Chapter 28
Income Taxation of Trusts
and Estates
Comprehensive Volume
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
1
The Big Picture (slide 1 of 3)
• Anna Jiang is the main breadwinner in her
family, which includes her husband Tom, a
social worker, and two children, Bobby, age 8,
and Sally, age 13.
• Anna has accumulated about $2 million in
after-tax investment accounts, largely made up
of growth stocks that do not regularly pay
dividends.
The Big Picture (slide 2 of 3)
• Anna has addressed the problem of probate
costs through joint property ownership, life
insurance policies, and beneficiary
arrangements for her retirement plans.
• She and Tom update their wills every five
years or so.
The Big Picture (slide 3 of 3)
• There is a history of Alzheimer’s disease in
Anna Jiang’s family.
– She wants to make certain that Tom and the
children will have adequate cash flow from the $2
million of investment assets if she becomes unable
to work.
• One of Anna’s colleagues suggests that she set
up a trust to take care of her family in case a
medical problem ever arises.
• Read the chapter and formulate your response.
What Is a Trust?
• Not defined in Code
– Usually refers to an arrangement created by a will
or by inter vivos (lifetime) declaration
– Trustee takes title to property for purpose of
protecting or conserving it for beneficiary
– Used to achieve various financial and other goals
Creation Of A Trust
• Typically, involves at least three parties:
– The grantor - transfers selected assets to the trust
entity
• Sometimes referred to as the settlor or donor
– The trustee - charged with the fiduciary duties
associated with the trust
• Usually is either an individual or a corporation
– The beneficiary - designated to receive income or
property from the trust
Common Motivations
for Creating a Trust (slide 1 of 5)
• Life Insurance Trust
– Holds life insurance policies on the insured
– Removes proceeds of policies from gross estate (if
irrevocable trust)
– Safeguards against receipt of proceeds by young or
inexperienced beneficiary
Common Motivations
for Creating a Trust (slide 2 of 5)
• “Living” (revocable) Trust
–
–
–
–
–
Manages assets
Reduces probate costs
Provides privacy for asset disposition
Protects against medical or other emergencies, and
Provides relief from the necessity of day-to-day
management of the underlying assets
Common Motivations
for Creating a Trust (slide 3 of 5)
• Trust for minors
– Provides funds for college education
– Shifts income to lower-bracket taxpayers
– Allows parents to retain some control over
children’s use of assets
Common Motivations
for Creating a Trust (slide 4 of 5)
• “Blind” trust
– Holds assets of grantor without his/her input or
influence (e.g., while grantor holds political office
or some other sensitive position)
• Retirement trust
– A special tax-exempt trust that manages asset
contributions under a qualified retirement plan
Common Motivations
for Creating a Trust (slide 5 of 5)
• Divorce trust
– Manages assets of an ex-spouse and ensures they
will be transferred on a prescribed schedule to
named beneficiaries
• Liquidation trust
– Manages assets and final dissolution of a
corporation undergoing a complete liquidation
Structure of Typical Trust
What Is an Estate?
• Created upon the death of every individual
– Collects and conserves an individual’s assets,
satisfies all liabilities, and distributes the
remaining assets to heirs
Structure of Typical Estate
Nature of Trust
and Estate Taxation
• In general, taxable income of trusts or estates
is taxed to the entity or to its beneficiaries to
the extent that each has received the
accounting income of the entity
– Whoever receives the accounting income of the
entity, or some portion of it, is liable for the
income tax that results
Filing Requirements
• Fiduciary must file a Form 1041, U.S. Income
Tax Return For Estates and Trusts, in the
following situations:
– For an estate with gross income > $600
– For a trust that either has any taxable income or, if
no taxable income, has gross income of $600 or
more
• Due date is 15th day of fourth month following
year-end
Tax Accounting Periods, Methods, and
Payments (slide 1 of 2)
• Tax year
– Estates can use calendar year or fiscal year
– Trusts must use a calendar year
Tax Accounting Periods, Methods, and
Payments (slide 2 of 2)
• Estimated tax payments
– Trusts and estates are required to make quarterly
estimated tax payments using same schedule as
individuals
• Applies to estates and grantor trusts only for tax years
ending two or more years after date of decedent’s death
• Charitable trusts and private foundations are exempt
from making estimated tax payments
Tax Rates for Estates and Trusts
Taxable Income
But Not
Over
Over
$ -0$2,300
2,300
5,450
5,450
8,300
8,300
11,350
11,350
........
Tax is:
15%
$ 345.00 + 25%
$1,132.50 + 28%
$1,930.50 + 33%
$2,937.00 + 35%
Of Amount
Over
$ -02,300
5,450
8,300
11,350
Note: tax on dividend income and net long-term capital gains
of fiduciary is limited to 15%
Personal Exemptions
Estates
Simple trusts(generally)
All other trusts (primarily
complex trusts)
$600
$300
$100
Alternative Minimum Tax
• May apply to an estate or trust in any year
– AMTI calculation is generally the same as for
individuals
– Annual exemption = $22,500, with phaseout
– Rate = 26% on first $175,000 AMTI, 28%
thereafter
Accounting Income, DNI and Taxable
Income of the Entity and Beneficiaries
Entity Accounting Income
• Accounting income is based on the controlling
document
– Either the document or state law determines
whether amounts are allocated to corpus or current
income
– If the entity distributes income currently, that
income should generally correspond to accounting
income
Common Allocations:
Income or Corpus
Allocable to Income
Allocable to Corpus
-Ordinary and operating net
income from trust assets
-Interest, dividend, rent, and
royalty income
-Stock dividends
-One-half of fiduciary fees/
commissions
-Depreciation on business assets
-Casualty gain/loss on
income-producing assets
-Insurance recoveries on
income-producing assets
-Capital gain/loss on investment
assets
-Stock splits
-One-half of fiduciary fees/
commissions
Taxation of Estates and Trusts
(slide 1 of 2)
• Generally, estates and trusts act as conduits for
income received, and taxation is at beneficiary
level
– This is codified through allowance of a distribution
deduction
Taxation of Estates and Trusts
(slide 2 of 2)
• Exceptions:
– Complex trusts accumulate income for specified
times (e.g., until beneficiary is age 30)
– Estates are not always required to make current
distributions
• In these cases, or other cases where the entity
is not required to distribute current income, the
entity itself is taxed
Property Distributions
(slide 1 of 2)
• Generally, entity does not recognize gain or
loss
– Beneficiary takes same basis in asset as it had in
the estate or trust
– Distribution absorbs distributable net income
(DNI) and qualifies for a distribution deduction to
extent of the lesser of:
• Basis to beneficiary
• FMV on date of distribution
Property Distributions
(slide 2 of 2)
• Property distributions (cont’d)
– Trustee or executor can elect to recognize gains
and losses on assets distributed in kind
• Beneficiary’s basis in asset would be FMV
• Distribution absorbs distributable net income (DNI) and
qualifies for a distribution deduction equal to FMV on
date of distribution
The Big Picture – Example 7
Property Distributions
• Return to the facts of The Big Picture on p. 28-2.
• Assume that Anna has established the Jiang Family
Trust.
– The trust distributes a painting, basis of $40,000 and fair
market value of $90,000, to beneficiary Sally.
– Sally’s basis in the painting is $40,000.
• The distribution absorbs $40,000 of the Jiang Trust’s
DNI, and the trust claims a $40,000 distribution
deduction relative to the transaction
The Big Picture – Example 8
Property Distributions
• Assume the same facts as in Example 7, except
that the Jiang Trust’s basis in the painting is
$100,000.
– Sally’s basis in the painting is $100,000.
• The distribution absorbs $90,000 of the Jiang
Trust’s DNI, and the trust claims a $90,000
distribution deduction.
Deductions Allowed
(slide 1 of 3)
• Deductions are allowed for ordinary and
necessary expenses for:
– A trade or business
– Production of income
– Management, conservation, or maintenance of
property
– Determination, collection, or refund of any tax
Deductions Allowed
(slide 2 of 3)
• Other deductions
– No deduction is allowed for expenses related to the
production or collection of tax-exempt income
– Cost recovery deductions are allocated
proportionately to the recipients of accounting
income
– Deductions are allowed for casualty or theft losses
and NOLs
– Wash sale and related party rules apply
Deductions Allowed
(slide 3 of 3)
• Other deductions (cont’d)
– May be eligible for the domestic production activities
deduction
• Computation of qualified production activities income (QPAI) is
made at the entity level
• Each beneficiary receives, as a pass-through from the entity, his or
her share of QPAI and the W–2 wages paid, based on the
proportion of entity accounting income received
– Charitable contribution deduction is allowed to the extent
of amounts included in gross income for the year
• Deemed to be made proportionately from each of the income
elements of entity accounting income
The Big Picture – Example 17
Charitable Contribution Deduction (slide 1 of 2)
• Return to the facts of The Big Picture on p. 28-2.
• Again assume that Anna has established the
Jiang Family Trust.
• The trust has 2011 gross rent income of
$80,000, expenses attributable to the rents of
$60,000, and tax-exempt interest from state
bonds of $20,000.
The Big Picture – Example 17
Charitable Contribution Deduction (slide 2 of 2)
• Under the trust agreement, the trustee is to pay
30% of the annual trust accounting income to
the United Way, a qualifying organization.
– Accordingly, the trustee pays $12,000 to the
charity in 2012.
• 30% X $40,000.
– The charitable contribution deduction allowed for
2011 is $9,600.
• ($80,000/$100,000) X $12,000.
The Big Picture – Example 18
Charitable Contribution Deduction
• Assume the same facts as in Example 17,
except that the trust instrument also requires
that the contribution be paid from the net rent
income.
• The agreement controls, and the allocation
formula need not be applied.
– The entire $12,000 is allowed as a charitable
deduction.
Distributable Net Income
(slide 1 of 3)
• Entity is allowed a deduction for distributions
to beneficiaries
– Distributable net income (DNI) is used to compute
the amount of the deduction
• Maximum amount beneficiaries pay tax on
– The character of income in DNI is preserved to the
beneficiaries
• Maximum amount of distribution deduction
Distributable Net Income
(slide 2 of 3)
• Calculating DNI
– Step 1: Determine entity’s taxable income before
the distribution deduction
• Includes all of entity’s income, deductions, gains, losses
and exemption
Distributable Net Income
(slide 3 of 3)
• Calculating DNI (cont’d)
– Step 2: Make the following adjustments to entity’s
taxable income to determine distributable net
income:
• Add back:
– Personal exemption
– Net tax-exempt interest
– Net capital losses
• Subtract net capital gains allocable to corpus
Distribution Deduction
– For estates and complex trusts, distribution
deduction is the lesser of:
• Deductible portion of DNI, or
• The taxable amount actually distributed
– For a simple trust, full distribution is always
assumed
Entity Taxable Income
• Entity taxable income is calculated as
follows:
Entity taxable income before
the distribution deduction
Less: Distribution deduction
Entity taxable income
Allocation of DNI
(slide 1 of 6)
• Each type of DNI must be allocated
proportionately to income beneficiaries
– This prevents manipulation of tax liabilities by
assigning, for example, tax-exempt income to high
bracket taxpayers, and taxable income to low
bracket taxpayers
Allocation of DNI
(slide 2 of 6)
• Amount taxable to beneficiaries
– For a simple trust
• DNI is the maximum taxable amount
• May be less if DNI includes tax-exempt interest
• If more than one income beneficiary, apportion elements
of DNI ratably
Allocation of DNI
(slide 3 of 6)
• Amount taxable to beneficiaries (cont’d)
– For estates and complex trusts
• Use a two-tier system
– Income required to be distributed is categorized as a first-tier
distribution
– All other amounts properly paid, credited or required to be
distributed are second-tier distributions
Allocation of DNI
(slide 4 of 6)
• Amount taxable to beneficiaries (cont’d)
– If only first-tier distributions are made and
those amounts exceed DNI, use the following
formula to allocate DNI among beneficiaries
First-tier dist. to beneficiary
First-tier dist. to all beneficiaries
×
DNI
= Beneficiary’s Share of DNI
Allocation of DNI
(slide 5 of 6)
• Amount taxable to beneficiaries (cont’d)
– If first and second-tier distributions are made and
first-tier distributions exceed DNI, use the
previous formula to allocate first-tier distributions
– Second-tier distributions are not taxed since all
DNI has been allocated
Allocation of DNI
(slide 6 of 6)
• Amount taxable to beneficiaries (cont’d)
– If first and second-tier distributions are made and firsttier distributions do not exceed DNI, use the following
formula to allocate DNI among beneficiaries
2nd-tier dist. to beneficiary
2nd-tier dist. to all beneficiaries
×
Remaining
DNI
= Beneficiary’s share of DNI
Character of Income
• Various classes of income retain their character
and flow through to beneficiaries
– If all DNI is distributed and there are multiple
beneficiaries, must allocate various classes of
income
• Distributions are treated as consisting of the same
proportion as the items that enter into the computation
of DNI
Trust Taxation Example
(slide 1 of 9)
The Alto Family Trust has the following income and
expenses:
Interest income
Tax-exempt income
Capital gain income
Fiduciaries fees
$8,000
$6,000
$4,000
$2,000
The trust agreement allocates fiduciaries fees to trust
income. Capital gains are allocated to trust corpus.
Trust Taxation Example
(slide 2 of 9)
1. Accounting income is as follows and is distributed to Sue,
the sole beneficiary, at the end of the year:
Interest income
$ 8,000
Tax-exempt income
Fiduciaries fees
Accounting income
6,000
(2000)
$12,000
Trust Taxation Example
(slide 3 of 9)
Fiduciary fees are allocated between interest income and taxexempt income before calculating trust taxable income:
Interest income × Fees = $ 8,000 × $2,000 = $1,143
Total income
$14,000
Tax-exempt inc. × Fees = $ 6,000 × $2,000 = $ 857
Total income
$14,000
Trust Taxation Example
(slide 4 of 9)
2. Taxable income of the trust, before the distribution
deduction, is as follows:
Capital gain
$ 4,000
Interest income
8,000
Less: fiduciaries fees
related to interest income
(1,143)
Less: exemption
( 300)
Taxable income before
distribution deduction
$10,557
Net tax exempt income is $6,000 less $857, or $5,143.
Trust Taxation Example
(slide 5 of 9)
3. Calculate Distributable Net Income (DNI) and the
distribution deduction as follows:
DNI:
Taxable income before DNI
$10,557
Plus: Exemption
300
Plus: Tax-exempt income (total)
6,000
Net of: Expenses allocated to tax-exempt income (
857)
Less: Capital gains allocated to corpus
( 4,000)
DNI
$12,000
In this case, since no expenses were allocated to corpus,
DNI is the amount actually distributed to the beneficiary.
Trust Taxation Example
(slide 6 of 9)
Distribution Deduction
The distribution deduction is the lesser of the amount
actually distributed ($12,000) or DNI net of tax-exempt
income (less expenses):
DNI
Less: tax-exempt income
Plus: expenses related to tax-exempt income
Distribution deduction
$12,000
( 6,000)
857
$ 6,857
Trust Taxation Example
(slide 7 of 9)
4. Determine trust taxable income after distribution deduction
Taxable income before distribution deduction
Distribution deduction
Taxable income
$10,557
( 6,857)
$ 3,700
Note: tax is limited to 15% since income is from capital gains
Trust Taxation Example
(slide 8 of 9)
5. Allocate DNI and its character to the beneficiaries.
DNI to Sue is $12,000, consisting of the following:
Gross income
Allocable fees
Net income, per
category
Interest
Income
$8,000
1,143
$6,857
Tax-Exempt
Income
$6,000
857
$5,143
Total .
$14,000
2,000
$12,000
Trust Taxation Example
(slide 9 of 9)
• Sue received a distribution of $12,000 from the
trust. She pays tax on $6,857, which
corresponds to tax on trust’s $8,000 of interest
income, and a deduction for a portion of the
trustee’s fees. She lost deductions of $857 for
fees allocated to tax-exempt income.
Refocus On The Big Picture (slide 1 of 4)
Anna Jiang and her family should consider the creation
of one or more trusts.
• One suggestion for the family might be:
1. Anna transfers some or all of the $2 million assets to the
Jiang Family Trust, with quarterly income payable to Tom
and the children.
– Recipients would be designated by the trustee, but all of the entity’s
accounting income must be distributed.
– In this way, the income could be directed to the beneficiary most in
need (e.g., to pay for education expenses or to start a new business).
– The children could be named first-tier beneficiaries, with Tom as a
second-tier income beneficiary.
Refocus On The Big Picture (slide 2 of 4)
2. While Anna is still healthy and earning a regular salary,
the trustee could accumulate the accounting income and
allow the corpus to build up.
– Alternatively, the trustee could make gifts to charity or fund
education plans for Bobby and Sally.
3. Anna should provide clear instructions to the trustee as to
her preferences on how the trust corpus should be
invested and specify which of Tom’s and the children’s
expenses should and should not be covered.
4. The children should be named as remainder beneficiaries
of the Jiang Family Trust.
– In case the trust corpus exceeds the estate tax bypass amount,
other remainder beneficiaries could be named in order to avoid
any generation-skipping tax (see Chapters 18 and 19).
5. Amendments to the trust document should be considered
whenever Tom and Anna update their wills.
Refocus On The Big Picture (slide 3 of 4)
What If?
• If Anna remains healthy, the Jiang Family Trust might
be terminated when the children reach the age of
majority, as the need for financial support will have
diminished.
• However, if Tom is unable or unwilling to take over
the management of the assets, the trust should
continue.
– In this event, the trustee might shift the focus to funding
long-term care for the couple, making charitable gifts, or
financing the education needs of grandchildren.
Refocus On The Big Picture (slide 4 of 4)
What If?
• The controlling trust document should be
worded to provide flexibility as to the purposes
and termination date of the trust.
• The trustee should be chosen from family
members or business associates who know
Anna and Tom well and are familiar with the
couple’s objectives.
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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