PBI Electronic Publication # EP-2669 Fiduciary Income Tax for Estates Paula M. Jones, Esquire McCarter & English, LLP Philadelphia A chapter from Post Mortem Estate Planning Pub. No. 4643, published June 2007 To purchase this book: See the PBI Online Bookstore at www.pbi.org Email info@pbi.org, or Call 1-800-932-4637 2007 Pennsylvania Bar Institute. All rights reserved. This file is licensed only to the person downloading this file from PBI s website, for printing and for saving to his or her personal computer. No further use is permitted. This file may not be shared electronically with any other person without the express written permission of the Pennsylvania Bar Institute. The Pennsylvania Bar Institute does not render any legal, accounting, or other professional services. The Institute s programs and publications are designed solely to help attorneys maintain their professional competence. In dealing with specific legal matters, the attorney using PBI publications or orally conveyed information should also research original sources of authority.
Biographies Paula M. Jones, Esq. Ms. Jones is an attorney with the law firm of McCarter & English LLP in Philadelphia, Pennsylvania. Ms. Jones concentrates her practice in estate planning, wills and trusts, tax planning, charitable giving and trust and estate administration for wealthy individuals, with a focus on individuals with international interests. Her articles addressing international issues in estate planning, global philanthropy, charitable planning and other topics in estate planning have been published in Immigration Law Today, the American Bar Associationʹs Practical Tax Lawyer Journal, and Planned Giving Today. She lectures frequently for organizations such as the Greater Philadelphia Planned Giving Council, the Pennsylvania Bar Association s Pennsylvania Bar Institute, Corporate Fiduciaries Association of Philadelphia and the Montgomery County Bar Association. She is the creator and producer of a public access television series on estate planning basics, titled Will Power: Wealthy or Not, Your Estate Matters. She is a member of the Philadelphia Estate Planning Council, the Greater Philadelphia Planned Giving Council and is Board Treasurer for the Chester County Estate Planning Council. For a decade prior to practicing law, Ms. Jones managed the membership department of a telecommunications association. i
Table of Contents Post-Mortem Estate Planning Chapter Nine: Fiduciary Income Tax For Estates Paula M. Jones, Esquire, McCarter & English, LLP, Philadelphia I. Introduction...249 II. Part I: Income...249 III. Part II: Deductions...253 IV. Part III: Sample Returns...256 ii
FIDUCIARY INCOME TAX FOR ESTATES Introduction Case Study: The Estate of Jane Decedent Jane Decedent died on August 8, 2002. Form 706, the federal estate tax return was filed nine months after the date of death. Form REV-1500, the Pennsylvania inheritance tax return was filed on the same day. Jane Decedent s estate passes to her two children in equal shares. Individual Income Tax Return An estate is a separate taxpayer from the individual who died. Jane Decedent s personal representative must report income from January 1 st of the last year alive through the date of death on a final federal individual income tax return, Form 1040. The estate then takes over and reports income forward from the date of death, August 8, 2002, on federal Form 1041 and state form PA-41. See Section 443(a)(2). Timing While it is definite that the tax year for an estate begins on the date of death, it is not definite when the reporting period should end. A practitioner can file a return reporting a period as short as one month, as long as twelve months, or any number of months in between. See Section 441. What factors determine when is the best time to file a return? There are many. These factors include the pattern of income received in the estate, the pattern of expenses that the estate incurs, the pattern of gain or losses triggered in the estate and how quickly the estate is being administered. It is the consideration of all of these factors and more that the practitioner must play with in order to determine when to file in each and every estate. Part I: Income Section 641(b) provides that the taxable income of an estate shall be computed in the same manner as that of an individual. Identify Income-Producing Probate Assets Remember that the estate is only reporting the income created by the probate estate, not by the gross estate. Begin by noting all of the incomeproducing probate assets from Form 706 or REV-1500. All assets in which the decedent had an interest are listed on Form 706. However, remember that the 249
Pennsylvania inheritance tax return will not always list qualified retirement plans, it will never list life insurance and it will never list jointly held assets of a husband and wife. If a retirement plan is payable to an estate or if a life insurance policy is payable to an estate, those assets become probate assets and the income must also be tracked on the fiduciary returns. In other words, if a decedent only files an inheritance tax return, be sure to include ALL probate assets on your list of assets to track. The Estate Account Now that you have identified all of the assets that are in the estate, note that one asset in the estate will not show up on any death tax return the estate account. In many cases, the estate opens up its own bank account in order to centralize assets and pay expenses. Be sure to note this account (and the interest it earns) as an asset to track. Begin Date for Tracking Income As stated above, the point to begin tracking the income of an asset is the date of death. Even if a particular asset is titled in the name of the decedent for a couple of months after death, legally it is considered part of the estate. So, for instance, if Jane Decedent s money market account has not been changed into the name of her estate until October of 2002, all of the income in that account is still tracked from the date of death. End Date for Tracking Income The estate needs to report income on assets until those assets are removed from the estate. One way estate assets will make their way out of an estate is when they are distributed to a beneficiary in-kind. For instance, if Jane Decedent has 1800 shares of Specific Motors and 7 months after her death the shares are distributed in kind to the residuary beneficiaries, any income produced by these shares are tracked from August 8, 2002 until the date of distribution to the beneficiaries, at the latest. The beneficiaries are then responsible for reporting any income earned on these shares from the date of distribution forward on their own individual tax returns. Other estate assets may be sold while still in the estate. This just creates two different phases of tracking income in the estate. Let s suppose Jane Decedent s Executor decides to sell her 1800 shares of Specific Motors instead of distributing them in kind. The sale is reported on Form 1041 as a gain or a loss. The proceeds of the sale of the stock is either distributed immediately as cash to the beneficiaries or it is placed in the estate checking account. If distributed out to the beneficiaries, the distribution ends the income tracking for those shares and the beneficiaries resume reporting the income any income that cash produces. If 250
instead the cash proceeds are added to the estate checking account, the income earned on the estate checking account is tracked and reported in the estate. Items of Income In Jane Decedent s estate, all of the income is listed on the supporting statement. This schedule lists the monthly bank interest on a checking account, interest earned on the cash account attached to a brokerage account, interest earned by the estate checking account and interest earned on a certificate of deposit. Note that the total income is listed on Page 1 Line 1 of Form 1041. Tax-Exempt Interest Please note the possibility of tax-exempt interest in an estate. Some assets are tax-exempt for federal purposes only and some are exempt for state purposes only and some are exempt for both. Any tax-exempt income is reported on a different statement on the Form 1041. For example, in general, municipal bonds are tax-exempt for federal income tax purposes and are tax-exempt in the state in which the bond is issued. A bond purchased from a municipality in the state of New York is tax-exempt for federal income tax purposes but is not tax-exempt on the Pennsylvania state fiduciary income tax return. A bond purchased from the PA Turnpike Commissions, however, is tax-exempt not only at the federal level but at the state level in Pennsylvania, as well. In Jane Decedent s estate, tax-exempt income includes municipal bond interest, a tax-exempt money market account, a tax-exempt bond fund and a handful of Pennsylvania municipal bonds. Note that this income is not included on Page 1 of Form 1041. It is noted on Page 2, under Other Information, line 1. Dividends The other source of income in an estate is dividends and they are reported on a separate statement. Jane Decedent s estate earned dividend income including stock dividends, cash dividends paid on cash accounts attached to brokerage accounts and mutual fund dividends. Note that the total of these dividends is listed on Form 1041 Line 2. Please note that whether a dividend is reinvested or paid outright in cash, it is reported in the same manner on Form 1041. This is not to say that a reinvested dividend is not an important factor to note it makes a difference in the mutual fund s basis if sold in the estate, which is covered later. Capital Gains and Losses 251
The tax rates for capital gains and losses are the same for an estate as for an individual. A short-term gain or loss applies to assets owned for less than one year and a long-term gain or loss applies to those assets owned for one year or longer. Estates are limited to a $3000 capital loss deduction each year, just like individuals are. This is one area of income that does not matter whether it stays in the estate or gets passed out to beneficiaries, since the tax rate is the same either way. Capital gains and losses are listed on a separate statement on Form 1041. The total net gains and losses are reported on Page 1 Line 4 of Form 1041. Calculations of Capital Gains and Losses What is the start date for determining the term of a capital asset in an estate? The characterization of the asset as long or short term is carried over from the characterization of the asset when the decedent was still alive. Therefore, if Jane Decedent owned her 1800 shares of Specific Motors for more than one-year as of the date of her death and the shares are sold in the estate 4 months after her date of death, the asset is a long-term asset, because it was characterized as such as of the decedent s death. See Section 1223(11) and 1014. Reinvested Dividends and Capital Gain/Loss Term If reinvested, the dividends earned by investments after the death of the decedent are used to purchase additional shares of the same mutual funds or stocks. These additional shares purchased in the estate are treated as if they are owned by a new taxpayer, the estate. The character of these capital assets as long-term or short-term is not related to the decedent because the decedent never owned these additional shares. The character of these shares are now subject to the same rules as an individual with regard to short-term and long-term gains and losses. Take the Vanguard Windsor Fund as an example. The Windsor Fund was owned by the decedent at the time of her death for longer than one year. After her death, the fund earned a dividend of $978.49. The dividend was automatically reinvested and was used to purchase an additional 80.204 shares on December 20, 2002, about four months after the decedent s death. The estate sold the entire fund on May 29, 2003. The portion of the fund already owned by the decedent on the date of her death was characterized as a long-term capital sale. The basis of this portion of the fund is the value reported on Form 706, since at death, any capital asset experiences a step up in the basis. In this case, the Windsor fund owned by the decedent as of the date of her death (all shares except the 80.204 shares purchased later) was valued at $132,422.32. It was sold on May 29, 2003 for $144,925.25 for a long-term capital gain of $12,502.93. The basis for the 252
additional 80.204 shares is the $978.49 purchase price on December 20, 2002. These shares were also sold on May 29, 2003 for $1069.12, triggering a gain of $90.63. This gain is short-term capital gain, because the assets were purchased by the estate and sold by the estate in less than one year. Capital Gains Distributions Note that if the Form 1041 is covering a period that includes the month of December and the decedent owned mutual funds, will probably receive capital gain distributions. The estate reports this distribution on a separate statement and it is included in the total capital gains and losses on the first page on Line 4. Calculation of Income At this point you have gathered all of the information for your income. You will report non-exempt income, dividends and capital gains and losses. These items will be combined to give the total income for the estate. These items are totaled on Page 1 Line 9 of Form 1041. Part II: Deductions An estate can take deductions, just an individual does, in order to offset the income that it earns. However, an estate has one deduction that an individual does not, the Income Distribution Deduction. An estate can take a deduction against the income it earns equal to the amount of the income that it distributes to estate beneficiaries. For instance, if an estate earns $4000 in interest and dividend income in a year, yet the estate also distributes $4000 of income to the beneficiaries, the estate nets $0 of taxable income. Surely the IRS will not let that $4000 of income avoid income taxation. The beneficiaries of the estate, the taxpayers who received the $4000, will report this income on their own individual income tax returns and will pay federal income tax on their own personal return. Tax Brackets It is important to pass out income annually from an estate. Even though the tax rates for an estate are the same as for an individual, an estate reaches each tax bracket much quicker than an individual does. A trust gets to the highest income tax bracket of 35% after only $9550 of income, whereas a single individual must earn over $300,000 to reach that same tax bracket. Therefore, an individual will always be paying a less tax than an estate will. Timing The same timing rules apply for deductions as they do for income. If the estate is only reporting income from the date of death through October of 2002 on 253
the first return, then the deductions incurred only in that period can be reported. Any remaining deductions will be taken on later returns. Double Deductions Note that if the estate has taken deductions on Form 706 they may not be used again on Form 1041. The use of deductions on the Pennsylvania inheritance tax return do not effect their use on the Form 1041, however. They can be used on both Form 1041 and the inheritance tax return. Note in the example that some deductions were used on Form 706 to offset the federal estate tax and the remainder of the deductions were used on Form 1041. All deductions were used on the Pennsylvania inheritance tax return. Form 706 or Form 1041? Because of the current income tax rates for a trust the federal estate tax is always higher than the highest bracket of federal income tax for an estate. Therefore, if there is any federal estate tax due, the deductions are best used to offset this tax first, because it begins at a minimum of 41%. Any leftover deductions should be used on Form 1041 to offset the fiduciary income tax, which does not exceed 35%. What is Deductible? Items that are deductible in an estate include administration expenses such as Executor s commission, attorneys and accountant fees, probate fees and expenses, costs, depreciation and casualty losses and expenses to store, conserve, maintain and distribute estate assets. Debts and funeral expenses are ordinarily deductible against state inheritance tax or federal estate tax. These expenses, however, are not deductible for fiduciary income tax purposes. Extent Deductible "Miscellaneous itemized deductions" are allowed, subject to a floor equal to 2% of adjusted gross income. Examples of these kinds of expenses include: charitable contributions and gifts under Section 170, medical and dental expenses under Section 213, taxes paid under Section 164, interest under Section 163. See Section 67(a). See the statement on the attached Form 1041 that lists examples of such deductions. The total is listed on Page 1 Line 15b of Form 1041. Section 213 states that medical deductions are deductible, but as stated above, no debts are allowed as deductions, This seems contrary in the case of medical expenses, since they must have been incurred while the decedent was alive. There is a special rule under Section 213(c) that allows any medical 254
expenses incurred by the decedent and paid within one year after death as an allowable deduction. All other deductible expenses are fully deductible and not subject to a 2% floor of adjusted gross income. See the statement on the attached Form 1041 that lists examples of such deductions. The total is listed on Page 1 Line 15a of Form 1041. Note that some expenses are separated on different schedules and statements on Form 1041. For instance, the executor s commission would be listed on Page 1 Line 12 and attorney and accountant fees are listed on Page 1 Line 14. Deductions are totaled on Page 1 Line 16. The adjusted total income is calculated on Page 1 Line 17 by taking the total income listed on Page 1 Line 9 and subtracting the total deductions on Page 1 Line 15. This results in the estate's "adjusted total income." Calculating the Income Distribution Deduction A unique feature of the fiduciary income tax is the income distribution deduction. The estate takes a deduction against the amount of income that has been distributed out of the estate in the time period reported. Does this mean that estate income is not taxed? No. By distributing the income out of an estate, the income is just shifted to the beneficiaries rather than the estate. This information is reported on Schedule K-1s that are included in Form 1041. Observe Schedule B on Page 2 of Form 1041 for the calculation of the income distribution deduction. Line 1 on Schedule B is the adjusted total income reported on Line 17 of Page 1. The adjusted total income equals the total income minus the total deductions, as calculated above Allocation of Deductions to Tax-Exempt Income Line 2 of Schedule B shows how an proportional amount of deductions not subject to the 2% floor are allocated to tax-exempt income. In the estate, there is income (not including capital gains and losses) and tax-exempt income. Calculate what percentage the tax-exempt income bears to the total income in the estate. Deductions are allocated against the tax-exempt income and nonexempt income proportionally. Therefore, on Schedule B Line 2, the adjusted tax-exempt interest is the total tax-exempt interest minus the allocable deductions. Fiduciary Accounting Income 255
Fiduciary accounting income (FAI) is the amount of income required to be distributed currently. Schedule B Line 9 lists this number. To calculate FAI, add the total amount of nonexempt income, the total amount of tax-exempt income (without deductions allocable to it) and all capital gains and losses. Subtract from this number any expenses that are directly attributed to income. In other words, if the instrument or local law states that certain expenses must be paid from income, rather than principal or corpus of the estate, subtract these. This results in FAI. The amount of tax-exempt income is reported on Schedule B Line 12 and removed from FAI in order to come up with the first tentative income distribution deduction on Line 13. Distributable Net Income The distributable net income is automatically calculated by adding the adjusted total income to the adjusted tax-exempt interest and is reported on Schedule B Line 7. However, the second tentative income distribution deduction is calculated on Line 14 of Schedule B by taking Line 7 and removing the taxexempt interest. Compare the amounts on Line 13 and 14. Put the smaller number on Line 15. This is the "income distribution deduction" that can be taken on Page 1 Line 18. This shows how the income distribution deduction is limited to the distributable net income. Personal Exemption Deduction Just an individual must meet a minimum amount of income in order to be required to file a return, an estate has the same requirement. It is called the personal exemption. The exemption amount for an estate is $600. This exemption appears on Page 1 Line 20 of Form 1041. This exemption amount is allowed in the first year and subsequent years, but not in the final year. Note that it is used only after all other deductions have been calculated, including the income distribution deduction. Part III: Sample Returns Pennsylvania Fiduciary Income Tax The PA-41 is fairly straightforward in that it only reports income and does not allow any deductions. Interest income is reported on Page 1 Line 1. Keep in mind that the interest that was tax-exempt for federal income tax purposes may 256
not be tax-exempt at the state level. For instance, the West Virginia bond that was tax-exempt at the federal level is fully taxable in Pennsylvania. (If instead the decedent was a resident of West Virginia, this bond would be tax-exempt at the state level and all the Pennsylvania bonds would be taxable.) See the corresponding statement that lists each item of income. Dividend income is reported on Page 1 Line 2. Note that capital gains distributions, reported on a separate schedule on the federal return, are reported with dividends at the state level. Capital gains and losses are reported on Page 1 Line 3. Schedule L is the counterpart to Schedule K-1 at the federal level. The income reportable by the beneficiaries will most likely be different on both forms, since no deductions are allowed on the PA-41. Back to Timing If the estate is filing a final fiduciary income tax return, certain rules apply that do not apply in other years. For instance, if there are more deductions than income reported in the final year, all excess deductions can be passed out to the beneficiaries (on Schedule K-1) for use on their own personal income tax returns. See Section 642(b). Also, capital gains or losses realized in an estate are usually taxed in the estate in all years except the final year. See Treas. Reg. Section 1.643(a)-3. In the final year, these capital gains can be passed out to the beneficiaries. Also in the final year, any unused capital loss carryover of the estate or trust is available to the beneficiaries. See Section 642(h). Federal Fiduciary Income Tax Return Example A and B Example A shows all of the activity in the estate in one year alone. All income is reported with all deductions. All of the income and capital gains are distributed to the beneficiaries upon termination of the estate. Note the ultimate result for the beneficiaries on Schedule K-1. Each beneficiary must report $29,614.55 on their personal income tax returns. Compare this situation with Example B. The same income and deductions occur in the estate within a one year period of time. Notice how by picking two different tax years the ultimate tax result for the beneficiaries is more favorable than in Example A. The first tax year is from August 1, 2002 through June 30, 2003. Most income is reported with all the gains in the estate. Most of the deductions, except for a few, (most notably the attorney's fees) are taken against the income in Year 1. Note that the capital gains are taxable in the estate. Since the tax rate for 257
capital gains in an estate is the same as for an individual, there is no advantage to paying the gains in the estate versus by the beneficiaries. This first year has a very similar result to Example A's return. Year 2 of Example B, however, is where a practitioner can make a difference by "playing with" the timing on fiduciary returns. The final year is a one-month year, from July 1, 2003 through July 31, 2003. There is only $20.12 in income. Because there is no tax-exempt income realized in this final year, none of the deductions are allocable to tax-exempt income. Therefore, the entire deduction can be used. The attorney fee was paid in this month (and a couple of other deductible expenses) and can be used to offset the small amount of income. This leaves $5380.07 of excess deductions. In other words, only those deductions up to the amount of income could be used in the estate. Excess deductions are those deductions that cannot be used and these can be passed out to the beneficiaries for use on their own personal income tax returns. Note Schedule K- 1 for each beneficiary. There is no income to report, since the deductions offset the income completely and the excess deductions are listed on Line 13a. Therefore, on Example A return, the beneficiaries just had to report all income. Using Example B, the beneficiaries had to report all income, but also receive a sizeable deduction to use on their personal income tax returns. This is just one example of how timing can be manipulated to produce the most benefit to clients. 258