1. 14-1 ©2008 Prentice Hall, Inc.

2. 14-2 ©2008 Prentice Hall, Inc. INCOME TAXATION OF TRUSTS & ESTATES (1 of 2)  Basic concepts  Principles of fiduciary accounting  Trust taxable income  Distributable net income (DNI)  Determining a simple trust’s taxable income

3. 14-3 ©2008 Prentice Hall, Inc. INCOME TAXATION OF TRUSTS & ESTATES (2 of 2)  Determining taxable income for complex trusts and estates  Income in respect of a decedent  Grantor Trusts

4. 14-4 ©2008 Prentice Hall, Inc. Basic Concepts  Inception  Reasons for creating trusts  Basic principles of fiduciary taxation  Definitions

5. 14-5 ©2008 Prentice Hall, Inc. Inception  Estate  Upon death of person whose assets are being administered  Trust  Inter vivos  Created while person is alive or under direction of will following death  Testamentary  Created by decedent’s will

6. 14-6 ©2008 Prentice Hall, Inc. Reasons for Creating Trusts  Tax saving aspects  Income splitting  Minimizing estate taxes  Nontax aspects  §2503 and Crummey trusts  Trustee manages assets for minor  Revocable trust  Reduces probate costs

7. 14-7 ©2008 Prentice Hall, Inc. Basic Principles of Fiduciary Taxation  Trusts and estates separate taxpayers  No double taxation  Deductions permitted for income distributed to beneficiaries  Conduit approach  Distributed income retains its character  Rules similar to individuals

8. 14-8 ©2008 Prentice Hall, Inc. Principles of Fiduciary Accounting (1 of 4)  Principal or corpus  Initial assets transferred by grantor plus certain additions/deductions required by provisions of trust instrument  Income  Earnings derived from principal but certain gains, losses or deductions may be considered adjustments to principal

9. 14-9 ©2008 Prentice Hall, Inc. Principles of Fiduciary Accounting (2 of 4)  Grantor  Party that transfers assets to the trust  Trustee  Party that administers the trust  Income Beneficiary  Party (or parties) who receives income when distributed by Trustee under provisions of trust instrument

10. 14-10 ©2008 Prentice Hall, Inc. Principles of Fiduciary Accounting (3 of 4)  Remaindermen  Party (or parties) who eventually receives trust principal  Same person may receive both income and principal  Simple trust  Must distribute all income annually,  Does not distribute any principal AND  Makes no contributions to charities

11. 14-11 ©2008 Prentice Hall, Inc. Principles of Fiduciary Accounting (4 of 4)  Complex trust  Any trust that is not a simple trust  Personal exemption  $300 if all income required to be distributed annually  $100 if current income may be retained

12. 14-12 ©2008 Prentice Hall, Inc. Formula for Taxable Income & Tax Liability (1 of 3) Gross Income - Deductions for expenses - Personal exemption = Taxable income before distribution - Distribution deduction = Trust taxable income

13. 14-13 ©2008 Prentice Hall, Inc. Formula for Taxable Income & Tax Liability (2 of 3) Trust taxable income x Tax rates in §§1(e) & 1(h) = Tax on taxable income - Credits = Net tax liability

14. 14-14 ©2008 Prentice Hall, Inc. Formula for Taxable Income & Tax Liability (3 of 3)  Deductions for expenses  Parallel expenses for individuals  Trustee fees deductible similar to a §212 expenses

15. 14-15 ©2008 Prentice Hall, Inc. Distributable Net Income (DNI) (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

16. 14-16 ©2008 Prentice Hall, Inc. Distributable Net Income (DNI) (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 Income  See Topic Review C14-2

17. 14-17 ©2008 Prentice Hall, Inc. Determining a Simple Trust’s Net Income (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

18. 14-18 ©2008 Prentice Hall, Inc. Determining a Simple Trust’s Net Income (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

19. 14-19 ©2008 Prentice Hall, Inc. Determining a Simple Trust’s Net Income (3 of 3)  Tax treatment of beneficiary if trust has > 1 beneficiary  Beneficiary’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 beneficiary Income required to be distributed to all beneficiaries

20. 14-20 ©2008 Prentice Hall, Inc. Determining Taxable Income for Complex Trusts & Estates  Complex trusts permit the following activities  Making distributions < current earnings  Distributing principal  Making charitable contributions  Complex trust’s DNI  Impact on beneficiaries

21. 14-21 ©2008 Prentice Hall, Inc. Complex Trust’s DNI (1 of 2)  Complex DNI not reduced by charitable contribution deduction when determining maximum distribution for mandatory distributions

22. 14-22 ©2008 Prentice Hall, Inc. 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

23. 14-23 ©2008 Prentice Hall, Inc. Impact on Beneficiaries (1 of 2)  In general  Beneficiary includes distributions as gross income up to current DNI for the trust  Accumulation distribution or throwback rules attempt to tax individual as if distributions were made annually  Higher trust tax rates make accumulation less desirable

24. 14-24 ©2008 Prentice Hall, Inc. Impact on Beneficiaries (2 of 2)  Tax treatment of beneficiary if trust has > 1 beneficiary  Beneficiary’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

25. 14-25 ©2008 Prentice Hall, Inc. Income in Respect of a Decedent (IRD) (1 of 4)  Most individuals use cash basis  IRD is income constructively received, but not actually received before death  Interest on CDs, bonds or savings  Salary, commissions or bonus  Dividends received after date of death with record date before death

26. 14-26 ©2008 Prentice Hall, Inc. Income in Respect of a Decedent (IRD) (2 of 4)  IRD must be included  As gross income on estate’s income tax return AND  As part of the gross estate for transfer tax purposes

27. 14-27 ©2008 Prentice Hall, Inc. Income in Respect of a Decedent (IRD) (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

28. 14-28 ©2008 Prentice Hall, Inc. Income in Respect of a Decedent (IRD) (4 of 4) §691(c) deduction for the year X Total §691(c) deduction = Net IRD included in gross inc for the year ----------------- Total Net IRD

29. 14-29 ©2008 Prentice Hall, Inc. Grantor Trusts (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 income  Even if income distributed to beneficiaries

30. 14-30 ©2008 Prentice Hall, Inc. Grantor Trusts (2 of 2)  Types of grantor trusts  Revocable trusts  Post-1986 Reversionary interest trusts  See Topic Review C14-4

31. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 14-31 ©2008 Prentice Hall, Inc.