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Chapter 20. Income Taxation of Trusts and Estates. The Big Picture (slide 1 of 3). Anna Jiang is the main breadwinner in her family, which includes her husband Tom, a social worker, and two children, Bobby, age 8, and Sally, age 13.

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Chapter 20

Chapter 20

Income Taxation of Trusts and Estates


The big picture slide 1 of 3
The Big Picture (slide 1 of 3)

Anna Jiang is the main breadwinner in her family, which includes her husband Tom, a social worker, and two children, Bobby, age 8, and Sally, age 13.

Anna has accumulated about $2 million in after-tax investment accounts, largely made up of growth stocks that do not regularly pay dividends.


The big picture slide 2 of 3
The Big Picture (slide 2 of 3)

Anna has addressed the problem of probate costs through joint property ownership, life insurance policies, and beneficiary arrangements for her retirement plans.

She and Tom update their wills every five years or so.


The big picture slide 3 of 3
The Big Picture (slide 3 of 3)

There is a history of Alzheimer’s disease in Anna Jiang’s family.

She wants to make certain that Tom and the children will have adequate cash flow from the $2 million of investment assets if she becomes unable to work.

One of Anna’s colleagues suggests that she set up a trust to take care of her family in case a medical problem ever arises.

Read the chapter and formulate your response.


What is a trust
What Is a Trust?

  • Not defined in Code

    • Usually refers to an arrangement created by a will or by inter vivos (lifetime) declaration

    • Trustee takes title to property for purpose of protecting or conserving it for beneficiary

    • Used to achieve various financial and other goals


Creation of a trust
Creation Of A Trust

  • Typically, involves at least three parties:

    • The grantor - transfers selected assets to the trust entity

      • Sometimes referred to as the settlor or donor

    • The trustee - charged with the fiduciary duties associated with the trust

      • Usually is either an individual or a corporation

    • The beneficiary - designated to receive income or property from the trust


Common motivations for creating a trust slide 1 of 5
Common Motivations for Creating a Trust(slide 1 of 5)

  • Life Insurance Trust

    • Holds life insurance policies on the insured

    • Removes proceeds of policies from gross estate (if irrevocable trust)

    • Safeguards against receipt of proceeds by young or inexperienced beneficiary


Common motivations for creating a trust slide 2 of 5
Common Motivations for Creating a Trust (slide 2 of 5)

  • “Living” (revocable) Trust

    • Manages assets

    • Reduces probate costs

    • Provides privacy for asset disposition

    • Protects against medical or other emergencies, and

    • Provides relief from the necessity of day-to-day management of the underlying assets


Common motivations for creating a trust slide 3 of 5
Common Motivations for Creating a Trust (slide 3 of 5)

  • Trust for minors

    • Provides funds for college education

    • Shifts income to lower-bracket taxpayers

    • Allows parents to retain some control over children’s use of assets


Common motivations for creating a trust slide 4 of 5
Common Motivations for Creating a Trust (slide 4 of 5)

  • “Blind” trust

    • Holds assets of grantor without his/her input or influence (e.g., while grantor holds political office or some other sensitive position)

  • Retirement trust

    • A special tax-exempt trust that manages asset contributions under a qualified retirement plan


Common motivations for creating a trust slide 5 of 5
Common Motivations for Creating a Trust (slide 5 of 5)

  • Divorce trust

    • Manages assets of an ex-spouse and ensures they will be transferred on a prescribed schedule to named beneficiaries

  • Liquidation trust

    • Manages assets and final dissolution of a corporation undergoing a complete liquidation



What is an estate
What Is an Estate?

  • Created upon the death of every individual

    • Collects and conserves an individual’s assets, satisfies all liabilities, and distributes the remaining assets to heirs



Nature of trust and estate taxation
Nature of Trust and Estate Taxation

  • In general, taxable income of trusts or estates is taxed to the entity or to its beneficiaries to the extent that each has received the accounting income of the entity

    • Whoever receives the accounting income of the entity, or some portion of it, is liable for the income tax that results


Filing requirements
Filing Requirements

  • Fiduciary must file a Form 1041, U.S. Income Tax Return For Estates and Trusts, in the following situations:

    • For an estate with gross income > $600

    • For a trust that either has any taxable income or, if no taxable income, has gross income of $600 or more

  • Due date is 15th day of fourth month following year-end


Tax accounting periods methods and payments slide 1 of 2
Tax Accounting Periods, Methods, and Payments (slide 1 of 2)

  • Tax year

    • Estates can use calendar year or fiscal year

    • Trusts must use a calendar year


Tax accounting periods methods and payments slide 2 of 2
Tax Accounting Periods, Methods, and Payments (slide 2 of 2)

  • Estimated tax payments

    • Trusts and estates are required to make quarterly estimated tax payments using same schedule as individuals

      • Applies to estates and grantor trusts only for tax years ending two or more years after date of decedent’s death

      • Charitable trusts and private foundations are exempt from making estimated tax payments


Tax rates for estates and trusts 2012

Taxable Income Tax is:

But Not Of Amount

Over Over Over

$ -0- $2,400 15% $ -0-

2,400 5,600 $ 360.00 + 25% 2,400

5,600 8,500 $1,160.00 + 28% 5,600

8,500 11,650 $1,972.00 + 33% 8,500

11,650 ........ $3,011.50 + 35% 11,650

Note: tax on dividend income and net long-term capital gains of fiduciary is limited to 15%

Tax Rates for Estates and Trusts - 2012


Personal exemptions

Estates $600

Simple trusts (generally) $300

All other trusts (primarily

complex trusts) $100

Personal Exemptions


Alternative minimum tax
Alternative Minimum Tax

  • May apply to an estate or trust in any year

    • AMTI calculation is generally the same as for individuals

    • Annual exemption = $22,500

      • Phases out at a rate of one-fourth of the amount by which AMTI exceeds $75,000

    • AMT tax rate = 26% on first $175,000, 28% thereafter



Entity accounting income
Entity Accounting Income Beneficiaries

  • Accounting income is based on the controlling document

    • Either the document or state law determines whether amounts are allocated to corpus or current income

    • If the entity distributes income currently, that income should generally correspond to accounting income


Common allocations income or corpus

Allocable to Income BeneficiariesAllocable to Corpus

-Ordinary and operating net -Depreciation on business assets

income from trust assets -Casualty gain/loss on

-Interest, dividend, rent, and income-producing assets

royalty income -Insurance recoveries on

-Stock dividends income-producing assets

-One-half of fiduciary fees/ -Capital gain/loss on investment

commissions assets

-Stock splits

-One-half of fiduciary fees/

commissions

Common Allocations: Income or Corpus


Taxation of estates and trusts slide 1 of 2
Taxation of Estates and Trusts Beneficiaries(slide 1 of 2)

  • Generally, estates and trusts act as conduits for income received, and taxation is at beneficiary level

    • This is codified through allowance of a distribution deduction


Taxation of estates and trusts slide 2 of 2
Taxation of Estates and Trusts Beneficiaries(slide 2 of 2)

  • Exceptions:

    • Complex trusts accumulate income for specified times (e.g., until beneficiary is age 30)

    • Estates are not always required to make current distributions

  • In these cases, or other cases where the entity is not required to distribute current income, the entity itself is taxed


Property distributions slide 1 of 2
Property Distributions Beneficiaries(slide 1 of 2)

  • Generally, entity does not recognize gain or loss

    • Beneficiary takes same basis in asset as it had in the estate or trust

    • Distribution absorbs distributable net income (DNI) and qualifies for a distribution deduction to extent of the lesser of:

      • Basis to beneficiary

      • FMV on date of distribution


Property distributions slide 2 of 2
Property Distributions Beneficiaries(slide 2 of 2)

  • Property distributions (cont’d)

    • Trustee or executor can elect to recognize gains and losses on assets distributed in kind

      • Beneficiary’s basis in asset would be FMV

      • Distribution absorbs distributable net income (DNI) and qualifies for a distribution deduction equal to FMV on date of distribution


The big picture example 7 property distributions
The Big Picture – Example 7 BeneficiariesProperty Distributions

Return to the facts of The Big Picture on p. 20-1.

Assume that Anna has established the Jiang Family Trust.

The trust distributes a painting, basis of $40,000 and fair market value of $90,000, to beneficiary Sally.

Sally’s basis in the painting is $40,000.

The distribution absorbs $40,000 of the Jiang Trust’s DNI, and the trust claims a $40,000 distribution deduction relative to the transaction


The big picture example 8 property distributions
The Big Picture – Example 8 BeneficiariesProperty Distributions

Assume the same facts as in Example 7, except that the Jiang Trust’s basis in the painting is $100,000.

Sally’s basis in the painting is $100,000.

The distribution absorbs $90,000 of the Jiang Trust’s DNI, and the trust claims a $90,000 distribution deduction.


Deductions allowed slide 1 of 3
Deductions Allowed Beneficiaries(slide 1 of 3)

  • Deductions are allowed for ordinary and necessary expenses for:

    • A trade or business

    • Production of income

    • Management, conservation, or maintenance of property

    • Determination, collection, or refund of any tax


Deductions allowed slide 2 of 3
Deductions Allowed Beneficiaries(slide 2 of 3)

  • Other deductions

    • No deduction is allowed for expenses related to the production or collection of tax-exempt income

    • Cost recovery deductions are allocated proportionately to the recipients of accounting income

    • Deductions are allowed for casualty or theft losses and NOLs

    • Wash sale and related party rules apply


Deductions allowed slide 3 of 3
Deductions Allowed Beneficiaries(slide 3 of 3)

  • Other deductions (cont’d)

    • May be eligible for the domestic production activities deduction

      • Computation of qualified production activities income (QPAI) is made at the entity level

      • Each beneficiary receives, as a pass-through from the entity, his or her share of QPAI and the W–2 wages paid, based on the proportion of entity accounting income received

    • Charitable contribution deduction is allowed to the extent of amounts included in gross income for the year

      • Deemed to be made proportionately from each of the income elements of entity accounting income


The big picture example 18 charitable contribution deduction slide 1 of 2
The Big Picture – Example 18 BeneficiariesCharitable Contribution Deduction(slide 1 of 2)

Return to the facts of The Big Picture on p. 20-1.

Again assume that Anna has established the Jiang Family Trust.

The trust has 2012 gross rent income of $80,000, expenses attributable to the rents of $60,000, and tax-exempt interest from state bonds of $20,000.


The big picture example 18 charitable contribution deduction slide 2 of 2
The Big Picture – Example 18 BeneficiariesCharitable Contribution Deduction(slide 2 of 2)

Under the trust agreement, the trustee is to pay 30% of the annual trust accounting income to the United Way, a qualifying organization.

Accordingly, the trustee pays $12,000 to the charity in 2012.

30% X $40,000.

The charitable contribution deduction allowed for 2012 is $9,600.

($80,000/$100,000) X $12,000.


The big picture example 19 charitable contribution deduction
The Big Picture – Example 19 BeneficiariesCharitable Contribution Deduction

Assume the same facts as in Example 18, except that the trust instrument also requires that the contribution be paid from the net rent income.

The agreement controls, and the allocation formula need not be applied.

The entire $12,000 is allowed as a charitable deduction.


Distributable net income slide 1 of 3
Distributable Net Income Beneficiaries(slide 1 of 3)

  • Entity is allowed a deduction for distributions to beneficiaries

    • Distributable net income (DNI) is used to compute the amount of the deduction

      • Maximum amount beneficiaries pay tax on

        • The character of income in DNI is preserved to the beneficiaries

      • Maximum amount of distribution deduction


Distributable net income slide 2 of 3
Distributable Net Income Beneficiaries(slide 2 of 3)

  • Calculating DNI

    • Step 1: Determine entity’s taxable income before the distribution deduction

      • Includes all of entity’s income, deductions, gains, losses and exemption


Distributable net income slide 3 of 3
Distributable Net Income Beneficiaries(slide 3 of 3)

  • Calculating DNI (cont’d)

    • Step 2: Make the following adjustments to entity’s taxable income to determine distributable net income:

      • Add back:

        • Personal exemption

        • Net tax-exempt interest

        • Net capital losses

      • Subtract net capital gains allocable to corpus


Distribution deduction
Distribution Deduction Beneficiaries

  • For estates and complex trusts, distribution deduction is the lesser of:

    • Deductible portion of DNI, or

    • The taxable amount actually distributed

  • For a simple trust, full distribution is always assumed


Entity taxable income

Entity taxable income is calculated as follows: Beneficiaries

Entity taxable income before

the distribution deduction

Less: Distribution deduction

Entity taxable income

Entity Taxable Income


Allocation of dni slide 1 of 6
Allocation of DNI Beneficiaries(slide 1 of 6)

  • Each type of DNI must be allocated proportionately to income beneficiaries

    • This prevents manipulation of tax liabilities by assigning, for example, tax-exempt income to high bracket taxpayers, and taxable income to low bracket taxpayers


Allocation of dni slide 2 of 6
Allocation of DNI Beneficiaries(slide 2 of 6)

  • Amount taxable to beneficiaries

    • For a simple trust

      • DNI is the maximum taxable amount

      • May be less if DNI includes tax-exempt interest

      • If more than one income beneficiary, apportion elements of DNI ratably


Allocation of dni slide 3 of 6
Allocation of DNI Beneficiaries(slide 3 of 6)

  • Amount taxable to beneficiaries (cont’d)

    • For estates and complex trusts

      • Use a two-tier system

        • Income required to be distributed is categorized as a first-tier distribution

        • All other amounts properly paid, credited or required to be distributed are second-tier distributions


Allocation of dni slide 4 of 6

Amount taxable to beneficiaries (cont’d) Beneficiaries

If only first-tier distributions are made and those amounts exceed DNI, use the following formula to allocate DNI among beneficiaries

Allocation of DNI (slide 4 of 6)


Allocation of dni slide 5 of 6
Allocation of DNI Beneficiaries(slide 5 of 6)

  • Amount taxable to beneficiaries (cont’d)

    • If first and second-tier distributions are made and first-tier distributions exceed DNI, use the previous formula to allocate first-tier distributions

    • Second-tier distributions are not taxed since all DNI has been allocated


Allocation of dni slide 6 of 6

Amount taxable to beneficiaries (cont’d) Beneficiaries

If first and second-tier distributions are made and first-tier distributions do not exceed DNI, but the total of both first-tier and second-tier distributions does exceed DNI, the second-tier beneficiaries recognize income as shown below

Allocation of DNI (slide 6 of 6)


Separate share rule
Separate Share Rule Beneficiaries

  • For the sole purpose of determining the amount of DNI for a complex trust or an estate with more than one beneficiary

    • The substantially separate and independent shares of different beneficiaries in the trust or estate are treated as separate trusts or estates

  • The separate share rule is designed to

    • Prevent the inequity that results if the corpus payments are treated under the regular rules applicable to second-tier beneficiaries

    • Also results in the availability of extra entity personal exemptions and in a greater use of lower entity tax brackets


Character of income
Character of Income Beneficiaries

  • Various classes of income retain their character and flow through to beneficiaries

    • If all DNI is distributed and there are multiple beneficiaries, must allocate various classes of income

      • Distributions are treated as consisting of the same proportion as the items that enter into the computation of DNI


Trust taxation example slide 1 of 9

The Alto Family Trust has the following income and expenses: Beneficiaries

Interest income $8,000

Tax-exempt income $6,000

Capital gain income $4,000

Fiduciaries fees $2,000

The trust agreement allocates fiduciaries fees to trust income. Capital gains are allocated to trust corpus.

Trust Taxation Example(slide 1 of 9)


Trust taxation example slide 2 of 9

1. Accounting income is as follows and is distributed to Sue, the sole beneficiary, at the end of the year:

Interest income $ 8,000

Tax-exempt income 6,000

Fiduciaries fees (2000)

Accounting income $12,000

Trust Taxation Example (slide 2 of 9)


Trust taxation example slide 3 of 9

Fiduciary fees are allocated between interest income and tax-exempt income before calculating trust taxable income:

Interest income × Fees = $ 8,000 × $2,000 = $1,143

Total income $14,000

Tax-exempt inc. × Fees = $ 6,000 × $2,000 = $ 857

Total income $14,000

Trust Taxation Example (slide 3 of 9)


Trust taxation example slide 4 of 9

2. Taxable income of the trust, before the distribution deduction, is as follows:

Capital gain $ 4,000

Interest income 8,000

Less: fiduciaries fees

related to interest income (1,143)

Less: exemption ( 300)

Taxable income before

distribution deduction $10,557

Net tax exempt income is $6,000 less $857, or $5,143.

Trust Taxation Example (slide 4 of 9)


Trust taxation example slide 5 of 9

3. Calculate Distributable Net Income (DNI) and the distribution deduction as follows:

DNI:

Taxable income before DNI $10,557

Plus: Exemption 300

Plus: Tax-exempt income (total) 6,000

Net of: Expenses allocated to tax-exempt income ( 857)

Less: Capital gains allocated to corpus ( 4,000)

DNI $12,000

In this case, since no expenses were allocated to corpus, DNI is the amount actually distributed to the beneficiary.

Trust Taxation Example (slide 5 of 9)


Trust taxation example slide 6 of 9

Distribution Deduction distribution deduction as follows:

The distribution deduction is the lesser of the amount actually distributed ($12,000) or DNI net of tax-exempt income (less expenses):

DNI $12,000

Less: tax-exempt income ( 6,000)

Plus: expenses related to tax-exempt income 857

Distribution deduction $ 6,857

Trust Taxation Example(slide 6 of 9)


Trust taxation example slide 7 of 9

4. Determine trust taxable income after distribution deduction

Taxable income before distribution deduction $10,557

Distribution deduction ( 6,857)

Taxable income $ 3,700

Note: tax is limited to 15% since income is from capital gains

Trust Taxation Example (slide 7 of 9)


Trust taxation example slide 8 of 9

5. Allocate DNI and its character to the beneficiaries. deduction

DNI to Sue is $12,000, consisting of the following:

Interest Tax-Exempt

Income Income Total .

Gross income $8,000 $6,000 $14,000

Allocable fees 1,1438572,000

Net income, per

category $6,857 $5,143 $12,000

Trust Taxation Example (slide 8 of 9)


Trust taxation example slide 9 of 9
Trust Taxation Example deduction(slide 9 of 9)

  • Sue received a distribution of $12,000 from the trust.

    • She pays tax on $6,857

      • Corresponds to tax on trust’s $8,000 of interest income, and a deduction for a portion of the trustee’s fees.

    • She lost deductions of $857 for fees allocated to tax-exempt income.


Refocus on the big picture slide 1 of 4
Refocus On The Big Picture deduction(slide 1 of 4)

Anna Jiang and her family should consider the creation of one or more trusts.

One suggestion for the family might be:

Anna transfers some or all of the $2 million assets to the Jiang Family Trust, with quarterly income payable to Tom and the children.

Recipients would be designated by the trustee, but all of the entity’s accounting income must be distributed.

In this way, the income could be directed to the beneficiary most in need (e.g., to pay for education expenses or to start a new business).

The children could be named first-tier beneficiaries, with Tom as a second-tier income beneficiary.


Refocus on the big picture slide 2 of 4
Refocus On The Big Picture deduction(slide 2 of 4)

While Anna is still healthy and earning a regular salary, the trustee could accumulate the accounting income and allow the corpus to build up.

Alternatively, the trustee could make gifts to charity or fund education plans for Bobby and Sally.

3. Anna should provide clear instructions to the trustee as to her preferences on how the trust corpus should be invested and specify which of Tom’s and the children’s expenses should and should not be covered.

The children should be named as remainder beneficiaries of the Jiang Family Trust.

In case the trust corpus exceeds the estate tax bypass amount, other remainder beneficiaries could be named in order to avoid any generation-skipping tax (see Chapters 18 and 19).

5. Amendments to the trust document should be considered whenever Tom and Anna update their wills.


Refocus on the big picture slide 3 of 4
Refocus On The Big Picture deduction(slide 3 of 4)

What If?

If Anna remains healthy, the Jiang Family Trust might be terminated when the children reach the age of majority, as the need for financial support will have diminished.

However, if Tom is unable or unwilling to take over the management of the assets, the trust should continue.

In this event, the trustee might shift the focus to funding long-term care for the couple, making charitable gifts, or financing the education needs of grandchildren.


Refocus on the big picture slide 4 of 4
Refocus On The Big Picture deduction(slide 4 of 4)

What If?

The controlling trust document should be worded to provide flexibility as to the purposes and termination date of the trust.

The trustee should be chosen from family members or business associates who know Anna and Tom well and are familiar with the couple’s objectives.



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