FIDUCIARY INCOME TAXES

Transcription

1 FIDUCIARY INCOME TAXES 12 Miscellaneous Itemized Deductions Qualified Revocable Trust Case Study Appendix: Treasury Regulation LEARNING OBJECTIVES Understand the effect of choosing the tax year ending date for a decedent s estate After completing this session, participants will be able to perform the following job-related actions: Make the deceased spousal unused exclusion amount election on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return Explain the reasons for making the I.R.C. 645 election to report a qualified revocable trust s income and expenses on the decedent s estate Form 1041 Determine whether an expense of an estate or trust is subject to the 2% of adjusted gross income floor for miscellaneous itemized deductions Calculate the deductions that an estate or trust can claim when calculating net investment income for purposes of the net investment income tax Determine the basis of assets a taxpayer receives from a decedent INTRODUCTION For income tax purposes the death of a taxpayer requires an allocation of income and deductions among the decedent s final return, the fiduciary returns for the decedent s estate and/or trust, and the beneficiaries of the estate or trust. The 2010 increase to $5,000,000 (with costof-living adjustments for deaths after 2011) in the value of assets that can be transferred free of federal estate or gift taxes reduces many taxpayers need for estate and gift tax planning. This allows taxpayers to focus their tax planning on income tax issues, such as making the best use of the tax brackets of (a) the decedent, (b) the decedent s estate or trust, and (c) the beneficiaries, as well as maximizing the benefit of adjusting the basis of assets to their date-of-death value. Taxpayers who are subject to the net investment income tax (NIIT) can also focus on maximizing the advantage of estate administration 2014 Land Grant University Tax Education Foundation, Inc. 361

2 expenses that qualify as a deduction in calculating net investment income. This chapter is primarily a case study that examines the income tax effect of transferring assets at death. However, it begins with an explanation of the final regulations for allocating estate and trust expenses between those that are subject to the 2% of adjusted gross income (AGI) floor and those that are not. The case study applies those rules. MISCELLANEOUS ITEMIZED DEDUCTIONS Final regulations provide guidance to estates and grantor trusts for allocating expenses between those that are subject to the 2%-of-AGI floor and those that are not subject to that floor. I.R.C. 67(a) requires individual taxpayers to reduce otherwise allowable miscellaneous itemized deductions by 2% of the taxpayer s AGI. I.R.C. 67(b) defines miscellaneous itemized deductions by providing an exclusive list of expenses that are not miscellaneous itemized deductions. Generally, estates and trusts calculate AGI in the same manner as individuals [I.R.C. 67(e)]. However, costs paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in the estate or trust are not subject to the 2%-of-AGI floor [I.R.C. 67(e)(1)]. Developments in Proposed regulations issued in 2007 provided that costs that are unique to estates and trusts were not subject to the 2%-of-AGI floor, but an expense that could be incurred by an individual was subject to the 2%-of-AGI floor. On January 16, 2008, the U.S. Supreme Court held that the fees an estate or a nongrantor trust paid to an investment adviser generally are subject to the 2%-of-AGI floor [Knight v. Commissioner, 552 U.S. 181 (2008)]. The court s interpretation of I.R.C. 67(e) differed from the 2007 proposed regulations. The court said the proper reading of I.R.C. 67(e), which asks whether the expense would not have been incurred if the property were not held in such trust or estate, requires an inquiry into whether a hypothetical individual who held the same property outside of a trust customarily or commonly would incur such expenses. Expenses that are customarily or commonly incurred by individuals are subject to the 2%-of-AGI floor. 362 INTRODUCTION In response to the Knight decision, the Treasury Department and the IRS provided interim guidance in Notice , I.R.B. 593, stating that a final Treas. Reg would be consistent with the Supreme Court s holding in Knight. The notice said the final regulations would also address the issue raised when a nongrantor trust or estate pays a bundled fiduciary fee for costs incurred in-house by the fiduciary, some of which are subject to the 2%-of-AGI floor and some of which are fully deductible without regard to the 2%-of-AGI floor. Because final regulations would not be issued prior to the due date for filing 2007 income tax returns, taxpayers were not required to determine the portion of a bundled fiduciary fee that was subject to the 2%-of-AGI floor under I.R.C. 67 for any tax year beginning before January 1, Instead, for each such tax year, taxpayers could deduct the full amount of the bundled fiduciary fee without regard to the 2%-of-AGI floor. Because payments by the fiduciary to third parties for expenses subject to the 2%-of-AGI floor are readily identifiable, they must be treated separately from the otherwise bundled fiduciary fee. Subsequent IRS notices extended the interim guidance to tax years beginning before the date final regulations were published. On September 7, 2011, the Treasury Department published a new notice of proposed rulemaking [REG , I.R.B. 533] and withdrew the 2007 proposed regulations. The 2011 proposed regulations provided that a cost included in the definition of miscellaneous itemized deductions under I.R.C. 67(b) that is incurred by an estate or a nongrantor trust would be subject to the 2%-of-AGI floor if the cost would commonly or customarily be incurred

3 by a hypothetical individual holding the same property. The proposed rules described ownership costs, tax preparation fees, and investment advisory fees as costs that are incurred commonly or customarily by individuals, and said such costs also include expenses that do not depend upon the identity of the payer (that is, whether the payer is an individual or an estate or trust). Final Regulations The final regulations that the Treasury Department and the IRS adopted on May 9, 2014, generally retain the 2011 proposed regulations with minor modifications [T.D. 9664, I.R.B. 1045]. They are effective for tax years beginning on or after May 9, 2014, and they specifically address several expenses. The new regulations are set out in full in the appendix at the end of this chapter. Certain Fiduciary Expenses Treas. Reg (b)(6) lists certain fiduciary expenses that are not commonly or customarily incurred by individuals, and thus are not subject to the 2%-of-AGI floor, as including 1. probate court fees and costs, 2. fiduciary bond premiums, 3. legal publication costs of notices to creditors or heirs, 4. the cost of certified copies of the decedent s death certificate, and 5. costs related to fiduciary accounts. Commonly or Customarily Incurred The final regulations removed the reference to costs that do not depend on the identity of the payer. New Treas. Reg (a) provides that a cost is subject to the 2%-of-AGI floor to the extent that it 1. is included in the definition of miscellaneous itemized deductions under I.R.C. 67(b), 2. is incurred by an estate or a nongrantor trust, and 3. would commonly or customarily be incurred by a hypothetical individual holding the same property. The type of product or service rendered to the estate or nongrantor trust (rather than the description of the cost of that product or service) is determinative of whether the cost commonly or customarily would be incurred by a hypothetical individual owning the same property. Costs that are incurred commonly or customarily by individuals include costs incurred in defense of a claim against the estate, the decedent, or the nongrantor trust that are not related to the existence, validity, or administration of the estate or trust [Treas. Reg (b)]. Ownership Costs Ownership costs are costs that are commonly or customarily incurred by a hypothetical individual owner of such property. Therefore, ownership costs are subject to the 2%-of-AGI floor. Treas. Reg (b)(2) defines ownership costs as costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property, such as condominium fees, real estate taxes, insurance premiums, maintenance and lawn services, automobile registration and insurance costs, and partnership costs deemed to be passed through to and reportable by a partner. The regulations clarify that the following expenses are not miscellaneous itemized deductions and therefore are not subject to the 2%-of- AGI floor: 1. Real estate taxes, because they are fully deductible under I.R.C. 62(a)(4) or 164(a) 2. Costs incurred in connection with a trade or business or for the production of rents or royalties, because they are fully deductible under I.R.C. 62(a)(4) or Partnership costs reportable by a partner if the partnership cost is fully deductible Tax Return Preparation Costs Treas. Reg (b)(3) provides that costs relating to all estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent s final individual income tax returns are not subject to the 2%-of-AGI floor. Final Regulations

4 The costs of preparing all other tax returns (for example, gift tax returns) are costs commonly and customarily incurred by individuals and thus are subject to the 2%-of-AGI floor. Investment Advisory Fees Treas. Reg (b)(4) provides that fees for investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) are fees that would be incurred commonly or customarily by a hypothetical individual investor and therefore are subject to the 2%-of-AGI floor. However, certain incremental costs of investment advice beyond the amount that normally would be charged to an individual investor are not subject to the 2%-of-AGI floor. For this purpose, an incremental cost is a special, additional charge that is added solely because the investment advice is rendered to a trust or estate rather than to an individual or attributable to an unusual investment objective or the need for a specialized balancing of the interests of various parties (beyond the usual balancing of the varying interests of current beneficiaries and holders of remainder interests) so that a reasonable comparison with individual investors would be improper. The portion of the investment advisory fees not subject to the 2%-of-AGI floor is limited to the amount, if any, that exceeds the fees normally charged to an individual investor. Appraisal Fees FINAL COPYRIGHT 2014 LGUTEF Certain appraisal fees incurred by an estate or a nongrantor trust are not incurred commonly or customarily by an individual and thus are not subject to the 2%-of-AGI floor [Treas. Reg. 1.67(b)(5)]. These fees include appraisals to determine assets fair market value (FMV) as of the decedent s date of death (or the alternate valuation date), to determine FMV for purposes of making distributions, or that are otherwise required to properly prepare the estate s or trust s tax returns or a generation-skipping transfer tax return. The cost of appraisals for other purposes (for example, insurance) is an expense commonly or customarily incurred by individuals and is subject to the 2%-of-AGI floor. 364 MISCELLANEOUS ITEMIZED DEDUCTIONS Bundled Fees A bundled fee (generally, a fee that includes both costs that are subject to the 2%-of-AGI floor and costs that are not) must be allocated between those two categories of costs. If a bundled fee is not computed on an hourly basis, only the portion attributable to investment advice (including any related services that would be provided to any individual investor as part of the investment advisory fee) is subject to the 2%-of-AGI floor. Payments made to third parties from the bundled fee are subject to the 2%-of-AGI floor if they would have been subject to the 2%-of-AGI floor if the estate or nongrantor trust had paid them directly. The 2%-of-AGI floor also applies to any payments for expenses that are separately assessed by the fiduciary or other service provider, if the expenses are commonly or customarily incurred by an individual. Equitable Treatment The unbundling requirement in the final regulations is appropriate because it provides equitable tax treatment to similarly situated taxpayers. Taxpayers that pay investment fees to a third-party investment adviser and those that pay investment fees as part of a bundled fee should receive similar tax treatment. Reasonable Method Any reasonable method may be used to allocate a bundled fee between the costs that are subject to the 2%-of-AGI floor and the costs that are not subject to the reduction [Treas. Reg (c)(4)]. Facts that may be considered in determining whether an allocation is reasonable include, but are not limited to, the percentage of the value of the corpus subject to investment advice, whether a third-party adviser would have charged a comparable fee for similar advisory services, and the amount of the fiduciary s attention to the trust or estate that is devoted to investment advice as compared to dealings with beneficiaries and distribution decisions and other fiduciary functions.

5 Limitations Reduce Burden The limitations to the unbundling requirement reduce administrative burdens. A fiduciary fee, an attorney s fee, or an accountant s fee that is not computed on an hourly basis is fully deductible except for amounts allocable to investment advice. When amounts are traceable to separate payments, the administrative burden associated with subjecting these amounts to the 2%-of-AGI floor is insubstantial. Such separate payments include amounts paid out of the bundled fee by the fiduciary to third parties, if those amounts would have been subject to the limitation if they had been paid directly by the estate or nongrantor trust; and amounts that are separately assessed (in addition to the usual or basic fiduciary fee or commission) by the fiduciary or other service provider that are commonly or customarily incurred by an individual. The final regulations permit the Treasury Department and the IRS to provide safe harbors in future published guidance. QUALIFIED REVOCABLE TRUST The income tax reporting for a decedent s estate and a qualified revocable trust can be combined on one Form A qualified revocable trust (QRT) is a decedent s trust that previously was treated as a grantor trust because the grantor retained the power to revoke it. An electing trust is a QRT that is treated as taxed as part of the decedent s estate for income tax purposes because an irrevocable election was made under I.R.C The election is made by filing Form 8855, Election To Treat a Qualified Revocable Trust as Part of an Estate, and checking the section 645 election box on line G of Form The trustee of the trust and the executor of the estate generally make the election together, but the trustee can make it alone if no executor has been appointed. Form 8855 must be filed by the due date (including extensions) for Form 1041 for the estate s first tax year, even if the combined estate and trust have less than $600 of gross income. When the election is made, both the trustee of the QRT and the executor of the estate agree to allocate the tax burden of the combined entity in a manner that reasonably reflects the separate tax obligations of the QRT and the estate, and to ensure that the allocable tax is paid in a timely manner. Income before Date of Death Grantor trust income received before the grantor s death is reported on the grantor s final Form Trust income received afterward is reportable on Form This usually requires the trustee of a QRT to file a Form 1041 for a short tax year beginning with the decedent s death and ending December 31, if the I.R.C. 645 election is not made. If the trustee and executor have agreed to make the election, the QRT is not required to file the short-year return, even if the election has not been made by the trust return s due date. However, if a valid election is not subsequently made, the QRT may be subject to the failure-tofile and failure-to-pay penalties and interest on any unpaid tax. Tax Advantages Making the I.R.C. 645 election allows a QRT to take advantage of several tax opportunities that are available to estates but not to trusts: 1. Fiscal-year tax reporting that can shift income into different tax years 2. The special allowance for rental real estate activity losses with active participation (allowed to estates for tax years ending less than 2 years after the date of the decedent s death) Tax Advantages

6 3. The charitable deduction for amounts set aside for charity but not yet transferred 4. The exemption from estimated tax payment requirements, if the trust does not otherwise qualify under the name and EIN of the trust to notify the IRS that the trust is no longer in existence. The trust s income, deductions, and credits are not reported on this final trust Form 1041 because they must be included in the Form 1041 filed for the combined trust and estate. Election Period The election period is the period of time during which the trust is treated as part of the estate, and it is generally not more than 2 years. It begins on the date of death. It ends when the electing trust and related estate distribute all of their assets, or on the day before the applicable date, if that date comes first. The applicable date depends on whether a Form 706 is required. If the estate transfer tax return is not required, the applicable date is 2 years after the date of death. If Form 706 is required, the applicable date can extend beyond the 2-year period, until 6 months after the final determination of estate tax liability [Treas. Reg (f)(2)]. Filing Form 1041 The executor of the estate is responsible for filing a combined Form 1041 for the estate and for all electing trusts. The return is filed under the name and employer identification number (EIN) of the estate, and the Decedent s estate box is checked as the type of entity at the top of Form The executor must attach a statement to Form 1041 listing the name of each electing trust, the trust s EIN, and the name and address of the trustee. If there is no executor, the trustee of the electing trust (now called a filing trust) files Form 1041, treating the trust as an estate and using the EIN that the QRT obtained after the decedent s death. The trustee may choose a fiscal year during the election period. (If there is more than one electing trust, the trustees must agree on a filing trustee.) The electing trust and the related estate are treated as separate shares for computing distributable net income (DNI) and calculating distributions [Treas. Reg (e)(2)(iii)]. If the electing trust terminates during the election period, the trustee must file a final Form 1041 Separate Share Rule If a trust or estate has multiple beneficiaries that have substantially separate and independent shares, their shares are treated as separate trusts or estates for the sole purpose of determining the DNI allocable to each beneficiary [I.R.C. 663(c)]. This ensures that the beneficiaries receive the correct allocations of the combined income. Termination Year The estate Form 1041 for the termination tax year includes the estate s income, deductions, and credits for the entire year, and the electing trust s income, deductions, and credits through the last day of the election period. On that day there is a deemed distribution of the electing trust s assets and its share of the income to a new trust [Treas. Reg (h)]. The estate takes an income distribution deduction for the deemed distribution of income, and the new trust includes the distribution in its income. The estate return is marked as final if the estate will not continue after the close of the tax year. Generally, neither the estate nor the electing trust (if either s existence continues) needs a new EIN. However, if there was no executor, and if the electing trust was a filing trust, the trust needs a new EIN if it continues to exist after the termination date. A continuing estate also keeps its same yearend, but if the electing trust continues to exist, it must use a calendar year, and it may need to file a short-year return. 366 QUALIFIED REVOCABLE TRUST

7 CASE STUDY The following case study illustrates the allocation of an estate s expenses under Treas. Reg , as well as other tax issues that arise after the death of a taxpayer. Frances Goodnight died on May 9, 2014, the day the final regulations under I.R.C. 67(e) became effective. Frances had what she believed to be a moderate estate, most of which was owned by her revocable trust. She had made no lifetime taxable gifts. Her three children, Preston Spencer, Harry Spencer, and Julie Spencer, are the beneficiaries of her probate estate, her individual retirement account (IRA), and her trust. Preston is the executor of her estate and a cotrustee of her trust. The other cotrustee of the trust is Kenneth Broker, Frances s trusted financial adviser, who is highly trained in securities matters and who will give all financial advice to the trust and receive a trustee s commission for his services. Her husband, George Goodnight, who survives, is independently wealthy. Because this is a second marriage for both of them, they agreed in a premarital agreement that George is not a beneficiary of Frances s estate. However, the premarital agreement requires Frances s estate to make the deceased spousal unused exclusion (DSUE) amount election so that George and his heirs can benefit from the amount of Frances s estate tax applicable exclusion amount that her estate does not use. In addition to distributing the assets in Frances s estate and trust according to her wishes, her executor s tax objectives in administering the estate and trust are 1. to minimize income taxes paid by the estate, trust, and beneficiaries by a. spreading the income of the estate and trust among the income tax brackets of the estate, trust, and beneficiaries, and b. passing as many excess deductions as possible to the beneficiaries at the conclusion of the administration period; 2. to manage the cost basis of assets (which has become the most important tax-planning issue for most taxpayers as a result of the increased applicable exclusion amount); and 3. to preserve Frances s DSUE amount for the benefit of George Goodnight and his family. Gross Estate Frances s gross estate for federal estate tax purposes was $2,816,895, as summarized in Figure 12.1 and further explained in the following discussion. Because her gross estate is less than the $5,340,000 filing threshold, the sole reason for her executor to file a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, is to make the DSUE election. Probate Estate Frances s small probate estate consisted of a 2012 Cadillac CTS appraised at $23,500 and a $3, checking account at Your Friendly Bank. The executor paid $450 for vehicle insurance on June 1, 2014, which provided insurance through September 15, The executor sold the car for $23,500 on September 15, 2014, and liquidated the bank account for $3, ($3, $4.95 of interest earned after Frances date of death). The executor paid an attorney $750 to probate the estate. The $25, net probate estate (see Figure 12.2) remained in the estate s non-interest-bearing checking account until it was distributed equally to the three children on March 15, Probate Estate 367

8 FIGURE 12.1 Summary of Frances Goodnight s Gross Estate Probate Estate 2012 Cadillac CTS $ 23,500 Checking account 3,545 Total $ 27,045 IRA 354,750 Life insurance 175,000 Trust Condominium 450,000 Townhouse 425,000 Stock 835,000 Interest in Spencer Company, LP 550,000 Total 2,260,000 Total $2,816,795 FIGURE 12.2 Frances Goodnight s Probate Estate Assets 2012 Cadillac CTS $23, Checking account 3, Total assets $27, Expenses Vehicle insurance $ Attorney fees Subtract total expenses (1,200.00) Net probate estate $25, Nonprobate Assets The nonprobate assets Frances owned at the date of her death included an IRA, a life insurance policy, and the assets in her revocable trust. Individual Retirement Account Frances had an IRA at Your Hometown Brokerage Company that was worth $354,750 on the date of her death. Frances had no income tax basis in the IRA because it was funded through rollovers of pretax amounts from employer plans. All three children accepted the inherited IRA and will take required minimum distributions (RMDs) yearly. Because Frances had received her RMD for the year of death, no additional distribution was required in Inherited IRAs See pages 5 16 of this book for an explanation of the rules for taking distributions from inherited IRAs. 368 CASE STUDY

9 Life Insurance Policy Frances also owned a life insurance policy at Greatful Insurance Company. She was the insured, and the proceeds were payable to her children equally. The face value of the policy was $150,000, and it paid out $175,000 of insurance, $ of postmortem dividends, and $ of interest. The $175,000 of insurance proceeds is included in Frances s gross estate, but those proceeds and the postmortem dividends are not subject to income tax. The $ of interest is taxable income to the beneficiaries one-third to each. It is not income to the estate. Dividends Paid on Insurance Policies Amounts that life insurance companies pay to a policyholder as dividends are not true dividends [I.R.C. 316(b)(1) and 808(e)]. Instead they are treated as a return of part of the policyholder s premiums and are not includable in the policyholder s gross income unless the total amount distributed exceeds the total premiums the policyholder paid. Revocable Trust FINAL COPYRIGHT 2014 LGUTEF The cotrustees agreed to $7,500 of commissions each (which includes all financial advice) during the administration period. The trust paid Kenneth $3,000 on December 31, 2014, for his investment services and paid the remaining $4,500 of his fee as well as Preston s $7,500 fee on March 15, The trust paid $32,565 of attorney s fees for trust administration. The terms of Frances s revocable trust allow the trustees to make non pro rata distributions of trust assets to satisfy the distributions required at the time of Frances s death. The following assets were in the trust at the time of Frances s death. Stock Portfolio Frances s $835,000 stock portfolio includes stocks that earned the following qualified dividends: $9,300 through December 31, 2014 $3,600 from January 1, 2015, through March 15, 2015 (the date the trust was closed and the portfolio was divided among the beneficiaries) Spencer Company, LP The trust owned a 75% interest in Spencer Company, LP, an investment partnership. The trust s 75% interest was appraised at $550,000, and the trustee paid $6,500 for the appraisal. The partnership distributed $5,000 to the trust on three dates after Frances s death: June 1, 2014; October 1, 2014; and January 1, The trust s share of Spencer Company s 2014 income and deductions after Frances s death until December 31, 2014, included $12,500 of net income, $500 of short-term capital gain, and $950 of miscellaneous itemized deductions relating to investments. From January 1, 2015, through March 15, 2015 (the date the trust was closed and its interest in Spencer Company was divided equally among the three beneficiaries), the trust s share of income and deductions from Spencer Company was $6,000 of net income, and $400 of miscellaneous itemized deductions relating to investments. Spencer Company attached a statement to the 2015 Schedule K-1 (Form 1065), Partner s Share of Income, Deductions, Credits, etc., that it sent to the trust saying all of the income is investment income for purposes of the NIIT and all of the deductions are deductible for purposes of the NIIT. Vacation Townhouse Frances s vacation townhouse is in St. Petersburg, Florida, and was in the rental pool except for 2 weeks each year when Frances used it. Frances paid $225,000 for the vacation home on June 1, 2008, and it was valued at $425,000 as of the date of her death. The date-of-death appraisal from St. Pete Appraisal Company cost the trust $1,435, which was paid on August 15, The trustee took the property out of the rental pool immediately after Frances s death to minimize any damage to the premises and to get it ready to sell. Nonprobate Assets

10 Before the trust sold the townhouse, it paid $4,325 of real property taxes on June 15, 2014, that were assessed on June 1, 2014; and $450 of monthly maintenance and service costs on the first day of each month, totaling $1,800. The trust sold the townhouse for $465,000 on September 15, The closing statement shows that the trust received a $225 credit for maintenance and service costs; the trust received a $3,225 credit for real property taxes; the trust paid $32,575 in closing costs, which included filing costs, broker costs, and attorney s fees. The trustees added the proceeds from the sale of the townhouse to the stock portfolio. Condominium The condominium, Frances s personal residence, was valued at $450,000 on her date of death. The trust paid $1,245 to Superior Appraisal Company on July 15, 2014, for the appraisal. On December 15, 2014, the estate paid $350 to the same company for a renewal appraisal to confirm that it had adequate insurance coverage on the condominium. The condominium was distributed to Julie Spencer, the youngest of the Frances s children, as part of her share of the trust. On the March 15, 2015, date of settlement, the condominium was worth $500,000. Julie s brothers agreed not to take into account the $50,000 increase in value as a special consideration for their younger sister, who is financially not as well off as her brothers. The three beneficiaries also agreed to each take a 25% interest in Spencer Company and offset Julie s receipt of the condominium with a reduction of her share of the stock portfolio. Value at Time of Settlement By the time of the settlement, the stock portfolio had grown to $1,328,250 (including the proceeds from the sale of the townhouse and the qualified dividends), and the value of the 75% interest in Spencer Company had decreased to $510,000, for a $2,288,250 ($450,000 value of condominium + $1,328,250 stock portfolio + $510,000 value of Spencer Company) total for purposes of dividing the trust. Figure 12.3 shows the portion of each asset that was distributed to each beneficiary to give each of them $782,750 ($2,348,250 3) of assets. FIGURE 12.3 Distribution of Trust Assets Total Julie s Share Preston s Share Harry s Share All trust assets $2,288,250 $762,750 $762,750 $762,750 Subtract FMV of condominium ( 450,000) (450,000) ( 0) ( 0) Subtract FMV of Spencer Company, LP ( 510,000) (170,000) (170,000) (170,000) Stock portfolio $1,328,250 $142,750 $592,750 $592,750 Income Tax Issue In Rev. Rul , C.B. 159, the IRS ruled that a disproportionate distribution of assets between two beneficiaries resulted in recognition of gain. The transaction was treated as if the assets were distributed proportionately and the beneficiaries then exchanged assets between them, triggering the recognition of gain. In that ruling both the trust instrument and local law were silent as to the trustee s authority to make a non pro rata distribution of property in kind. In Letter Ruling (April 22, 1994), the IRS stated that a non pro rata distribution of assets from a trust will be a taxable disposition of the trust assets unless the power to make non pro rata distributions is either expressly stated in 370 CASE STUDY

11 the trust instrument or is authorized under state law. Because the trustee did not have the power to make non pro rata distributions in that ruling, the taxpayers had to recognize gain. In Letter Ruling ( June 21, 1996), the IRS ruled that a nonproportionate distribution did not trigger recognition of gain because the executors and trustees had the power to make nonproportionate distributions. The IRS further ruled that because the distribution was not a taxable disposition, the basis of the assets in the beneficiaries hands would be the same as the basis in the trustees hands. [See also Letter Ruling (August 22, 2003)]. In this case study the trustees of Frances s trust had the power to make nonproportionate distributions. Therefore, no gain is triggered as a result of a deemed exchange of assets among the beneficiaries. Gift Tax Issue Because Preston and Harry agreed to value the condominium at $450,000 rather than its $500,000 FMV at the time it was distributed to Julie, they each made a gift of their one-third share of the $50,000 reduction in value ($16,667). Hometown Accountants, LLC told Preston and Harry they had each made an indirect gift that they must report on a 2015 Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. Assuming the annual gift tax exclusion is $14,000 for 2015, Harry s indirect gift will use $2,667 ($16,667 $14,000) of his lifetime applicable exclusion amount. Because Preston is married, he and his wife can make the gift-splitting election on his gift tax return for That allows him to use his wife s annual exclusion as well as his own to exclude the full $16,667 from his taxable gifts for 2015 and not use any of his lifetime applicable exclusion amount. Tax Returns As executor of Frances s estate and cotrustee of her trust, Preston Spencer is responsible for filing the following tax returns and 2014 Forms 1040 Preston discovered that Frances had extended the due date for her 2013 Form 1040, U.S. Individual Income Tax Return, and had not filed the return at the time of her death. As executor of her estate, he hired Hometown Accountants to prepare the return. The trust paid the $7,500 total of taxes, penalties, and interest due on the 2013 tax return and the accountants $3,250 fee on September 30, Also on September 30, 2014, the trust paid Hometown Accountants $3,250 to prepare Frances s 2014 (final) tax return and the trust paid the $5,650 taxes due with that return. Form 706 for Estate As noted earlier, the sole reason for filing Form 706 for Frances s estate is to make the DSUE election, as required by the premarital agreement between Frances and George. Therefore, the trust paid $7,500 on March 15, 2015, to Hometown Accountants for preparing and filing Form 706 to make that election. Figure 12.4 shows Form 706, Part 2 Tax Computation, lines 1 12, and Figure 12.5 shows Form 706, Part 6 Portability of Deceased Spousal Unused Exclusion (DSUE), Sections A C for Frances s estate. The $2,523,205 DSUE amount reported on line 10 of Part 6 is the result of subtracting Frances s $2,816,795 taxable estate from her $5,340,000 basic exclusion amount. DSUE Election Gift-Splitting Election See pages of the 2012 National Income Tax Workbook for a discussion of the gift-splitting election. See Issue 7 (pages ) in the Individual Taxpayer Issues chapter of this book for further explanation and illustration of the DSUE election. Tax Returns

12 FIGURE 12.4 Form 706, Part 2 for Estate of Frances Goodnight FIGURE 12.5 Form 706, Part 6 for Estate of Frances Goodnight 372 CASE STUDY

13 2014 Form 1041 for Estate Preston Spencer, as the executor of Frances s estate and cotrustee of her trust, and Kenneth Broker, as cotrustee of her trust, elected to close the estate s initial tax year on December 31, Figure 12.6 lists the forms that are shown as figures in this part of the case study. The information that must be reported on supporting statements for the forms is included in notes that explain the entries on the forms and schedules, but the supporting statements are not shown in this case study. FIGURE 12.6 Estate s Form 1041 and Attachments Form or Schedule Figure Page Form 1041 (page 1) Schedule B of Form Schedule G of Form Schedule D (Form 1040) Form 8949 (page 2) Schedule E (Form 1040) page Form The second and final tax year of the estate ended on March 15, The estate and trust elected under I.R.C. 645 to treat Frances s trust, a qualified revocable trust (QRT), as part of the estate, by filing Form 8855, Election To Treat a Qualified Revocable Trust as Part of an Estate, and checking the section 645 election box on line G of Form Therefore, the trust was not required to file a separate tax return. (The Form 8855 is not shown in this case study.) Hometown Accountants charged $4,675 (which was paid on March 15, 2015) for preparing the two Forms 1041, U.S. Income Tax Return for Estates and Trusts, for Frances s estate. Hometown Accountants s fee included tax advice to the estate, trust, and beneficiaries during the administration period. Figure 12.8 on page 377 shows the first page of the 2014 Form Estate Information (Boxes A G) Preston Spencer s title as executor of the estate and his address are included in the name and address box. The box A selection is Decedent s estate. Box B reports that no Schedules K-1 (Form 1041), Beneficiary s Share of Income, Deductions, Credits, etc., are attached to the return. Schedule K-1 Not Required The instructions for Form 1041 require Schedules K-1 (Form 1041) only if the trust or decedent s estate claims an income distribution deduction. The three beneficiaries, Julie, Preston, and Harry Spencer, did not receive any distributions from the estate or the trust during the estate s initial tax year and the estate will not claim an income distribution deduction on line 18 of Form Accordingly, the estate does not need to prepare Schedules K-1 (Form 1041) for them. Box F is checked to indicate that this is the initial tax year for the estate. Box G is checked to indicate the estate and trust filed Form 8855 to make the I.R.C. 645 election to treat and tax the trust as part of the estate. The estate EIN is entered to the right of the section 645 checkbox. Income (Lines 1 9) Hometown Accountants reported $5 ($4.95 rounded up) of interest income from Frances s bank account on line 1. They reported $9,300 of qualified dividends from the trust s brokerage account on lines 2a and 2b. The $7,925 of capital gains reported on line 4 is the sum of the $500 short-term capital gain from Spencer Company and the $7,425 gain from the sale of the townhouse, as shown on Form 8949, Sales and Other Dispositions of Capital Assets, in Figure on page 381 and on Schedule D (Form 1041), Capital Gains and Losses, in Figure on pages There was no gain or loss from the sale of the 2012 Cadillac CTS because it sold for its date-of-death value. Line 5 reports the $12,500 of ordinary income from Spencer Company that was first entered on Schedule E (Form 1040), Supplemental Income and Loss, as shown in Figure on page 382. The estate s $29,730 total income is reported on line 9. Deductions The estate has several allowable deductions. Line 11: Taxes The trust can deduct $1,100 the $4,325 of real property taxes it paid on June 15, 2014 for the townhouse, reduced by the $3,225 credit it Tax Returns

14 received from the buyer on the real estate closing statement. Treas. Reg. 1.67(b)(2) specifically lists taxes that are deductible under I.R.C. 164(a) as being fully deductible. The trust cannot deduct the income taxes, penalties, and interest it paid for Frances s 2013 Form 1040 or the taxes paid for her final Form Line 14: Attorney, Accountant, and Return Preparer Fees The attorney s $750 fee for probating Frances s estate is clearly an expense that would not have been incurred but for the administration of the estate and therefore is not subject to the 2%-of- AGI floor. Treas. Reg (b)(3) specifically lists the cost of preparing the decedent s final tax return as not being subject to the 2%-of-AGI floor. Therefore, the $4,000 sum of the $750 attorney s fees for probating Frances s estate and the $3,250 fee for preparing her final return is deducted on line Form 1040 Preparation Fee Arguably, the fee for preparing Frances s 2013 Form 1040 could be excluded from the 2%-of- AGI floor because the executor of her estate has a fiduciary duty to file that return. However, Treas. Reg (b)(3) does not include those fees in the list of tax preparation fees that are not subject to the 2%-of-AGI floor, and it states that the costs of preparing all other tax returns (for example, gift tax returns) are costs commonly and customarily incurred by individuals and thus are subject to the 2%-of-AGI floor. Therefore, they are not included on line 15a in this case study. Line 15a: Other Deductions Not Subject to the 2% Floor The appraisal fees for determining the date-ofdeath values of the condominium ($1,245), the townhouse ($1,435), and the 75% interest in Spencer Company ($6,500) are all fully deductible [Treas. Reg (b)(5)]. The $9,180 total of those amounts is reported on line 15a. Line 15c: Allowable Miscellaneous Itemized Deductions Subject to the 2% Floor Figure 12.7 itemizes the $9,575 of miscellaneous itemized deductions that would commonly or customarily be incurred by a hypothetical individual owning the same property and that therefore are subject to the 2%-of-AGI floor [Treas. Reg. 1.67(b)(1)]. The estate s $15,950 AGI is the $29,730 total income reduced by the $13,180 of administrative expenses and the $600 exemption deduction. The $9,256 allowable miscellaneous itemized deduction reported on line 15c of Form 1041 is the $9,575 of total itemized deductions reduced by $319 ($15,950 2%). Line 18: Income Distribution Deduction The estate has no income distribution deduction for two reasons. 1. Gains from the sale or exchange of capital assets are excluded from distributable net income [I.R.C. 643(a)(3)]. Schedule B, Income Distribution Deduction, shown in Figure 12.9 on page 378, calculates the zero distributable net income on line 7 by subtracting the $7,925 of capital gains on line 6 from the $6,194 of adjusted total income on line Even if the estate had distributable net income on line 7 of Schedule B, the amount on line 15 is limited to the total amount that was distributed. Because there were no distributions in 2014, the income distribution deduction would be zero even if there were distributable net income. Line 20: Exemption Decedent s estates are allowed a $600 exemption deduction [I.R.C. 642(b)(1)]. 374 CASE STUDY

15 FIGURE 12.7 Miscellaneous Itemized Deductions Insurance for 2012 Cadillac CTS $ 450 Maintenance fees for townhouse Monthly fees paid $1,800 Subtract credit on closing statement ( 225) Net maintenance fees for townhouse 1,575 Investment services from Kenneth Broker 3,000 Fee for preparing 2013 Form ,250 Fee for appraisal of condominium for insurance 350 Deductions relating to investments from Spencer Company, LP 950 Total miscellaneous itemized deductions subject to 2%-of-AGI floor $9,575 Calculation of AGI Total income (line 9 of Form 1041) $29,730 Subtract allowable administrative deductions (lines 14 and 15a of Form 1041) (13,180) Subtract exemption deduction ( 600) AGI $15,950 Subtract 2% of AGI ($15,950 2%) ( 319) Allowable miscellaneous itemized deduction (Form 1041, line 15c) $9,256 Taxable Income The estate computes its $5,594 taxable income on line 22 by first totaling its $23,536 of deductions on line 16, subtracting those deductions from its $29,730 of total income reported on line 9, and entering the $6,194 of adjusted total income on line 17. The $600 exemption deduction on line 21 reduces the taxable income to $5,594, as reported on line 22. Total Tax The $608 total tax reported on line 23 is the sum of the $464 income tax and $144 net investment tax (NIIT) from the Form 1041 Schedule G, Tax Computation, that is shown in Figure 12.9 on page 378. The $464 of income tax is calculated in Part V, Tax Computation Using Maximum Capital Gains Rates, of Schedule D (Form 1041), as shown in Figure on pages Because the $5,594 of taxable income is less than the $7,925 of long-term capital gain, all of the taxable income is treated as long-term capital gain. The 0% tax rate applies to the first $2,500 of the capital gain, and the 15% rate applies to the remaining $3,094 ($5,594 $2,500). Trust and Estate Tax Brackets The maximum tax rates for trusts and estates are the same as those for individuals. However, the tax brackets for trusts and estates are much narrower than the brackets for individuals. Therefore, a trust or estate has much less capital gain taxed at the 0% rate than an individual. Net Investment Income Tax The $144 of NIIT is calculated on Form 8960, Net Investment Income Tax Individuals, Estates, and Trusts, shown in Figure on page 383. The entire $29,730 of total income reported on line 9 of Form 1041 is included in the total investment income reported on line 8 of Form 8960 because Spencer Company reported that all of the income is investment income. If the estate or trust had income that was not subject to the NIIT, that income would not be included on Form Treas. Reg (f)(3)(viii) allows estates and trusts to deduct administrative expenses to the extent they are allocable to net investment Tax Returns

16 income. In this case all of the expenses on lines 11, 14, and 15a of Form 1041 are allocable to net investment income. Therefore, the $14,280 sum of those expenses is reported on line 10 of Form Taxpayers can also deduct miscellaneous itemized deductions to the extent they are allocable to net investment income. In this case the $950 miscellaneous expense from Spencer Company is all allocated to net investment income. However, Treas. Reg (f)(7) allows taxpayers to deduct miscellaneous itemized deductions from net investment income only to the extent they are deductible for regular income tax purposes after applying the 2%-of-AGI floor under I.R.C. 67. The deduction is limited to the lesser of 1. the portion of the taxpayer s miscellaneous itemized deductions (before the applying the 2%-of-AGI floor) that is properly allocable to items of income or net gain included in determining net investment income, or 2. the taxpayer s total miscellaneous itemized deductions allowed after applying the 2%-of- AGI floor. In this case the amount for item 1 is $950, and the amount for item 2 is the $9,256 deduction reported on line 15c of Form Because $950 is the lesser of the two amounts, the estate can deduct the full $950 of miscellaneous itemized deductions allocable to investment income on line 9c of Form The $14,500 net investment income reported on line 12 is the $29,730 total investment income reduced by the $15,230 of total deductions and modifications. Line 19c reports the $3,800 AGI in excess of the NIIT threshold for estates and trusts. It is the excess of the $15,950 AGI calculated in Figure 12.7 on page 375 over the $12,950 threshold for estates and trusts in Because the $3,800 AGI in excess of the threshold is less than the $14,500 net investment income, the NIIT reported on line 21 is $144 ($3, %). 376 CASE STUDY

17 FIGURE Form 1041 for Estate of Frances Goodnight (page 1) 12 Tax Returns 377

18 FIGURE Form 1041 for Estate of Frances Goodnight (page 2) 378 CASE STUDY

19 FIGURE Schedule D (Form 1040) for Estate of Frances Goodnight (page 1) 12 Tax Returns 379

20 FIGURE Schedule D (Form 1040) for Estate of Frances Goodnight (page 2) 380 CASE STUDY