Principles of Taxation: Advanced Strategies Slide 15-1 Chapter 15 Income Taxation of Trusts and Estates McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trusts Slide 15-2 Created when a donor transfers property to a fiduciary or trustee for the benefit of one or more beneficiaries Trust property is called corpus or principal Two ways trusts may be created Donor may create during his or life (inter vivos trust) May be created by will (testamentary trust) McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trusts – Nontax Purposes Slide 15-3 May get professional management through use of a corporate trustee such as a bank Useful for providing for beneficiaries incapable of managing property such as children Useful if income beneficiaries different from remaindermen Trusts may be useful in minimizing estate costs McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trusts Donor control May be irrevocable Slide 15-4 Donor control May be irrevocable Donor gives up control over property May be revocable Donor may revoke trust and take back property Result is incomplete gift for gift and estate tax purposes Treated as grantor trust with donor taxable on all income even if trust is not revoked McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trusts Slide 15-5 Simple trust Trust required to distribute all of its accounting income Makes no charitable contributions No distributions out of corpus Complex trust Any trust that is not a simple trust McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Taxation of Trust and Estates (Overview) Slide 15-6 Modified conduit approach Trusts and estates are allowed a deduction for income distributed and taxed to their beneficiaries Trusts and estates are taxable on any income not distributed McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Taxable Income Calculation Slide 15-7 Step 1: Calculate trust accounting income Step 2: Calculate trust taxable income before income distribution deduction Step 3: Compute distributable net income (DNI) and the distribution deduction Step 4: Subtract the distribution deduction from the amount in step w to determine trust taxable income McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Taxable Income Calculation (continued) Slide 15-8 Step 5: Calculate trust tax liability Step 6: Allocated DNI and the distribution deduction to the beneficiaries to determine the amount and character of income taxed to each beneficiary McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Accounting Income Slide 15-9 Importance: determines which items are allocated to income and distributable to beneficiaries and which items are allocated to principal If trust document is silent on allocation, state law controls McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Common Allocations Income Principal Slide 15-10 Income Principal Interest, dividends, rents, royalties Capital gains and losses on investments Operating income Casualty losses and insurance recoveries Operating expense Extraordinary repairs Taxes levied on income Taxes levied on principal McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Taxable Income Slide 15-11 Computed in a manner similar to individual taxable income No adjusted gross income concept No standard deduction McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Depreciation Slide 15-12 May be deductible by trust, beneficiaries or allocated between them Trust document controls If document silent, depreciation apportioned based on share of trust accounting income In such a situation a simple trust would allocate all depreciation to beneficiaries McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Slide 15-13 Other Expenses Any expense attributable to earning tax-exempt income is nondeductible Indirect expenses such as trust administration fees must be allocated between taxable and tax-exempt income based upon their proportion of total income McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Exemptions Slide 15-14 All trusts entitled to a personal exemption except in final year Trusts required to distribute all income annually receive an exemption of $ 300 Other trusts receive $ 100 exemption McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Distributable Net Income Slide 15-15 Defines the maximum possible income distribution deduction and maximum possible income from trust taxable to beneficiaries McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Distributable Net Income Calculation Slide15-16 Start: Taxable income before distribution deduction Add : Personal exemption Subtract: Capital gains allocated to principal Add: Capital losses allocated to principal Add: Tax-exempt interest Subtract: Expenses allocated to tax-exempt income McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Tax Liability Slide 15-17 Tax rates are steeply progress reaching the maximum rate of 39.6% with only $ 8,900 of taxable income Often beneficiaries in lower rate brackets McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Taxation of Trust Beneficiaries Slide 15-18 Income taxable to trust beneficiaries in total is limited to DNI Beneficiaries of simple trusts and beneficiaries of first tier distributions from complex trust taxed proportionately on share of income distributed Second tier distributions only taxable to beneficiaries if first tier does not exceed DNI McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Character of Income Slide 15-19 If more than one type of income is distributed from a complex trust, it must be allocated proportionately amount income beneficiaries McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Separate Share Rule Slide 15-20 Applies when trust has multiple beneficiaries and each is entitled to a substantially separate and independent share of income and assets Character and amount of distribution computed as though each share was a separate trust McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Property Distributions Slide 15-21 Trust Property Distributions Property passes out at its adjusted basis Trust does not recognize gain or loss on distribution Beneficiary takes carryover basis Holding period tacks McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Property Distributions Slide 15-22 Trust Property Distributions At the option of the trustee, the trust may elect to recognize gain on distributions of appreciated property Distribution treated as made at fair market value to beneficiary Holding period begins on date of the distribution McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Trust Filing Requirements Slide 15-23 All trusts must use a calendar year end All trusts must file if over $ 600 of gross income or any taxable income McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Income Taxation of Estates Slide 15-24 Income Taxation of Estates Basically same rules as for taxation of trusts Distributions allocated between principal and income based upon will or state law McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Income in Respect of a Decedent Slide 15-25 Income earned before death of decedent but not properly reportable on final income tax return Items are subject to both income tax and estate tax Related expenses are referred to as deductions in respect of a decedent Deductions in respect of a decedent are deductible for both income and estate tax McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Estate Administration Expenses Slide 15-26 May be claimed as deductions against estate tax return or income tax return but not both To claim on income tax return, personal representative must file election not to claim as deductions on estate tax return McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

Estate Exemptions and Filing Requirements Slide 15-27 $ 600 exemption May utilize a fiscal year No estimated payments required for two years after decedent’s death McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc