Trust Taxation Basics

Usually when I discuss the requirement of filing the fiduciary income tax returns, my clients get really upset: “Another tax? This is unbelievable!” You have already explained to them the final individual income tax return of the decedent, then the estate tax requirements and maybe the GST tax. When you start to explain the fourth requirement of the fiduciary income tax, they are overwhelmed and become very angry with Uncle Sam.

You will explain to them that the estate or the trust is a separate entity, and when this entity receives income it is a taxable event. Instead of filing a Form 1040, it is a Form 1041. There is always a period of administration between the death of the grantor and the distribution of the trust or the funding of sub-trusts. During that period, the trust may receive income that needs to be reported. The trustee will pay the debts and funeral expenses of the decedent prior to the trust’s distribution.

Fiduciary Responsibility. No matter what your client may feel, the fiduciary is personally liable for payment of fiduciary income tax. When there are co-fiduciaries, only one needs to file the return. However, all of them are jointly and severally liable. When there are assets located in another state from where the decedent lived, this is called an “ancillary estate,” and a local state fiduciary income return may have to be filed.

Filing Threshold Requirement. A Form 1041 must be filed for the following:

· Any estate or trust that has gross income of $600 or more;

· Any trust that has any taxable income for the taxable year; or

· Any estate or trust that has a beneficiary who is a non-resident alien, regardless of the amount of gross or taxable income.

The Fiduciary may want to file a return that is not required, because the estate or trust has net operating losses or capital losses to be carried over. The Virginia fiduciary income tax return is Form 770.

Form 1041 – U.S. Income Tax Return for Trusts and Estates. On the top portion of the return, you will have to define for which entity you are filing this return. You should be familiar with the distinction between simple trust, complex trust, and grantor type trust. The IRS offers three optional filing methods for a grantor trust. A trust qualifies as “simple” if the instrument requires that all income must be distributed, or provides no instruction on any amount to be paid, or there is no invasion of principal allocated. A “complex” trust is a non-simple trust. A grantor type trust is when the trust is not recognized as a separate entity from the settlor/grantor or that the owner has not relinquished complete dominion and control over the trust. For instance, the grantor kept a reversionary interest, has a power of election, or retained a life estate.

The return is 4 pages long, and divided into three portions on the first page: income, deductions, and tax and payments. It includes the following schedules:

- Schedule A – Charitable Deduction

- Schedule B – Income Distribution Deduction

- Schedule G – Computation of Tax

- Schedule I – Alternative Minimum Tax

Additional separate schedules may be required, such as:

- Schedule D – Capital Gains and Losses

- Schedule E – Supplement Income and Loss

- Schedule F – Profit or Loss From Farming

- Form 4979 – Sales of Business Property

- Schedule J – Accumulation Distributions for Certain Complex Trusts

- Schedule K-1 – Beneficiaries Share of Income, Deductions, Credits, Etc.

In most of your income tax return, there will be distributions, which will include distribution of all of the income. Most likely, there will be no tax to pay because you will report on Schedule K-1 the income distributed to the beneficiaries. The beneficiaries will have to report the income they received in their individual income tax returns.

When the trustee or executor receives a commission, you will have to issue a 1099[18] and report to the IRS the number of 1099s you have issued for the year.

Exemptions. The federal exemption rate varies as follows:

· $600 for estates,

· $300 for trusts that are required to distribute all their income,

· $100 for all other trusts.

Filing Place. The fiduciary’s legal residence or principal place of business determines the IRS Service Center for filing purposes. A Virginia fiduciary files with the IRS Center in Cincinnati, Ohio.

Fiscal v. Calendar Year. For an estate, the taxable year will start from the date of death of the decedent to either December 31 or stretch to 12 months. If the decedent died June 5, 2007, the fiscal year of the estate will be from June 5, 2007 to May 31, 2008. The federal return will be due 3 ½ months after, so by September 15, 2008.

Election to a Single Tax Entity. All trusts must use calendar-year reporting. There is an exception to this rule. When a revocable trust became irrevocable upon the death of the settlor, the trustee can elect to treat the revocable trust and probate estate as a single tax entity under I.R.C. Section 645 before the applicable date. The applicable date is two years after the date of death when there is no federal estate tax return due. The applicable date is 6 months after the final determination of the federal estate tax liability when a federal estate tax return is due. The fiduciary will make the election by filing the Form 8855. The election must be made no later than the due date of the federal income tax return for the first taxable year of the estate.

Estimated Tax Payments. Estates and trusts are subject to the estimated tax rules and must pay estimated income tax in the same manner as individuals. The penalty for underpayment of estimated tax is waived for a decedent’s estate for any tax year that ends before the second anniversary of the decedent’s death.

Separate Share Rule. In order to minimize conflicts about allocation of income, deductions, and tax liability, the fiduciary can use the separate share rule provided under I.R.C. Section 663 (c). Substantially separate and independent shares of different beneficiaries in a trust or estate are treated as separate trusts or estates. The amount of distributable net income for any share is computed as if each share were a separate estate. Therefore, any deduction or loss that is applicable solely to one separate share would not be available to any other separate share of the same estate.

Distribution Net Income (DNI). The beneficiaries are taxed on the taxable components of DNI distributed or deemed to have been distributed to them. The trust or estate is taxed on taxable items not included in DNI, such as capital gains, or on the taxable components of DNI not distributed to beneficiaries.

Specific bequests and cash legacies are not treated as being made from DNI. All depends on whether the entity is required to distribute fiduciary income and whether such distributions are made. For trusts requiring the distribution of income, all DNI is distributed and the trust is usually taxed only on capital gains. When the estate or the trust is not required to distribute all fiduciary income, the income tax return can be very complex because the DNI can be spread between the entity and the beneficiaries.

However, the Uniform Principal and Income Act of 1997 created a power of equitable adjustment.[19] As a result, the traditional notions of “income” and “principal” have changed.[20] Capital gains, which have historically been treated as principal, may not be treated as income, and dividends and interest may not be treated as principal. The trustee can now implement the total return investment strategy. The trustee will have to make a reasonable apportionment between the income and remainder beneficiaries of the total return of the trust for the year, including ordinary income, capital gains, and appreciation.

Deductions. Medical deductions are not available for trusts and estates. There is no dependency exemption because the entity has no dependents.

Estates are allowed to an income tax charitable deduction for amounts permanently set aside for charitable purposes. Revocable trusts are allowed a charitable deduction only for amounts paid to charities. Usually the amounts paid to a charity are treated as expenses rather than as a distribution to beneficiaries. Although the amount paid to a charity is not considered a distribution, DNI is reduced by the amount of income paid to a charity.

Deductions for depreciation, depletion, and amortization are allowed in full to the entity if the entity makes no distribution.

Fiduciary fees, and attorney and CPA fees, are reported on lines 12 and 14 of the return.

The deductions for miscellaneous itemized expenses are allowed depending if they exceed two-percent of the adjusted gross income or not. On line 15(a) of the return, the fiduciary will report the deductions not subject to the two-percent requirement. Deductions include casualty and theft losses, domestic production activities, net operating loss deduction, and the estate’s or trust’s share of amortization, depreciation, and depletion not claimed elsewhere. On line 15(b) of the return, the fiduciary will report deductions if they exceed 2 percent of the adjusted gross income. Deductions include investment advisory fees and subscriptions to investment advisory publications, cost of safe deposit box, and administration expenses that would not be incurred if the property were not in the estate or the trust. Of course, the fiduciary has to either elect to report them on the estate tax return or on the fiduciary income tax return. If they are reported on the fiduciary income tax return, the fiduciary will have to attach a statement declaring: (1) that amounts allowable as deductions under I.R.C. §§ 2053 and 2054 have not been taken as deductions on the estate tax return, and (2) that the fiduciary waives the right to have those amounts allowed as deductions under I.R.C. §§ 2053 and 2054.

The IRS draws a distinction between “estate management expenses” and “estate transmission expenses,”[21] which is important when there are estate tax marital deductions or estate tax charitable deductions. The value of the marital share is reduced by the amount of the estate transmission expenses paid from the marital share. The estate transmission expenses[22] are expenses that would not have been incurred but for the decedent’s death and the consequent necessity of collecting the decedent’s assets, paying the decedent’s debts and death taxes, and distributing the decedent’s property to those who are entitled to receive it. Examples of this include: executor commissions and attorney fees, probate fees, and appraisal fees. Estate transition expenses should be reported on the estate tax return.

The estate management expenses are incurred in connection with the investment of estate assets or with their preservation or maintenance during a reasonable period of administration. For instance, investment advisory fees, stock brokerage commissions, custodial fees, and interest. Estate management expenses can either be reported on the estate tax return or on the fiduciary income tax return.

If the estate has made distributions, the deductions are apportioned by reference to the location of fiduciary income, not by reference to DNI.

If the trust has made distributions, the deductions are apportioned between the income beneficiaries and the trustee on the basis of the amount of trust income allocable to each. When the instrument or local law requires or permits the trustee to maintain a depreciation reserve, the deduction is first allocated to the trustee to the extent of the depreciation reserve.

Income in Respect of a Decedent (IRD). IRD is a fiduciary income tax deduction available in order to reduce the impact of double taxation. The following assets received may be taxable both for estate tax purposes and for income tax:

- Accrued interests, dividends, rents

- Installment sale gain

- Qualified retirement money

- Deferred compensation

- Annuity income

- Certain partnership income

- Certain S corporation income

To determine the estate tax attributable to IRD, the fiduciary needs to calculate what would have been the federal estate tax if all IRD had been excluded. This difference of tax can be reported as a deduction on the fiduciary income tax. The deduction must be allocated proportionately to the beneficiary.

Income Tax Rates. The tax rates are steeper than for individual income tax. A 35% tax is collected on taxable income over $10,050. The alternative minimum tax has a minimum rate of 26 percent with an exemption of $22,500.