We get numerous questions at CALT (Center f0r Agricultural Law and Taxation) concerning income tax issues associated with trusts and estates. This month we provide a short primer on a few of the basic principles of trust and estate taxation. We have and will continue to develop more in-depth articles on TaxPlace, but here we address some of the key points on a surface level.
Clearly the income taxation of estates and trusts is much more the focus of estate planners today than it was in the past. With the federal estate tax exemption being $5.39 million per decedent, the vast majority of estates have no need for estate planning as a means of saving federal estate tax. At the same time, however, income tax rates have gone up.
With the compressed tax brackets that apply to trusts and estates, that puts income tax planning at a premium. Presently, the top bracket rate of 39.6 percent is reached when income levels exceed slightly over $12,000. When state tax is added in, and the net investment income tax, that rate could be nearly 50 percent.
General rules. Subchapter J of the Internal Revenue Code governs the income taxation of estates and trusts (I.R.C. §641, et seq.).
19 Points to Keep in Mind:
- An estate or a trust is a separate taxable entity.
- The taxable income of an estate or trust is generally computed in the same manner as it is for individuals, with some exceptions.
- A fiduciary may elect a fiscal year for an estate.
- A trust may use a fiscal year if it elects under I.R.C. §645.
- The income of a trust or an estate is taxed either to the entity or to the beneficiary. However, the exemptions are different for an estate as compared to a trust ($600 for an estate; $300 for a simple trust; $100 for all other types of trusts). There are also different rules for charitable deductions.
- Depreciation deductions are allocated between the estate/trust and the beneficiary(ies).
- Administrative expenses can be deducted either on the federal estate tax (Form 706) or the fiduciary income tax return (Form 1041).
- The executor can split the executor’s fee (if any) between Form 706 and Form 1041, and they are generally not subject to the 2 percent floor on itemized deductions. Recent regulations bear on this issue. Generally, it’s a good “rule of thumb” to claim expenses associated with the estate/trust on the return which is subject to the highest tax rate – probably the income tax return.
- Deductions that are attributable to tax-exempt income are non-deductible.
- The part of the trustee or executor fee that is attributable to tax-exempt income is not deductible.
- If income is accumulated inside a trust or an estate, it is taxed to the estate or trust rather than the beneficiary(ies). If it is distributed, the trust of the estate gets a deduction for the amount of the distribution limited to “distributable net income” (DNI). The beneficiary accounts for income that has been actually distributed to that particular beneficiary (subject to the DNI limitation).
- DNI = taxable income + distribution deduction + personal exemption – capital gains (but add back in capital losses that are allocated to principal (except in the year of termination)) – extraordinary dividends and taxable stock dividends allocated to corpus (for simple trusts) + net tax-exempt income.
- The DNI rules are different as applied to simple trusts as compared to complex trusts and estates.
- A fiduciary (executor/trustee) can treat a distribution to a beneficiary that is made within 65 days of a new year as being made on December 31 of the prior year. This is done by an irrevocable election made by the due date of the return. The election is an annual election.
- Specific bequests do not carry out DNI if they are made all at once or in three or fewer installments and are ascertainable as of the decedent’s death. A specific bequest is not deductible by the trust/estate, and is also not taxable to the beneficiary.
- For residuary bequests, an estate/trust can elect to recognize gains or losses. The distribution carries out DNI, with the amount of DNI depending on whether the I.R.C. §643 election was made.
- A charitable bequest must be paid from gross income and in accordance with the will/trust.
- For trusts, depreciation is apportioned between the income beneficiary and the trust either by the terms of the trust or on the basis of the trust income allocable between the beneficiary and the trust. For estates, it’s allocable based on income allocable to the beneficiary and the estate.
- The I.R.C. §645 election, when made, results in a “qualified revocable trust” being treated as part of the decedent’s estate for income tax purposes. The election is made via Form 8855.
These are just some of the basic income tax issues associated with trusts and estates. For more detailed information, consult TaxPlace.