Bring SPF. Take CPE. JULY 6, 7, & 8. Ocean City, MD Clarion Resort Fontainebleau Hotel

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1 Bring SPF. Take CPE. JULY 6, 7, & 8 Ocean City, MD Clarion Resort Fontainebleau Hotel

2 It s not about climbing the ladder. It s about serving your team, your organization, and yourself. It s about being a CPA who can lead well. LEADERSHIP ACADEMY Fostering CPAs leadership and strategic skills to move careers forward, faster. AUGUST In the fast-approaching future, successful CPAs must be leaders. Leadership Academy is the starting point for unlocking the full potential in the profession s best and brightest young CPAs. This three-day event is cited by past participants as a transformative boost to their careers. Event ID: Towson Sheraton Baltimore North UP TO 20 CPE CREDITS BLIonline.org/LeadershipAcademy

3 SAVE THE DATE: DECEMBER 15, 2016 Johns Hopkins Applied Physics Lab CPA INNOVATION TECHNOLOGY LEADERSHIP Future-ready CPAs growing to meet the opportunities of tomorrow. TRACKS TECHNOLOGY SKILLS Learning practical tools and techniques TECHNOLOGY STRATEGY Planning the future of your infrastructure FUTURE-READY CPAs Leading and preparing for change in your organization INNOVATION PARTNERS

4 Beach Retreat July 7th Preparation of Form Practical Issues CONNECT PROTECT ACHIEVE Presented by: Maryland Association of CPAs / 901 Dulaney Valley Road, Suite 800, Towson, MD /

5 Werner Rocca Seminars, Ltd. rocca.com 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 1

6 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) 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) 2

7 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. 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. 3

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 The Three Questions All trusts can be specifically defined and classified by asking three specific questions of them Understanding these three questions can best help you understand the purpose of the trust and the technique or techniques that it is being used for 4

9 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) Question #2 Can the Trust be changed, altered, amended, or revoked? Yes (Trust is revocable) No (Trust is irrevocable) 5

10 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? Question #3 For Federal Income Tax purposes, how is the Trust classified? Grantor Simple Complex So WHAT IS INCOME????? 6

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

12 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 Complex Trust Any non Grantor Trust that is not a Simple Trust! (Yes, the Internal Revenue Code defines it this way!) 8

13 Distributable Net Income (DNI) 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. Income to be Distributed Currently 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 is controlling. 9

14 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 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 10

15 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 General Rule Taxation of Income A general rule of income taxation of estates and trusts is as follows: Income, if taxable at all, is only taxed once: To the Trustor (if the Trust is a Grantor Trust); or To the Trust (or Estate) itself; or To the Beneficiary 11

16 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 Obamacare Taxes 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. 12

17 Deductions Generally, similar to those of individual income taxation Differences Allocation of deductions to non taxable income No standard deduction Loss carry forwards will pass to beneficiaries at final return Exemptions Amounts Simple Trust $300 Complex Trust $100 Estates $600 Have not changed in amount since 1976! 13

18 Fiduciary Accounting Allocation of Income and Principal Again, governing instrument is the 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 is researched 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 14

19 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. 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. 15

20 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 9 Questions The Information Portion Name of Entity Name and title of Fiduciary Address of Entity 16

21 Part A Type of Entity Decedent s Estate Simple Trust Complex Trust Qualified Disability Trust ESBT Part A Type of Entity (continued) Grantor Type Trust Bankruptcy Estate Chapter 7 Bankruptcy Estate Chapter 11 Pooled Income Fund 17

22 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 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 18

23 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. 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 19

24 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 become irrevocable upon the Trustor s death) Part G The 645 Election (cont.) Advantages of the IRC 645 Election The use of a fiscal year The $25,000 PAL deduction for active participation for two years after the date of death under IRC 469(i)(4) The qualification by the combined or electing entity as an S corporation shareholder 20

25 Part G The 645 Election (cont.) Advantages of the IRC 645 Election (cont.) Charitable contribution deduction is allowed for income set aside as well as actually paid A loss deduction is available for a pecuniary bequest satisfied with depreciated property even though the parties are related under IRC 267 The Nine 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? 21

26 The Nine 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? The Nine 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 22

27 The Nine Questions (cont.) 7. The IRC 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. The Nine 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 23

28 The Body This is the main portion of the Form 1041 It is divided into Income, Deductions, and Tax Payment sections Other Schedules flow into these line items 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 24

29 Example 1099 Discrepancy Time Line 2014 Jan 1 Dec 31 Oct.31 Facts: Client dies on October s for the year 2014: $2,400 Interest Income from ABC Bank $1,200 Dividend Income from XYZ, Inc. Example 1099 Discrepancy (cont.) Time Line 2014 Jan 1 Dec Period 1041 Period Oct.31 Facts: Client dies on October s for the year 2014: $2,400 Interest Income from ABC Bank $1,200 Dividend Income from XYZ, Inc. 25

30 Example 1099 Discrepancy (cont.) Time Line 2014 Jan 1 Dec Period 1041 Period Oct.31 Facts: Client dies on October s for the year 2014: $2,400 Interest Income from ABC Bank $1,200 Dividend Income from XYZ, Inc. Allocation can be proportionate or actual Income Line Items (cont.) Line 3 Business Income or Loss, and Line 6 Farm Income or Loss Use 1040 Schedule C (or Schedule F) No SE Tax for the 1041 period! Same post mortem opportunity as Lines 1 and 2 26

31 Income Line Items (cont.) Line 4 Capital Gain or Loss Use special 1041 Schedule D Issue: Basis of Decedent s assets no longer subject to full step up (special 2010 issue which does not apply for 2011 returns) Issue: Holding period is deemed to be longterm for decedent s capital assets 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 27

32 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 is where IRD is listed 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 28

33 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 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 29

34 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 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 30

35 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. 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 Therefore, the sum of the Schedule K 1 allocations should equal the total distribution deduction 31

36 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. 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 32

37 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 Reduce capital gains allocated to corpus 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 33

38 Distributable Net Income (DNI) 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. Contact Information Werner Rocca Seminars, Ltd. (215) rocca.com Art Werner art.werner@werner rocca.com Anthony Rocca arocca@wernerandrocca.com Follow us on 34