Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Income Taxation Of Trusts & Estates
• General Scheme of Taxation: Trusts or estates pay
income tax on the amount retained and beneficiaries pay income
tax on the amount of income actually distributed to them, so that
income is taxed only once
• DNI (Distributable Net Income):
– Ensures the trust or estate receives a deduction for the
amount distributed and provides a limit for the deduction
– Sets the limit on the portion of distributions taxable to
beneficiaries
– “Conduit theory” ensures the character of distributions to
beneficiaries remains the same as in the hands of the trust or
estate
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
DNI Example 1
Trust earns $10,000 of distributable net income. Trustee distributes
$6,000 to the beneficiary, receives a $6,000 deduction, and retains
the remaining $4,000 as undistributed net income on which trustee
must pay income taxes at tax rates.
Beneficiary
Reports $6,000 of
income on
individual tax
return
$6,000
Distribution
DNI $10,000
earned income
$4,000 of
undistributed net
income (UNI)
taxed at trust rates
Trust Corpus
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
DNI Example 2
Trust earns $10,000 of distributable net income. Trustee distributes
$12,000 to the beneficiary, receives a $10,000 deduction, and the
trust has no tax liability. The beneficiary will have to pay taxes on
the $10,000 as ordinary income, but the $2,000 from trust corpus will
be tax free to the beneficiary.
Beneficiary
Reports $10,000 of
income as taxable
and $2,000 as
return of principal on
individual tax return
$10,000
Distribution
DNI $10,000
earned income
Assume $0 UNI
$2,000
Distribution
Copyright 2011, The National Underwriter Company
Trust Corpus
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Income Taxation of Trusts
Trust distributions retain the character of the income earned in the
trust when they are distributed to the beneficiary. For example, if a
Charitable Remainder Trust makes a distribution of $50,000, the
beneficiary will be taxed according to the “income first rule”:
Beneficiary
Reports income based
on the character of the
trust distribution. All
income received by the
beneficiary will be
taxed as ordinary
income to the extent
the trust earns ordinary
income, then capital
gain, then tax free.
$10,000 taxed as
ordinary income
$30,000 taxed as
capital gain
$8,000 tax free
$2,000 tax free
return of principal
Copyright 2011, The National Underwriter Company
Interest income
$10,000
Capital gain
income $30,000
Tax-free income
$8,000
Trust Corpus
$1,000,000
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Income Taxation Of Trusts
• Basic Question: Who will be taxed on the trust
income? The beneficiary, the trust or the grantor?
• Multiple Trust Rule: If trusts have the same:
– Grantor(s)
– Beneficiaries and
– The principal purpose of the trust is avoidance of federal
income tax
the trusts are treated as one trust and their incomes
aggregated in computing federal income tax liability
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Income Taxation Of Trusts & Estates (2011)
Taxable Income
$0
to $2,300
2,300
to
5,450
5,450
to
8,300
8,300
to 11,350
11,350
to
-------
Tax on.
Lower.
Amount
$0
345.00
1,132.50
1,930.50
2,937.00
Copyright 2011, The National Underwriter Company
Tax
Rate on
Excess
15%
25%
28%
33%
35%
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Simple vs. Complex Trust
• Simple Trust: Trust agreement requires
– All trust income to be distributed currently to beneficiaries
– Trust may not make distributions from amounts other than
current income
– Principal may not be distributed
– No charitable gifts can be made by this type of trust or it will
be deemed a complex trust for that year
– Personal exemption $300
• Complex Trust: Any trust which is not a simple trust
– Allowed deduction for actual income distributions
– Taxed at trust rates on income retained
– Personal exemption $100
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Grantor Trust Rules
• Grantor is taxed on the trust income whether or not
grantor actually receives the income
• IRC Sections 671 - 677
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 671 Substantial Owner Rules
• Grantor under this rule is the owner only for income
tax purposes, the estate tax exclusion must be
tested under estate tax rules
• Grantor deemed recipient of trust income and
allowed deduction to extent of trust expenses or
credits
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 673 Reversionary Interest Rules
• For income tax purposes, the grantor is treated as
the owner of that portion of the trust:
– In which the grantor or grantor’s spouse hold a reversionary
interest in corpus or income
– The reversionary interest exceeds 5% of the value of the
property in which the reversionary interest is retained at
time of inception or addition
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 674 Beneficial Interest Rules
• Where grantor of a trust, a nonadverse party, or both
can control beneficial enjoyment of a trust, the
grantor is taxed as the owner of the trust for income
tax purposes
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 675 Administrative Power Rules
• Retention by grantor, or a nonadverse party, of the
following administrative powers can cause the
grantor to be deemed the owner of the corpus of a
trust for income tax purposes:
– Powers that enable the grantor to purchase, exchange, or
otherwise deal with or dispose of the corpus or income of
the trust for less than adequate consideration in money or
money’s worth;
– Powers that allow the grantor to borrow trust corpus or
income without adequate interest or security;
Copyright 2011, The National Underwriter Company
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 675 Administrative Power Rules
• Retention by grantor, or a nonadverse party, of the
following administrative powers can cause the
grantor to be deemed the owner of the corpus of a
trust for income tax purposes (cont’d):
– Powers of administration exercisable in a nonfiduciary
capacity by any person without the consent or approval of
any person in a fiduciary capacity such as:
• Power to vote stock of a corporation in which grantor or the
trust has a significant voting interest
• Power to control investment of trust funds
• Power to reacquire the trust corpus by substituting other
property of an equivalent value
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 676 Power To Revoke Rules
• If grantor can revoke the trust either acting alone
or with a nonadverse party, the grantor is treated
as the owner of that portion of the trust for income
tax purposes
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 677 Income For Benefit of Grantor Rules
• Grantor treated as owner of a trust for income tax
purposes if income from the trust is or may:
– At the discretion of the grantor, a nonadverse party, or both,
be:
• Distributed to the grantor
• Held or accumulated for future distribution to the grantor, or
• Applied to payment of premiums on life insurance policies on
life of the grantor or grantor’s spouse
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 677 Income For Benefit of Grantor Rules
• Grantor treated as owner of a trust for income tax
purposes if income is:
– Distributed to the grantor’s spouse
– Held or applied for future distribution to the grantor’s
spouse, or
– Applied to payment of premiums on life insurance policies
on life of the grantor’s spouse
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 678 Person Other Than Grantor Rules
• If a person other than the grantor has the power,
exercisable solely by himself, to vest corpus or
income in himself, such a person is treated as the
owner of the corpus, so that trust income will be
taxable to that individual
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Income Taxation of Estates
• Decedent’s Final Return
– Must be filed on the regular due date, April 15th, of the
following year
– Executor or administrator responsible for filing decedent’s
individual return and the estate income tax return
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Sec. 691 Income In Respect Of A Decedent (IRD)
• Cash-basis vs. accrual taxpayers
• Income received after decedent’s death is taxed to
the recipient of the payments in the same manner it
would have been taxed to the decedent
• No step-up in basis for IRD income
• Estate or beneficiary that includes an IRD item is
entitled to a deduction on the same income tax
return for the amount of additional federal estate tax
attributable to inclusion of that item in decedent’s
federal estate tax return
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Taxation Of The Estate
• The estate is a separate taxable entity that must
pay tax on its income at the compressed trust and
estate tax rates
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Taxation Of The Estate
• Estate income tax deductions:
– Reasonable administrative costs including executor’s fees,
legal fees in connection with administration of the estate,
expenses of preparing the income tax return of the estate
• Note: Executor must decide whether it is more advantageous
to take these expenses as income or estate tax deductions
– $600 personal exemption
– Deduction for amounts distributed to beneficiaries
• Note: “Income first rule” applies to distributions so that no
matter which property the executor pays the income from, the
distribution will be deemed to have come from ordinary income
first then principal
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Basis Determination
• What Basis Is & Why It Is Important
– Basis is what a person or other taxpayer “paid” for the
property
– Basis is used to determine how much gain (or loss) is
incurred upon a sale of property
– Gain = Amount realized – Adjusted basis
• Note: Higher the basis  Lower the gain
– Basis is the key factor in determining the allowable
depreciation deduction taken on buildings and other
business investments
• Note: High basis advantageous
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
No Step-Up If Decedent Acquired Property By Gift
Within A Year Of Death If Property Left To Donor Or
Donor’s Spouse
- if decedent received gift of appreciated property during
the 1-year period ending on date of death and
- property acquired from decedent by (or passes from
decedent to) donor of property (or donor spouse)
Basis of that property hands of donor (or donor
spouse) is decedent’s adjusted basis of property
immediately before death.
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Effect Of Step-up Basis Rules On Stock
Redemption & Cross Purchase Agreements
Stock includable in decedent’s estate receives new
basis equal to either
- value at death
- alternative valuation date (if selected)
• Usually close to redemption value
• Typically, little to no gain recognized by estate or other
seller of stock upon redemption
Copyright 2011, The National Underwriter Company
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Overall Effect
• If low income tax basis in relation to market value,
have incentive to hold property until death so estate
can sell without income tax on appreciation in value
• If expect inflation, future increase in value, and
potential increase in death taxes, have incentive for
current sale
• If asset value falls below basis, consider sale and
recognize loss
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
EGTRRA 2001
• Provides replacement of stepped-up basis with
modified carryover basis system for one year for
property acquired from decedent dying in 2010
• Property receives basis equal to lesser of
– Adjusted basis of decedent (plus limited step-up amount)
– Fair market value of porperty on decedent date of death
Copyright 2011, The National Underwriter Company
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
EGTRRA 2001
• Executor of decedent’s estate may increase basis
transferred assets up to total of $1.3 million
• Property passing to decedent’s spouse may be
stepped-up an additional $3 million
• Step-up in basis for property acquired from
nonresident non-citizen decedent cannot exceed
$60,000
• Basis of any property cannot be stepped up above
fair market value
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
2010 Tax Act
• Repealed modified carryover basis rules for 2011
and 2012
• For 2010, the rules apply unless the executor elects
to subject the estate to the post 2010 estate tax
rules
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Issues in Community Property States
• Property held by spouses in a community property
state as the separate property of one spouse will be
included in that spouse’s estate and receive a new
basis at death
• Entire property can go to surviving spouse under the
marital deduction rules and will not be subject to tax
Copyright 2011, The National Underwriter Company
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Issues in Community Property States
• Important to distinguish between property held by
decedent as separate property and property held by
decedent and spouse as community property
– In both cases, property will receive step-up (or step-down)
to fair market value for federal estate tax purposes
– Value of community property will be lower because each
spouse owns only 50% of the property
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Federal Income Tax Issues
Chapter 19
Tools & Techniques of
Estate Planning
Basis Adj. for Taxable Distribution or Direct Skips
Fair market value of transferred property $1,000,000
Adjusted basis before GST transfer
$600,00
GST imposed on transfer (35% in 2011)
$350,000
Net appreciation [$1,000,000 - $600,000]
$400,000
Basis increase
[$35,000,000 x ($400,000 / $1,000,000)]
$140,000
Transferee’s basis [$600,000 + $140,000]
$740,000
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