TRUST TAXATION: INCOME, CAPITAL GAINS, DISTRIBUTIONS
A.
When a Trust can Use a Grantor's Tax ID and When it Needs Its Own
Tax ID
I.
Trusts with gross income of $600 or more are required to file
an annual income tax return (IRS Form 1041, except certain
charitable trusts).1 If a trust beneficiary is a nonresident alien,
the trust must file an annual income tax return regardless of
gross income.2
II.
Non-grantor trusts
a.
Defined in the negative. That is, a non-grantor trust is
any trust that is not a “grantor trust” (to be discussed
later).
b.
A non-grantor trust is required to obtain its own tax ID
when property is transferred to the Trustee.
c.
Note that a formerly grantor trust that becomes a nongrantor trust will become a separate taxable entity
upon termination of grantor trust status and as such,
will be required at such time to obtain a tax ID (or new
tax ID if it already had one).
III.
Grantor trusts
a.
A “grantor trust” is a trust the property of which is
partly or wholly deemed to be owned, for federal
income tax purposes, by its grantor or a beneficiary
1
IRC § 6012(a)(4).
2
IRC § 6012(a)(5).
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under IRC §§ 671 – 678. Thus, all items of income,
deduction, and credit attributable to such trust
property is ultimately reported and taxable to such
deemed-owner.
i.
For example, a revocable trust is a grantor trust
to its grantor under IRC § 676 and as such, its
separate existence is ignored for federal income
tax purposes and all of trust property, for federal
income tax purposes, is treated as still owned by
the grantor.
b.
Reporting methods (3):
i.
Traditional method – Trustee must obtain a tax
ID and file a “skeletal” IRS Form 1041 with a
statement or letter that indicates the trust’s
income, deduction, and credit that are deemed
owned by its grantor. Practically speaking, this
is similar to a Schedule K-1.
ii.
Alternative Method 1 – The Trustee is not
required to obtain a tax ID and under this
method, the Trustee may furnish the name and
tax ID of the grantor and the address of the trust
to all payors of trust income.3
1.
Under this method, the Trustee is not
required to file any type of return with the
3
Treas. Reg. § 1.671-4(b)(2)(i)(A).
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IRS, but must furnish the grantor with a
statement:
A.
That shows all items of income,
deduction, and creditor for the
year; and
B.
That identifies the payor of each
item of income; and
C.
That provides the grantor with
information necessary to take
these
items
into
account
in
computing the grantor’s income;
and
D.
That informs the grantor that
these items must be included in
the grantor’s taxable income.4
iii.
Alternative Method 2 – Trustee must obtain a
tax ID and furnish to all payors during the year
the name, tax ID and address of the trust.5
Under this method, the trustee must file with the
IRS one or more 1099s showing the income paid
to the trust and showing the trust as the payor
and the grantor as the payee. This is a very
cumbersome method and rarely employed.
4
Treas. Reg. § 1.671-4(b)(2)(ii).
5
Treas. Reg. § 1.671-4(b)(2)(i)(B).
Page 3
B.
Structuring Trust Income Taxation
I.
Generally speaking, each non-grantor trust is a quasipassthrough entity that pays income tax on income that is not
distributed to its beneficiaries. To the extent a beneficiary
received
a
distribution
of
income,
the
income
tax
consequences generally flow through to the beneficiary who
must report the income on his or her income tax returns as if
he or she had received the income directly. IRC §§ 652 and
662. To accomplish this result, the trust receives a distribution
deduction for distributions of income currently made to
beneficiaries, subject to certain rules discussed below.
II.
C.
Tier Rule
Accounting vs. Taxable Income: Taxable Income Calculations
I.
IRC § 643(b) defines trust accounting income as “[t]he amount
of income of the…trust for the taxable year determined under
the terms of the governing instrument and applicable local
law. Items of gross income constituting extraordinary
dividends or taxable stock dividends which the fiduciary,
acting in good faith, determines to be allocated to principal
under the terms of the governing instrument and applicable
local law shall not be considered income.”
II.
Consequently, accounting income is receipts allocated to
income less expenditures or disbursements charged to
income.
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III.
The taxable income of a trust, on the other hand, is calculated
generally in the same manner as for individuals—that is,
taxable income is equal to gross income less certain allowable
deductions.6
Consequently, each non-grantor trust must
report all items of income under IRC §§ 61 and 691 (income in
respect of a decedent) and is entitled to the same deductions
allowed to individuals unless limited under certain IRC
Sections.
Many of the exceptions to the deductions are
provided for in IRC § 642.
D.
Distributable Net Income – IRC § 643(a)
I.
Distributable Net Income (or “DNI”) is a concept that is unique
to estates and non-grantor trusts, it preserves the character of
the trust’s income that is passed through to the beneficiaries
through distributions.
II.
Calculated as the trust’s taxable income with the following
modifications:
a.
Increased by the amount of the trust’s personal
exemption; and
b.
Increased by tax-exempt interest; and
c.
Increased by any deduction for distributions to
beneficiaries; and
d.
Reduced
by
any
capital
gains
allocated
to
corpus/principal.7
6
IRC §§ 641(b) and 63.
7
IRC § 643(a).
Page 5
E.
Capital Gains Tax
I.
Capital gains are derived from the sale or disposition of a
capital asset to the extent the amount realized from such sale
or disposition exceeds the cost basis of such capital asset.
II.
Net capital gains are included in gross income.8
III.
Capital gains are generally allocated to principal unless such
gains are allocated to income pursuant to the trust agreement
or local law.9
IV.
Capital gains tax rate varies depending on whether the net
capital gain is long-term or short-term.
Due to the
compressed nature of the tax brackets applicable to nongrantor trusts, the highest long-term capital gains rate (20%)
for undistributed capital gains is reached at a low amount of
income ($13,150). Undistributed short-term capital gains are
taxed the same as ordinary income and thus, can reach the
highest rate (37%) at that same threshold ($13,150).
V.
In addition, a 3.8% tax is imposed on certain passive net
investment income of a trust (including capital gains).10
F.
Basis Management
I.
The basis of property acquired by a trust from a decedent by
virtue of his or her death (that is, property that was included
8
IRC § 61(a)(3).
9
See O.C.G.A. § 53-12-420(2).
10
See IRC Section 1411.
Page 6
in the decedent’s gross estate) is generally the fair market
value of such property as of the decedent’s death.11
II.
All other property acquired by a trust generally receives a
carry-over basis (that is, the same basis as in the hands of the
transferor immediately prior to the transfer).12
G.
Trust Deductions, Elections, Expenses
I.
As noted above, non-grantor trusts are entitled to the same
deductions allowed to individuals unless limited under certain
IRC Sections. Most of the special rules that apply to nongrantor trusts are contained in IRC § 642. Examples include:
a.
The personal exemption applicable to complex trusts is
$100, and the personal exemption applicable to simple
trusts is $300.13
b.
IRC § 642(c) addresses the charitable deduction
available to non-grantor trusts.
It is important to
review the requirements of IRC 642(c) when drafting a
trust that is intended to make charitable contributions.
II.
Importantly, a non-grantor trust is not allowed to take a
deduction for expenses that have been claimed on the
grantor’s estate tax return under IRC §§ 2053 and 2054.14
11
IRC § 1014(a)(1). But see IRC § 691.
12
IRC § 1015(a).
13
IRC § 642(b)(2).
14
IRC § 642(g).
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III.
Some excess deductions and loss carryovers remaining on
termination of a non-grantor trust are carried over to the
beneficiaries who succeed to the property of the trust.15
IV.
Notably,
formerly
deductible
miscellaneous
itemized
deductions (e.g., investment advisory fees and tax advice that
would have been deductible under IRC § 212) are not
deductible under the TCJA.16
These are nondeductible
expenses of the trust.
V.
Certain expenses that are unique to trusts and estates are
deductible and not subject to the 2% floor.17 The test to
determine whether an expense is deductible under IRC § 67(e)
is whether an individual would have incurred such cost in the
absence of a trust.18 Examples: fiduciary bond premiums and
probate fees.
VI.
Non-grantor trusts are also entitled to the deductions under
IRC §§ 199A, 651, and 661. These are discussed in greater
detail below.
VII.
Practitioners must be aware of various elections applicable to
non-grantor trusts. Common elections include the following:
a.
An election to be treated as an ESBT or QSST if the trust
will be holding S corporation stock.
15
IRC § 642(h).
16
IRC § 67(g).
17
IRC § 67(e).
18
Knight, Trustee v. Comm’r, 552 U.S. 181 (2008).
Page 8
b.
An election under IRC § 645 to treat a qualified
revocable trust as part of the estate for federal income
tax purposes.
c.
An election under IRC § 663(b) to treat distributions
made within the first 65 days of the following tax year
of the trust as having been made in the previous year.
H.
Qualifying for the 199A 20% Deduction
I.
Deduction added to the IRC as part of the TCJA of 2017. The
deduction will expire at the end of year 2025.
II.
Allows taxpayers (other than C corporations) to deduct from
their taxable income up to 20% of the net ordinary income
derived from certain qualified businesses.
III.
The deduction is limited to the lesser of:
a.
(i) 20% of the taxable income of the non-grantor trust
(excluding capital gains) and
b.
(ii) 20% of the QBI
i.
QBI is business income derived from a qualified
trade or business.
A “qualified trade or
business” is any trade or business other than a
“specified service trade or business” (“SSTB”)
and excluding any income derived in the
capacity as an employee.19 “SSTB” is any trade
or business involving the performance of
services in the fields of health, law, accounting,
19
IRC § 199A(d)(1).
Page 9
actuarial sciences, performing arts, consulting,
athletics, financial services, and various others
where the principal asset of the trade or
business is the reputation or skill of one or more
of its employees or owners.20 This is usually not
an issue for non-grantor trusts.
ii.
There are various limitations on the QBI
depending on (i) the non-grantor trust’s taxable
income, (ii) type of trade or business, (ii) the
amount of W-2 wages paid with respect to such
trade or business and (iii) the unadjusted basis
of qualified property held for use in such trade
or business.
iii.
This is a very complex computation typically
done by software.
IV.
Important rules for non-grantor trusts in relation to the 199A
deduction
a.
The threshold taxable income amount over which the
199A deduction is limited is $164,900 (for 2021), and
such threshold amount considers the deduction for
distributions to beneficiaries.21
b.
The threshold taxable income amount and the various
other items (e.g., basis of property and W-2 wages) that
20
See IRC § 199A(d)(2).
21
Treas. Reg. § 1.199A-6(d)(3)(iv).
Page 10
enter into the calculation of QBI is determined at the
entity level.
c.
After the determination of the various items that enter
into the calculation of QBI, those items are allocated
between the non-grantor trust and its beneficiaries on
the basis of DNI.22
I.
Discretionary Distributions in Lieu of Tax
I.
Generally speaking, a non-grantor trust is allowed a deduction
for distributions made by such trust to its beneficiaries.23 The
deduction has limitations which are discussed below.
II.
As a result, distributions generally reduce or eliminate the
income tax liability of the non-grantor trust. To the extent the
non-grantor trust accumulates income, the trust will be
required to pay income tax on such accumulated income.
J.
Tax Consequences of Distributions
I.
Simple Trusts
a.
A simple trust is a non-grantor trust that (i) is required
to distribute all of its fiduciary accounting income to its
beneficiaries currently, (ii) is prohibited from making
any current distributions to tax-exempt organizations
under IRC § 642(c), and (iii) does not distribute any
principal to its beneficiaries currently.24
22
Treas. Reg. § 1.199A-6(d)(3)(iii).
23
IRC §§ 651 and 661.
24
IRC § 651(a).
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b.
The distribution deduction for simple trusts is limited
to the lesser of the trust’s (i) DNI reduced by taxexempt income of the trust and any deductions
allocable to such tax-exempt income and (ii) fiduciary
accounting income.25
c.
Unless allocated to income and distributed, capital
gains are ordinarily taxable to the trust and paid by the
trust.
d.
A beneficiary who receives a distribution from a simple
trust is required to include in his or her gross income
the amount of income that was deducted.26 Moreover,
the character of the income passes through from the
trust to the beneficiary.27
II.
Complex Trusts
a.
All other non-grantor trusts that are not “simple trusts,”
(as defined above) are complex trusts.28
b.
The distribution deduction for complex trusts is equal
to the sum of (i) the amount of income required to be
distributed and (ii) any other amounts that are
“properly paid or credited or required to be distribute
25
IRC § 651(b).
26
IRC § 652(a).
27
IRC § 652(b).
28
See IRC § 661 (“other than a trust to which subpart B applies”).
Page 12
for such taxable year”; provided, however, such
deduction is limited to the trust’s DNI.29
c.
Generally, distributions will carry out income of the
complex trust (to the extent of DNI, as adjusted for taxexempt income and allocable deductions) to its
beneficiaries who must report such income on their
income tax returns.30
i.
Tier system –
1.
Tier 1 – Mandatory distributions of
income.31 DNI is allocated to this tier
first.
2.
Tier
2
–
All
other
deductible
distributions.32 To the extent DNI is not
fully allocated to Tier 1 (above), the
remaining
DNI
is
allocated
proportionately among the beneficiaries
who receive all other distributions.
ii.
Exceptions to the rule that distributions carry
out income to the recipient-beneficiary:
1.
Amounts paid or credited as a gift or
bequest of a “specific sum of money or of
29
IRC § 661(a) and (c).
30
IRC §§ 661(b) and 662
31
IRC § 662(a)(1).
32
IRC § 662(a)(2).
Page 13
specific property” that is paid or credited
all at once or in not more than 3
installments.33
2.
Amounts paid or permanently set aside
or otherwise qualifying for the charitable
deduction under IRC § 642(c).34
3.
Double deduction for distribution is
denied if credited in a preceding year.35
K.
Accumulation Distribution for Some Complex Trusts36
I.
The after-tax undistributed income of a complex trust that is
eventually distributed to a beneficiary is subject to a
“throwback tax.”
The throwback tax does not apply to
distributions from qualified trust after 1998. For this purpose,
a “qualified trust” is any trust other than (i) a foreign trust, (ii)
a domestic trust that was at any time a foreign trust, or (iii) a
domestic trust that was created before March 1, 1984 (other
than a trust that would not be aggregated under IRC § 643(f)).
L.
Form 1041 Preparation
I.
Gross income is reported on Lines 1-9.
II.
Deductions are reported on Lines 10-22.
33
IRC § 663(a)(1).
34
IRC § 663(a)(2).
35
IRC § 663(a)(3).
36
IRC § 665.
Page 14
a.
The charitable contribution under IRC § 642(c) is
calculated on Schedule A.
b.
The distribution deduction under IRC §§ 651 or 661 is
calculated on Schedule B.
III.
Tax computation and payments are resolved in Lines 23-30.
a.
The computation of the tax and payments are made on
Schedule G.
M.
Tax Elections and Other Post-Mortem Tax Planning
I.
IRC § 645 – Allows a qualified revocable trust to be treated as
part of the probate estate.
This election may provide an
opportunity to defer payment of income tax on income
accumulated within the trust if a fiscal year is selected.
II.
IRC 663(b) – Allows a trust to treat a distribution made or
credited within the first 65 days of the next tax year as having
been made on the last day of the preceding tax year.
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