Federal Taxation II Chapter 28 Review Questions

CHAPTER 28

INCOME TAXATION OF TRUSTS AND ESTATES

TRUE/FALSE

1. Trusts are created exclusively to reduce tax liabilities.

ANS: FTax consequences generally are secondary to the decision to create a trust.

PTS: 1 REF: p. 28-2 | Table 28-1

2. A trust might be used to carry out asset transfers required in a divorce.

ANS: T REF: Table 28-1

3. The fiduciary is a separate tax-paying entity.

ANS: TFiduciaries pay tax on accumulated income.

PTS: 1 REF: Example 1

4. A remainder beneficiary generally must wait until the trust terminates to receive any distribution of income.

ANS: FFiduciaries generally pay out income at least once each year.

PTS: 1 REF: Figure 28-1

5. With respect to a trust, the terms creator, donor, and grantor are synonyms.

ANS: T REF: p. 28-4

6. Corpus, principal, and assets of the trust are synonyms.

ANS: T REF: p. 28-4

28-1

Income Taxation of Trusts and Estates 28-2

7. The executor manages the assets of the decedent’s taxable estate.

ANS: FThe executor manages the assets of the decedent’s probate estate.


8. The IRS works to extend as long as possible the term of an estate to the longest period necessary to distribute assets and satisfy debts of the decedent.

ANS: FThe IRS usually wants to shorten the life of an estate.

PTS: 1 REF: p. 28-5

9. Trusts typically use a calendar tax year.

ANS: T REF: p. 28-7

10. The fiduciary entity pays tax on the income that it distributes to beneficiaries.

ANS: FThe entity’s tax falls only on accumulated income, if any.


11. A fiduciary entity may incur a liability for the AMT.

ANS: TA fiduciary may be subject to the AMT.

PTS: 1 REF: p. 28-8

12. The first step in computing a fiduciary’s taxable income is the determination of its distributable net income for the year.

ANS: FFiduciary accounting income is computed first.


13. Generally, interest income is allocated to fiduciary income.

ANS: T REF: Table 28-3

14. Distribution of an appreciated asset triggers immediate gain recognition to the trust.

ANS: FThe distribution is tax-deferred unless an election is made.

PTS: 1 REF: Example 9 | Example 10

15. Income in respect of a decedent is subject to both income and estate tax at the Federal level.

ANS: T REF: Example 11


16. An example of an expense in respect of a decedent is the state income taxes attributable to the taxpayer’s last paycheck, uncollected at death.


17. With respect to a selling expense incurred by an estate in disposing of the decedent’s property, a deduction can be claimed on the Form 1041 only if the executor waives the corresponding deduction in computing the Federal estate tax.

ANS: TThe deduction can be assigned to either return but not both, with the deduction going by default to the Form 706.

PTS: 1 REF: p. 28-14

18. The executor of the Globe Estate has reported a $10 million gross estate for the entity, and a taxable estate that exceeds the exemption equivalent by $10,000. The estate incurred a $50,000 sales commission in disposing of the decedent’s assets. There was no exempt income this year. The executor can claim a $10,000 deduction for the commission against the taxable estate, thereby eliminating the estate tax liability. The remaining $40,000 can be deducted on the Form 1041 for the year of the expenditure.

ANS: TAdministrative expenses can be allocated between the returns as the executor directs.

PTS: 1 REF: p. 28-14

19. Cost recovery deductions are assigned pro rata to the recipients of distributable net income.

ANS: FSuch amounts are assigned to recipients of entity accounting income.


20. An estate can claim a § 199 domestic production activities deduction.

ANS: TThe deduction that can be claimed is proportionate to the entity’s retained accounting income.

PTS: 1 REF: p. 28-15

21. A trust passes through to its beneficiaries the data needed to compute the domestic production activities deduction.

ANS: T REF: p. 28-15

22. Beneficiaries can deduct in the loss year a proportionate share of a trust’s current-year net operating loss.

ANS: FThe entity retains the NOL and all related carryovers.

PTS: 1 REF: p. 28-15


23. When a trust makes a gift to a qualifying charity, a deduction is allowed only to the extent of 10% of distributable net income.

ANS: FNo such percentage limitation applies to fiduciaries.

PTS: 1 REF: p. 28-16

24. A complex trust can claim a Year 1 deduction for a gift to charity, where the contribution was made in Year 2 out of gross income recognized in Year 1.

ANS: TA one-year grace period is allowed by § 642(c)(1), but only where the contribution came from currently recognized gross income.

PTS: 1 REF: p. 28-16

25. Eighty percent of the income received by the Atom Trust this year constituted municipal bond interest. Atom’s trustee also made a $50,000 gift to the United Fund, a qualifying charity. The charitable deduction associated with this gift is limited to $10,000.

ANS: TSection 265 disallowance rules apply to the charitable contributions of a fiduciary. A proportionate share of the payment is deemed paid from the exempt income and is nondeductible.


26. A fiduciary’s distribution deduction assures that current-year income is taxed only once.


27. Harry, the sole income beneficiary, received a $40,000 distribution from the Lucy Trust, in a year when the trust’s distributable net income was $30,000. Harry’s AGI can increase by as much as $40,000.

ANS: FThe AGI increase is limited by distributable net income.

PTS: 1 REF: p. 28-17


ANS: TThe AGI increase is limited by distributable net income.

PTS: 1 REF: p. 28-17


ANS: FAGI cannot increase by more than the amount of the distribution.

PTS: 1 REF: p. 28-17


30. One-third of the Hermann Estate’s distributable net income consists of qualifying dividends. Thus, when income beneficiary Susie receives a $30,000 income distribution from the estate, $10,000 of it qualifies for the 15% tax rate.

ANS: TThe make-up of DNI passes through to the income beneficiary.

PTS: 1 REF: p. 28-17

31. In computing distributable net income (DNI) for a trust, one removes capital gains allocable to corpus.


32. The Gable Trust reports $20,000 business income and $10,000 exempt interest income, and it paid a $3,000 fiduciary fee. Gable’s distributable net income includes $10,000 for the interest income.

ANS: FDNI includes the $9,000 net exempt income.

PTS: 1 REF: p. 28-17

33. The Gable Trust reports $20,000 business income and $10,000 exempt interest income, and it paid a $3,000 fiduciary fee. Gable’s distributable net income includes the full $3,000 deduction for the fees.

ANS: TDNI includes exempt income, net of related disallowed deductions.

PTS: 1 REF: p. 28-17

34. The Gable Trust reports $20,000 business income and $10,000 exempt interest income, and it paid a $3,000 fiduciary fee. Gable’s distributable net income includes $9,000 for the interest income.

ANS: TDNI includes net exempt income.

PTS: 1 REF: p. 28-17

35. The Crown Trust distributed one-half of its accounting income to Lee this year. Lee also is allocated one-half of Crown’s credit for building low-income housing.


36. “Second-tier distributions” are allowed by the will or trust document to be made at the discretion of the fiduciary.

ANS: TFirst-tier distributions are those required by the controlling document.

PTS: 1 REF: p. 28-21

37. When DNI includes exempt interest income, the beneficiaries exclude from their own gross incomes a proportionate share of distributions received.



38. In the year in which an estate terminates, its beneficiaries receive and can use as their own any unexpired NOL carryforwards proportionately to the corpus assets that they received.


39. Tax planning usually dictates that very high-income and -wealth individuals be specified as first-tier beneficiaries of a trust arrangement.

ANS: FThese parties should be assigned as second-tier beneficiaries, to minimize their exposure to DNI, as they likely do not need the cash flow for living expenses.

PTS: 1 REF: p. 28-26

MULTIPLE CHOICE

1. The special tax rules regarding the income taxation of trusts and estates are included in which Subchapter(s) of the Internal Revenue Code?a. Cb. Jc. Kd. Qe. V and W

ANS: B REF: p. 28-3

2. Which of the following is a typical duty of an executor?a. Pay funeral expenses.b. Pay off the decedent’s financial liabilities.c. Distribute the net assets of the probate estate.d. Manage the decedent’s assets until they are liquidated or distributed.e. All of the above

ANS: E REF: Figure 28-1

3. Which of the following is a typical duty of a trustee?a. Determine the date on which trust terminates.b. Modify the language of the trust instrument so as to lower the entity’s Federal income tax.c. Pay the estate taxes of the grantor.d. Allocate items between income and corpus using Subchapter J rules.e. All of the above.

ANS: A REF: Figure 28-1


4. Which of the following is a typical duty of a trustee?a. Take title to the assets belonging to the entity.b. File the entity’s tax returns.c. Invest the assets that comprise the corpus of the entity.d. Distribute trust income of the beneficiaries in accordance with the provisions of the trust

instrument.e. All of the above.

ANS: E REF: Figure 28-1

5. Parties to an estate do not typically include the:a. Decedent.b. Executor.c. Trustee.d. Beneficiary.

ANS: C REF: Figure 28-1

6. Which of the following statements is false, with respect to the income taxation of an estate?a. The estate likely receives amounts of income in respect of a decedent immediately upon

the decedent’s death.b. The estate is a tax-reporting, not a tax-paying, entity.c. The estate may need to make estimated tax payments.d. The IRS will look to terminate the estate if it determines that the entity is being kept open

simply to avoid income tax liabilities.

ANS: BThe estate pays income tax on any amounts accumulated.

PTS: 1 REF: p. 28-6

7. The Code defines a “simple trust” as which of the following?a. One which is allowed to file Form 1041-EZ.b. One which has only one income beneficiary.c. One which has only one remainder beneficiary.d. One whose grantor was not a corporation.e. One which must distribute its accounting income every year.

ANS: E REF: p. 28-5

8. The Wilson Trust is required to distribute its accounting income every year, one-half to Missy Wilson, and one-half to the Lung Cancer Research Center. What is the Trust’s personal exemption?a. $0.b. $100.c. $300.d. $600.e. $2,500, indexed for inflation.

ANS: C REF: Example 3


9. The Jain Estate is required to pay its entire annual accounting income to Sam and Janet. The estate’s personal exemption is:a. $0.b. $100.c. $300.d. $600.e. Some other amount.

ANS: D REF: p. 28-8

10. The Jain Trust is required to pay its entire annual accounting income to Sam and Janet. The trust’s personal exemption is:a. $600.b. $300.c. $100.d. $0.e. Some other amount.

ANS: B REF: Example 3

11. The Jain Trust is required to pay its entire annual accounting income to the Daytona Museum, a qualifying charity. The trust’s personal exemption is:a. $600.b. $300.c. $100.d. $0.e. Some other amount.


12. The Rodriguez Trust generated $35,000 in alternative minimum taxable income (AMTI) this year. The marginal AMT rate to which the trust is subject is:a. 0%.b. 20%.c. 26%.d. 28%.e. Some other rate applies.

ANS: C REF: p. 28-8


13. The trustee of the Epsilon Trust distributed an asset to Telly, a qualifying income beneficiary. The asset’s basis to the trust was $10,000, and its fair market value on the distribution date was $50,000. Which of the following statements is true?a. Lacking any election by the trustee, the trust recognizes $40,000 gross income on the

distribution.b. Lacking any election by the trustee, Telly’s basis in the asset is $10,000.c. Lacking any election by the trustee, Telly’s basis in the asset is stepped up to $50,000.d. Assuming that the trustee made an election under § 643(e), the trust is allowed a $10,000

distribution deduction for this transaction.e. Assuming that the trustee made an election under § 643(e), Telly recognizes $10,000 gross

income on the distribution.

ANS: B REF: Example 7 to 10

14. Three months after Emma died, her executor received the final $10,000 installment of Emma’s Super Lottery winnings from the state. Which of the following statements is true?a. The $10,000 is included only in Emma’s gross estate.b. The $10,000 is subject to tax only on her estate’s income tax return.c. The $10,000 is subject to neither income nor estate tax, because it was received after

Emma’s death.d. The $10,000 is both included in Emma’s gross estate, and subject to tax on her estate’s

income tax return.e. None of the above.

ANS: D REF: Example 11 to 13

15. Beneficiary Terry received $40,000 from the Urgent Trust. Trust accounting income for the year was $100,000. The trust generated $30,000 in cost recovery deductions. How much can Terry deduct with respect to the cost recovery deductions that Urgent generated?a. $30,000.b. $18,000.c. $12,000.d. $0.e. Some other amount.

ANS: C$30,000 (cost recovery deductions) [$40,000 (accounting income received by Terry) ÷ $100,000 (entity accounting income)].


16. Three weeks after Tina died, her brother Tony properly received Tina’s last paycheck from her employer. The gross amount of the check was $4,000, and a $200 deduction for state income taxes was subtracted in computing the net amount of the payment. Which of the following statements is true?a. The $200 is deductible both on Tony’s income tax return and on Tina’s estate tax return.b. Tony deducts the $200 on his income tax return, even if he is subject to the alternative

minimum tax.c. The $200 is deductible only in computing Tina’s taxable estate.d. Tina’s executor deducts the $200 only on Tina’s last income tax return.e. The $200 is deductible only on the income tax return of Tina’s estate.

ANS: A REF: Example 13


17. Which, if any, of the following statements relates to the tax treatment of both estates and trusts?a. The entity is required to distribute all of its income currently to its beneficiaries.b. The entity must use the same tax year as its creator (i.e., grantor, decedent).c. In the year of its termination, the entity’s net operating loss carryovers are passed through

to its beneficiaries.d. None of the above.

ANS: CSee page 28-25. As to choice a., see p. 28-5; for choice b., see p. 28-17; for choice c., see p. 28-7.

PTS: 1 REF: p. 28-23 | p. 28-5 | p. 28-16 | p. 28-7

18. The distributable net income (DNI) of a fiduciary taxpayer:a. Marks the maximum amount of gross income that income beneficiaries must report when

receiving distributions.b. Constitutes the maximum amount for the fiduciary’s distribution deduction.c. Specifies the character of the distributions in the hands of the year’s income beneficiaries.d. All of the above.

ANS: D REF: p. 28-17

19. A fiduciary’s distributable net income includes:a. Taxable income from qualifying dividends.b. Capital gains allocable to corpus.c. Net capital losses of the entity.d. The $5,000 annual exemption amount.

ANS: AChoice b. is subtracted; choice c. is added back.

PTS: 1 REF: p. 28-17

20. Delphi is a complex trust. This year it distributed all of its accounting income and $5,000 from corpus. Delphi’s taxable income for the year is:a. ($5,000).b. $0.c. ($300).d. ($100).e. Not determinable from the information given.

ANS: DAfter computing distributable net income and the distribution deduction, a fiduciary entity that distributes all of its accounting income generally “wastes” its personal exemption.


21. Which of the following is the annual maximum amount to be included as gross income by all of the income beneficiaries of the trust or estate?a. Distributable net income.b. Entity taxable income.c. Adjusted gross income.d. Fiduciary accounting income.e. $1 million, indexed for inflation ($1,300,000 for 2007).

ANS: A REF: p. 28-17


22. The Roz Trust has distributable net income for the year of $100,000 and no income from tax-exempt sources. Under the terms of the trust instrument, the trustee must distribute $30,000 to Roger and $30,000 to Sally. After payment of these amounts, the trustee is empowered to make additional distributions at its discretion. Exercising this authority, the trustee distributes an additional $40,000 to Roger and $40,000 to Sally. How much income from the trust must Sally recognize?a. $90,000.b. $60,000.c. $50,000.d. $40,000.e. Some other amount.

ANS: CThe amounts distributed to Roger and Sally represent first- and second-tier distributions from the trust. The computations below reflect the amounts taxable to each of the beneficiaries.

BeneficiariesRoger Sally Totals

First-tier distributions $30,000 $30,000 $ 60,000Total distributable net income 100,000Available for second-tier distributions $ 40,000

Second-tier distributions

To Roger $40,000To Sally 40,000Total $80,000

Taxable to Roger: 40/80 $40,000 20,000Taxable to Sally: 40/80 $40,000 20,000Total taxable amount $50,000 $50,000

PTS: 1 REF: Example 24 to 27


23. The Roz Trust has distributable net income for the year of $100,000 and no income from tax-exempt sources. Under the terms of the trust instrument, the trustee must distribute $30,000 to Roger and $30,000 to Sally. After paying these amounts, the trustee is empowered to make additional distributions at its discretion. Exercising this authority, the trustee distributes an additional $10,000 to Roger and $30,000 to Sally. How much gross income from the trust must Sally recognize?a. $80,000.b. $60,000.c. $50,000.d. $20,000.e. Some other amount.

ANS: BSally is taxed on $30,000 for the first-tier distribution and $30,000 on the second-tier, computed as follows.


On the first-tier distributions $30,000 $30,000 $ 60,000Total distributable net income 100,000DNI available for second-tier distributions $ 40,000

Second-tier distributions $10,000 $30,000 $ 40,000

Second-tier amount taxable to Roger: 10/40 $40,000 = $10,000Second-tier amount taxable to Sally: 30/40 $40,000 = $30,000



24. The Roz Trust has distributable net income for the year of $100,000 and no income from tax-exempt sources. Under the terms of the trust instrument, the trustee must distribute $30,000 to Roger and $30,000 to Sally. After paying these amounts, the trustee is empowered to make additional distributions at its discretion. Exercising this authority, the trustee distributes an additional $10,000 to Roger and $30,000 to Sally. How much gross income from the trust must Roger recognize?a. $60,000.b. $50,000.c. $40,000.d. $30,000.e. Some other amount.

ANS: CRoger is taxed on $30,000 for the first-tier distribution and $10,000 on the second-tier, computed as follows.


First-tier distributions $30,000 $30,000 $ 60,000Total distributable net income 100,000DNI available for second-tier distributions $ 40,000

Second-tier distributions $10,000 $30,000 $ 40,000

Second-tier amount taxable to Roger: 10/40 $40,000 = $10,000Second-tier amount taxable to Sally: 30/40 $40,000 = $30,000


25. The Roz Trust has distributable net income for the year of $100,000 and no income from tax-exempt sources. Under the terms of the trust instrument, the trustee must distribute $80,000 to Roger and $80,000 to Sally. After paying these amounts, the trustee is empowered to make additional distributions at its discretion. Exercising this authority, the trustee distributes an additional $40,000 to Roger and $20,000 to Sally. How much gross income from the trust must Sally recognize?a. $50,000.b. $75,000.c. $80,000.d. $100,000.e. Some other amount.

ANS: ADNI is distributed in full with the first-tier distributions for the tax year. Thus, Sally is taxed on her 80/160 share of the DNI, or $50,000.

PTS: 1 REF: p. 28-21


26. The Roz Trust has distributable net income for the year of $100,000 and no income from tax-exempt sources. Under the terms of the trust instrument, the trustee must distribute $80,000 to Roger and $80,000 to Sally. After paying these amounts, the trustee is empowered to make additional distributions at its discretion. Exercising this authority, the trustee distributes an additional $40,000 to Roger and $20,000 to Sally. How much gross income from the trust must Roger recognize?a. $120,000.b. $100,000.c. $80,000.d. $40,000.e. Some other amount.

ANS: EDNI is distributed in full with the first-tier distributions for the tax year. Thus, Roger is taxed on his 80/160 share of the distribution, or $50,000.

PTS: 1 REF: p. 28-21

27. The Dual Trust generated a net operating loss this year of $100,000. The Trust will terminate in seven more years. How much of this loss can the Trust, its sole income beneficiary, Diane, or its sole remainder beneficiary, Duke, deduct this year?a. Diane deducts $100,000.b. Duke deducts $100,000.c. Diane and Duke each deduct $50,000.d. Diane, Duke, and the Trust each deduct $33,333.e. Neither beneficiary nor the trust gets a deduction this year.

ANS: E REF: Example 31

28. During the current year, the Madison Trust received $40,000 of taxable interest income, paid trustee’s commissions of $4,000, and had no other income or expenses. The trust instrument requires that $20,000 be paid annually to Marilyn, and $40,000 be paid annually to Domingo. How much gross income must Marilyn and Domingo recognize?a. $20,000 by Marilyn and $40,000 by Domingo.b. $20,000 by Marilyn and $20,000 by Domingo.c. $12,000 by Marilyn and $24,000 by Domingo.d. $18,000 by Marilyn and $18,000 by Domingo.e. None of the above.

ANS: COn the first tier, distributable net income of $36,000 is attributable to the two income beneficiaries, pro rata to the amounts required to be distributed to each. Thus, Marilyn recognizes $12,000 (2/6 $36,000), and Domingo recognizes $24,000 (4/6 $36,000).

PTS: 1 REF: Example 26 | §§ 652(a) and 662(a)


29. The Roz Trust has distributable net income for the year of $100,000 and no income from tax-exempt sources. Under the terms of the trust instrument, the trustee is required to distribute $30,000 to Roger and $60,000 to Sally. After payment of these amounts, the trustee is empowered to make additional distributions at its discretion. Exercising this authority, the trustee distributes an additional $40,000 to Roger, and $40,000 to Sally. How much income from the trust must Roger recognize?a. $70,000.b. $65,000.c. $60,000.d. $30,000.e. Some other amount.

ANS: BThe amounts distributed to Roger and Sally represent first- and second-tier distributions from the trust. The following computations reflect the amounts taxable to each of the beneficiaries.


First-tier distributions $30,000 $60,000 $ 90,000Total distributable net income 100,000DNI available for second-tier distributions $ 10,000

Second-tier distributions

To Roger $40,000To Sally 40,000Total $80,000

Taxable to Roger: 40/80 $10,000 5,000Taxable to Sally: 40/80 $10,000 5,000Total taxable amount $35,000 $65,000


30. Which, if any, of the following statements relates to the tax treatment of estates but not trusts?a. The entity must file an income tax return if its gross income for the year is $600 or more.b. Separate share accounting can be used.c. The entity can be liable for estimated tax payments.d. The entity is terminated upon completion of its legal responsibilities.e. None of the above.

ANS: DBoth estates and trusts must file a Form 1041 if gross income for the year is $600 or more (p. 28-7). Both must file estimated taxes and can use the separate share rule (p. 28-23), while statement d. applies only to the estate: the controlling instrument specifies the trust’s termination date.



31. The Edgerton Estate generated distributable net income (DNI) this year of $100,000, one-fourth of which was tax-exempt interest, and the balance of which was long-term capital gain. Kyle Edgerton, the sole income beneficiary of the Estate, received a distribution of the entire $150,000 fiduciary income of the entity. How does Kyle report the distribution?a. $100,000 ordinary income.b. $150,000 ordinary income.c. $75,000 long-term capital gain, $25,000 exempt interest.d. $75,000 long-term capital gain, $75,000 exempt interest.e. $50,000 long-term capital gain, $50,000 exempt interest.

ANS: C REF: Example 29

32. The Eagleton Trust generated distributable net income (DNI) this year of $120,000, one-third of which was portfolio income, and the balance of which was exempt interest. Under the terms of the trust, Clara Eagleton is to receive an annual income distribution of $40,000. At the discretion of the trustee, additional distributions can be made to Clara or to Clark Eagleton III. This year, the trustee’s distributions to Clara totaled $50,000. Clark received $100,000. How much of the trust’s DNI is assigned to Clara?a. $0.b. $40,000.c. $47,273.d. $50,000.e. $120,000, under the “majority of income” rule.

ANS: C$40,000 first-tier + [$80,000 (remaining DNI) $10,000/$110,000 (Clara’s share of all second-tier distributions)].


33. The Eagleton Trust generated distributable net income (DNI) this year of $120,000, one-third of which was portfolio income, and the balance of which was exempt interest. Under the terms of the trust, Clara Eagleton is to receive an annual income distribution of $40,000. At the discretion of the trustee, additional distributions can be made to Clara, or to Clark Eagleton III. This year, the trustee’s distributions to Clara totaled $50,000. Clark received $100,000. How much of the trust’s DNI is assigned to Clark?a. $0.b. $55,000.c. $72,727.d. $110,000. e. $120,000, under the “generation-skip” rule.

ANS: C$80,000 (remaining DNI) $100,000/$110,000 (Clark’s share of all second-tier distributions).



34. To reduce trustee commissions, the Emily Trust is operated as though it were two trusts (i.e., with 70-year-old Grandma and 7-year old Skippy each holding equal shares). This year the trust generated distributable net income (DNI) of $80,000. The trustee distributed $90,000 to Grandma this year: $40,000 as her one-half share of the entity’s income, and $50,000 as a distribution of principal. How much of the year’s distributable net income is assigned to Grandma?a. $0.b. $40,000.c. $50,000.d. $80,000.e. $90,000.


35. The Williamson Estate generated distributable net income (DNI) this year of $120,000, one-third of which was tax-exempt interest, and the balance of which was long-term capital gain. Muffy Williamson, the sole income beneficiary of the Estate, received a distribution of the entire $150,000 fiduciary income of the entity. How is this distribution accounted for by Muffy?a. $150,000 ordinary income.b. $120,000 ordinary income.c. $60,000 long-term capital gain, $60,000 exempt interest.d. $100,000 long-term capital gain, $50,000 exempt interest.e. $80,000 long-term capital gain, $40,000 exempt interest.

ANS: E REF: Example 29

36. The trust instrument provides that Tamara, the sole income beneficiary, is to receive $8,000 annually. If the trust accounting income is not sufficient to pay this amount, the trustee is empowered to invade corpus to the extent necessary. During the current year, the trust has distributable net income (DNI) of $100,000, including $25,000 of tax-exempt interest. In accordance with the trust instrument, $8,000 is paid to Tamara. How much income is taxable to Tamara for the current year?a. $0.b. $6,000.c. $8,000.d. $100,000.e. None of the above.

ANS: BTamara’s income is limited to $8,000, since this is the amount that is required to be distributed annually from the complex trust. However, the trust’s income retains its character in the hands of the beneficiaries. Since 25% of distributable net income represents tax-exempt income, $2,000 of the amount received by Tamara is nontaxable.



37. Which of the following restrictions applies concerning distributions to trust beneficiaries?a. Special allocations of income types are allowed, assuming that they carry substantial

economic effect.b. Special allocations of income types are allowed, even if not provided for in the trust

instrument.c. Special allocations are allowed, but only for portfolio income items.d. Special allocations are allowed, but only in the trust’s termination year.e. Special allocations are not allowed under Subchapter J.

ANS: A REF: p. 28-23 | Example 30

38. The Raven Trust was terminated this year and David, the beneficiary of the corpus, received all of the trust assets. The trust had a $10,000 net operating loss; this was the only tax year in which the trust operated a business. The entity has one income beneficiary, Flo. As a result of these transactions:a. The trust carries back the NOL to a prior tax year to offset its portfolio income.b. Flo claims the $10,000 NOL on her Form 1040.c. David claims the $10,000 NOL on his Form 1040.d. The $10,000 NOL is lost forever.

ANS: CLosses in the termination year are assigned proportionately to the corpus beneficiaries. The losses are subject to the 2%-of-AGI floor.


39. The Drabb Trust owns a plot of business-related land, basis of $50,000, fair market value of $38,000. Drabb is subject to a 28% marginal income tax rate. Its sole beneficiary, Eddie, is subject to a 15% marginal income tax rate. Drabb’s current-year distributable net income is $95,000. What is the most preferable action for the trustee of Drabb to take, considering only the related tax consequences?a. Sell the land to a third party.b. Distribute the land to Eddie and make no § 643(e) election.c. Distribute the land to Eddie and make a § 643(e) election.d. Neither sell nor distribute the land.

ANS: AThe Drabb Trust is subject to a higher marginal rate than is Eddie, so the realized $12,000 loss will be most valuable if it is recognized by Drabb. A distribution of the asset to Eddie will not trigger a deductible loss, however, even if a § 643(e) election is made, because a fiduciary and a beneficiary of the same trust are related parties. Thus, the asset must be transferred to a third party, if Drabb is to generate a currently deductible loss.



MATCHING

For each of the following independent statements, choose the best answer.a. Tax attribute of estates onlyb. Tax attribute of complex trust onlyc. Tax attribute of estates and complex trustsd. Tax attribute of neither estates nor complex trusts

1. The entity’s deduction for charitable contributions relates to the taxable income items it earns.2. The entity’s AMT liability is paid by the grantor.3. The entity must file an income tax return if its gross income for the year is $600 or more.4. The entity can choose between the cash and accrual methods of reporting its income and deductions.5. The entity is entitled to a personal exemption of $300.6. In the year of termination, the entity’s net operating loss carryovers are passed through to the

beneficiaries.7. The entity’s fiduciary is generally free to select the date of the entity’s termination.8. The entity can be operated under the separate share rule.9. The entity is an information-reporting, not a tax-paying, taxpayer.10. Distributions to beneficiaries are accounted for with a two-tier system.11. A decedent created the entity.12. Entity accounting income is determined by the SEC.13. For a calendar-year entity, the Form 1041 is due on April 15.14. Essentially, any tax year can be chosen.

1. ANS: C REF: p. 28-162. ANS: D REF: p. 28-83. ANS: C REF: p. 28-6 NOTE: § 6012(a)4. ANS: C REF: p. 28-7

NOTE: An estate or complex trust can use any accepted method of reporting its income and deductions.5. ANS: D REF: p. 28-8

NOTE: A trust may receive a $300 exemption, if it is required to distribute current accounting income. An estate always receives a $600 exemption.

6. ANS: C REF: p. 28-24 NOTE: § 642(h)7. ANS: A REF: Figure 28-1

NOTE: In most instances, though, a trust terminates upon a specific date or upon the occurrence of a specific event.

8. ANS: C REF: p. 28-22NOTE: The separate share rule can be used by estates and complex trusts.9. ANS: D REF: p. 28-6NOTE: Tax is due from the entity on any accumulated income.10. ANS: C REF: p. 28-2011. ANS: C REF: Figure 28-1NOTE: Often a will is used to create a trust.12. ANS: D REF: p. 28-9

NOTE: Entity accounting income is derived from state law and the trust or will.13. ANS: C REF: p. 28-714. ANS: A REF: p. 28-7


COMPLETION

1. The grantor of a trust generally designates both ____________________ and ____________________ beneficiaries under the controlling agreement.

ANS: income, remainderPTS: 1 REF: Figure 28-1

2. A living trust is a _________________________ entity that is used to avoid probate upon the death of the grantor.

ANS: revocable.PTS: 1 REF: Table 28-1

3. Under the general rules of Subchapter J, whoever receives the ____________________ income of a trust or estate is the one who pays tax on it.

ANS: accountingPTS: 1 REF: p. 28-6

4. ____________________ can select any tax year-end, but ____________________ generally must use a calendar tax year.

ANS: Estates, trustsPTS: 1 REF: p. 28-7

5. The Form 1041 of a calendar-year trust is due on ____________________ 15.

ANS: AprilPTS: 1 REF: p. 28-6

6. Subchapter J applies a modified ____________________ principle in deriving the tax liability for estates, trusts, and their beneficiaries.

ANS: conduit or pass-through.PTS: 1 REF: p. 28-5

7. Every ____________________ trust is allowed a $____________________ personal exemption.

ANS: simple, 300PTS: 1 REF: Example 3

8. A fiduciary entity computes its alternative minimum tax in a manner similar to that used for a(n) ____________________.

ANS: individual.PTS: 1 REF: p. 28-8


9. The first step in deriving the fiduciary’s taxable income is to determine its ____________________ ____________________.

ANS: accounting incomePTS: 1 REF: Figure 28-2

10. Generally, an estate’s taxable income is computed in a manner similar to that used for a(n) ____________________.

ANS: individualPTS: 1 REF: p. 28-8

11. Entity accounting income is controlled by the terms of the ____________________ or ____________________.

ANS: will, trustPTS: 1 REF: p. 28-9

12. By____________________ various items to entity accounting income, the will or trust determines the size of the distribution to the income beneficiaries.

ANS: allocating.PTS: 1 REF: p. 28-9

13. Capital gain/loss of a trust usually is allocable to ____________________.

ANS: corpusPTS: 1 REF: Table 28-3

14. A casualty loss of a trust usually is allocable to ____________________.

ANS: corpusPTS: 1 REF: Table 28-3

15. When a beneficiary receives a distribution from a trust of an asset other than cash, generally a(n) ____________________ basis is assigned to the asset.

ANS: carryoverPTS: 1 REF: p. 28-11

16. When a beneficiary receives a distribution from a trust of an asset other than cash, the realized loss could be disallowed under the ____________________ ____________________ rule.

ANS: related partyPTS: 1 REF: p. 28-12


17. A fiduciary’s ____________________ ____________________ deductions are assigned corresponding to the disposition of entity accounting income for the year.

ANS: cost recoveryPTS: 1 REF: p. 28-15

18. A gift to charity is deductible on an estate’s Form 1041 if it is made within ____________________ ____________________ of the end of the tax year.

ANS:one year1 year

PTS: 1 REF: p. 28-16

19. The deduction for a fiduciary’s gift to charity is disallowed proportionate to its ____________________ income realized during the year.

ANS: exemptPTS: 1 REF: Example 17

20. _________________________ ____________________ ____________________ is the maximum amount that can be included in the beneficiaries’ gross incomes from the fiduciary for the year.

ANS: Distributable net incomePTS: 1 REF: p. 28-17

21. A fiduciary assigns its tax credits to beneficiaries corresponding to the disposition of its ____________________ ____________________ for the year.

ANS: accounting incomePTS: 1 REF: p. 28-20

22. A ____________________ tier distribution is one that must be made by the fiduciary to the beneficiary.

ANS: firstPTS: 1 REF: p. 28-21

ESSAY1. Are estates and trusts taxed like individuals? Corporations? Partnerships? Explain.

ANS:Fiduciary entities are taxed in a unique fashion under Subchapter J of the Code. Although the flow-through concept (similar to partnerships and S corporations) is used, the fiduciary is a separate taxable entity. But the concept of distributable net income echoes that of the corporate tax structure. By this means, double taxation is avoided by allowing a deduction for payments to beneficiaries. The tier system in accounting for distributions is unique and does not have comparable use elsewhere in the Code.

PTS: 1 REF: p. 28-3


2. List some of the most commonly encountered motivations for creating fiduciary entities.

ANS:Trusts often are used to shift management responsibilities for assets (e.g., in saving for college or retirement, or to protect against medical difficulties). Fiduciary entities can be used by politicians, divorcing couples, liquidating or bankrupt corporations, and by those executing an estate plan. Trusts also are attractive vehicles for holding special-use assets, such as life insurance policies and investment portfolios.

PTS: 1 REF: Table 28-1

3. Identify the principal roles that are present when an estate is created. A trust.

ANS:An estate of a decedent is created either by law or by will. The executor manages the decedent’s assets and satisfies any obligations. Distributions are made to income beneficiaries. When the estate terminates, the corpus is distributed to the remainder beneficiaries.

A trust is created when the grantor transfers assets to the trustee, who takes titles to the assets so assigned. The trustee manages the corpus, making distributions to the income beneficiaries. When the trust terminates, the corpus is distributed to the remainder beneficiaries.


4. What is a simple trust? A complex trust?

ANS:Under the rules of Subchapter J, a simple trust (1) must distribute it entire accounting income every year, (2) have no charitable beneficiaries, and (3) distribute no corpus.

A complex trust is one that is not a simple trust. The classification as simple or complex is made every year.

PTS: 1 REF: p. 28-5

5. What factors should be considered in choosing a trustee?

ANS:An individual trustee is a good choice when he/she has financial and legal knowledge and is aware of the grantor’s wishes. An institutional trustee is a good choice when professional asset management is required, perpetual life span is desired, and conflicts of interest might develop.

Compromise approaches would be to appoint institutions as co-trustees, to hire professionals on a per-engagement basis when special skills are needed, or to use financial professionals who already are involved in the funding of the trust and who offer their expertise on a gratis or discounted basis.

PTS: 1 REF: Tax in the News on p. 28-6


6. How does the alternative minimum tax affect fiduciary entities?

ANS:An estate or trust is subject to the alternative minimum tax (AMT) if it reports sufficient preference and adjustment items. Any AMT liability must be paid through the fiduciary’s estimated tax payments.

There is no ACE adjustment for fiduciaries, but the entity is allowed a $22,500 personal exemption in computing AMT income. The exemption is phased out beginning when AMTI exceeds $75,000. Applicable tax rates are 26% on the first $175,000 of AMTI, and 28% thereafter.

PTS: 1 REF: p. 28-8

7. How is entity accounting income computed? What role does it play in Subchapter J?

ANS:Entity accounting income is computed using state fiduciary laws and GAAP, to comply with the specifications of the will or trust agreement. Accounting income is the first computation needed in deriving DNI and the taxable income of the entity.

The Uniform Principal and Income Act, last revised in 1997, provides common rules for the states to adopt in characterizing entity accounting income. Generally, operating and investment income is allocated to income beneficiaries, capital gain/loss and cost recovery is allocated to corpus, and fiduciary fees are split equally between the two.

PTS: 1 REF: p. 28-9 | Table 28-3

8. When a fiduciary distributes to a beneficiary a non-cash asset, how is the realized gain or loss treated?

ANS:By default (i.e., no election is made), an in-kind distribution is not a taxable event for the fiduciary. The beneficiary takes a carryover basis in the asset received. By election, however, the fiduciary can recognize the realized gain or loss on the date of the distribution. But if the related party rules apply, the recognition of any loss may be deferred.

PTS: 1 REF: p. 28-11 | p. 28-12

9. Describe how an estate or trust treats “income in respect of a decedent.”

ANS:Income in respect of a decedent (IRD) occurs when a fiduciary or beneficiary receives an item that was earned but not recognized as gross income during the lifetime of the decedent. In general, IRD is treated in the following fashion.

IRD is included in the gross estate, and in the gross income of the ultimate recipient.

There is no step-up or step-down of the basis of an IRD item.

Expenses related to generating the IRD are deductible by the recipient, and by the gross estate.

Any AMT preference and adjustment the IRD would have generated for the decedent is carried over to the recipient.

PTS: 1 REF: p. 9-13


10. The Circle Trust has some exempt interest income for the year. How does this investment income affect Circle’s deduction of its fiduciary fees? Charitable contributions?

ANS:A proportionate amount of the deduction for the fees and contributions is disallowed in computing entity taxable income. The disallowed portion of the deduction is the amount paid or accrued times the following fraction.

Exemption items of entity accounting incomeTotal accounting income

An exception can apply to the contribution deduction. If the will or trust agreement specifies that the charitable gift must be made from a taxable income source, the full deduction is allowed.

PTS: 1 REF: p. 28-13 | p. 28-14

11. Can a trust or estate claim a deduction for cost recovery? Explain.

ANS:If the fiduciary entity is operating a trade or business, or holds investment property that generates cost recovery deductions, those deductions are allocated among the recipients of entity accounting income. If any accounting income is retained by the entity, therefore, it can claim an allocable portion of the cost recovery deductions.



12. What is meant by the term “distributable net income?” What is its significance in connection with the income taxation of estates, trusts and their beneficiaries?

ANS:Distributable net income for any taxable year means the taxable income of the estate or trust adjusted for the following:

distributions to beneficiaries

the personal exemption

corpus capital gains and losses

extraordinary dividends and taxable stock dividends

tax-exempt interest

foreign income

dividends

Reg. § 1.643(a)-0 states that the term distributable net income has no application except in the taxation of estates and trusts and their beneficiaries. It limits the deductions allowable to estates and trusts for amounts paid, credited, or required to be distributed to beneficiaries, and it is used to determine how much of an amount paid, credited, or required to be distributed to a beneficiary is includible in his or her gross income. DNI also is used to determine the character of distributions to the beneficiaries.

PTS: 1 REF: p. 28-17


13. List several key planning ideas with respect to the income taxation of a complex trust and its beneficiaries.

ANS:Where fiduciary entities are used to shift income among taxpayers, the following planning objectives should be kept in mind.

Sprinkling trusts allow flexibility for the trustee to direct income in a tax-wise manner.

High-income and high-wealth taxpayers usually should be given second-tier beneficiary status.

Income shifting goals are limited by the fiduciary’s high marginal tax rates, and by the kiddie tax.

Trust vehicles should be restricted to cases where professional management will produce asset returns sufficient to justify the associated administrative costs.

Where investments in exempt securities are attractive, direct ownership rather than trustee control may be preferable, so that the § 103 exclusion can be retained by the grantor.

Fiduciaries can be liable for an alternative minimum tax.

In addition, entity termination dates should be chosen so as to maximize fiduciary deductions, but not to bunch beneficiary income recognition. The 65-day rule can be useful in accounting for year-end distributions. Fiduciary expenses generally should be claimed by the taxpayer who is subject to the highest marginal income tax rate.

PTS: 1 REF: p. 28-24 | p. 28-27

Federal Taxation II Chapter 28 Review Questions

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