CHAPTER 13 INCOME TAXATION OF TRUSTS AND ESTATES LECTURE NOTES

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1 CHAPTER 13 INCOME TAXATION OF TRUSTS AND ESTATES LECTURE NOTES 13.1 AN OVERVIEW OF SUBCHAPTER J What is a Trust? 1. A trust is an arrangement created by a will or by a lifetime declaration, through which a trustee takes title to property for the purpose of protecting or conserving it for the beneficiaries, under the ordinary rules applied in chancery or probate courts. 2. Key parties for trust creation are the following. a. Grantor (donor, settlor). Person who places the property in the trust. b. Trustee (either individual or corporate). Party responsible for maintaining assets placed in the trust in accord with the trust instrument. c. Trust beneficiary. One entitled to the income from the trust property is called an income beneficiary. If the income interest is based on the life of the beneficiary, such person is called a life tenant. Remainder Beneficiary. Party to whom trust assets will be distributed at the trust termination. Reversionary trust. Trust assets are returned to the grantor at the expiration of the trust arrangement. 3. Trusts not recognized. a. Grantor trust. Grantor names self trustee and therefore retains virtual control over property. Not recognized for tax purposes. b. Trust in which the grantor, trustee, and sole beneficiary are the same person. Other Definitions 4. Relevant to trust and estate taxation terms. a. Corpus: Assets that the grantor transfers to the trust that become the body or principal of the trust. b. Typical trusts have two types of beneficial interests. Reversionary interests also exist. 20-1

2 Annual Edition/Instructor s Guide with Lecture Notes Income interest receives the accounting income. Remainder interest receives the corpus remaining at the termination of the trust. Reversionary interest is where the corpus to revert to the grantor when the trust terminates. c. Trust terms. Term certain is for a specific number of years. Until a specified event occurs; for example, for the life of the beneficiary (life tenant). d. Sprinkling trust: A trust where the trustee can determine, within guidelines, either the timing of income or corpus distributions to specific beneficiaries. e. Simple trusts. Required to distribute its entire accounting income each year. Beneficiaries are not qualified charities. Make no distributions of corpus during the year. f. Complex trust is a trust that cannot qualify as a simple trust. What is an Estate? 5. Estate definition. Separate taxable entity created upon death of every individual. a. During administration period, decedent s legal representative is responsible for collecting and conserving all assets, satisfying all claims against the estate, and distributing any remainder to the appointed heirs. b. Estates also have 3 key parties. Decedent. Executor. A decedent s legal representative appointed under the will (or called the administrator if appointed by the probate court because there is no will). Has a fiduciary responsibility to operate the estate. Beneficiary. One who will receive the assets and/or income from the estate. c. Termination of estate is somewhat discretionary. May be incentive to use estate as an income-shifting device. ADDITIONAL LECTURE RESOURCE The termination date of trusts or estates sometimes can offer planning opportunities for the client or tax advisor. Generally, if the entity is in a lower tax bracket than are the available beneficiaries, income should be accumulated in the trust or estate, so that exemptions and lower-brackets can be used with the respect to the related income. For instance, the 6166 election seems to justify keeping the estate open for up to 17 calendar years. Maintenance of an intangible asset, such as the works and likeness of a performing artist, also would work.

3 Chapter 20 Income Taxation of Trusts and Estates 20-3 A trust s scheduled termination date cannot violate the local-law interpretation of the rule against perpetuities. Recall that, in the feature Body Heat, Kathleen Turner became interested in William Hurt because she knew he previously had violated the rule against perpetuities NATURE OF TRUST AND ESTATE TAXATION 6. Trusts and estates are separate tax entities and use a modified pass-through approach. a. Text Table 20.2 summarizes similarities and differences of pass-through entities. b. General scheme of income taxation of estates, trusts, and beneficiaries is to tax the entity s income to beneficiaries, or the entity, but not to both. Tax Accounting Periods and Methods 7. Trusts and estates choose their own accounting methods and taxable years and need not use the same methods as the grantor of the trust or the decedent of the estate. a. Trusts and estates accounting methods available to individuals. b. An estate is a new taxpayer and therefore chooses its own taxable year. Estates may have a variety of year-ends. c. Trusts generally have a calendar year end for tax purpose. Tax Rates and Personal Exemptions 8. Congress is concerned with taxpayers using trusts as income-shifting devices and has passed laws to discourage this behavior. a. Federal income tax rates for trusts and estates reach the 35% bracket at taxable income of $11,350 (in 2011). b. Width of the 15% bracket is only $2,300. Thus, tax rates for estates and trusts are very compressed and are the most steeply graduated in the Code. c. Dividends and long-term capital gains are taxed at same rates as for individuals (0% and 15%). 9. Trusts and estates have personal exemptions. a. For an estate the amount is $600. b. For a trust the amount is $300 for a trust distributing all of its current income and $100 for all other trusts. Alternative Minimum Tax 10. Entities have $22,500 annual exemption phased out at a 25% rate when AMTI exceeds $75,000.

4 Annual Edition/Instructor s Guide with Lecture Notes 11. Alternative minimum tax at a 26% or 28% (AMTI Exclusion > $175,000) rate. State income taxes also may apply to trusts and estates. ADDITIONAL LECTURE RESOURCE Unexpected Consequences When You Soak the Rich. Some commentaries suggest that fiduciary taxation has fallen prey to the soak the rich approach. The tax rates that apply to the income retained by trusts and estates have increased and the width of the lower brackets have become so narrow that these entities now are subject to the highest marginal rate structure in U.S. income tax law at very low income. Higher tax rates for trusts and estates affect all fiduciary arrangements, however, even those designed for reasons other than tax avoidance. Perhaps by design, these rate changes have dampened the tax avoidance planning potential of fiduciary entities as a means of shifting income among generations (e.g., from parent to child) or over time (i.e., from the taxpayer s present tax return to a future one). As with tax reforms meant to curb perceived abuses, there are also unintentional hardships as the tax rates have deepened the tax burden on fixed-income retirees, incapacitated individuals, children of divorced parents, and other commonly encountered fiduciary beneficiaries. Most trust beneficiaries are passive recipients of investment income generated by a stock portfolio managed by a corporate trustee or by the distant managers of the mutual funds in which the assets are invested. In a typical year, a trust enters into very few new transactions. For the most part, there is little portfolio turnover, and periodic interest and dividends are collected. Under such circumstances, high taxes on income other than dividends and long-term capital gains are meant to encourage the trusts to distribute income to the beneficiaries. However, the beneficiaries exercise little decision-making authority over the yield or timing of the entity s distributions, which are fixed by the controlling instrument. Are the goals of the steeply progressive tax rates hitting their targets? 13.3 TAXABLE INCOME OF TRUSTS AND ESTATES 12. Figures 20.2 and 20.3 in text illustrate the computation of determining the entity s taxable income. These are very useful for understanding the process. Entity Accounting Income 13. First step in determining the tax liability is to compute accounting income. Whenever the Code uses the term income for trusts and estates, it refers to accounting income. a. Under state law entity accounting income is the amount a beneficiary of a simple trust or estate is eligible to receive for the year. b. Calculation of accounting income is under the control of the grantor or decedent through the trust agreement or will. c. Entity accounting income is generally defined by state law and most states base law on the Uniform Principal and Income Act that essentially constitutes GAAP.

5 Chapter 20 Income Taxation of Trusts and Estates 20-5 Gross Income 14. Estate or trust taxable income is computed similarly to individuals, with some exceptions. a. Estates and complex trusts are subject to more generous limitations concerning their deductions for charitable contributions. b. No standard deduction. c. Unused loss carryovers are allocated to the beneficiaries when the entity terminates. d. Estates are not allowed deductions to extent that the items have been claimed as deductions for Federal estate tax purposes. e. Allowed deduction for taxable income distributed or required to be distributed to its beneficiaries. 15. Generally, no gain or loss is realized on property distributions to a beneficiary pursuant to the provisions of a will or trust instrument. a. Distributed property has the same basis to the beneficiary as it did to the entity. b. Distribution absorbs distributable net income (DNI explained later) and qualifies for a distribution deduction (discussed later). c. Trustee or executor can elect to realized gain or loss relative to the distributed asset. (1) Beneficiary s basis in the property will be its fair market value on the date of distribution. Trustee or executor can direct the related gain or loss into the hands of the optimal taxpayer. (2) Related party provisions of 267 limit the effectiveness of this technique, for losses when the beneficiary qualifies as a related party. 16. Income in respect of a decedent (IRD). Gross income amounts to which a decedent is entitled, but which properly are not includible in the final income tax return under the method of accounting employed by the decedent. a. Includes traditional IRAs, rents, interest, salary, etc accrued but not received by cash basis taxpayer. Also includes, death benefits from retirement plans. b. Value of IRD is included in the gross estate but there is no step-up or step-down to fair market value. That is, beneficiary receives a carryover basis. c. Recipient of IRD is taxed on the difference between the basis and amount received and in the same manner as the decedent would have been taxed. Expenses associated with IRD are deductible by recipient (expense IRD). d. The Code allows the recipient of IRD to claim an income tax deduction for the death tax attributable to the IRD income.

6 Annual Edition/Instructor s Guide with Lecture Notes ADDITIONAL LECTURE RESOURCE Refer to the Tax in the News item Pick the Home State for Your Trust Carefully (p ). Here is a listing of the states that have modified or removed from their statutes the Rule Against Perpetuities. Alaska Arizona Colorado Delaware District of Columbia Florida Idaho Illinois Maine Maryland Michgan Missouri Nebraska Nevada New Hampshire New Jersey North Carolina Ohio Pennsylvania Rhode Island South Dakota Tennessee Utah Virginia Washington Wisconsin Wyoming Ordinary Deductions 17. Ordinary and necessary deductions and expenses associated with production of income ( 162 and 212) are deductible by estates and trusts as are reasonable expenses for administrating the entity. a. Administration expenses and losses for estate tax purposes (Form 706) cannot be claimed on the estate income tax return (Form 1041) unless the estate files a form waiving the deductions for estate tax purposes. b. Fiduciary may allocate these expenses between Forms 706 and 1041 and need not claim the deductions entirety on either return. 18. Cost recovery deductions are assigned proportionately among the recipients of the entity accounting income. Depreciation recapture provisions also apply. 19. Trusts or estates can qualify for the 199 domestic production activities deduction (DPAD). Based on pro rata allocations of entity accounting income, the entity and the income beneficiaries share W-2 wages and qualified production activities income (QPAI). The 199 deduction is then computed separately by the beneficiaries and the entity. Deductions for Losses 20. Estates and trusts are subject to loss deduction limits similar to individuals. a. Nonbusiness casualty and theft losses not covered by insurance. b. Estates and trust may create and deduct net operating losses (NOLs). c. Capital losses are only deduction on the estate tax return (Form 1041) not on the estate return (Form 706). Same rules as for individuals apply. Charitable Contributions 21. Estates and trusts are allowed charitable contributions similar to individuals.

7 Chapter 20 Solutions to Research Problems 20-7 a. However, these entities have no percentage limitation on contributions. (1) Deduction is limited to amounts actually included in the gross income of the entity and only to the extent of entity accounting income. (2) If entity has exempt income, contribution is treated as made proportionately from exempt and taxable income unless the will or trust agreement specifies the income source of the contribution. b. Contributions must meet certain conditions. (1) Must be paid pursuant to the will or trust agreement and the amount is determinable based on the document. (2) Recipient must be a qualified organization, which includes certain foreign charities. (3) Deductions are permitted for amounts paid in the year immediately following the current tax year. Thus, contributions made in 2010 may be deducted in Deductions for Distributions to Beneficiaries 22. Estates and trusts are allowed a deduction for distributions made to beneficiaries during the current tax year. A critical value used in determining this deduction is distributable net income (DNI), which provides an approximation of current economic income available for distributions. a. Allowance of distribution deductions is an example of modified pass-through approach utilized in taxation of estate and trusts. b. DNI has several functions. (1) It is the maximum distribution amount that can be taxable to the beneficiaries. (2) It is the maximum amount that the entity can use for the distribution deduction. (3) The character of income items in DNI carryover to the beneficiaries. c. Computation of DNI and entity taxable income (Examples 21 and 22). (1) Compute taxable income before distribution deduction (TIBDD). (2) Determine DNI by adjusting TIBDD by the following items. Add personal exemption. Add net tax-exempt income. Add net capital losses. Subtract any net capital gains allocable to corpus. (3) Calculate the distribution deduction by subtracting net tax-exempt income.

8 Annual Edition/Instructor s Guide with Lecture Notes Tax Credits (4) Subtract the lesser of the following from TIBDD. Deductible portion of DNI. Taxable income actually distributed. 23. Income tax credits are allocated between the estate or trust and its beneficiaries on the basis of the accounting income allocable to each TAXATION OF BENEFICIARIES 24. DNI determines the amount that can be taxed to the beneficiaries. a. Income passed through to the beneficiaries retains its specific tax character. Therefore, it is taxed to the beneficiaries in the same manner as if it was taxed to the estate or trust (modified pass-through approach). b. Beneficiaries are taxed on the entity s income distributed or required to be distributed in the taxable year in which or with which the entity s taxable year ends. Distributions by Simple Trusts 25. Maximum amount that beneficiaries of a simple trust are taxed on is their proportionate share of the entity s DNI, regardless of whether an actual distribution is made. a. When the entity has tax-exempt income included in DNI, the taxable amount to the beneficiaries could be less than the DNI. b. Income items of DNI are apportioned ratable according to the required distributions to the beneficiaries. Distributions by Estates and Complex Trusts 26. Distributions from estates and complex trusts are categorized into a two-tier system that determines the taxability of the distributions. a. Income required to be distributed currently, whether or not actually distributed, is categorized as a first-tier distribution. If only first-tier distributions are made and sum of distributions is less than DNI, each beneficiary s distribution is included in gross income. If only first-tier distributions are made, and sum of distributions exceeds DNI, each beneficiary s distribution is included in gross income to the extent of her or his proportionate share of DNI. b. All other amounts properly paid, or distributed are second-tier distributions. Not included in gross income if first-tier distributions exceed DNI. Fully included in gross income if the sum of the first-tier and second-tier distributions are less than DNI (Example 29). When both first-tier and second-tier distributions are made and the firsttier distributions do not exceed DNI, second-tier distributions are included

9 Chapter 20 Solutions to Research Problems 20-9 in gross income proportionately to the extent of the remaining DNI over the first-tier distributions (Example 28). 27. Elective separate share rule of 663(c) allocates DNI of a single estate or trust as if there are separate entities for each beneficiary. This prevents inequities that could result when corpus distributions are treated as second-tier distributions. Character of Income 28. As a general rule, various classes of income (portfolio, passive, capital, tax-exempt) have the same character in the hands of the beneficiaries that they had when received by the estate or trust. a. If the entity has multiple beneficiaries and all DNI is distributed, each class of income is allocated to beneficiaries in proportion to the income received by each. b. If the entity distributes only part of DNI, distributions are treated as being in the same proportion as the items that are included in DNI. 29. Similar to partnerships, estates and trusts can make special allocations of deductions or income, provided that such special allocations are permitted in the trust agreement and have substantial economic effect. Losses in the Termination Year 30. Ordinarily, NOLs and capital losses do not flow through to beneficiaries. a. Exception is in the terminating year when beneficiaries receive direct benefits from loss carryovers. The carryover losses are subject to the same limitations applicable to individuals. b. If the entity incurs negative taxable income in the termination year, the loss flows directly to the beneficiaries. They are taken as a miscellaneous deduction from AGI and subject to the 2%-of-AGI floor. The Sixty-Five-Day Rule 31. The 65-day rule allows the executor or trustee to treat amounts paid or credited to the beneficiaries in the first 65 days of the entity s tax year as if they were paid on the last day of the preceding taxable year. This rule allows some time to make tax-wise distributions or accumulations GRANTOR TRUSTS 32. In a grantor trust the grantor retains beneficial enjoyment or control over trust property or income. The Code taxes the grantor on the trust income and the trust is disregarded for tax purposes. Reversionary Trusts 33. Creation of a reversionary trust is subject to the gift tax provisions and if the grantor dies before the income interest expires, the reversionary interest is included in the grantor s estate.

10 Annual Edition/Instructor s Guide with Lecture Notes Powers Retained by the Grantor 34. If a grantor fails to abide by the restrictions, the trust will be treated as a grantor trust. The grantor must not retain the following powers. Control beneficial enjoyment of trust income or corpus. Power to dispose of the trust income without approval of an adverse party, who is any person having a substantial beneficial interest and would be affected adversely by the actions of the grantor. Administrative powers to have transactions with the trust for less than adequate and full consideration. Powers to borrow from the trust without adequate interest or security. Revoke the trust. Distribute trust income or hold and accumulate trust income for future distributions for the benefit of grantor or spouse. Use trust income for payments of premiums on insurance policies on the life of the grantor or spouse. Use trust income for legal obligations of support when income actually used for this purpose. 35. Holding the following powers will not cause income to be taxed to the grantor. Allocate trust income or corpus among charitable beneficiaries. Invade corpus on behalf of a designated beneficiary. Withhold income from beneficiaries during their minority or disability. Allocated receipts and disbursements between income and corpus PROCEDURAL MATTERS 36. Fiduciaries of estates or trusts are required to file Form 1041 (U.S. Fiduciary Income Tax Return) by the fifteenth day of the fourth month following the close of entity s taxable year in the following situations. a. Estate s gross income for the year is $600 or more. b. Trust s has taxable income or, if the trust has no taxable income, but gross income is $600 or more. 37. Fiduciary entities must make estimated tax payments throughout the year, on the same payment schedule as individuals. a. Exception to estimated payment requirement for estates and grantor trusts for their first 2 tax years. b. Charitable trusts and private foundations do not make estimated payments.

11 Chapter 20 Solutions to Research Problems ETHICS & EQUITY Who Should Be a Trustee? A family member might find it too difficult to carry out fiduciary duties, such that a third party might be a better choice for all involved. The trust and the survivors might discover that they have conflicting interests, and that some degree of objectivity would be welcome during the administration period. 38. Another of an executor s duties is to file the decedent s last Form On a joint return, the signatures are made by the executor and the surviving spouse. The return is due on April 15, even though the spouses on a joint return have different tax year ends.