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14-1©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-2
INCOME TAXATION OF INCOME TAXATION OF TRUSTS & ESTATESTRUSTS & ESTATES (1 of 2) (1 of 2)
Basic conceptsPrinciples of fiduciary accountingFormula for trust taxable income
and tax liabilityDistributable net income (DNI)Determining a simple trust’s
taxable income
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-3
INCOME TAXATION OF INCOME TAXATION OF TRUSTS & ESTATESTRUSTS & ESTATES (2 of 2) (2 of 2)
Determining taxable income for complex trusts and estates
Income in respect of a decedentGrantor trust provisionsTax planning considerationsCompliance and procedural
considerations
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-4
Basic ConceptsBasic Concepts
InceptionReasons for creating trustsBasic principles of fiduciary
taxationDefinitions
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-5
Inception
Estate Upon death of person whose assets
are being administeredTrust
Inter vivosCreated while person is alive or under
direction of will following deathTestamentary
Created by decedent’s will
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-6
Reasons for Creating Trusts
Tax saving aspectsIncome splittingMinimizing estate taxes
Nontax aspects§2503 and Crummey trusts
Trustee manages assets for minorRevocable trust
Reduces probate costs
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-7
Basic Principles of Fiduciary Taxation
Trusts and estates separate taxpayers
No double taxationDeductions permitted for income
distributed to beneficiariesConduit approach
Distributed income retains its characterRules similar to individuals
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-8
Principles of Fiduciary Principles of Fiduciary Accounting Accounting (1 of 4)(1 of 4)
Principal or corpusInitial assets transferred by grantor plus
certain additions/deductions required by provisions of trust instrument
IncomeEarnings derived from principal but
certain gains, losses or deductions may be considered adjustments to principal
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-9
Principles of Fiduciary Principles of Fiduciary Accounting Accounting (2 of 4)(2 of 4)
GrantorParty that transfers assets to a trust
TrusteeParty that administers a trust
Income BeneficiaryParty (or parties) who receives income
when distributed by Trustee under provisions of trust instrument
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-10
Principles of Fiduciary Principles of Fiduciary Accounting Accounting (3 of 4)(3 of 4)
RemaindermenParty (or parties) who eventually
receives trust principalSame person may receive both income
and principalSimple trust
Must distribute all income annually,Does not distribute any principal ANDMakes no contributions to charities
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-11
Principles of Fiduciary Principles of Fiduciary Accounting Accounting (4 of 4)(4 of 4)
Complex trustAny trust that is not a simple trust
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-12
Formula for Trust Taxable Formula for Trust Taxable Income & Tax Liability Income & Tax Liability (1 of (1 of
3)3)
Gross Income- Deductions for expenses- Personal exemption= Taxable income before
distribution- Distribution deduction= Trust taxable income
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-13
Formula for Trust Taxable Formula for Trust Taxable Income & Tax Liability Income & Tax Liability (2 of (2 of
3)3)
Trust taxable income x Tax rates in §§1(e) & 1(h)= Tax on taxable income - Credits= Net tax liability
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-14
Formula for Trust Taxable Formula for Trust Taxable Income & Tax Liability Income & Tax Liability (3 of (3 of
3)3)
Deductions for expensesParallel expenses for individualsTrustee fees deductible similar to §212 exp2% of AGI floor may apply to certain expPersonal exemption
$300 if all income required to be distributed annually
$100 if current income may be retained
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-15
Distributable Net Income Distributable Net Income (DNI)(DNI)(1 of 2)(1 of 2)
DNI is maximum distribution deduction & income reportable by beneficiaries
No distribution deduction available for portion of distribution deemed to consist of tax-exempt income even though net tax-exempt income included in DNI
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-16
Distributable Net Income Distributable Net Income (DNI)(DNI)(2 of 2)(2 of 2)
Taxable income before distributions+ Personal exemption already deducted- Capital gains added to principal+ Capital losses subtracted from principal+ Tax exempt interest (net of expenses)= Distributable Net IncomeSee Topic Review 2
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-17
Determining a Simple Determining a Simple Trust’sTrust’s
Net Income Net Income (1 of 3)(1 of 3)
Must distribute all of its net accounting income currently
Aggregate gross income reported by beneficiaries cannot exceed DNI
Income received by beneficiaries retains its character
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-18
Determining a Simple Determining a Simple Trust’sTrust’s
Net Income Net Income (2 of 3)(2 of 3)
Allocation of expenses to tax-exempt income
Tax-exempt income
(net of exp. directly
attributable thereto)
X
Accounting income
(net of all direct exp)
=
Indirect expenses allocable to non-taxable income
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-19
Determining a Simple Determining a Simple Trust’sTrust’s
Net Income Net Income (3 of 3)(3 of 3)
Tax treatment of beneficiary if trust has > 1 beneficiaryBeneficiary’s share of gross income if
DNI lower than net accounting income is fraction of DNI shown below
Income required to be distributed to such beneficiaryIncome required to be distributed to all beneficiaries
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-20
Determining Taxable Determining Taxable Income for Complex Income for Complex
Trusts & EstatesTrusts & Estates
Complex trusts permit the following activitiesMaking distributions < current earningsDistributing principalMaking charitable contributions
Complex trust’s DNIImpact on beneficiaries
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-21
Complex Trust’s DNI(1 of 2)
Complex DNI not reduced by charitable contribution deduction when determining maximum distribution for mandatory distributions
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-22
Complex Trust’s DNI(2 of 2)
DNI reduced when calculating deductible discretionary distributions
Distribution deduction is smaller of DNI or sum of mandatory and other amounts properly paid
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-23
Impact on Beneficiaries(1 of 2)
In generalBeneficiary includes distributions as gross
income up to current DNI for the trustAccumulation distribution or throwback
rules attempt to tax individual as if distributions were made annually
Higher trust tax rates make accumulation less desirable
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-24
Impact on Beneficiaries(2 of 2)
Tax treatment of beneficiary if trust has > 1 beneficiaryBeneficiary’s share of gross income
if total income required to be distributed exceeds DNI
Income required to be distributed currently to beneficiary
Aggregate income required to be distributed to all beneficiaries currently
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-25
Income in Respect of a Income in Respect of a Decedent (IRD)Decedent (IRD) (1 of 4)(1 of 4)
Most individuals use cash basisIRD is income constructively
received, but not actually received before deathInterest on CDs, bonds or savingsSalary, commissions or bonusDividends received after date of
death with record date before death
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-26
Income in Respect of a Income in Respect of a Decedent (IRD)Decedent (IRD) (2 of 4) (2 of 4)
IRD must be included As gross income on estate’s
income tax return ANDAs part of the gross estate for
transfer tax purposes
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-27
Income in Respect of a Income in Respect of a Decedent (IRD)Decedent (IRD) (3 of 4) (3 of 4)
Estate may claim an income tax deduction for the extra transfer tax due because these items were counted as part of the estate
No step-up in basis for IRD items
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-28
Income in Respect of a Income in Respect of a Decedent (IRD)Decedent (IRD) (4 of 4) (4 of 4)
§691(c)deduction
for the year
XTotal
§691(c)deduction
=
Net IRD included in gross inc for the year
-----------------
Total Net IRD
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-29
Grantor Trust ProvisionsGrantor Trust Provisions(1 of 2)(1 of 2)
Grantor does not give up enough control or economic benefit to be a completed transfer
Grantor taxed on some or all of trusts incomeEven if income distributed to
beneficiaries
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-30
Grantor Trust ProvisionsGrantor Trust Provisions(2 of 2)(2 of 2)
Types of grantor trustsRevocable trustsPost-1986 Reversionary interest
trustsSee Topic Review 4
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-31
Tax Planning Tax Planning ConsiderationsConsiderations
(1 of 2)(1 of 2)
Changes that reduced the benefit of using trusts to shift incomeTax rates for fiduciaries are very
compressedChildren under 18 (and some > 18) are
taxed at parents’ higher on unearned income even if from a trust or estate
Dividend income taxed at max of 15%
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-32
Tax Planning Tax Planning ConsiderationsConsiderations
(2 of 2)(2 of 2)
Timing of distributionsSprinkling trust maximize flexibility in
timing of distributions to each beneficiary to maximize tax savings
Property distributionsTrustee may elect to recognize gain on
appreciated property distributedEstates are free to adopt any fiscal year
©2010 Pearson Education, Inc. Publishing as Prentice Hall
14-33
Compliance and Compliance and Procedural Procedural
ConsiderationsConsiderations
Filing requirementsForm 1041 if gross income ≥$600Due date 15th day of 4th month
following year endForm 7004 for automatic 5-mo
extension
©2010 Pearson Education, Inc. Publishing as Prentice Hall
Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark at University of Northern Colorado’s
Kenneth W. Monfort College of [email protected]
14-34©2010 Pearson Education, Inc. Publishing as Prentice Hall