Slide 15-1
Principles of Taxation:
Advanced Strategies
Chapter 15
 Income Taxation of Trusts and Estates

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 15-2
Trusts
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Created when a donor transfers property to a
fiduciary or trustee for the benefit of one or more
beneficiaries
Trust property is called corpus or principal
Two ways trusts may be created
 Donor may create during his or life (inter vivos
trust)
 May be created by will (testamentary trust)
McGraw-Hill/Irwin
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Slide 15-3
Trusts- Nontax Purposes
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May get professional management through use of
a corporate trustee such as a bank
Useful for providing for beneficiaries incapable of
managing property such as children
Useful if income beneficiaries different from
remaindermen
Trusts may be useful in minimizing estate costs
McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 15-4
Trusts

Donor control
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May be irrevocable

Donor gives up control over property
May be revocable

Donor may revoke trust and take back property

Result is incomplete gift for gift and estate tax
purposes

Treated as grantor trust with donor taxable on
all income even if trust is not revoked
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Slide 15-5
Trusts
Simple trust
 Trust required to distribute all of its
accounting income
 Makes no charitable contributions
 No distributions out of corpus
 Complex trust
 Any trust that is not a simple trust

McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 15-6
Taxation of Trust and Estates
(Overview)
Modified conduit approach
 Trusts and estates are allowed a deduction
for income distributed and taxed to their
beneficiaries
 Trusts and estates are taxable on any
income not distributed

McGraw-Hill/Irwin
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Slide 15-7
Trust Taxable Income
Calculation
Step 1: Calculate trust accounting income
Step 2: Calculate trust taxable income before
income distribution deduction
Step 3: Compute distributable net income (DNI) and
the distribution deduction
Step 4: Subtract the distribution deduction from the
amount in step 2 to determine trust
taxable income
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Slide 15-8
Trust Taxable Income
Calculation (continued)
Step 5: Calculate trust tax liability
Step 6: Allocated DNI and the distribution
deduction to the beneficiaries to
determine the amount and character of
income taxed to each beneficiary
McGraw-Hill/Irwin
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Slide 15-9
Trust Accounting Income
Importance: determines which items are
allocated to income and distributable to
beneficiaries and which items are allocated
to principal
 If trust document is silent on allocation,
state law controls

McGraw-Hill/Irwin
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Slide 15-10
Common Allocations
Income
Principal
Interest, dividends, rents,
royalties
Capital gains and losses on
investments
Operating income
Casualty losses and
insurance recoveries
Operating expense
Extraordinary repairs
Taxes levied on income
Taxes levied on principal
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Slide 15-11
Trust Taxable Income

Computed in a manner similar to individual
taxable income
 No adjusted gross income concept
 No standard deduction
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Slide 15-12
Depreciation
May be deductible by trust, beneficiaries or
allocated between them
 Trust document controls
 If document silent, depreciation apportioned
based on share of trust accounting income
 In such a situation a simple trust would
allocate all depreciation to beneficiaries

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Slide 15-13
Other Expenses
Any expense attributable to earning taxexempt income is nondeductible
 Indirect expenses such as trust
administration fees must be allocated
between taxable and tax-exempt income
based upon their proportion of total income

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Slide 15-14
Exemptions
All trusts entitled to a personal exemption
except in final year
 Trusts required to distribute all income
annually receive an exemption of $ 300
 Other trusts receive $ 100 exemption

McGraw-Hill/Irwin
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Slide 15-15
Distributable Net Income

Defines the maximum possible income
distribution deduction and maximum possible
income from trust taxable to beneficiaries
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Slide15-16
Distributable Net Income
Calculation
Start:
Add:
Subtract:
Add:
Add:
Subtract:
McGraw-Hill/Irwin
Taxable income before distribution
deduction
Personal exemption
Capital gains allocated to principal
Capital losses allocated to principal
Tax-exempt interest
Expenses allocated to tax-exempt
income
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 15-17
Trust Tax Liability
Tax rates are steeply progress reaching the
maximum rate of 38.6% with only $ 9,200
of taxable income
 Often beneficiaries in lower rate brackets

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Slide 15-18
Taxation of Trust Beneficiaries
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Income taxable to trust beneficiaries in total is
limited to DNI
Beneficiaries of simple trusts and beneficiaries of
first tier distributions from complex trust taxed
proportionately on share of income distributed
Second tier distributions only taxable to
beneficiaries if first tier does not exceed DNI
McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc
Slide 15-19
Character of Income

If more than one type of income is
distributed from a complex trust, it must be
allocated proportionately amount income
beneficiaries
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Slide 15-20
Separate Share Rule
Applies when trust has multiple
beneficiaries and each is entitled to a
substantially separate and independent share
of income and assets
 Character and amount of distribution
computed as though each share was a
separate trust

McGraw-Hill/Irwin
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Slide 15-21
Trust Property Distributions
Property passes out at its adjusted basis
 Trust does not recognize gain or loss on
distribution
 Beneficiary takes carryover basis
 Holding period tacks
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McGraw-Hill/Irwin
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Slide 15-22
Trust Property Distributions

At the option of the trustee, the trust may
elect to recognize gain on distributions of
appreciated property
 Distribution treated as made at fair
market value to beneficiary
 Holding period begins on date of the
distribution
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Slide 15-23
Trust Filing Requirements
All trusts must use a calendar year end
 All trusts must file if over $ 600 of gross
income or any taxable income
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Slide 15-24
Income Taxation of Estates
Basically same rules as for taxation of trusts
 Distributions allocated between principal
and income based upon will or state law
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McGraw-Hill/Irwin
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Slide 15-25
Income in Respect of a
Decedent
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Income earned before death of decedent but not
properly reportable on final income tax return
Items are subject to both income tax and estate tax
Related expenses are referred to as deductions in
respect of a decedent
Deductions in respect of a decedent are deductible
for both income and estate tax
McGraw-Hill/Irwin
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Slide 15-26
Estate Administration
Expenses

May be claimed as deductions against estate
tax return or income tax return but not both
 To claim on income tax return, personal
representative must file election not to
claim as deductions on estate tax return
McGraw-Hill/Irwin
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Slide 15-27
Estate Exemptions and Filing
Requirements
$600 exemption
 May utilize a fiscal year
 No estimated payments required for two
years after decedent’s death
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McGraw-Hill/Irwin
Copyright (c) 2003 by the McGraw-Hill Companies Inc