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14-2

INCOME TAXATION OF INCOME TAXATION OF TRUSTS & ESTATESTRUSTS & ESTATES (1 of 2) (1 of 2)

Basic conceptsPrinciples of fiduciary accountingFormula for trust taxable income

and tax liabilityDistributable net income (DNI)Determining a simple trust’s

taxable income

©2010 Pearson Education, Inc. Publishing as Prentice Hall

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INCOME TAXATION OF INCOME TAXATION OF TRUSTS & ESTATESTRUSTS & ESTATES (2 of 2) (2 of 2)

Determining taxable income for complex trusts and estates

Income in respect of a decedentGrantor trust provisionsTax planning considerationsCompliance and procedural

considerations


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Basic ConceptsBasic Concepts

InceptionReasons for creating trustsBasic principles of fiduciary

taxationDefinitions


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Inception

Estate Upon death of person whose assets

are being administeredTrust

Inter vivosCreated while person is alive or under

direction of will following deathTestamentary

Created by decedent’s will


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Reasons for Creating Trusts

Tax saving aspectsIncome splittingMinimizing estate taxes

Nontax aspects§2503 and Crummey trusts

Trustee manages assets for minorRevocable trust

Reduces probate costs


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Basic Principles of Fiduciary Taxation

Trusts and estates separate taxpayers

No double taxationDeductions permitted for income

distributed to beneficiariesConduit approach

Distributed income retains its characterRules similar to individuals


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Principles of Fiduciary Principles of Fiduciary Accounting Accounting (1 of 4)(1 of 4)

Principal or corpusInitial assets transferred by grantor plus

certain additions/deductions required by provisions of trust instrument

IncomeEarnings derived from principal but

certain gains, losses or deductions may be considered adjustments to principal


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GrantorParty that transfers assets to a trust

TrusteeParty that administers a trust

Income BeneficiaryParty (or parties) who receives income

when distributed by Trustee under provisions of trust instrument


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RemaindermenParty (or parties) who eventually

receives trust principalSame person may receive both income

and principalSimple trust

Must distribute all income annually,Does not distribute any principal ANDMakes no contributions to charities


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Complex trustAny trust that is not a simple trust


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Formula for Trust Taxable Formula for Trust Taxable Income & Tax Liability Income & Tax Liability (1 of (1 of

3)3)

Gross Income- Deductions for expenses- Personal exemption= Taxable income before

distribution- Distribution deduction= Trust taxable income


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3)3)

Trust taxable income x Tax rates in §§1(e) & 1(h)= Tax on taxable income - Credits= Net tax liability


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3)3)

Deductions for expensesParallel expenses for individualsTrustee fees deductible similar to §212 exp2% of AGI floor may apply to certain expPersonal exemption

$300 if all income required to be distributed annually

$100 if current income may be retained


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Distributable Net Income Distributable Net Income (DNI)(DNI)(1 of 2)(1 of 2)

DNI is maximum distribution deduction & income reportable by beneficiaries

No distribution deduction available for portion of distribution deemed to consist of tax-exempt income even though net tax-exempt income included in DNI


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Distributable Net Income Distributable Net Income (DNI)(DNI)(2 of 2)(2 of 2)

Taxable income before distributions+ Personal exemption already deducted- Capital gains added to principal+ Capital losses subtracted from principal+ Tax exempt interest (net of expenses)= Distributable Net IncomeSee Topic Review 2


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Determining a Simple Determining a Simple Trust’sTrust’s

Net Income Net Income (1 of 3)(1 of 3)

Must distribute all of its net accounting income currently

Aggregate gross income reported by beneficiaries cannot exceed DNI

Income received by beneficiaries retains its character


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Allocation of expenses to tax-exempt income

Tax-exempt income

(net of exp. directly

attributable thereto)

X

Accounting income

(net of all direct exp)

=

Indirect expenses allocable to non-taxable income


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Tax treatment of beneficiary if trust has > 1 beneficiaryBeneficiary’s share of gross income if

DNI lower than net accounting income is fraction of DNI shown below

Income required to be distributed to such beneficiaryIncome required to be distributed to all beneficiaries


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Determining Taxable Determining Taxable Income for Complex Income for Complex

Trusts & EstatesTrusts & Estates

Complex trusts permit the following activitiesMaking distributions < current earningsDistributing principalMaking charitable contributions

Complex trust’s DNIImpact on beneficiaries


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Complex Trust’s DNI(1 of 2)

Complex DNI not reduced by charitable contribution deduction when determining maximum distribution for mandatory distributions


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Complex Trust’s DNI(2 of 2)

DNI reduced when calculating deductible discretionary distributions

Distribution deduction is smaller of DNI or sum of mandatory and other amounts properly paid


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Impact on Beneficiaries(1 of 2)

In generalBeneficiary includes distributions as gross

income up to current DNI for the trustAccumulation distribution or throwback

rules attempt to tax individual as if distributions were made annually

Higher trust tax rates make accumulation less desirable


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Impact on Beneficiaries(2 of 2)

Tax treatment of beneficiary if trust has > 1 beneficiaryBeneficiary’s share of gross income

if total income required to be distributed exceeds DNI

Income required to be distributed currently to beneficiary

Aggregate income required to be distributed to all beneficiaries currently


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Income in Respect of a Income in Respect of a Decedent (IRD)Decedent (IRD) (1 of 4)(1 of 4)

Most individuals use cash basisIRD is income constructively

received, but not actually received before deathInterest on CDs, bonds or savingsSalary, commissions or bonusDividends received after date of

death with record date before death


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Income in Respect of a Income in Respect of a Decedent (IRD)Decedent (IRD) (2 of 4) (2 of 4)

IRD must be included As gross income on estate’s

income tax return ANDAs part of the gross estate for

transfer tax purposes


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Estate may claim an income tax deduction for the extra transfer tax due because these items were counted as part of the estate

No step-up in basis for IRD items


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§691(c)deduction

for the year

XTotal

§691(c)deduction

=

Net IRD included in gross inc for the year

-----------------

Total Net IRD


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Grantor Trust ProvisionsGrantor Trust Provisions(1 of 2)(1 of 2)

Grantor does not give up enough control or economic benefit to be a completed transfer

Grantor taxed on some or all of trusts incomeEven if income distributed to

beneficiaries


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Grantor Trust ProvisionsGrantor Trust Provisions(2 of 2)(2 of 2)

Types of grantor trustsRevocable trustsPost-1986 Reversionary interest

trustsSee Topic Review 4


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Tax Planning Tax Planning ConsiderationsConsiderations

(1 of 2)(1 of 2)

Changes that reduced the benefit of using trusts to shift incomeTax rates for fiduciaries are very

compressedChildren under 18 (and some > 18) are

taxed at parents’ higher on unearned income even if from a trust or estate

Dividend income taxed at max of 15%


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Tax Planning Tax Planning ConsiderationsConsiderations

(2 of 2)(2 of 2)

Timing of distributionsSprinkling trust maximize flexibility in

timing of distributions to each beneficiary to maximize tax savings

Property distributionsTrustee may elect to recognize gain on

appreciated property distributedEstates are free to adopt any fiscal year


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Compliance and Compliance and Procedural Procedural

ConsiderationsConsiderations

Filing requirementsForm 1041 if gross income ≥$600Due date 15th day of 4th month

following year endForm 7004 for automatic 5-mo

extension


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