2013 cch basic principles ch18

Chapter 18

Income Taxation of Trusts and Estates

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CCH Federal Taxation Basic Principles 2 of 58

Chapter 18 Exhibits

Chapter 18, Exhibit Contents A

1. Five Key Elements of Every Trust

2. Trust Life Cycle Illustrated

3. Definition of Terms

4. Computing Tax Liability—Fiduciary vs. Nonfiduciary

5. Gross Income—Income in Respect of Decedent

6. Income in Respect of Decedent—Tax Treatment

7. Gross Income—Property Distributions

8. Deductions—Depreciation and Depletion

9. Deductions—Capital Losses

10. Deductions—Miscellaneous Itemized Deductions

11. Deductions—Casualty Losses and Charitable Contributions

12. Personal Exemptions


Chapter 18 Exhibits

Chapter 18, Exhibit Contents B

13. Distribution Deduction—Simple Trusts

14. The Distribution Deduction—Step 1: Computing State Law/ Accounting Income

15. Assignments to Corpus and Income—Default Designations

16. The Distribution Deduction—Step 2: Computing Taxable Income Before Distribution Deduction

17. The Distribution Deduction—Step 3: Computing Distributable Net Income

18. The Distribution Deduction—Step 4: Computing the Distribution Deduction

19. Computing Taxable Income of Simple Trusts—Example

20. Filing Requirements for Estates and Trusts


Five Key Elements of Every Trust

1. Grantor. The grantor is the person who transfers property to the trust. The grantor often referred to as trustor, settlor or donor.

2. Trust property. Property must be transferred to the trust. It can be transferred during life, after death through the grantor’s will, through a gift, or by the exercise of a power of appointment (“POA”). It can be cash, a life insurance policy, stock, or any other asset that serves the intent of the grantor.

Chapter 18, Exhibit 1a


3. Trustee. The trustee is the person responsible for managing and administering a trust. The trustee may be the grantor, a trusted friend, a family member, a bank trust department, or any combination of these and other persons. The trustee generally will hold legal title to the assets in the trust but not beneficial title.

(a) Legal title means the trust assets are owned in the name of the trustee, the trustee has specific duties and responsibilities for the trust property, or has certain powers concerning the disposition of the trust property.

(b) Beneficial title to the trust property is held by the beneficiaries of the trust.

Chapter 18, Exhibit 1b



4. Beneficiary. It’s important to know that the persons who are beneficiaries can be determined; that is, the description should be clear and certain. If “my descendants” are the named beneficiaries, there must be a time for making the determination of who the descendants are. Otherwise, it would be impossible to know when to make distributions from the trust.

(a) Possible issue. A possible issue might be: Are grandchildren born after the trust had been established to be included as beneficiaries?

(b) Remainderman. When the trust has fulfilled its purpose, the

money and assets it holds are distributed to the remainderman and the trust is terminated.

Chapter 18, Exhibit 1c



5. Intent of Trust. Every trust has a purpose which motivates the grantor to set the trust up in the first place. The intent can relate to one or a combination of the following intents:

(a) Benefiting a particular beneficiary.

(b) Providing for the maintenance of certain assets, such as the old family homestead.

(c) Achieving certain tax benefits, such as through charitable remainder trusts or marital trusts.

Chapter 18, Exhibit 1d



Trust Life Cycle Illustrated

(a) Grandma has her attorney prepare a trust agreement. (b) Grandma then transfers $100,000 in bonds to her daughter, Tressie,

as trustee of the trust. (c) Tressie is required by the terms of the trust document to invest the

$100,000 in bonds and use all of the interest each year to pay for the college expenses of Tressie’s two sons, Grandma’s grandchildren.

(d) When the youngest of Tressie’s two sons reaches the age of 25, Tressie is instructed to divide the money in the trust equally and distribute it to each of the two boys.

(e) When the distribution is completed, the trust is terminated.



Trust Life Cycle Illustrated

Legal title. The $100,000 Grandma transferred is owned by Tressie, as trustee of the trust. Thus, Tressie holds legal title to the bonds “in trust” for the beneficiaries.

Beneficial title. Tressie’s two sons hold beneficial title. Only they have the right to benefit from the interest and principal value of the bonds.



Definition of Terms

Inter vivos trust. A trust created during the life of the grantor.

Testamentary trust. A trust created by the will of a decedent.



Definition of Terms

Simple trusts. The following characteristics are required:

(a) 100% of state law/accounting income must be distributed currently. This term is explained later in this chapter. (b) None of the corpus,(often referred to as res or principal) may be distributed. (c) No charitable contributions may be made by the trust.

Complex trust. This is any trust other than a simple trust.



Definition of Terms

Grantor trust. This is any trust in which the grantor is the constructive beneficiary. Income from the res of a trust that constructively benefits the grantor is taxed to the grantor on his/her personal return. The trust is disregarded for income tax purposes.

Reversionary interest. If the grantor retains the remainder interest, the interest is known as a reversionary interest. In other words, the res, i.e., property, reverts to the grantor when the trust terminates.



Definition of Terms

Beneficiary exposure. On certain fiduciary income, the beneficiaries of these fiduciary entities, and not the fiduciary (i.e., estate or trust), are personally subject to income tax.

Contrast with estate and gift taxes. Estate and gift taxes are not income taxes. They are taxes on the transfer of assets from one person to another. The donor or estate, not the recipient, must generally pay the tax.



Computing Tax Liability—Fiduciary vs. Nonfiduciary

Estates and Trust (Fiduciary) Individuals (Non-fiduciary)

Income “From Whatever Source Derived,” including Income in Respect of Decedent (IRD)

Income “From Whatever Source Derived”

– Exclusions – Exclusions

– Cost of Goods Sold – Cost of Goods Sold

= Gross Income = Gross Income

– Deductions For AGI – Deductions For AGI

= AGI = AGI




Taxable Income Before Distribution Deduction

=

Personal Exemptions

$3,800 in 2012 per exemption

–Personal Exemptions:

Estate: $600 total.

Simple trust: $300 total.

Complex trust: $100 total.

–

Greater Of: Standard Deduction, Itemized Deductions

–Itemized Deductions

(standard deduction. is not allowed)

–

Individuals (Non-fiduciary) Estates and Trust (Fiduciary)





– Distribution Deduction:

Lesser of:

(1) Distributed amount. (For simple trusts, this is the same as the trust accounting income);

(2) Deductible “DNI.”

N/A

= Taxable Income = Taxable Income

x Fiduciary Tax Rate (same for estates and trusts)

x Personal Tax Rates (based on filing status)

= Gross Regular Tax Liability = Gross Regular Tax Liability





– Credits & Prepayments (Apportioned between fiduciary entity & beneficiaries)

– Credits & Prepayments

= Net Regular Tax Liability Or Receivable

= Net Regular Tax Liability Or Receivable

+ Alt. Min. Tax (If Any) + Alt. Min. Tax (If Any)

+ FICA Taxes + FICA Taxes

= Net Tax Due Or Refund = Net Tax Due Or Refund



Gross Income—Income in Respect of Decedent

Gross income (GI). GI for trusts and estates is similar to GI for individuals, except for (1) income in respect of decedent (IRD) and (2) property distributions to beneficiaries.

GI from income in respect of decedent (IRD). The gross income of an estate or trust may include IRD that the entity received, if the property from which the IRD is related has not been willed to a named beneficiary. However, if a decedent’s will names an individual as heir to specified property, then any IRD resulting from that property is taxable to the individual, not to the estate or trust. IRD is all amounts to which a decedent was entitled as gross income but which were not includible in computing taxable income on the decedent’s final return. For cash basis decedents, the income was earned but not received (e.g., payroll check). For accrual basis decedents, the income was not properly accrued. Most decedents follow the cash basis of accounting.



Examples of IRD for Cash Basis Decedents:

Before Death: After Death:

Salary earned. Salary received.

Credit sales. Collection on A/R.

Gain on sale of property. Proceeds from sale received.

Rent accrued. Rent received.

Interest accrued on installment note. Interest received on installment note.

Cash dividends declared and recorded (i.e., decedent was a stockholder on date of record).

Cash dividends received.

Gross Income—Income in Respect of Decedent



Income in Respect of Decedent—Tax Treatment

Double taxation. Income in respect of decedent (IRD) is taxable as gross income to the recipient (i.e., estate or heir) AND includible in the gross estate at asset value. Such treatment may seem harsh. However, it is consistent with the treatment of earned income for all taxpayers. For example, if a taxpayer makes a cash gift derived from previously taxed earned income, the cash gift would be subject to gift tax after the appropriate exclusions.




IRD amount realized. IRD is valued at fair market value on the date of death (or alternative valuation date).

Basis in IRD received by recipient. The basis of recipients (i.e., estate or heirs) is the same as the decedent’s basis.

Gain or loss to recipient. Gain on IRD is taxable upon receipt, on the difference between IRD value and IRD basis.

Character of gain or loss. Same as if recognized by the decedent.



Deductions in respect of decedent (DRDs). DRDs are expenses connected with IRD that were not reported on the decedent’s final return.

(a) Examples. Examples include interest expense and state income taxes, accrued but unpaid by decedent; and fiduciary fees incurred after death but in connection with IRD.

(b) Tax treatment. IRD expenses are deductible by both the recipient and the estate. This slightly mitigates the double taxation of IRD explained above. The deduction is for or from AGI, depending upon the character of the related IRD.




Gross Income—Property Distributions

Tax Treatment

An estate or trust may, from time to time, distribute property to a beneficiary under the provisions of the will or trust document. The tax treatment for property distributions depends on whether the estate or trust elects to be taxed.



Gross Income—Property Distributions

Tax Treatment(i) Property distributions WITHOUT election to be taxed. An

estate or trust does not recognize gain or loss upon its distribution of property to a beneficiary under the provisions of the will or trust document. The distributed property has the same basis to the beneficiary as it did to the estate or trust.

(ii) Property distributions WITH election to be taxed. An executor or trust can elect to recognize gain or loss on in-kind property distributions (i.e., property specified in the will or trust document for distribution). If the election is made, the beneficiaries get a step-up basis equal to the FMV at date of distribution.



Deductions—Depreciation and Depletion

General Rule. As a general rule, deductions for and from AGI are treated the same as for individuals.

Postponed Loss Rules. Certain losses realized by the estate or trust may be disallowed, as they are for individual taxpayers. Examples include postponed losses under the Code Sec. 267 related party rules, and postponed losses under the Code Sec. 1091 wash sale rules.




Either an estate or trust may be entitled to a depreciation or depletion deduction if it holds qualified property. Computations are the same as for individuals. However, the special rules below explain how much of a deduction can actually be taken by an estate or trust.

Estates. The allowable deduction for depreciation or depletion must be apportioned between the estate and the heirs on the basis of fiduciary income allocable to each.



Deductions—Depreciation and DepletionTrusts. Trusts are permitted greater flexibility than estates in receiving depreciation and depletion deductions. A trust may deduct depreciation or depletion from gross income to the extent a reserve is required or permitted under the trust instrument or local law, and income is set aside for the reserve and it actually remains in the trust. Any part of the deduction in excess of the reserve is then allocated between the income beneficiaries and the trust in the same manner as with estates, i.e., on the basis of the fiduciary income allocable to each. If all of the current accounting income is distributed to the beneficiaries, e.g., in the case of simple trusts, then the trust is not entitled to a depreciation deduction.



Example: Determining the Trust Depreciation Deduction.George creates a trust, naming Billy and Betty as income beneficiaries. The property transferred to the trust is income producing depreciable property. Pursuant to the trust instrument, the income from the trust is to be distributed 60% to Billy and 40% to Betty. In addition, the trustee is permitted to set aside income as a depreciation reserve. In the current year, depreciation on the trust property amounts to $25,000, and the trustee allocates $15,000 of trust income as a depreciation reserve. As a result, the trust can claim a $15,000 depreciation deduction; Billy can claim $6,000 ($6,000 = 60% x [$25,000 – $15,000]); and Betty can claim $4,000 ($4,000 = 40% x [$25,000 – $15,000]).




Deductions—Capital Losses

Capital losses. Same treatment as for individual taxpayer. In most cases, capital losses are allowable only on the fiduciary income tax return, i.e., not on the estate tax return.

Chapter 18, Exhibit 9


Deductions—Miscellaneous Itemized Deductions

Assignment between entity and income beneficiary. As with depreciation, the amount of fiduciary and other miscellaneous itemized expenses deductible to an estate or trust is based on the assignment of related income specified in the trust instrument or by state law. Only the portion of expenses related to income assigned to the estate or trust is deductible by the entity.




Disallowed deductions. The portion of fiduciary and other miscellaneous expenses attributable to tax-exempt income is not deductible. Often this requires an allocation based on the following formula:

(a) (b) x (c), where(a) = Total expense;(b) = Exempt income (c) = Total accounting income (This is the amount that the

income beneficiaries of a simple trust are eligible to receive from the entity.)




No 2% AGI floor. Fiduciary fees and other expenses that would NOT be incurred by an individual taxpayer are NOT subject to the 2%-of-AGI floor. All investment expenses are subject to the tracing rules, i.e., any portion allocable to tax-exempt income are not deductible. (Recall that miscellaneous itemized deductions that could be incurred by an individual taxpayer are subject to a 2%-of-AGI floor. These include investment counseling fees and safe deposit boxes.)



Deductions—Casualty Losses and Charitable Contributions

Casualty or Theft Losses. The tax treatment for these losses is the same as for individual taxpayers.

Election by executor. In some instances, casualty and theft losses may be allowable deductions for either fiduciary income tax purposes or estate tax purposes under Code Sec. 2054. In this case, the fiduciary income tax deduction is NOT allowed unless the executor elects to waive the estate tax deduction.




Charitable Contributions. Bequests to qualified charitable organizations are deductible from fiduciary gross income if the will or trust instrument states that contributions are payable out of income. No ceiling. The deduction is not subject to the usual

50%/30%/20% AGI ceilings for individuals, rather, 100% of the estate income is deductible, regardless of the source (ordinary or long-term capital gain) and regardless of the charity (public or private).



Entire interest must be donated. The entire interest of the decedent in the underlying property must generally be donated. Trust interests may enable deductible transfers of partial interests in underlying property. An inter vivos contribution (as opposed to a bequest) may result in exclusion of the property value from the GE and a current deduction for regular taxable income.

Nondeductible if paid out of corpus. If contributions are paid out of corpus, they are deductible for estate tax and NOT for fiduciary income tax purposes.

Complex trust characterization. If a trust makes a charitable contribution, it is, by definition, a complex trust since simple trusts are required to distribute all income currently and cannot set aside any amount for charitable contributions.




Personal Exemptions

Allowable Amounts. Estates: $600 Complex trusts: $100 Simple trusts: $300

A personal exemption is not allowable for the year the estate or trust terminates.



Distribution Deduction—Simple Trusts

Explanation of Distribution Deduction. Any trust, complex or simple, or estate, is allowed a deduction for some or all of a distribution to an income beneficiary (the “distribution deduction”). The income beneficiary must report as gross income all or some portion of the distribution.

Corporate Wages Analogy. Recall that a corporation is allowed a deduction for employee wages; the employee receives gross income in the form of compensation. To this extent, corporations and employees are analogous to fiduciary entities and income beneficiaries. In the case of the simple trust, the basic issue is the allocation of fiduciary income between trust and beneficiaries.



Distribution Deduction—Simple Trusts

Steps in computing the distribution deduction: 1. Compute state law/accounting income;2. Compute taxable income before the distribution deduction;3. Compute distributable net income (DNI); 4. Compute the distribution deduction.

(Students may find the second and fourth steps to be conceptually easy; the first and third steps conceptually difficult.)



The Distribution Deduction—Step 1: Computing State Law/Accounting Income

This is the amount of income governed by state law that is used for fiduciary accounting purposes. For simple trusts, it’s the amount distributed to income beneficiaries. (Recall that a simple trust requires current distribution of all its accounting income, while a complex trust can accumulate income.)



The Distribution Deduction—Step 1: Computing State Law/Accounting Income

Controlling the assignments to corpus and income.

State law governs what is principal and income of an estate or trust for federal income tax purposes. However, many states have adopted the Revised Uniform Principal and Income Act. The Act and state laws provide that the estate or trust instrument controls how revenues and expenditures will be assigned to corpus and fiduciary income. Thus, the calculation of accounting income is virtually under the control of the decedent (for estates) or grantor (for trusts), through a properly drafted will or trust instrument. By allocating specific items of revenue and expenditures either to corpus (i.e., accumulated income) or to income beneficiaries (i.e., distributed income), the desires of the decedent or grantor are put into effect.



Assignments to Corpus and Income—Default Designations

State laws provide default designations in the event that the will or trust instrument fails to assign revenue and expenditures to corpus and income beneficiaries. Typical default assignments are shown in the following slide.



Typical Assignments to Corpus and Income Beneficiaries.

Increasing Corpus Increasing Accounting Income

Proceeds from sale of rental property Rental income

Insurance proceeds for assets lost in casualties Insurance proceeds for lost profits

Nontaxable stock dividends Taxable stock dividends

Nontaxable stock rights Taxable stock rights

Liquidating dividends Cash dividends

Decreasing Corpus Decreasing Accounting Income

Principal payments on business loans Interest expense on business loans

Capital expenditures Depreciation

Fiduciary fees Rent collection fees

Federal and state tax on capital gains Federal and state tax on fiduciary income




NotesThese designations are provided for by the Revised Uniform Principal and Income Act; however, they can be modified in a will or trust instrument.

The net of increases and decreases to accounting income represents the amount that the income beneficiaries of an estate or simple trust are eligible to receive from the entity. It is often based on the desires of the decedent or grantor rather than federal income tax law. Therefore, entity accounting income does not affect the determination of taxable income before the distribution deduction. It does however, effect how much of a distribution deduction the estate or trust is entitled to receive.




The Distribution Deduction—Step 2: Computing Taxable Income Before

Distribution DeductionComputation. These items are determined in much the same way as for individual taxpayers:

Gross IncomeLess: ExclusionsLess: Cost of goods soldLess: Deductions for and from AGILess: Personal exemptionsEqual: Taxable income before distribution deduction



The Distribution Deduction—Step 3: Computing Distributable Net Income

Function of Distributable Net Income (DNI). DNI is the value necessary to determine any estate or trust’s distribution deduction and therefore its taxable income for the year. It serves two primary functions:

DNI is the maximum amount of a distribution that is

taxable to beneficiaries. DNI is also the maximum amount that the estate or

trust can use as a distribution deduction for the year.


CCH Federal Taxation Basic Principles 46 of 58Chapter 18, Exhibit 17b

Formula for Computing DNIStart with: taxable income before the distribution deduction

+ Personal exemptions (estates: $600, simple trusts: $300; complex trusts: $100).

+ Tax exempt interest, net of related expenses.

+ Net capital losses.

– Net capital gains allocable to corpus. (In other words, the only net capital gains included in DNI are those attributable to income beneficiaries (or to charitable contributions in the case of estates and complex trusts). Capital gains not included in DNI will be taxable to the estate or trust.

= DNI



Observation

Since taxable income before distribution deduction (TIBDD) is computed by deducting all of the allowable deductions (whether allocated to corpus or entity accounting income), these items must be “purged” from TIBDD to arrive at DNI. The effect is to decrease the taxable income of the beneficiaries. The actual distribution to the beneficiaries may exceed DNI because the distributions are not reduced by expenses allocable to corpus.




The Distribution Deduction—Step 4: Computing the Distribution Deduction

Computation

Distributable net income (DNI) includes the net tax-exempt income of the trust or estate. That amount must be removed from DNI in computing the distribution deduction.

Computation of distribution deduction:

DNI - net tax exempt income.



FACTS: The Caligari trust is required to distribute its current accounting income annually to its two beneficiaries, Bob and Bertha. Capital gains and losses and all other expenses are allocable to corpus, pursuant to the trust instrument. No provision is made for depreciation in the trust instrument. Therefore, it will follow income. During the taxable year, the Caligari trust incurs the following items:


Computing Taxable Income of Simple Trusts—Example


Rental income $250,000

Rental expenses 80,000

Depreciation on rental property 70,000

Dividend income 60,000

Taxable interest income 50,000

Tax-exempt interest income 40,000

Net long-term capital gains 30,000

Fiduciary fees 20,000




QUESTIONS:

(1) Determine trust accounting income.

(2) Determine taxable income before the distribution deduction.

(3) Determine DNI.

(4) Determine distribution deduction.

(5) Determine taxable income to the Caligari trust.





Item Totals Step 1: Accounting

Income

Step 2 & 5:

Taxable Income (TI) Before & After Distrib. Deduction

Step 3 & 4:

DNI & Distribution Deduction

Rental income 250,000 250,000 * 250,000

Rental expenses 80,000 (80,000) (80,000)

Depreciation on rental property

70,000 0

(Amount is not a distributable

item)

0

(Deduction is available only to beneficiaries since no

accounting income is accumulated.)

Dividend income 60,000 60,000 * 60,000

Taxable int. inc. 50,000 50,000 * 50,000

Tax-exempt interest income

40,000 40,000 * 0

(since tax-exempt)



Item Totals Step 1: Accounting Income

Step 2 & 5:

Taxable Income (TI) Before & After Distrib. Deduction

Step 3 & 4:

DNI & Distribution Deduction

Net long-term capital gains 30,000 0

(Allocable to corpus, not income)

30,000

Fiduciary fees 20,000 0

(Allocable to corpus, not income)

(18,000 )

(20m-2m, where 2m =

20m x [40m400m*])

Acctg. Income 320,000

Exemption (300) (for simple trusts)

Taxable inc. before distribution. ded.

291,700 291,700

Exemption 300

Corpus capital gain/loss (30,000)

Chapter 18, Exhibit 19e



Item Totals Step 1: Acctg.

Income

Step 2 & 5: Taxable Income (TI) Before &

After Distrib. Deduction

Step 3 & 4: DNI & Distribution Deduction

Addback: “Net” tax-exempt interest income

38,000

(40m-2m)[$2m fid. exp. is related to tax exempt

income]

DNI 300,000

Less: “Net” tax-exempt interest income

38,000

(40m-2m)[$2m fid. exp. is related to tax exempt

income]

Distribution ded. (262,000) 262,000

Taxable income 29,700

* These income elements of trust accounting income are used to allocate fiduciary expenses between deductible and nondeductible portions.

Chapter 18, Exhibit 19f



Notes1. Trust Accounting Income, $320,000. This includes the tax-exempt interest income,

but not the fiduciary fees or capital gains, since, pursuant to the trust document, they are assigned to corpus. Bob and Bertha receive $160,000 each from the trust for the current year.

2. Taxable Income Before The Distribution Deduction, $291,700. This amount is

computed as directed by the Code. Tax-exempt interest is excluded under Code Sec. 103. The trust properly does not deduct any depreciation for the rental property. The depreciation deduction is available only to the recipients of the Caligari trust’s accounting income for the year. Thus, the deduction will be split equally between Bob and Bertha. Only a portion of the fiduciary fees are deductible because some of the fees are traceable to the tax-exempt income.

Chapter 18, Exhibit 19g



3. DNI, $300,000. This amount reflects the required adjustments.

4. Distribution Deduction, $262,000. The distribution deduction is the lesser of the distributed amount, $320,000, or the deductible portion of DNI, $262,000. This represents both a deduction to Caligari trust and gross income to Bob and Bertha ($131,000 each).

5. Taxable Income Of Caligari Trust, $29,700. This amount can be verified by a quick check. Caligari has distributed all of its taxable income to Bob and Bertha except the $30,000 capital gain. The $300 exemption reduces taxable income to $29,700.

Chapter 18, Exhibit 19h



Filing Requirements for Estates and Trusts

Estates Trusts

Minimum Gross Income Filing Requirements

Gross income

$600

Gross income (GI)

$600

Minimum Taxable Income Filing Requirements

Only gross income $600 requires filing.

Any taxable inc. requires filing, even if GI < $600

IRS form for reporting income estate/trust income

Form 1041 Form 1041

IRS form for reporting estate tax

Form 706 N/A

Filing deadline for trust income tax

3-1/2 months after taxable year-end

3-1/2 months after taxable year-end

Filing deadline for estate tax 9 months after death N/A



Filing Requirements for Estates and Trusts

Estates Trusts

Tax year Calendar or fiscal Calendar only

Accounting method Cash or accrual Cash or accrual

Standard deduction Not available Not available

Personal exemptions $600 $300

(simple trust)

$100 (complex trust)


2013 cch basic principles ch18

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