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BNY MELLON WEALTH MANAGEMENT

Income Taxation of Trusts and Estates –Basics and Beyond

Jeremiah W. Doyle IVSenior Vice President

BNY Mellon Private Wealth ManagementBoston, MA

September, 2010

41st Annual Chesapeake Tax Conference


What We’ll Cover – Part I, The Basics• Structure of Subchapter J• Basic Rules• Distributable Net Income (DNI)• Types of Trusts• Trust Accounting Income (TAI)• Taxable Income• Distribution System – How DNI Gets Allocated

– Tier System– Separate Share Rule– 65 Day Rule– Specific Bequests

• Charitable Deductions• Depreciation• Terminations – Capital Loss C/O and Excess Deductions• Administration Expenses

– Allocating Expenses to Tax Exempt Income

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Income Taxation of Trusts and EstatesCode Outline

PART I, SUBCHAPTER J– Subpart A - Sec. 641-646 - General Rules– Subpart B - Sec. 651-652 - Simple Trusts– Subpart C - Sec. 661-664 - Complex Trusts and CRT– Subpart D - Sec/ 665-668 - Accumulation Distributions– Subpart E - Sec. 671-678 - Grantor Trusts– Subpart F - Sec. 681-685 - Misc. Rules

PART II, SUBCHAPTER J– Sec. 691-692 - Income in Respect of a Decedent


Income Taxation of Trusts and Estates

• Separate Taxable Entities

• Taxable Income Computed in Same Manner as Individuals (Sec. 641(b))

• Own Tax Year and Method of Accounting

• Receive Income/Pay Expenses

• Income Taxed to Entity or Beneficiary

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2010 Fiduciary Income Tax Rates

Over Not Over

0 2,300 15%

2,300 5,350 25%

5,350 8,200 28%

8,200 11,200 33%

11,200 35%



Income Taxed to Either Entity or Beneficiary

– If income is accumulated and not deemed distributed, it is taxed to the trust or estate

– If income distributed:

• Trust gets deduction for amount of distribution

• Beneficiary accounts for income distributed on his own tax return

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Income Taxation of Trusts and EstatesDNIDistributable Net Income (DNI) governs:

– Amount of trust or estate’s distribution deduction

– Amount beneficiary accounts for on his own return

– Character of income in beneficiary’s hands



Trust/Estate Beneficiary

DNI acts as ceiling on entity’s

distribution deduction

DNI acts as ceiling on amount beneficiary

accounts for on his return

DNI

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DNI - Sec. 643(a)

Start With Taxable Income and . . .

– Add back the distribution deduction– Add back the personal exemption– Subtract out capital gains/add back capital losses allocable to

principal (except in the year of termination)– Subtract out extraordinary dividends and taxable stock

dividends– Add back net tax-exempt income


DNI - Sec. 643(a)Note: capital gains generally taxed to trust or estate

– Exception: year of termination

Note: The rules regarding DNI and the distribution deduction are applied differently to simple trusts versus complex trusts and estates

Distributions of principal as well as income will “carry out” DNI

– Exception: Specific bequests under Sec. 663(a)(1)

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Types of Trusts

• Simple

• Complex

• Grantor


Simple Trust

• Required to distribute accounting income annually

• Makes no principal distributions, and

• Makes no distributions to charity

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Complex Trust

• Accumulates income

• Makes discretionary distributions of income or mandatory or discretionary distributions of principal, or

• Makes distributions to charity


Grantor Trust

• Grantor or beneficiary has one or more “powers” described in Sec. 673-678

• Result: All income, expenses and credits “flow through” and are taxed to the Grantor or beneficiary regardless of whether distributions are made

• Subpart A-D, Subchapter J (rules for taxation of trusts and estates) do not apply to Grantor trusts

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Trust Accounting Income (TAI)

• Governs amount of distributions

• Trustee allocates receipts/disbursements between accounting income and principal

• Accounting income and principal is determined by governing instrument or, if instrument silent, by state law

– May be governed by UPIA or unitrust statute


Trust Accounting Income (TAI)

TAI Taxable Income

Corp Bond Int √ √

Capital Gains √

Muni Bond Int √

Expenses ? ?

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Trust Accounting Income - TAIBACKGROUND

• Prudent Investor Act– Modern portfolio theory – invest for total return

Replaces the traditional notions of income and principal– Enactment of the Uniform Principal and Income Act– Enactment of Unitrust statutes


Trust Accounting Income - TAITRUST ACCOUNTING INCOME

– Could be TAI defined under:• Traditional definition of income and principal• Unitrust statute

– Must be no less than 3%, no more than 5% of FMV of trust assets • Uniform Principal and Income Act

– Requirements:»Trust is managed under the Uniform Prudent Investor Act»The beneficiary must be eligible for income distributions»The distribution is not favorable to one beneficiary over another

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Taxable Income of Trust or Estate• Computed same as individual

• Exemptions: $600/$300/$100

• Different rules for charitable deductions

• Depreciation deduction allocated between entity and beneficiary

• Distribution deduction

• Administration expenses - some not subject to 2% floor

• AGI - same as individual except (a) personal exemption, (2) distribution deduction and (3) some administration expenses are subtracted “off the top,” i.e. subtracted from taxable income to arrive at AGI


Distributions - Simple TrustBeneficiary Taxed on Lower of TAI or DNI

Gains Taxed to Trust

Simple Trust

Beneficiary

DNI

GainsTrust Gets Distribution Deduction Equal to DNI

Beneficiary Accounts for DNI

Trust income retains its character in Beneficiary’s hands

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Distributions - Complex Trusts and Estates

ComplexTrust DNI

GainsGains and DNI Taxed to Trust

Trust/Estate Accumulates Income


Distributions - Complex Trusts and Estates

Beneficiary Taxed on Distributions Up to DNIGains Taxed to Trust

ComplexTrust

Beneficiary

DNI

GainsTrust Gets Distribution Deduction Equal to Distributions up to DNI

Beneficiary Accounts for Distributions Up to DNI

Trust income retains its character in Beneficiary’s hands

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651 661

662652

Simple Trusts Complex Trusts/Estates

Distributions - Applicable Code Sections


651 661

662652



Distribution Deduction

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651 661

662652



Distribution Deduction

Amt BeneAccounts For


Allocation of DNIFOUR IMPORTANT COMCEPTS:

• Tier System• Separate Share Rule• 65 Day Rule (§663(b) election)• Specific Bequests - §663(a)(1)

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Complex Trust and EstatesTier System

Two tiers:

– First Tier - Distribution of income required to be distributed currently

– Second Tier - Distribution of all other amounts paid, credited or required to be distributed


Complex Trust and EstatesTier System

First Tier Beneficiary

Second Tier Beneficiary

DNI

DNI is taxed first to FTB and any balance of DNI is taxed to STB

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Complex Trust and EstatesTier System - Example

Facts: $40,000 DNI and TAITrust requires A receive 50% of incomeTrustee makes discretionarydistributions of $20,000 to each B and C

A is FTB (Gets 50% of $40,000 TAI)

B and C are STB (Discretionary Benes)



$40,000 DNI

($20,000) DNI for FTB

$20,000 DNI for STB

2 STB$10,000 DNI for Each STB

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$40,000 DNI

A B C

$20,000 DNI

FTB

$10,000 DNI

STB

$10,000 DNI

STB


Separate Share Rule

Solely for purposes of computing DNI, substantially separate and independent shares of different beneficiaries of a trust aretreated as separate trusts.

Effect: Treat multiple beneficiaries of single trust or estate as if each were the sole beneficiary of a single trust solely for determining how much DNI each distribution carries out.

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Separate Share RuleEstate has $10,000 DNI for 2004

Two Equal Beneficiaries: A and B

Distributes $10,000 to A in 2004

A taxed on $10,000

Estate has $5,000 DNI for 2005

Distributes $10,000 to B in 2005

B taxed on $5,000

Same amount paid in 2 different years, different tax result


Separate Share RuleEstate has $10,000 DNI for 2004

Two Equal Beneficiaries: A and B

Distributes $10,000 to A in 2004

A taxed on $5,000 ($10,000 DNI/2)

Estate has $5,000 DNI for 2005

Distributes $10,000 to B in 2005

B taxed on $2,500 ($5,000 DNI/2)

DNI computed based on 2 separate shares

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Separate Share Rule• Applies to estates and trusts

• DNI computed separately for each share

• Mandatory, not elective

• Only Affects share of DNI– Doesn’t allow filing multiple returns– Doesn’t allow separate calculation of tax


65 Day Rule aka Sec. 663(b) Election

• Applies to complex trusts and estates

• Allows fiduciary to treat distribution made within 65 days of Y/E as being made on 12/31 of preceding year

• Election must be made by due date of return

• Election is irrevocable

• Year by year election (e.g. good for 1 year only)

• Limited to > DNI less current year distributions or TAI not distributed

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65 Days

12/312005 2006



65 Days

12/312005 2006

Facts: $10,000 DNI for 2005

Distributes $6,000 in 2006

$6,000

$4,000

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Specific Bequests - Sec. 663(a)(1)

• Bequest of specific sum of money or specific property do not carry out DNI

• Requirements:– Paid all at once, or– Paid in not more than 3 installments

• Not deductible by trust/estate or taxable to beneficiary


Charitable Deduction - Sec. 642(c)• Requirements:

– Paid from gross income– Paid pursuant to the governing document

• Unlimited in amount

• No distribution deduction

• Generally, must be actually paid in current year or preceding year– Estates and pre- 1969 trusts get charitable deduction if

“permanently set aside”

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Depreciation - Sec. 642(e)

Trusts:– Depreciation apportioned between income beneficiary and the

trust per trust document– If no provisions in trust, depreciation apportioned on basis of

trust income allocable between bene and trust

Estates:– Depreciation allocable on basis of income allocable to bene

and estate


Depreciation - Sec. 642(e)Example

FACTS:• Trust owns apartment building• $2,500 depreciation deduction• Trust pays all income to beneficiary

Beneficiary is entitled to entire $2,500 depreciation deduction

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Depreciation - Sec. 642(e)Exceptions

GR: Depreciation allocated based in TAI allocated to trust/estate and beneficiary

2 exceptions - both apply to trusts:– Trust inst or local law indicates who get depreciation deduction– Trustee maintains depreciation reserve, trust gets deduction to

extent trustee transfers income to reserve for depreciation


Depreciation - Sec. 642(e)ExampleFACTS:

• Depreciation deduction is $5,000• TAI is $20,000• Inst requires trustee to maintain depreciation reserve• Trustee transfers $5,000 of income for depreciation reserve

RESULT: Entire $5,000 depreciation deduction is allocated to trust

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Termination of Trusts and Estates - Sec. 642(h)/Unused Loss Carryovers and Excess Deductions

• NOL, capital loss c/o and “excess deductions” pass to the beneficiary on termination of an estate or trust

• Pass through only in the year of termination


Capital Loss C/O

• Unused capital loss c/o passes to beneficiary in year of termination of trust or estate

• No time limit on beneficiary to use capital loss c/o

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Capital Loss C/OExample

FACTS:• Trust incurs $30,000 LTCL in 2004. • Trust terminates in 2005, LTCL c/o still $30,000 • $30,000 LTCL c/o passes to beneficiary on termination• Beneficiary can use LTCL c/o to offset his own personal capital

gains or, if he has no gains, deduct up to $3,000 each year against ordinary income


“Excess Deductions”

• “Excess deductions” occur where trust/estate expenses exceed income in year of termination

• “Excess deductions” pass through to beneficiary on termination of trust/estate

– Beneficiary can deduct on his personal return

• Deductible as miscellaneous itemized deduction subject to 2% floor

– If beneficiary doesn’t itemize, he can’t use deduction

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“Excess Deductions”Example

FACTS:• Estate has $30,000 of income and $50,000 executor’s fee for

2005.• Estate terminates in 2005• “Excess deductions” are $20,000 ($30,000 - $50,000)• Estate reports the $20,000 excess deduction to the beneficiary

on a Form K-1 (“tax letter”)• Beneficiary can take $20,000 “excess deduction” on his own

personal return as a miscellaneous itemized deduction subject to the 2% floor


Administration Expenses

• Consist of attorney’s fees, accountant’s fees, executor’s commissions, filing fees, surety bonds premiums, appraisal fees,etc.

• Deductible on Federal estate tax return (706) or fiduciary income tax return (1041), but not both

• Fiduciary can elect where to take expenses (706 or 1041) - the so-called Sec. 642(g) election

• Generally, not subject to 2% floor– Test: would expenses be uncommon (or unusual or unlikely)

for an individual to incur?• Generally, claim on return with highest tax rate

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Non-Deductible Expenses - Sec. 265

• Sec. 265 disallows any deduction attributable to T/E income• Generally applies to deductions for production of income, usually

trustee’s fees and executor’s fees• If trust/estate has T/E income, portion of trustee’s and executor’s

fees are nondeductible• No specific allocation formula

– Fiduciary can use any reasonable method


Non-Deductible Expenses - Sec. 265Example

FACTS:• Trust has $30,000 taxable interest and $10,000 T/E interest• Incurs $20,000 trustee fee• Portion of trustee fee attributable to T/E income is non-

deductible

$10,000 T/E income$40,000 Total income

x $20,000 fees = $5,000 non-deductible

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Resources• Federal Income Taxation of Estates, Trusts and Beneficiaries, 3rd

Edition by Ferguson, Freeland and Ascher (Aspen/CCH)• 1041 Deskbook (Practitioners Publishing Co)• Income Taxation of Trusts and Estates, 852-3rd (BNA portfolio –

Estate, Gift and Trust series)• Federal Income Taxation of Decedents, Estates and Trusts, 23rd

Edition (Nov. 2007) (CCH)• Federal Income Taxation of Trusts and Estates, by Zaritsky and

Lane, 3rd Edition (RIA/Thompson/West)• Income Taxation of Fiduciaries and Beneficiaries by Abbin, 2

volumes, 2008 Edition (CCH)


Example of a 2009 Fiduciary Income Tax Return for a Complex Trust

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Facts• Trust provides that 50% of the income must be paid currently to

Will

• During 2009 the trustee makes the following discretionarydistributions:– 25% of the income to Cam– 25% of the income to charity

• No reserve for depreciation is required

Question: What type of trust is this and why?


INCOME Rents 40,000Tax Int. 30,000T/E Int 15,000LTCG 8,000

EXPENSES Depr/Rental 6,000R/E Rent Ex 14,000Tr Fee-Prin 1,000Tr Fee-Inc 2,000Char DedExemptionTotal

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Distribution of Income

Required: 50% to Will

Discretionary: 25% to Cam

25% to Charity


INCOME TAI Rents 40,000 40,000Tax Int. 30,000 30,000T/E Int 15,000 15,000LTCG 8,000 -

EXPENSES Depr/Rental 6,000 -R/E Rent Ex 14,000 (14,000)Tr Fee-Prin 1,000 -Tr Fee-Inc 2,000 (2,000)Char DedExemptionTotal 69,000

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INCOME TAI Rents 40,000 40,000Tax Int. 30,000 30,000T/E Int 15,000 15,000LTCG 8,000 -



INCOM E TAI Rents 40,000 40,000Tax Int. 30,000 30,000T/E Int 15,000 15,000LTCG 8,000 -


Enter on Form 1041, Sch. B,

Line 8

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Amount of TAI Received by Each Beneficiary

Will: 50% x 69,000 TAI = 34,500

Cam: 25% x 69,000 TAI = 17,250

Charity: 25% x 69,000 TAI = 17,250

Total 69,000


INCOM E TAI TI Rents 40,000 40,000 40,000Tax Int. 30,000 30,000 30,000T/E Int 15,000 15,000 -LTCG 8,000 - 8,000

78,000EXPENSES Depr/Rental 6,000 - -R/E Rent Ex 14,000 (14,000) (14,000)Tr Fee-Prin 1,000 - (2,471)Tr Fee-Inc 2,000 (2,000) -Char Ded (14,206)Exemption (100)Total 69,000 47,223

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INCOME TAI TI Rents 40,000 40,000 40,000Tax Int. 30,000 30,000 30,000T/E Int 15,000 15,000 -LTCG 8,000 - 8,000


Enter on Form 1041,

Page 1, Line 17




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Depreciation Deduction

• No reserve for depreciation

• Depreciation follows accounting income

• All accounting income is distributed to Will, Cam and the charity

• Therefore, the trust is not entitled to deduct any depreciation

• Beneficiaries are entitled to depreciation deduction




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Trustee Fee Allocable to T/E Income

15,000 T/E Income85,000 Gross TAI x 3,000 Total Tr Fees = 529



15,000 T/E Income

85,000 Gross TAIx 3,000 Total Tr Fees = 529

(529)

2,471 Deductible Tr Fees

Non-Deductible

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15,000 T/E Income

85,000 Gross TAIx 17,250 TAI Charity = 3,044

3,044Non-Deductible

Charitable Deduction 14,206

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DNI TI before Dist Ded 47,223Add: Exemption 100Add: Net T/E Income 15,000 Less: ND Tr Fee (529) Less: ND Char Ded (3,044) 11,427Less: LTCG (8,000) DNI 50,750

Calculation of DNI


DNI TI before Dist Ded 47,223Add: Exemption 100Add: Net T/E Income 15,000 Less: ND Tr Fee (529) Less: ND Char Ded (3,044) 11,427Less: LTCG (8,000) DNI 50,750

Calculation of DNI

Enter on Form 1041, Sch. B, Line 7

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Components of DNI

47.06%RentalIncome

35.29%TaxableInterest

17.65%T/E

Interest 100%Total

Gross TAI 40,000 30,000 15,000 85,000LESS:Rental Exp (14,000) (14,000)Tr. Fees (1,412) (1,059) (529) (3,000)Char Ded (8,118) (6,088) (3,044) (17,250) Totals 16,470 22,853 11,427 50,750


Application of the Tier System

Will is a FTB - entitled to 50% of the income or $34,500

Cam is a STB - discretionary distribution of $17,250

How do we allocate DNI between FTB and STB???

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Now We’ve Got a Problem!!!

FTB Will gets distribution of $34,500

STB Cam gets distribution of $17,250

Total Distributions $51,750

But DNI is only $50,750!!!


The Tier System Solves Our Problem

FTB Will - Receives $34,500; limited to DNI of $50,750

Share of DNI

$34,500

STB Cam - Receives $17,250; limited to remaining DNI: 50,750 less 34,500 or $16,250

$16,250

Total (Equal to DNI) $50,750

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The Tier System Solves Our Problem

FTB Will - Receives $34,500; limited to DNI of $50,750

Share of DNI

$34,500

STB Cam - Receives $17,250; limited to remaining DNI: 50,750 less 34,500 or $16,250 $16,250

Total (Equal to DNI) $50,750

% of DNI

67.98

32.02

100


Remember This??? - Components of DNI

47.06%Rental Income

35.29%TaxableInterest

17.65%T/E

Interest

100% Total

Gross TAI 40,000 30,000 15,000 85,000 LESS: Rental Exp (14,000) (14,000)

Tr. Fees (1,412) (1,059) (529) (3,000)

Char Ded (8,118) (6,088) (3,044) (17,250)

Totals 16,470 22,853 11,427 50,750

Will and Cam get 67.98% and 32.02%, respectively, of each of these items

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67.98%Will

32.02%Cam Total

RentalIncome 11,196 5,274 16,470TaxableInterest 15,536 7,317 22,853T/EInterest 7,768 3,659 11,427

Total 34,500 16,250 50,750

Trustee reports these amounts to Will and

Cam on separate K-1s


67.98%Will

32.02%Cam Total


Total 34,500 16,250 50,750

Will Reports $26,731 of TI

$26,731

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67.98%Will

32.02%Cam Total


Total 34,500 16,250 50,750

Cam Reports $12,592 of TI

$12,592


But . . Aren’t We Missing Something???

Will Reports

Cam Reports

$26,731 $12,592Taxable Income

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YES! - Depreciation

Will Reports

Cam Reports


Depreciation (3,000) (1,500)

Net Taxable Income $23,731 $11,092


Where’s the Other $1,500 of Depreciation?

Will Reports

Cam Reports


Depreciation (3,000) (1,500)

Net Taxable Income $23,731 $11,092

It is Allocated to Charity and is Wasted!!!

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67.98%Will

32.02%Cam Total


Total 34,500 16,250 50,750

The Distribution Deduction is $39,323


Trust’s Taxable Income

TI Before Dist Deduction $47,223

Distribution Deduction $39,323

Taxable Income $7,900

The taxable income is the LTCG less the $100 exemption

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Trust’s Taxable Income

TI Before Dist Deduction $47,223

Distribution Deduction $39,323

Taxable Income $7,900

The taxable income is the LTCG less the $100 exemption

Report on Form 1041,

Page1, Line22


Summary• Compute TAI• Figure Distribution Beneficiaries Get• Calculate Taxable Income

– Allocate Depreciation– Allocate Expenses to T/E Income

• Calculate DNI• Apply Tier System

– Allocate DNI• Send K-1s to Beneficiaries• Complete 1041

Thank God for Tax Software!!!

Download - Income Taxation of Trusts and Estates – Basics and Beyondmacpamedia.org/.../2010CTC/Income_Taxation_of_Trusts_and_Estates… · Income Taxation of Trusts and Estates ... Boston,

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