Estate (cont.) IRC 2033 includes in the gross estate all probate assets IRC includes in the gross estate all non-probate assets

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2 Overview Certain entities are created for planning purposes. These entities are separate and apart from individuals or businesses. Income in these entities needs to be accounted for and taxed if held within the entity itself This course deals with the procedures outlined in Subchapter J of the IRC

3 Estate Defined For State purposes, it is a legal entity established at the instance of death to protect and to preserve all probate assets until the probate assets can be distributed to the individuals or entities who have a proper right to it For Federal purposes, it is the total of all assets owned or controlled by a decedent valued at their highest and best use (IRC 2031)

4 Estate (cont.) IRC 2033 includes in the gross estate all probate assets IRC includes in the gross estate all non-probate assets

5 Estate (cont.) For purposes of this course, the State definition applies (A Federal Form 1041 is prepared for an Estate based on the State definition of an Estate)

6 Probate What is Probate? Legal definition: The act of proving that an instrument purporting to be a Last Will and Testament was executed in accordance with legal requirements and of determining its validity thereby. In addition a Probate Court is a special court of law having specific jurisdiction of proceedings incident to the settlement of a decedent s estate.

7 Trust Defined A right of property, real or personal, held by one party for the benefit of another. A Trust implies the bifurcation of an asset into legal title and equitable title. The Trust holds the legal title to the asset; the beneficiary holds the equitable title to the asset.

8 The Players The Trustor a/k/a Settlor or Grantor The Trustee Can be human or non-human The Beneficiaries Must equal 100 % of the eventual distribution of the trust corpus

9 The Three Questions All trusts can be specifically defined and classified by asking three specific questions of them Understanding these three questions can help you understand the purpose of the trust and the tax strategies that it is designed to accomplish

10 Question #1 How is the Trust created? (Trusts can be created in only in one of two ways.) Inter-vivos (a separate legal document) Testamentary (within a Last Will and Testament)

11 Question #2 Can the Trust be changed, altered, amended, or revoked? Yes (Trust is revocable) No (Trust is irrevocable)

12 Caveat Can you have a revocable inter-vivos trust? Can you have an irrevocable inter-vivos trust? Can you have a revocable testamentary trust? Can you have an irrevocable testamentary trust?

13 Question #3 For Federal Income Tax purposes, how is the Trust classified? Grantor Simple Complex So WHAT IS INCOME?????

14 Grantor Trust A legal trust under applicable state law that is not recognized as a separate taxable entity for income tax purposes because the Trustor has not relinquished complete dominion or control over the trust. For income tax purposes, all income in a Grantor Trust is taxed to the Trustor of the trust and is reported on the Trustor s 1040

15 Grantor Trust (cont.) All revocable trusts are Grantor Trusts Some irrevocable trusts are Grantor Trusts; these trusts fall within IRC

16 Grantor Trust (cont.) IRC Sections applicable to Grantor Trusts 673 Reversionary interests 674 Control over beneficial enjoyment 675 Administrative powers 676 Right to revoke 677 Right/control of income 678 Powers possessed by persons other than the Grantor

17 Persons Other Than The Grantor (IRC Sec. 678) A third person is treated as the owner of any portion of a trust as to which the third person has: a power exercisable to vest the corpus or income in such third person a power that, had it been retained by the grantor, would have caused the grantor to be taxed as the owner Examples of circumstances triggering third party grantor status include: General Powers of Appointment Right of withdraw in accordance with trust instrument

18 Persons Other Than The Grantor (cont.) Owner of a Portion Treas. Regs. Sec (a) provides that if the Grantor or another person is the owner of any portion of a trust then include the items of income, deduction, and credit attributable to or included in that portion Examples of third party owners that may be of any portion include: Section 2503(c) trust for a minor after the beneficiary waives withdrawal rights at 21 Beneficiary right to withdraw income and or corpus upon attaining a specific age

19 Simple Trust The trust instrument requires that all income must be distributed currently The trust instrument does not provide that any amounts are to be paid, permanently set aside, or used for charitable purposes The trust does not distribute amounts allocated to the corpus of the trust

20 Complex Trust Any non-grantor Trust that is not a Simple Trust! (Yes, the Internal Revenue Code defines it this way!)

21 Generally A Trust or Estate is taxable as a separate entity on taxable income itretains A Trust or Estate is treated as a conduit for amounts distributed or deemed distributed to its beneficiaries Income tax rates are compressed Character of income does not change Grantor Trusts not treated as separate taxable entity Estates may choose a fiscal year and trusts must generally use a calendar year Schedule K-1 is used to notify beneficiaries of amounts to be included on their individual income tax returns

22 Distributable Net Income (DNI) - Definition The income distribution deduction allowable to estates and trusts for amounts paid, credited, or required to be distributed to beneficiaries is limited to distributable net income (DNI). This amount is also used to determine how much of an amount paid, credited, or required to be distributed to a beneficiary will be includable in his or her gross income.

23 Income to be Distributed Currently - Defined Income required to be distributed is income that is required under the terms of the governing instrument and applicable local law to be distributed in the year that it is received. The governing document language trumps local law. If the governing document is silent, local law iscontrolling.

24 Fraudulent Trusts Abusive Trusts are always irrevocable trusts IRS Warnings Civil sanctions Criminal sanctions

25 Issues with Regard to Filing When to File a Form th day of the 4 th month following the year-end of the entity Generally April 15

26 Trusts vs. Estates Estates may elect a fiscal year Generally, Trusts must adopt a calendar year Exceptions Certain Charitable Trusts (IRC 501(a)) Certain Charitable Trusts (IRC 4947(a)(1)) Grantor Trusts (IRC )) A Trust making the IRC 645 election

27 Employer Identification Number Every Estate or Trust that is required to file a Form 1041 is required to have a separate Employer Identification Number (EIN) Grantor Trusts where the Trustor and the Trustee are the same may use the Trustor s Social Security Number as an identifying number; no 1041 is required Who is the responsible party? (Wait for the example)

28 General Rule Taxation of Income A general rule of income taxation of estates and trusts is as follows: Income, if taxable at all, isonly taxed once: To the Trustor (if the Trust is a Grantor Trust); or To the Trust (or Estate) itself; or To the Beneficiary A combination of the above

29 General Rule Character of Income A general rule with regard to the character of income within an estate or a trust is that the entity does not change the character of the income within it when the income leaves the entity Tax-free income remains tax-free Ordinary income remains ordinary income Capital gains remain capital gains 20% capital gain rate applies when income exceeds highest rate

30 Inclusion of Amounts in Beneficiary Income Simple Trust Include in income the amount required to be distributed Estates and Complex Trust Tier 1: Include in income the amount required to be distributed (or such amount up to the beneficiary s share of DNI) Tier 2: Include in income all other amounts properly paid, credited or required to be distributed (or such amount up to the beneficiary s share of DNI) Separate shares? (Treas. Regs. Sec (c)-1 et seq.)

31 Separate Share Issues Fiduciary determines that separate economic interests exist The rule is applicable to estates and trusts If so, amount of DNI is computed as if each separate share is a separate trust or estate Allocate DNI among separate shares in accordance with the amount of income each share entitled to under the governing instrument Deductions or loss allocable to one share of the trust or estate not available to any other share QRT is always a separate share of the estate and may contain two or more separate shares

32 Separate Share Issues (cont.) Separate share allocation can t be used: to get more than one deduction for the personal exemption to split the undistributed income of the trust into several shares to be taxed at lower brackets The separate share rule is not elective. If the rule applies it must be used.

33 Allocation of Deductions Deductions directly attributable to a specific class of income are deducted from that income Deductions not directly attributable to a specific class may be allocated to any class Does the fiduciary have a choice? Caveat: Reasonable portion must be allocated to tax-exempt income Excess deductions attributable to a class may be allocated to another class Caveat: Excess deductions attributable to passive activity cannot be allocated to non-passive activity Caveat: Excess deductions attributable to tax-exempt cannot be allocated to any other class

34 Income Tax Issues (continued) Non Grantor Trust Issues General Rules For the most part, Subchapter J of the Internal Revenue Code is very similar to the parts of the Internal Revenue Code dealing with Individual Income Taxation. Before 2018, there were five tax brackets (15%, 25%, 28%, 33%, and 39.6%) The brackets are compressed compared to individual rates There are four brackets beginning in 2018 See following slide

35 1041 Income Tax Rate Schedule 2017 (with compressed tax brackets) Income Amount Marginal Rate 0 - $2,550 15% $2,551 - $6,000 25% $6,001 - $9,150 28% $9,151 - $12,500 33% $12,501 and above 39.6% (Note: There was no 35% bracket!)

36 Income Tax Issues (cont d) Tax Rate Schedule 2018 Non Grantor Trust Tax Rates Income Amount Marginal Rate 0 - $2,550 10% $2,551 - $9,150 24% $9,151 - $12,500 35% $12,501 and above 37%

37 Obamacare Taxes Estates and Trusts are subject to the 3.8% surtax on the lesser of: Undistributed net investment income, or the amount by which adjusted gross income exceeds the top bracket for estate and trust income taxation.

38 Visualization Case Study Estate of William Smith (Administrative Entity) Is 1041 required? (Potential 645 election) Pour-Over Will

39 Visualization Case Study William Smith Revocable Trust Pour-Over from Estate Adm. Trust of William Smith A B

40 Distribution/Funding Issues Kenan vs. Commis., 114 F. 2d 217 (2 nd Cir. 1940) General Rule: Distribution of non-cash assets by a fiduciary in satisfaction of a pecuniary obligation triggers realization of gain/loss by the estate or trust n/a to fractional shares or a formula gift Must be obligation to pay a specific amount of $ or transfer of specific property Satisfaction of obligation made with other property Results in deemed sale by entity Entity may recognize the loss which is an exception to the general rule of IRC Section 267

41 Exemptions Amounts Simple Trust - $300 Complex Trust - $100 Estates - $600 Have not changed in amount since 1976!

42 Fiduciary Accounting Allocation of Income and Principal Again, governing instrument isthe key When the governing instrument is silent, then state law is relied on (The Income and Principal Act of the specific state) If the Income and Principal Act of the state can not address the issue, then the Common Law, if any, controls

43 Fiduciary Accounting (cont.) Income in Respect of a Decedent ( IRD ) IRA Distributions made to the Estate Principal or income? Failure in planning? What are the minimum distribution rules vis-à-vis the owner? Does the calculation of the required minimum distribution to the owner require the naming of a beneficiary? Distribution is taxable as ordinary income Is the income tax paid by the Estate or by the estate beneficiary(ies)?

44 Distribution Deduction Unique to income taxation of estates and trusts Any amount of income that is properly distributed from an estate or a trust is deducted from the entity and is included as taxable income (in it s character) to the beneficiary

45 Distribution Deduction (cont.) The deduction is computed on Schedule B of the Form 1041 Essentially, the deduction is limited to the lower of accounting income, taxable income, or the actual distribution itself.

46 Overview This portion of the course is designed to teach the participant how to prepare a Federal Form 1041 line-by-line An understanding of the basics of Subchapter J of the Internal Revenue Code would be helpful to the participant.

47 Reviewing the Form 1041 The main portion of the Form 1041 can be broken down into three separate areas: The Information Portion The Body The 10 Questions

48 The Information Portion Name of Entity Name and title of Fiduciary Address of Entity

49 Part A Check All That Apply Decedent s Estate Simple Trust Complex Trust Qualified Disability Trust ESBT

50 Part A Type of Entity (continued) Grantor Type Trust Bankruptcy Estate Chapter 7 Bankruptcy Estate Chapter 11 Pooled Income Fund

51 Parts B, C, D, and E Number of Schedule K-1s Attached Employer Identification Number Date Entity Created Non-Exempt Charitable and Split-Interest Trusts

52 Part F Check Applicable Boxes Initial Return Final Return Amended Return Change in Trust s Name Change in Fiduciary Change in Fiduciary s Name Change in Fiduciary s Address NOL Carryback

53 Part G The 645 Election IRC 645 The Taxpayer Relief Act of 1997 created a new type of entity under IRC Sec By election, a qualified revocable trust (QRT) can be treated as an estate for income tax purposes. Starting in 2013, include TIN of QRT with highest asset value

54 Part G The 645 Election (cont.) When this election is made, all of the rules relating to: Tax Elections Fiscal years Methods of Accounting Termination of a Probate Estate

55 Part G The 645 Election (cont.) Election is made when there is both: An Estate; and A Revocable Trust (Can be made when there is a Revocable Trust that becomes irrevocable upon the Trustor s death)

56 Part G The 645 Election (cont.) Form 8855 Election to Treat a Qualified Revocable Trust as Part of an Estate QRT is any trust (or part of a trust) that, on the date the decedent died, was treated as owned by the decedentunder IRC 676 by reason of a power to revoke that was exercisable by the decedent. Election period begins on the date of the decedent's death and ends on the earlier of: The date all assets have been distributed, or The day before the applicable date

57 Part G The 645 Election (cont.) Applicable Date If 706 is required to be filed then the later of: 2 years after the date of the decedent s death, or 6 months after the final determination of liability for estate tax (see page 3 of instructions) If 706 is not required to be filed: 2 years after the date of the decedent s death

58 The Ten Questions 1. Did the Estate or Trust receive tax-exempt income? 2. Did the Estate or Trust receive contract assignment earning? 3. Did the Estate or Trust have an interest in a bank account in a foreign country?

59 The Ten Questions (cont.) 4. Did the Estate or Trust receive a distribution from a foreign trust? 5. Did the Estate or Trust receive or pay qualified residence interest?

60 The Ten Questions (cont.) 6. The IRC 663(b) election (The 65 Day Rule) Distributions made within 65 days of the estates or trust's subsequent tax year end may be deemed to have been made as of the last day of the tax year The estate or trust will still be afforded a distribution deduction

61 The Ten Questions (cont.) 7. TheIRC 643(e)(3) election Allows a Fiduciary to realize a capital gain inherent in the assets that are subject to distribution The capital gain is recognized by the entity (subject to pass-through to a beneficiary) The Beneficiary takes a fair market value basis in the property distributed.

62 The Ten Questions (cont.) 8. Is the Estate open for more than 2 years? 9. Are any present or future Trust Beneficiaries Skip Persons? This is a GST issue 10.???

63 The Body This is the main portion of the Form 1041 It is divided into Income, Deductions, and Tax Payment sections OtherSchedules flow into these line items

64 Income Line Items Line 1 Interest Income, and Line 2 Dividend Income Note - There is no equivalent of a 1040 Schedule B Note There could be a 1099 discrepancy

65 Example 1099 Discrepancy Time Line Jan 1 Dec 31 Oct.31 Facts: Client dies on October s for the year 2015: $2,400 Interest Income from ABC Bank $1,200 Dividend Income from XYZ, Inc.

66 Example 1099 Discrepancy (cont.) Time Line Jan 1 Dec Period 1041 Period Oct.31 Facts: Client dies on October s for the year 2015: $2,400 Interest Income from ABC Bank $1,200 Dividend Income from XYZ, Inc.

67 Example 1099 Discrepancy (cont.) Time Line Jan 1 Dec Period 1041 Period Oct.31 Facts: Client dies on October s for the year 2015: $2,400 Interest Income from ABC Bank $1,200 Dividend Income from XYZ, Inc. Allocation can be proportionate or actual

68 Income Line Items (cont.) Line 3 Business Income or Loss, and Line 6 Farm Income or Loss Use 1040 Schedule C (or Schedule F) However, use 1040 Schedule E if Farm rented to others No SE Tax for the 1041 period! Same post-mortem opportunity as Lines 1 and 2

69 Income Line Items (cont.) Line 4 Capital Gain or Loss Use special 1041 Schedule D In Part III - allocate portion attributable to beneficiary (if applicable) and portion attributable to estate/trust Issue: Holding period is deemed to be longterm for decedent s capital assets

70 Income Line Items (cont.) Line 5 Rents, Royalties, Partnerships, and other Estates and Trusts Use 1040 Schedule E No SE Tax for the 1041 period! Same post-mortem opportunity as Lines 1 and 2

71 Income Line Items (cont.) Line 7 Ordinary gain or loss Form 4797 is attached Line 8 - Other Income List all items on a separate schedule Usually, this iswhere IRD is listed

72 Deduction Line Items Special Issue: Estate Administration Expenses Can be deducted either on Form 706 or on Form 1041 or split - but never can the deduction be taken twice! Examples: Attorney Fees, Accounting Fees, Executor Commissions, Probate Fees, Filing Fees, Costs of Protecting Estate Assets, and Appraisals

73 Deduction Line Items (cont.) Line 10 Interest Line 11 Taxes Line 12 Fiduciary Fees Line 13 Charitable Deduction From 1041 Schedule A Documents must allow for it Line 14 Attorney, Accountant, and Return Preparer Fees

74 Deduction Line Items (cont.) Line 15a Miscellaneous deductions not subject to the 2% floor Line 15b Miscellaneous deductions subject to the 2% floor SUBTOTAL (line 16): Add lines 10 through 15b SUBTOTAL Line 17): Subtract line 9 from line 16 to get Adjusted Total Income

75 Deduction Line Items (cont.) Line 18 Income Distribution Deduction Be patient! Discussion on Schedule B to follow Line 19 Estate Tax Deduction Line 20 Exemption SUBTOTAL Line 21): Add Lines 18 through 20

76 The Income Distribution Deduction Form 1041, Schedule B (page 2 of the 1041) Distributable Net Income (DNI) DNI creates a tax presumption that any distribution is made from income first It helps determine how much of the income of a trust or estate is taxed to the fiduciary and how much is taxed to the beneficiaries. It also determines the character of the income taxed to each

77 The Income Distribution Deduction (cont.) Distributions from the entity to a beneficiary carry out DNI to the beneficiary to the extent of DNI. This rule applies whether the actual distribution comes from the income or from the corpus. The following exceptions apply: Specific bequests of property or money payable in not more than three installments do not carry out DNI; and Payments of required bequests to charity do not carry out DNI

78 The Income Distribution Deduction (cont.) Distributable Net Income (DNI) (cont.) The amount of this distribution deduction is equal to the lesser of: The taxable portion of DNI, or The amount actually distributed or required to be distributed.

79 The Income Distribution Deduction (cont.) The distribution deduction is calculated on Schedule B of Form 1041 While this calculation determines the distribution deduction, it also determines the amount of taxable income allocated to a particular beneficiary as well as the character of the income (dividends, interest, tax-ex., etc.) The sum of the Schedule K-1 allocations should equal the total distribution deduction

80 The Income Distribution Deduction (cont.) DNI is strictly a tax concept, a fiction that is one of many that we tax practitioners must deal with constantly. It departs from the customary incomeprincipal concept that forms the basic fiduciary accounting rules. Once you calculate fiduciary accounting income, you must put that number aside and concentrate on the different inquiry of trust taxable income.

81 The Mechanical Calculation of DNI IRC 643 (DNI) is a hybrid of taxable income and fiduciary accounting income The starting place for its calculation is trust taxable income followed by a series of adjustments as described below

82 The Mechanical Calculation of DNI (cont.) Begin with trust taxable income Add back the personal exemption Add back capital losses (if added to corpus) Add back net tax-exempt income that is allocated to income for FAI purposes Reduce taxable stock dividends and extraordinary cash dividends allocated to corpus Reducecapital gains allocated to corpus

83 Computing the DNI Schedule B compares the IRC 651 or 661 DNI (the taxable portion of IRC 643 DNI) with the taxable portion of the actual distribution. The deduction for distributions to beneficiaries is the lesser of : The total amount of distributions made or required to be made to the beneficiaries, or The DNI of the trust or estate

84 Contact Information Werner-Rocca Seminars, Ltd. (215) Art Werner Anthony Rocca Follow us on