 Paid Arkansas income tax of $2,000 State taxes were paid due to capital gains 16 // experience ideas

17 INCOME VERSUS PRINCIPAL EXAMPLE SOLUTION Total Principal Income Interest $10,000 $10,000 Muni-Interest $10,000 10,000 Dividends $20,000 20,000 Capital Gains $30,000 30,000 0 Total Revenue $70,000 $30,000 $40,000 Invest Fees $8,000 4,000 4,000 Trustee Fees $4,000 2,000 2,000 State Taxes $2,000 2,000 0 Total Expense $14,000 8,000 6,000 Excess $56,000 $22,000 $34, // experience ideas

18 18 // experience ideas

19 TYPES OF INCOME Trust accounting income and principal Who gets what Income: available to an income beneficiary Principal: available to current discretionary principal beneficiary or a remainder person. Refer to trust document and state Principal and Income Act. 19 // experience ideas

20 ACCOUNTING INCOME OR PRINCIPAL? Generally Accounting Income Dividends (taxable and non) Interest (taxable and non) Rents Distributions from partnerships and s corporations ½ Expenses Federal and State tax payments Principal Capital gains Distributions from partnerships? ½ Expenses Federal and State tax payments 20 // experience ideas

21 NON-GRANTOR TRUSTS 21 // experience ideas

22 CLASSIFYING THE TRUST Trust Grantor Non - Grantor Simple Complex 22 // experience ideas

23 WHAT IS A NON-GRANTOR TRUST? Treated as a separate taxpayer for income tax purposes See 641(b) Basic concept income taxed once 23 // experience ideas

24 SIMPLE TRUSTS The trustee: Required to distribute all of the income currently Cannot make charitable contributions 24 // experience ideas

25 POLLING QUESTION If a simple trust is required to distribute out all income, could the trust ever owe tax? A. Yes B. No C. Maybe 25 // experience ideas

26 SIMPLE TRUSTS Example language: Commencing with my death and during the life of my wife, the trustee shall pay to her all the income from the ABC Trust in convenient installments, at least as often as quarterly... The trust may also allow for discretionary distributions of principal. Example Marital Trust 26 // experience ideas

27 SIMPLE TRUST TAX RETURNS 27 // experience ideas

28 COMPLEX TRUSTS Not a simple trust Accumulation of income Distributes principal during the taxable year Trustee may be authorized to make charitable contributions Final year of a trust 28 // experience ideas

29 COMPLEX TRUSTS Example language: The trustee may, in its discretion, pay so much or all of the income or principal of the ABC trust to the beneficiary as the trustee determines to be necessary to maintain the beneficiaries standard of living // experience ideas

30 65 DAY RULE UNDER IRC 663(B) Applies to estate and complex trusts Allows fiduciary to treat distributions made within 65 days after year-end to be treated as if they were made as of December 31 st of the prior year Limited to DNI reduced by distribution made during the year Election is made by the due date of the tax return Irrevocable Annual Election 30 // experience ideas

31 HOW TO MAKE A 65 DAY ELECTION 31 // experience ideas

32 FIDUCIARY INCOME TAX RETURN FORM // experience ideas

33 COMPLEX TRUST TAX RETURNS 33 // experience ideas

34 BASIC REQUIREMENTS When required to file? Any taxable income for the year, OR Gross income of $600 or more, regardless of the amount of taxable income Due dates Estates on or before the 15 th day of the fourth month following the close of the estate s taxable year Trusts April 15 th Extensions Use Form 7004 for an automatic 5 1/2 month extension States? 34 // experience ideas

35 ESTIMATED PAYMENTS Estates and trusts (other than grantor trusts) must make quarterly estimated tax payments Same provisions effective for individuals Different income thresholds Exceptions: First two tax years of an Estate Tax liability for the current year is less than $1,000 No safe harbor available in initial year or year following a short year State requirements? Form 1041-T 35 // experience ideas

36 DEDUCTIONS Exemptions Charitable Net Operating Loss Depreciation Miscellaneous Itemized Deduction Trustee fees Legal and accounting

37 INCOME DISTRIBUTION DEDUCTION A deduction granted to the estate or trust for amounts distributed to beneficiaries. This eliminates the possibility of double taxation. Lesser of: The aggregate of: Income required to be distributed currently, and Other amounts paid, credited, or required to be distributed; OR Distributable net income less tax-exempt income as adjusted. 37 // experience ideas

38 DISTRIBUTABLE NET INCOME (DNI) DNI is taxable income computed with certain modifications: No income distribution deduction No exemption No capital gains and losses (generally) Look at trust document Final Year Includes tax exempt interest, adjusted for allocated expenses 38 // experience ideas

39 INCOME DISTRIBUTION DEDUCTION 39 // experience ideas

40 INCOME DISTRIBUTION DEDUCTION Shown on Form 1041, Page 1 Line // experience ideas

41 ALLOCATION OF EXPENSES Direct traced to a specific source of income. Indirect not specific to any type of income. Taxable Tax Exempt 41 // experience ideas

42 NET INVESTMENT INCOME TAX % Medicare surtax is imposed on the lesser of: Undistributed net investment income, or The excess of AGI over the threshold amount. The threshold amount for 2014 is $12,150 (income level at which the 39.6% rate applies) Material participation implications Form 8960 (same for individuals) 42 // experience ideas

43 TAX RATES If taxable income is: 2016 Tax Rate Schedule Over But no over Its tax is: Of the amount over $0 2,550 15% 2,550 5,950 $ % 2,550 5,950 9,050 1, % 5,950 9,050 12,400 2, % 9,050 12,400 3, % 12, // experience ideas

44 Exercise #1 44 // experience ideas

45 EXERCISE #1 TAI VERSUS DNI The XYZ Trust had the following income and expenses in Figure TAI and DNI. Income Expenses Dividends $12,000 Trustee Fees $2,000 Corporate Interest Municipal Interest $8,000 Tax Prep Fees $1,000 $10,000 Real Estate Taxes LTCG $20,000 State Income Taxes $1,000 $2, // experience ideas

46 TAI VERSUS DNI EXAMPLE SOLUTION TAI DNI Dividends $12,000 $12,000 Corp Interest 8,000 8,000 Muni Interest 10,000 10,000 Capital Gain 0 0 Total Revenue $30,000 $30,000 Trustee Fees 1,000 2,000 Tax Prep Fees 500 1,000 Real Estate Tax 1,000 1,000 State Income Tax 2,500 Total Expenses $2,500 $6,500 Totals $27,500 $23, // experience ideas

47 Estates 47 // experience ideas

48 ESTATE BASICS Separate taxable entity which is created upon the death of a decedent. Limited existence which terminates upon distribution to heirs and designated beneficiaries. Period is usually no longer than three years after death. 48 // experience ideas

49 DIFFERENCES FROM TRUSTS Exemption $600 versus $100 for complex trusts and $300 for simple trusts. Certain administration expenses or debts of the decedent may be deductible. Estate tax deduction. No estimated payment requirements in initial year Can have a fiscal year creating opportunity for income tax deferral 49 // experience ideas

50 TRUSTS SOLELY FOR CHARITABLE RECIPIENTS Two Options Seek Exemption from taxation under Section 501(a) by filing Form 1023 Do not seek exemption and pay income tax too Private Foundation Rules Distribute 5% to qualified charity No Self Dealing with donor and/or family File Form 990PF annually Tax on investment income at 2% 50 // experience ideas

51 TRUSTS SOLELY FOR CHARITABLE RECIPIENTS Non-Exempt Charitable Trusts Section 4947(a)(1) governs Deduction was allowed to donor Still subject to Private Foundation Rules Since the trust is not exempt from income taxes Normal trust tax rules apply If there is taxable income, Form 1041 must be filed No Form 1041 filing requirement if no taxable income 51 // experience ideas

52 52 // experience ideas

53 REVOCABLE TRUSTS AND DEATH OF THE GRANTOR THE BEGINNING 645 elections Income & deductions in respect of a decedent THE MIDDLE Allocating principal & income Passive activity rules THE END Termination 645 elections 53 // experience ideas

54 TO 645 OR NOT TO 645? What is it? Executor of estate & trustee of qualified revocable trust (QRT) created by decedent may elect for trust to be treated & taxed as part of estate for all tax years of estate ending after date of decedent s death & before applicable date 54 // experience ideas

55 DEFINITIONS FOR 645 ELECTION PURPOSES Qualified revocable trust (QRT): Trust treated as grantor trust because of right of revocation under 676 Applicable date: Date on which QRT ceases to be treated & taxed as part of decedent s estate under election Estate tax return is not required to be filed: Two years after date of decedent s death ( 645(b)(2)(A)), or Estate tax return is required to be filed: Six months after date of final determination of estate tax liability ( 645(b)(2)(B)) 55 // experience ideas

56 DEFINITIONS FOR 645 ELECTION PURPOSES Date of final determination of estate tax liability: Six months after issuance by Service of estate tax closing letter, unless estate tax refund claim is filed within 12 months after issuance of letter Date of final disposition of refund claim that resolves estate tax liability, unless suit is initiated within 6 months after final disposition of claim Date of execution of settlement agreement with Service that determines estate tax liability 56 // experience ideas

57 DEFINITIONS FOR 645 ELECTION PURPOSES Date of final determination of estate tax liability (cont.): Date of issuance of decision, judgment, decree or other order by court of competent jurisdiction resolving estate tax liability, unless notice of appeal or petition for certiorari is filed within 90 days after issuance, or Date of expiration of 6501 period of limitations for assessment of estate tax (Reg (f)(2)(ii)) 57 // experience ideas

58 ADVANTAGES OF 645 ELECTION Availability of fiscal year (Reg (e)(3)(i)) Avoid need to make estimated payments for two years after decedent s death (Reg (e)(4)) Ability to obtain charitable deduction for amounts permanently set aside for charity under 642(c)(2) (Reg (e)(2)(iv)) Ability to hold S corporation stock for duration of administration of estate (Reg (e)(3)(i)) Simplify number of tax returns 58 // experience ideas

59 WHO IS ELIGIBLE S CORPORATION SHAREHOLDER Individual (except nonresident alien) Estate of deceased individual during period of administration (Reg (b)-3(a)) QRT electing 645 Organizations exempt from tax under 501(a) Qualified retirement plan described in 401(a) Charitable organization described in 501(c)(3) Six specified trusts permitted under 1361(c)(2)(A) 59 // experience ideas

60 WHO IS ELIGIBLE S CORPORATION SHAREHOLDER Certain trusts permitted as shareholders ( 1361(c)(2)(A)) Grantor trust ( ) Former grantor trust (two years post-death)» Qualified subchapter S trust (QSST) Testamentary trust (two years post-funding) Electing small business trust (ESBT) Voting trust created to exercise voting power of stock Trust part of profit sharing or pension plan exempt under 401(a) 60 // experience ideas

61 ADVANTAGES OF 645 ELECTION Avoidance of passive loss active participation requirement under 469 for two years after death (Reg (e)(3)(i)) Use of $600 personal exemption (Reg (e)(2)(ii)(A)) Deferral of payment of income tax on income earned after date of death until due date of estate s fiduciary return (up to 11 months of deferral) 61 // experience ideas

62 DISADVANTAGES OF 645 ELECTION May not be advisable with estates/trusts with significant assets & incongruent beneficiaries Potential complications with separate share rule State residency/situs considerations 62 // experience ideas

63 MECHANICS OF 645 ELECTION How do you make election? Election must be made on estate s first timely income tax return (including extensions) & once made is irrevocable. Election is made by filing Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate, with Form Box in Item G of Form 1041 (page 1) should be checked No provision for relief for late elections! 63 // experience ideas

64 64 // experience ideas

65 MECHANICS OF 645 ELECTION Employer Identification Number: Revocable living trust becomes different taxpayer after grantor dies (Rev. Rul ). Trustee of QRT must obtain new EIN for QRT upon death of decedent Form SS-4 (Application for Employer Identification Number): When applying for EIN for QRT, indicate trust will make election to be treated as estate under 645 as there is no penalty for later changing this decision 65 // experience ideas

66 MECHANICS OF 645 ELECTION Which EIN to use? If there is probate estate, file under EIN of estate If trust is electing by itself without probate estate, file under EIN of QRT (Note: New EIN will be necessary on termination of 645 election). If there is no executor in this situation, trustee of trust files Form // experience ideas

67 MECHANICS OF 645 ELECTION What happens at end? On close of last day of election period, i.e., applicable date, distribution is deemed to be made by combined electing trust & related estate (Reg (h)(1)) 67 // experience ideas

68 645 ELECTION CASE STUDY #1 Decedent: Bob The Client Created Bob T. Client Revocable Trust on January 4, 2010, & transferred all outstanding shares of Client s Business, Inc. (S corporation) to trust Bob passed away November 15, 2010 Date closing letter issued: June 30, 2013 What is last day trust is eligible S corporation shareholder? 68 // experience ideas

69 645 ELECTION CASE STUDY #1 THE SOLUTION DOD: November 15, 2010 Form 706 filed February 15, 2012 Date closing letter issued: June 30, election period: 11/15/2010-6/29/2014 Plus: Two-year period under 1361(a)(1) June 29, // experience ideas

70 IRD & DRD Income in respect of a decedent (IRD): Items of gross income not properly includible in decedent s final/prior year return are taxed to decedent s successors in interest when received by them ( 691(a)) Items of IRD under 691 are not entitled to step-up in basis at decedent s death ( 1014(c)) Difficult to apply - requires us to consider Decedent s method of accounting Whether item constitutes IRD Code does not define what constitutes item of IRD & regulations provide little guidance 70 // experience ideas

71 IRD & DRD Three groups of items of IRD based on ways in which income is generated By providing use of property investment income, e.g., accrued interest & dividends declared but not paid By performing services, e.g., bonuses & other compensation or paid/payable following decedent s death; IRAs & qualified benefit plans upon which decedent has not been taxed By disposition of property, e.g., unrecognized gain on installment obligation 71 // experience ideas

72 IRD & DRD Income from flow-through entities Partnerships: Death of partner results in close of partnership s taxable year with respect to decedent partner ( 706(c)(2)(A). Decedent partner s share of partnership income will be included on his or her final tax return & no part of successor s share of partnership s distributive share will be IRD S corporations: Decedent shareholder in S corporation is required to include pro rata share of corporate income earned through date of death ( 1366(a)). Therefore, no part will be IRD 72 // experience ideas

73 IRD & DRD Income from flow-through entities (cont.) Fiduciaries:» Income actually distributed by fiduciary to cash method beneficiary before death is taxable to beneficiary on his or her final tax return, & any amount paid to beneficiary s estate is IRD (Reg (c)-2 & 1.662(c)-2)» If undistributed income passes to another beneficiary under terms of governing instrument, it will not constitute IRD 73 // experience ideas

74 IRD & DRD Courts have employed two tests in deciding whether particular item triggers IRD upon receipt Casual connection test: Where decedent s economic activities gave rise to post-death payment, payment is IRD upon receipt Right of income/entitlement test: Decedent must also have had right to that payment 691(a)(3) provides that item of IRD shall have same character in successor s hands as it would have had in decedent s 74 // experience ideas

75 IRD & DRD Deductions in respect of a decedent (DRD): 691(b) allows deduction on decedent s successor in interest who liquidates decedent s obligations, i.e., expenses accrued at date of death but paid after death Limited to expenses deductible under 162, 163, 212 & 611 Items of DRD are allowable under 2053(a)(5) for estate tax purposes as claims against estate & are also allowed as DRD for income tax purposes to person/entity paying those expenses 75 // experience ideas

76 IRD & DRD 691(c) provides deduction for estate tax paid with respect to item of IRD Reason is to mitigate effects of double taxation, i.e., IRD represents property interest taxable in decedent s gross estate for estate tax purposes Proportionate part of deduction is allowed to successor in interest for each period in which IRD is included in income Deduction is itemized deduction which is not subject to 2% floor under 67 Only allows for deduction of federal estate tax paid; no deduction is allowed for state death tax paid 76 // experience ideas

77 IRD & DRD CASE STUDY #1 Jack Client died on 1/1/2015 with following assets & liabilities Cash $2,000,000 Real estate 2,500,000 Installment note 1,000,000 Mortgage -500,000 Total 5,000,000 Installment note has zero basis. Mortgage is secured by real estate, & liability includes $25,000 of interest accrued to but unpaid at date of death. All assets pass as part of Jack s probate estate 77 // experience ideas

78 IRD & DRD CASE STUDY #1 Probate administration was completed on 9/1/2015. Upon closing estate, executor paid executor, attorney & accountant fees of $100,000 & interest on mortgage of $50,000. Executor also paid Illinois estate tax of $250,000. Residue of estate was distributed to Jack s daughter, Jill What are items of IRD & DRD? Is there deduction available under 691(c)? 78 // experience ideas

79 IRD & DRD CASE STUDY #1 THE SOLUTION Installment note is taxable to Jill as item of IRD under 691(a) & is not entitled to step-up in basis Jack s estate is entitled to DRD deduction under 691(b) for $25,000 interest expense accrued through date of death but paid by estate (interest is 163 expense) No 691(c) deduction is available as there is no federal estate tax paid (despite $250,000 of Illinois estate tax paid!) 79 // experience ideas

80 IRD & DRD CASE STUDY #2 Jack Client died on 1/1/2015 with following assets (assume no liabilities) Cash $2,000,000 IRA 2,000,000 Real estate 2,500,000 Total 6,500,000 IRA has zero basis All assets (except IRA) pass under Jack s revocable trust agreement to Jack s daughter, Jill. Jack s ex-wife, Jackie, is beneficiary of IRA 80 // experience ideas

81 IRD & DRD CASE STUDY #2 Estate was not probated. Upon closing estate, executor paid executor, attorney & accountant fees of $100,000. Executor also paid Illinois estate tax of $498,929 & federal estate tax of $188,428. Jackie receives distribution of entire IRA in 2015 What are items of IRD & DRD? Is there deduction available under 691(c)? 81 // experience ideas

82 IRD & DRD CASE STUDY #2 THE SOLUTION IRA is taxable to Jackie as item of IRD under 691(a) & is not entitled to step-up in basis There are no items of DRD Jackie is entitled to deduction for federal estate tax paid under 691(c) in // experience ideas

83 IRD & DRD CASE STUDY #2 THE SOLUTION 691(c) deduction is calculated as follows 1. Compute total FET value of all items of IRD» $2,000, Compute total amount of DRD for which deduction is claimed on Form 706» $0 3. Amount in (1) is reduced by amount in (2) to produce net value for FET purposes of all IRD items ( 691(c)(2)(B))» $2,000, // experience ideas

84 IRD & DRD CASE STUDY #2 THE SOLUTION 691(c) deduction is calculated as follows (cont.) 4. Compute FET attributable to net value ( 691(c)(2)(C)) WITH WITHOUT Cash $2,000,000 $2,000,000 IRA 2,000, Real estate 2,500,000 2,500,000 Total gross estate 6,500,000 4,500,000 Admin expenses -100, ,000 Tentative taxable estate 6,400,000 4,400,000 State death tax deduction -498, ,286 Taxable estate 5,901,071 4,285,714 Federal estate tax 188, // experience ideas

85 IRD & DRD CASE STUDY #2 THE SOLUTION 691(c) deduction is calculated as follows (cont.) 5. As IRD is received, proportionate part of FET determined in step (4) is deducted by recipient of IRD. Proportionate part is determined as follows under 691(c)(1)(A) IRD received x FET from step (4) Total IRD (FET value) For this purpose, IRD received is valued at lesser of actual amount received or its FET value. 85 // experience ideas

86 IRD & DRD CASE STUDY #2 THE SOLUTION 691(c) deduction is calculated as follows (cont.) IRD received x FET from step (4) Total IRD (FET value) $2,000,000 x $188,428 = $188,428 $2,000, // experience ideas

87 IRD & DRD CASE STUDY #3 Jack Client died on 1/1/2015 with following assets/liabilities Cash $2,000,000 IRA 2,000,000 Real estate 2,500,000 Installment note 2,000,000 Mortgage -500,000 Net 8,000,000 Installment note & IRA have zero basis. Mortgage liability includes $25,000 of interest accrued to but unpaid at date of death. All assets (except IRA) pass under Jack s revocable trust agreement to Jack s 2 daughters. Jack s ex-wife, Jackie, is beneficiary of IRA 87 // experience ideas

88 IRD & DRD CASE STUDY #3 Estate was not probated. Upon closing estate, executor paid executor, attorney & accountant fees of $100,000 & interest on mortgage of $50,000. Executor also paid Illinois estate tax of $665,669 & federal estate tax of $711,732 In 2015 & 2016, Jack s trust received payments on installment notes of $500,000 & $1,500,000, respectively. Jackie elected to receive distributions from IRA over 5 years What are items of IRD & DRD? Is there deduction available under 691(c)? 88 // experience ideas

89 IRD & DRD CASE STUDY #3 THE SOLUTION Installment note is taxable to Jack s trust as item of IRD & is not entitled to step-up in basis IRA is taxable to Jackie as item of IRD & is not entitled to stepup in basis Jack s trust, as payor, is entitled to DRD under 691(b) for $25,000 interest expense accrued through date of death but paid by estate (interest is 163 expense) (note additional $25,000 of interest expense paid is deductible by trust) 89 // experience ideas

90 IRD & DRD CASE STUDY #3 THE SOLUTION 691(c) deduction is calculated as follows 1. Compute total FET value of all items of IRD» $4,000,000 ($2M IRA & $2M installment note) 2. Compute total amount of DRD for which deduction is claimed on Form 706» $25, Amount in (1) is reduced by amount in (2) to produce net value for FET purposes of all IRD items ( 691(c)(2)(B))» $3,975, Compute FET attributable to net value ( 691(c)(2)(C)) 90 // experience ideas

91 IRD & DRD CASE STUDY #3 THE SOLUTION With Without Cash $2,000,000 $2,000,000 IRA 2,000, Real estate 2,500,000 $2,500,000 Installment note 2,000, Total gross estate 8,500,000 4,500,000 Mortgage -500, ,000 Admin expenses -125, ,000 Tentative taxable estate 7,875,000 3,900,000 State death tax deduction -665, Taxable estate 7,209,331 3,900,000 Federal estate tax 711, Difference 711, // experience ideas

92 IRD & DRD CASE STUDY #3 THE SOLUTION 691(c) deduction is calculated as follows (cont.) 5. As IRD is received, proportionate part of FET determined in step (4) is deducted by recipient of IRD. Proportionate part is determined as follows under 691(c)(1)(A) IRD received x FET from step (4) Total IRD (FET value) For this purpose, IRD received is valued at lesser of actual amount received or its FET value. 92 // experience ideas

93 IRD & DRD CASE STUDY #3 THE SOLUTION 691(c) deduction is calculated as follows (cont.) IRD received x FET from step (4) Total IRD (FET value) Jack s trust (2015): $475,000 x $711,732 = $85,050 $3,975,000 Jack s trust (2016): $1,500,000 x $711,732 = $268,578 $3,975, // experience ideas

94 IRD & DRD CASE STUDY #3 THE SOLUTION 691(c) deduction is calculated as follows (cont.) IRD received x FET from step (4) Total IRD (FET value) Jackie (2015): $400,000 x $711,732 = $71,620 $3,975, // experience ideas

95 PROPER PLACE TO DEDUCT Final 1040: Unrecovered basis of annuity Itemized deduction paid before death Carryover (decedent)» Capital loss» Charitable» NOL» Investment interest» PAL» Investment tax credit 95 // experience ideas

96 PROPER PLACE TO DEDUCT EITHER final 1040 OR 706: Medical expense of decedent paid within one year 706: Funeral expense Claim against estate of personal, non-deductible nature Administrative expenses attributable to exempt income 1041: Tax on estate income Real estate tax not accrued prior to death Interest accruing after death 96 // experience ideas

97 PROPER PLACE TO DEDUCT EITHER 1041 OR 706: Estate administration expense (except attributable to TEI) Unreimbursed casualty & theft loss BOTH 1041 & 706: Trade or business, interest or tax expense accrued prior to death Expense incurred for management, conservation or maintenance of property held for production of income or in connection with determination, collection or refund of tax accrued prior to death Alimony & maintenance payment accrued at death 97 // experience ideas

98 THE MIDDLE 98 // experience ideas

99 THE PRINCIPAL QUESTION Income: Money or property fiduciary receives as current return from principal asset (2000 Revised Uniform Principal & Income Act Section 102(4)) Principal: Property held in trust for distribution to remainder beneficiary when trust terminates (2000 Act Section 102(10)) Property rights governed by state laws Determination Governing instrument State law If neither provide guidance: Item should be allocated to principal (2000 Act Section 103(a)(4)) 99 // experience ideas

100 THE PRINCIPAL QUESTION Disposition of property: Principal Including capital gains in DNI under Reg (a)-3» Allocated to income by governing instrument and state law or pursuant to reasonable impartial exercise discretion by fiduciary» Treated consistently as part of distributions to a beneficiary» Actually distributed or considered by fiduciary in determining distributions Usually contrary to grantor s intent 100 // experience ideas

101 THE PRINCIPAL QUESTION Insurance proceeds: Principal, unless purchased to protect trust from loss of income (2000 Act Section 407) or separate interest of income beneficiary Corporate distributions: Cash dividends: Income Liquidating dividends: Principal Extraordinary dividends: Principal 101 // experience ideas

102 THE PRINCIPAL QUESTION Interest income: Income Exceptions» IRD» Tax-exempt» Imputed interest under 1274 Amortization of bond premiums & discounts: Principal» Exceptions Zero-coupon bonds Obligation has maturity of less than one year 102 // experience ideas

103 THE PRINCIPAL QUESTION Rental activities: Income Leaseholds, patents, copyrights & royalties subject to depletion 90% Principal 10% Income Retirement plans, IRAs & annuities DOD value or 90% Principal Post-death gain or 10% Income 103 // experience ideas

104 THE PRINCIPAL QUESTION Pass-through entities: Based on distributions from entity rather than income allocated on Schedule K-1 Earnings: Income Other assets: Principal» Property other than money» Money received for part or all of interest in entity» Money received in total or partial liquidation of entity» Capital gain dividends form RIC or REIT 104 // experience ideas

105 PASSIVE ACTIVITY LOSSES (PALS) What is it? System to defer losses from passive activities Who does it apply to? Individuals, estates & trusts Closely held C corporations Personal service corporations What does it apply to? Passive activities under 469(c)» Activity involving trade or business in which taxpayer does not materially participate» Generally any rental activity» Working interest in oil & gas property 105 // experience ideas

106 PASSIVE ACTIVITY RULES UNDER 469 Trade or business activities Reg (b)» Involve conduct of trade or business within meaning of 162» Conducted in anticipation of commencement of trade or business» Involve research or experimental activities under // experience ideas

107 PASSIVE ACTIVITY RULES UNDER 469 Investment activities Reg T(f)(2)(ii) Work as investor is not counted (unless directly involved on daily basis). Includes» Studying & reviewing financial data» Preparing/compiling summaries or analysis for individual s own use» Monitoring finances/operations in non-manager capacity Not customarily done by owners» Work of type not customarily done by owner» Principal purpose for work is to avoid PAL rules 107 // experience ideas

108 PASSIVE ACTIVITY RULES UNDER 469 Material participation Involved in operations of activity on regular, continuous & substantial basis ( 469(h)(1)) Seven tests under Reg T Limited partner presumed not materially participating except under tests one, five & six ( 469(h)(2)) 108 // experience ideas

109 MATERIAL PARTICIPATION BY TRUSTS & ESTATES Grantor trust: Material participation is measured by participation of grantor (Temp. Reg T(b)(2)) QSST: Participation is measured by participation of deemed owner of trust (beneficiary under 1361(d)(1)(B)) Estates & non-grantor trusts (including ESBTs) Reg , and Temp. Reg T(g) 109 // experience ideas

110 MATERIAL PARTICIPATION BY TRUSTS & ESTATES There will be some degree of uncertainty for determining material participation of trusts & estates until clarifying regulations under 469 are issued by IRS Legislative history: An estate or trust is materially participating in any activity if an executor or fiduciary, in his capacity as such, is so participating." (S. Rep. No , 99 th Cong., 2d Sess. 735 (1986) (emphasis added) 110 // experience ideas

111 MATERIAL PARTICIPATION BY TRUSTS & ESTATES Mattie K. Carter Trust v. United States (256 F. Supp. 2d 536): Texas District Court went beyond Senate report by concluding trust material participation is determined by reference to all persons who conduct business on trust s behalf, including employees as well as trustee Frank Aragona Trust v. Commissioner (142 T.C. No. 9): Tax Court held trust can be considered real estate professional under 469(c)(7) because personal services performed by individual trustees constituted personal services by trust. Court held services performed by individual trustees as employees count towards achieving material participation by trust 111 // experience ideas

112 MATERIAL PARTICIPATION BY TRUSTS & ESTATES TAM : IRS concluded that sole means for trust to establish material participation was by its fiduciaries being involved in operations PLR : IRS held that trust materially participates in business only if trustee is involved in operations of entity s activities on regular, continuous & substantial basis TAM : IRS concluded that sole means for trust to establish material participation in relevant activities of trust-owned business is if fiduciaries, in their capacities as fiduciaries, are involved in operations of relevant activities of trust-owned business on regular, continuous & substantial basis 112 // experience ideas

113 MATERIAL PARTICIPATION BY TRUSTS & ESTATES Don t like answer? Change trustee to someone who is active Add another fiduciary 113 // experience ideas

114 PASSIVE ACTIVITY LOSS (PAL) Fiduciary accounting income principles determine whether limitations apply at estate, trust or beneficiary level State law controls if governing instrument is silent on allocation of loss to income or principal Simple trust with PAL chargeable to income for FAI purposes will be taxed to estate/trust 114 // experience ideas

115 YOU AREN T MY PAL ANYMORE: FORMER ACTIVITIES Activity was passive in prior year Losses from when activity was passive may still offset income from that activity Excess losses remain passive 115 // experience ideas

116 YOU AREN T MY PAL ANYMORE: DISPOSITION Fully taxable transaction: Current & suspended losses become fully deductible ( 469(g)(1)) Beneficiaries are related parties ( 267(b)) Distribute to beneficiary: Basis of interest immediately before distribution is increased by amount of any suspended passive activity losses allocable to interest; none of suspended loss is allowed as deduction ( 469(j)(12)) Exception: Gain/loss is recognized on distribution in satisfaction of pecuniary bequest with appreciated or depreciated property 116 // experience ideas

117 YOU AREN T MY PAL ANYMORE: DISPOSITION By death: Generally, if decedent has unused PALs at death, transfer of property due to death is considered disposition under 469(g)(1) BUT, under 469(g)(2), if basis of passive activity property to transferee exceeds decedent s basis immediately before death, i.e., step-up in basis under 1014, suspended PAL is reduced & never used Permanently disallowed portion equals excess of» Basis of passive activity interest in hands of transferee, over» Decedent s adjusted basis in interest immediately before death 117 // experience ideas

118 THE END 118 // experience ideas

119 YOU AREN T MY PAL ANYMORE: TERMINATION Losses are not generally passed through to beneficiaries except upon termination Only NOLs, capital losses & excess deductions allowed as deduction to beneficiary ( 642(h)) PALs are not passed through to beneficiary during existence or termination of estate/trust Footnote all trust-related information necessary to prepare beneficiary individual income tax returns on Schedule K // experience ideas

120 645 ELECTION CASE STUDY #2 Decedent: A. Great Client Date of death: May 2, 2011 Form 706 filed: August 1, election made with initial Form 1041 filed January 7, 2013 Fiscal year-end of April 30 selected Date closing letter issued: April 13, // experience ideas

121 645 ELECTION CASE STUDY #2 THE SOLUTION When does 645 election period terminate? Election period began: May 2, 2011 (election filed 1/7/2013) Election period ended» Issuance of estate tax closing letter: April 13, 2013» Date of final determination of liability: October 13, 2013» Plus 6 months April 12, 2014 (Reg (f)(1)) 121 // experience ideas

122 645 ELECTION CASE STUDY #2 THE SOLUTION What are implications of termination to S corporation election of corporations whose shares are held by QRT? Termination of estate s interest in corporation Corporations must allocate items of income/loss on pro rata basis absent election to terminate year 122 // experience ideas

123 645 ELECTION CASE STUDY #2 THE SOLUTION What is impact of termination on Forms 1041? Combined estate & trust under 645 election» 5/2/2011-4/30/2012 Initial return; include Form 8855; report 2011 S corp. K-1» 5/1/2012-4/30/2013 Report 2012 S corp. K-1» 5/1/2013-4/12/2014 Report 2013 S corp. K-1; however, items of income are included in calculation of DNI of electing trust & treated as being distributed 123 // experience ideas

124 645 ELECTION CASE STUDY #2 THE SOLUTION What is impact of termination on Forms 1041? (cont.) Estate» 4/12/2014-4/30/2014 Report income for estate only» 5/1/2014-4/30/2015.and so on until closed Trust» 4/12/ /31/2014 Report 2013 K-1 from combined estate/trust; report 2014 S corp. K // experience ideas

125 645 ELECTION CASE STUDY #2 THE SOLUTION What needs to be done? Do nothing: Termination of S corporation election Evaluate options don t wait to act! Track deadline 125 // experience ideas

126 645 ELECTION CASE STUDY #2 THE SOLUTION What is last day trust can make ESBT election? Two-year period beginning on day S corporation stock is deemed to be distributed: April 12, 2016 Plus 2 months & 15 days. June 27, 2016 But wait, there s more. 126 // experience ideas

127 645 ELECTION CASE STUDY #2 THE SOLUTION Relief can be granted by IRS IRS has authority to treat late or unfiled S corporation election as being timely under 1362(b)(5) with reasonable cause for failure to timely file election IRS has authority to waive inadvertent invalid elections or terminations of S election caused by late or faulty S corporation election under 1362(f) 127 // experience ideas

128 645 ELECTION CASE STUDY #2 THE SOLUTION Rev. Proc allows relief to be approved without obtaining PLR in certain circumstances Covers all elections under subchapter S Request for relief must be filed within 3 years & 75 days after effective date of election Exception to 3-year rule for S corporation elections provided all returns have been filed as if S corporation status applied 128 // experience ideas

129 645 ELECTION CASE STUDY #2 THE SOLUTION Relief for late ESBT election under Rev. Proc Requesting trust intended to be ESBT Trust requests relief within 3 years & 75 days after effective date of election Failure to qualify was solely because election was not timely filed by due date Failure to make timely election was inadvertent & trustee seeking relief acted diligently to correct mistake upon its discovery 129 // experience ideas

130 645 ELECTION CASE STUDY #2 THE SOLUTION To request relief for late election when requirements of Rev. Proc are not met, entity must request Private Letter Ruling & pay user fee in accordance with Rev. Proc $2,200 for income under $250,000 $6,500 for income between $250,000 & $1,000,000 $28,300 for income above $1,000, // experience ideas

131 THANK YOU FOR MORE INFORMATION // For a complete list of our offices and subsidiaries, visit bkd.com or contact: Kevin G. Horn// Arkansas Tax Director khorn@bkd.com //