INCOME TAXATION OF
TRUST & ESTATES
SUBCHAPTER J
WILLIAM A. SNYDER
NICHOLAS E. CHRISTIN
CHAPTER 1
Introduction to
Subchapter J &
Calculation of FAI
ROADMAP
This presentation should enable you to
understand:
1.
In basic terms, how a simple trust,
complex trust and estate are taxed;
2.
How to allocate receipts and
disbursements to income or principal;
3.
Basic considerations in selecting a tax
year for estates and trusts;
4.
How will a beneficiary be taxed on a
distribution from a trust or estate;
ROADMAP
5.
6.
7.
Strategies to fully utilize deductions;
Tax consequences on funding various
trusts with appreciated property; and
When a beneficiary receives
appreciated assets what are tax
consequences in terms of gain
recognized and basis to the beneficiary.
HYBRID TAXATION
 Income will be taxed to either
Fiduciary or Beneficiary
 EITHER/OR model of Taxation
 No income will be double taxed
TAX RATES
 Prior to 1986, estates and trusts
reached their highest marginal
income tax bracket at or about the
same level as single taxpayers.
 For 2010, estates and trusts reach
their highest marginal bracket at
$11,200 of taxable income, whereas
taxpayers filing joint returns reach
their highest marginal bracket at
$373,650.
Section §641(b)
 Computation & Payment
“The taxable income of an estate
or trust shall be computed in
the same manner as in the case
of an individual, except as
otherwise proved in this part”
FIDUCIARY
ACCOUNTING INCOME
(FAI)
DEFINITION OF INCOME
 §643(b)
“For purposes of this subpart and
subparts B, C, and D, the term “income”,
when not preceded by the words
“taxable”, “distributable net”,
“undistributed net”, or “gross”, means
the amount of income of the estate or
trust for the taxable year determined
under the terms of the governing
instrument and applicable local law.”
Section 643(b)
 Section 643(b) directs us first to
GOVERNING INSTRUMENT & LOCAL LAW.
 The presentation will focus on FLORIDA law, but
out-of-state-ers will substitute their applicable
state law here.
 In FLORIDA – we look to the
UNIFORM PRINCIPAL AND INCOME ACT
(Codified in Chapter 738)
HOWEVER …
GOVERNING INSTRUMENT TRUMPS!
 For Allocation of
Income & Principal
ALWAYS look to
governing instrument
first, even before
STATE LAW
 If Fiduciary granted
discretion in
instrument, discretion
trumps state law.
Section 643(b)
 IF there is no discretionary power and no
provisions in the governing instrument,
then the UNIFORM PRINCIPAL & INCOME
ACT applies in Florida.
 If there is no rule in the UNIFORM
PRINCIPAL & INCOME ACT that pertains
to a receipt or charge, then the DEFAULT
allocation is to PRINCIPAL.
UNIFORM PRINCIPAL & INCOME ACT
FAI
 Used to calculate
 Tells us HOW to characterize the
RECEIPTS and EXPENDITURES of
the estate or trust as INCOME or
PRINCIPAL.
 Trusts are unique in that they have
both INCOME and PRINCIPAL
beneficiaries.
 IF a receipt is determined to be
income, the income beneficiary will
benefit to the detriment of the
principal beneficiary.
INCOME VS. PRINCIPAL
ITEMS ALLOCATED TO PRINCIPAL
ITEMS allocated to Principal:
1. To the extent not allocated to income under the UPIA, assets
received from a transferor during the transferor’s lifetime, a
decedent’s estate, a trust with a terminating income interest,
or a payor under a contract naming the trust or its trustee as a
beneficiary.
2. Money or other property received from the sale, exchange,
liquidation, or change in form of a principal asset, including
realized profit
EXPENSES allocated to Principal:
1.
Commissions on sale of an asset
2.
Cost of capital improvements
ITEMS ALLOCATED TO INCOME
• For FAI – Income is a
NET amount
INCOME:
1. interest from bonds
2. certificates of deposit
3.
cash dividends from stock
4. rental income from real estate
5. items of ordinary income
EXPENSES:
1. income taxes, property taxes
2. maintenance costs
SPLIT ALLOCATION
 FIDUCIARY FEES and
ADMINISTRATION EXPENSES for
trusts are typically SPLIT equally
between Income & Principal, unless
specifically allocated by State law or the
governing instrument.
CHAPTER 2
Calculation of Gross
Income & Tentative
Taxable Income
TAXABLE YEARS
OF TRUSTS & ESTATES
 Election under §645 with respect to
Qualified Revocable Trusts (QRT)
 Factors to consider when selecting an
estate’s year end
TENTATIVE TAXABLE INCOME
TTI = TAXABLE INCOME – DISTRIBUTION DEDUCTION
TTI is an intermediate step in calculating DNI
Section 63(a) says:
TAXABLE INCOME =
GROSS INCOME – DEDUCTIONS
ITEMS EXCLUDED FROM
GROSS INCOME
 SECTION 102 (a):
GROSS INCOME does NOT include property acquired by gift.
 SECTION 102(b):
Once property starts to generate income,
then it will be taxed.
 ALSO excluded from gross income:
1. Life insurance proceeds
2. Tax-exempt interest
3. Other items listed in code Section §103-139A
DEDUCTIONS
 SECTION §63 – STANDARD DEDUCTION:
There is NO standard deduction for a trust. 
 SECTION §642 - PERSONAL EXEMPTION:
$100 - Complex Trust
$300 - Simple Trust
$600 - Estate
DEDUCTIONS
 SECTION § 642(C ) – CHARITABLE DEDUCTION
§ 642( C) is not as limited as §170
Charitable Deduction is
allowable up to the amount
of GROSS INCOME.
DEDUCTIONS
 SECTION § 642(C ) – CHARITABLE DEDUCTION
Donation MUST be distributed pursuant to terms
of the governing instrument
distreibututions of
No deduction allowed for
amounts other than gross
income, such as tax exempt
income or corpus.
DEDUCTIONS
 SECTION §212 DEDUCTION:
EXPENSES INCURRED IN THE PRODUCTION OF INCOME
I.E. Basic Administrative Expenses
Unlike §162 for trade or business expenses,
§212 expenses in excess of income
do NOT create a net operating loss –
and are WASTED in a non-final year.
DEDUCTIONS
 SECTION §167 – DEPRECIATION DEDUCTION:
Section §167 is governed by the Regulations
GENERAL RULE:
DEPRECIATION FOLLOWS
INCOME.
DEDUCTIONS
 SECTION §67(e) & KNIGHT V. COMMISSIONER
QUESTION TO SUPREME COURT:
Are investment advisory fees incurred
to administer a trust deductible without
regard to the 2% floor?
ANSWER: NO! They are not unique
to trusts and are subject to the 2% floor.
DEDUCTIONS
 PROPOSED REGULATIONS UNDER §67(e)
UNIQUE OR NOT UNIQUE?
 Under the proposed Regs, Trustees must separate
trust administration expenses into those that are
unique to trusts and those that are not
 Referred to as “UNBUNDLING”
DEDUCTIONS
EXPENSES ALLOCABLE TO TAX-EXEMPT INTEREST
Deductions that would be allowable to an estate or
trust are DISALLOWED to the extent they are
attributable or apportioned to
TAX-EXEMPT INCOME
DEDUCTIONS
 Section §642(g) –
DISALLOWANCE OF DOUBLE DEDUCTION:
NO DOUBLE
DIPPING!
DEDUCTIONS
DIRECT & INDIRECT EXPENSES
ALLOCATION OF DEDUCTION RULES:
1. All deductible items directly attributable to one
class of income are allocated thereto.
2. Deduction that are not directly attributable to a
specific class of income may be allocated to any
item of income.
DEDUCTIONS
 HUBERT REGULATIONS:
Treasury Regulation §20.2056(b) – 4
Used to determine the deductibility of
“transmission expenses” that may be charged to
the marital bequest if it’s a residuary bequest.
MANAGEMENT vs. TRANSMISSION EXPENSES
ILLUSTRATION
FOR
CHAPTER 2
SEE PAGE 19 OF MATERIALS
CHAPTER 3
Distributable Net
Income
DISTRIBUTABLE NET INCOME (DNI)
DNI - the KEY to Subchapter J!
DISTRIBUTABLE NET INCOME (DNI)
 DNI is both a QUANTITATIVE & QUALITATIVE
measurement
 QUANTITATIVE limitation of the deduction
for the amount distributed to beneficiary
 QUALITATIVE characterization of the
distributions (i.e. ordinary income or tax
exempt)
DISTRIBUTABLE NET INCOME (DNI)
STEP ONE: Find TTI
STEP TWO: Apply modifications in §643 to TTI to
reach DNI.
SIMPLIFIED CALCULATION
TTI
XXXX
§643(a)(2)
+
§643(a)(3
< >
§643(a)(5)
+ Tax Exempt Int.
<§265 Exp.>
DISTRIBUTABLE NET INCOME (DNI)
 NO §651 or §661 DEDUCTION:
Because DNI serves as a QUANTITATIVE limit on
the distribution deduction, DNI does NOT take
into account the §651 distribution deduction for
simple trusts, nor the §661 distribution
deduction for complex trusts or estates.
DISTRIBUTABLE NET INCOME (DNI)
 NO §642 PERSONAL EXEMPTION
In order to prevent use of 2 personal exemptions
(one for the Trust and one for the beneficiary),
the Trust’s personal exemption under §642 is not
taken into account when calculating DNI.
DISTRIBUTABLE NET INCOME (DNI)
 EXCLUSION OF CAPITAL GAINS
GENERAL RULE: capital gains and losses will be
excluded from DNI.
HOWEVER, like every general rule – there is an
EXCEPTION: included in DNI if
Capital gains are allocated to FAI, allocated to
corpus, and paid, credited, or required to be
distributed to any beneficiary, or allocated to
corpus and paid, permanently set aside for
charitable purposes under §642(c)
DISTRIBUTABLE NET INCOME (DNI)
 ADD BACK NET TAX-EXEMPT INTEREST
Net tax-exempt
interest is tax exempt
interest reduced by any
amounts which would
be deductible in respect
of disbursement allocable to such interests
but for the provisions of §265 (relating to
disallowance of certain deductions).
ILLUSTRATION
FOR
CHAPTER 3
SEE PAGE 23 OF MATERIALS
CHAPTER 4
Simple Trusts
WHAT IS A SIMPLE TRUST?
THREE REQUIREMENTS:
1. Trust instrument must require ALL trust income
be distributed currently
2. Trust must make NO distributions from
principal in the taxable year of the trust
3. Trust must make no disbursements deductible
as charitable contributions under §642(c)
WHAT IS A COMPLEX TRUST?
A: Any trust that fails one of the
simple trust requirements!
A trust may be a simple
trust one year and a
complex trust in the
next year, depending on
whether it meets the
three simple trust requirements.
SIMPLE TRUSTS
 §651 Distribution Deduction
Simple Trusts get a §651 Distribution
Deduction for the FAI that the governing
instrument requires it to distribute.
LIMITATIONS on deduction:
1. §651 Deduction limited by DNI
2. No deduction allowed for tax-exempt
income
SIMPLE TRUSTS
 §651 DISTRIBUTION DEDUCTION
If FAI exceeds DNI, then the deduction
shall be limited to DNI. For this purpose,
the computation of DNI shall not include
tax-exempt income and the deductions
allocable thereto.
SIMPLE TRUSTS
 §651 DISTRIBUTION DEDUCTION
SIMPLIFIED CALCULATION
§651(a) Starting Point – FAI (See §643(b))
§651(b) Limit DNI (See §643(a))
§651(b) Adjust lesser of DNI or FAI by
removing net items of tax exempt income.
SIMPLE TRUSTS
§652 POTENTIAL GROSS INCOME (GI) OF
BENEFICIARY
 §652 determines the potential GI of a
beneficiary – which is the amount of income
required to be distributed to a beneficiary.
 If FAI exceeds DNI, and there is only 1 income
beneficiary, then beneficiary includes all of the
DNI in GI.
 If there are multiple beneficiaries, the total GI
includable by all beneficiaries is limited to DNI
and the amount is prorated among the
beneficiaries.
CHARACTER RULES
§652 (b) Characterization Rules
Amounts reported in beneficiaries Gross
Income shall have the same character in
the hands of the beneficiary as in the
hands of the trust.
Beneficiaries are treated as receiving their
pro rata shares of the NET items of DNI.
CHARACTER RULES - 2
SIMPLIFIED CALCULATION
§652(a) of each bene X DNI = §652(a) amount
Total §652(a)
§652(a) amount x Each Item of DNI/DNI
NET TAXABLE AMOUNT TO
BENEFICIARIES
Once we know the character of each item of
income under §652(b), we can determine
the net amount taxable to beneficiaries.
TAXABLE AMOUNT – TAX-EXEMPT INCOME =
NET TAXABLE AMOUNT
ILLUSTRATION
FOR
CHAPTER 4
SEE PAGE 30 OF MATERIALS
CHAPTER 5
Complex Trusts
COMPLEX TRUSTS
Q: WHAT IS A COMPLEX TRUST?
A: ONE THAT IS
NOT A SIMPLE TRUST!
i.e. A trust that fails one
of the three simple trust requirements
COMPLEX TRUSTS
Section §661 - Distribution Deduction for Complex
Trusts & Estates –
§661(a) – gives the amount of the deduction
§661(b) – gives the amount of tax exempt interest in
the amount distributed
§661(c ) – gives a limitation on the deduction by
removing the amount of net tax exempt interest
distributed
COMPLEX TRUSTS
§661 (a) creates a TIER system for beneficiaries. The total
distribution deduction equals the sum of §661 (a) (1)
amount and the §661 (a) (2) amount.
TIER ONE BENEFICIARIES
§661 (a) (1) amount is the amount that TIER ONE
beneficiaries receive. The first TIER beneficiaries are
beneficiaries who receive distributions of income
required to be distributed currently. The first TIER
distributions are deductible to the extent of DNI. They
receive priority DNI allocations proportionally based
on their share of FAI.
COMPLEX TRUSTS
TIER TWO BENEFICIARIES
§661(a)(2) tells us that the second TIER beneficiaries
receive “any other amount properly paid or credited or
required to be distributed for such taxable year.” This
includes discretionary distributions of income or
corpus and mandatory distributions of corpus.
The distributions to TIER TWO beneficiaries are also
deductible to the trust to extend of DNI.
 They share pro-rata any left over DNI
 Any amount they receive in excess of DNI = a
§102(a) tax-free GIFT!
COMPLEX TRUSTS
TAXABLE INCOME FOR COMPLEX TRUSTS
is very similar to Simple Trust calculation:
TAXABLE INCOME =
TTI - §661 DISTRIBUTION DEDUCTION
COMPLEX TRUSTS
§662 – Potential Gross income of
Beneficiaries
 Beneficiaries are taxed on distributions
ONLY to the extent that distributions
carry out DNI.
 I.E. the upper limit of the taxable
amount to the beneficiaries is DNI.
COMPLEX TRUSTS
§662(b) – Character of Beneficiary
Amounts
As with Simple Trusts, the amounts from §662(a) will
have the same character in the hands of the
beneficiaries as they had in the estate or trust.
§662(a) x each item of DNI
DNI
COMPLEX TRUSTS
NOTE: 65 DAY ELECTION
Under §663(b), a trustee can elect to treat
distributions made within the first 65 days of
the taxable year of a complex trust as paid in
the preceding year.
ILLUSTRATION
FOR
CHAPTER 5
SEE PAGE 40 OF MATERIALS
CHAPTER 6
SPECIFIC BEQUESTS
& §663(a)
SPECIFIC BEQUESTS & §663(a)
§663(a) – EXCEPTION
 Under §663(a), distributions of specific sums
of money or specific property are NOT
considered amounts properly paid to
beneficiaries for purposes of §661 or §662.
 Specific distributions are NEITHER
deductible by the trust NOR taxable to the
beneficiary.
4 REQUIREMENTS OF §663(a)
1. The amount must be properly paid or credited as a
gift or bequest;
2. The gift or bequest must be specific (if in money, a
specific sum of money, or if in property, specific
property);
3. The fiduciary must in fact pay or credit the amount
or property at once or in not more than three
installments; and
4. The gift or bequest must not be payable, pursuant to
the terms of the governing instrument, only from
the income
ILLUSTRATION
FOR
CHAPTER 6
SEE PAGE 46 OF MATERIALS
CHAPTER 7
DISTRIBUTIONS IN KIND
& KENAN ISSUES
DISTRIBUTIONS IN KIND
 KENAN V. COMMISSIONER

A distribution of appreciated non-cash assets
by a fiduciary in satisfaction of a pecuniary
obligation triggers realization of GAIN by the
trust or estate.

I.E. included in gross income and tentative taxable
income of the trust!
I.E. In certain instances a distribution of property is
treated as a sale or exchange

HOWEVER . . .
KENAN & FRACTIONAL SHARES
 HOWEVER,
If a formula gift or bequest (whether fixed
under the terms of the document or
ascertainable by formula) consists not of
an amount of money, but instead a
SHARE of all the entity’s assets, Kenan
does NOT apply.
TWO-PART KENAN TEST
 TWO REQUIREMENTS FOR KENAN:
1. There must be an obligation
to pay a specific amount of
money or to transfer a specific
property; and
2. There must be a satisfaction of that
obligation by a transfer of OTHER property
KENAN CONSISTENT WITH
EITHER/OR TAXATION SCHEME:
ILLUSTRATION
FOR
CHAPTER 7
SEE PAGE 49 OF MATERIALS
CHAPTER 8
§643(e)(3) ELECTION:
PULLING THE TRIGGER
§643(e)(3) Election
“PULLING THE TRIGGER” – Prof. Calfee
§643(e)(3) Election
GENERAL RULE: When a Fiduciary distributes
property in kind, this is generally NOT a
realization event.
EXECPTION: Under §643(e)(3) a fiduciary CAN
elect to treat an in-kind distribution (not in
satisfaction of a pecuniary amount or in place
of another assets) as a realization event, i.e.
can elect to recognize gain to the trust or
estate.
§643(e)(3) Election
IN SUMMARY, §643(e)(3) does 3 things:
1. Determines amount of gain or loss to the
entity recognized upon distribution to
beneficiary;
2. Tells the amount distributed for purposes of
§661 deduction and §662 inclusion; and
3. Tells the basis of the property in the hands of
the beneficiary.
NO §643(e)(3) Losses
Unlike in Kenan situations, §267 does NOT
allow entities to trigger a §643(e) loss.
ONLY gains may
be recognized
under §643(e)
§643(e)(3) & DNI
AS A GENERAL, LOGICAL RULE:
Elective gains under §643(e)(3) do NOT
enter into computation of DNI,
because gain is taxed to the entity
NOT the beneficiary.
§643(e)(3), §663(a) and Kenan
If §663(a) applies,
then §643(e)(3) does NOT apply.
KENAN gains and losses are MANDATORY,
while §643(e)(3) gains are ELECTIVE.
STRATEGY: PLANNING WITH
§643(e)(3)
ILLUSTRATION
FOR
CHAPTER 8
SEE PAGE 55 OF MATERIALS
CHAPTER 9
TERMINATION
PLAN AHEAD
FOR EXCESS LOSSES AND DEDUCTIONS
IN YEAR OF TERMINATION
§642(h)
Under §642(h), when an estate or trust terminates at
a time when it has unused net operating losses or
capital loss carryovers, or when it deductions
exceed its gross income
for the taxable year, unused
deductions can be transferred
to the Beneficiaries!
SUMMARY
ILLUSTRATION
#1
SEE PAGE 59 OF MATERIALS