Taxation of Trusts & Estates Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication, including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. If you would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us. Stephen J. Bigge, CPA Keebler & Associates, LLP 420 S. Washington St. Green Bay, WI Phone: (920)

Taxation of Trusts & Estates © 2015 Keebler & Associates, LLP All Rights Reserved 2 Foundational concepts Tax-sensitive planning

Foundational Concepts 3 © 2015 Keebler & Associates, LLP All Rights Reserved

Overview Foundational Concepts 4 © 2015 Keebler & Associates, LLP All Rights Reserved General tax rules Types of trusts Types of income Distributable Net Income (DNI) Tier rules Separate share rule 65-day rule (IRC §663(b)) Charitable deductions (IRC §642(c)) Income in Respect of a Decedent (IRD) 3.8% Net Investment Income Tax (NIIT) Other issues

Foundational Concepts 5 © 2015 Keebler & Associates, LLP All Rights Reserved General Tax Rules Trusts and estates are separate taxable entities –Receive income and pay expenses Taxable income computed similar to individuals –Exemption ○ $100 complex trust ○ $300 simple trust ○ $600 estate Method of tax accounting –Trusts – Calendar year (i.e. Jan. 1 st – Dec. 31 st ) –Estates – Fiscal or calendar year

Foundational Concepts 6 © 2015 Keebler & Associates, LLP All Rights Reserved General Tax Rules Income taxed to either the trust/estate or the beneficiary –If income is accumulated, then the income is taxed to the trust/estate –If income is distributed, then the trust/estate gets an income tax deduction and beneficiaries report taxable income

Foundational Concepts 7 © 2015 Keebler & Associates, LLP All Rights Reserved Types of Trusts Simple trusts –Required to distribute accounting income annually –Cannot make principal distributions –Cannot make distributions to charity Complex trusts –May accumulate income –May make either discretionary or mandatory distributions of income and/or principal –May make distributions to charity

Foundational Concepts 8 © 2015 Keebler & Associates, LLP All Rights Reserved Types of Trusts Grantor trusts –Trust and grantor treated as one taxpayer –Income taxed to grantor Charitable trusts –Split-interest trusts consisting of an income beneficiary and a remainder beneficiary ○ Charitable Lead Trust (CLT) – charity is the income beneficiary ○ Charitable Remainder Trust (CRT) – charity is the remainder beneficiary −Last for a term of years or life

Foundational Concepts 9 © 2015 Keebler & Associates, LLP All Rights Reserved Types of Income Fiduciary accounting income –Governed by state law and the trust instrument –Determines the amount that may or must pass to the trust’s or estate’s beneficiaries Tax accounting income –Governed by the federal income tax law –Determines who is taxed on the income

Foundational Concepts 10 © 2015 Keebler & Associates, LLP All Rights Reserved Types of Income Typical Types of Fiduciary Income Interest –Taxable –Tax-exempt Dividends Rents (net of expenses) Royalties

Foundational Concepts 11 © 2015 Keebler & Associates, LLP All Rights Reserved Types of Income Typical Types of Fiduciary Principal IRA value as of date of death Increases in asset value (i.e. growth) Realized long-term capital gain Realized short-term capital gain Proceeds from covered call writing

Foundational Concepts Assume that a complex trust had the following sources of income and deductions during the current tax year: Interest income$3,000 Tax-exempt interest income1,000 Dividend income6,000 Rental income10,000 Royalty income5,000 Long-term capital gains15,000 Taxes3,000 Trustee fees3,000 Attorney/accountant fees1,000 All indirect expenses 12 © 2015 Keebler & Associates, LLP All Rights Reserved Types of Income Fiduciary Income vs. Taxable Income Example

Foundational Concepts NOTE 1: Trust expenses (for fiduciary accounting purposes) were apportioned on a pro-rata basis between income and principal. NOTE 2: Under IRC §265, the trust’s deductible expenses (for income tax purposes) must be reduced for the portion that are allocable to tax-exempt income. 13 © 2015 Keebler & Associates, LLP All Rights Reserved Types of Income Fiduciary Income vs. Taxable Income Example (cont.)

Foundational Concepts 14 © 2015 Keebler & Associates, LLP All Rights Reserved Distributable Net Income (DNI) Determines the amount of the trust’s or estate’s income distribution deduction Determines how much the beneficiaries must report as income on their tax returns Determines the character (e.g. interest, dividends, etc.) of the taxable income in beneficiaries’ hands

Foundational Concepts DNI Trust/Estate DNI acts as a ceiling for purposes of the allowable deduction Beneficiary DNI acts as a ceiling for the total amount of income the beneficiary must report on his/her tax return 15 © 2015 Keebler & Associates, LLP All Rights Reserved Distributable Net Income (DNI)

Foundational Concepts Taxable income + Income distribution deduction + Exemption + Net tax-exempt income + Capital losses* = Distributable Net Income (DNI) * Except in the year of termination 16 © 2015 Keebler & Associates, LLP All Rights Reserved Distributable Net Income (DNI)

Foundational Concepts 17 © 2015 Keebler & Associates, LLP All Rights Reserved Distributable Net Income (DNI) Normally, capital gains and losses are trapped at the trust or estate level –However, in the year of termination, the capital gain/loss passes out to the beneficiaries Specific bequests do not carry out DNI to the beneficiaries –Not taxable to trust/estate or beneficiaries –Requirements o Paid at once OR o Paid in not more than 3 installments

Foundational Concepts Assume that a complex trust had the following sources of income and deductions during the current tax year: Interest income$15,000 Dividend income10,000 Rental income5,000 Long-term capital gains20,000 Taxes2,500 Trustee fees3,500 Attorney/accountant fees2, © 2015 Keebler & Associates, LLP All Rights Reserved Distributable Net Income (DNI) DNI Example

Foundational Concepts 19 © 2015 Keebler & Associates, LLP All Rights Reserved Distributable Net Income (DNI) DNI Example (cont.)

Foundational Concepts 20 © 2015 Keebler & Associates, LLP All Rights Reserved Tier Rules Apply to estates and complex trusts Two tiers –First tier beneficiary o Required distribution of income on a current basis –Second tier beneficiary o Receives any amount remaining (at the discretion of the trustee/executor)

Foundational Concepts Mandatory distributions of income Complex Trust First Tier Beneficiary DNI carries out to this beneficiary only to the extent that income exceeds the distribution made to the first tier beneficiary Second Tier Beneficiary Discretionary distributions of income and/or principal DNI carries out to this beneficiary first 21 © 2015 Keebler & Associates, LLP All Rights Reserved Tier Rules

Foundational Concepts 22 © 2015 Keebler & Associates, LLP All Rights Reserved Separate Share Rules Applies to estates and complex trusts Treats multiple beneficiaries of an estate or single trust as if each were the sole beneficiary Determines how DNI carries out to each beneficiary –DNI is computed separately for each share

Foundational Concepts 23 © 2015 Keebler & Associates, LLP All Rights Reserved Separate Share Rules Separate Share Example Assumptions Complex trust Two equal beneficiaries (S & D) Distributable Net Income (DNI) in 2015 = $30,000 Distributable Net Income (DNI) in 2016 = $10,000 Trust distributes $20,000 to S and $5,000 to D in 2015 Trust distributes $15,000 to D in 2016

2015 Tax Year2016 Tax Year Son$15,000$0 Daughter5,000 Trust10,0005,000 Total$30,000$10,000 Foundational Concepts 24 © 2015 Keebler & Associates, LLP All Rights Reserved Separate Share Rules Separate Share Example (cont.)

Foundational Concepts 25 © 2015 Keebler & Associates, LLP All Rights Reserved 65-Day Rule (IRC §663(b)) Applies to estates and complex trusts Allows fiduciary to treat distributions made within 65 days after year-end to be treated as if they were made as of December 31 st of the prior year –Limited to DNI (reduced by distributions made during the prior year) Election must be made by the due date of the tax return –Election is irrevocable –Annual election

Foundational Concepts /31 65 days Distributions for the 2015 tax year made during this period will be treated as have been made as of 12/31/2015 (if a timely election is made) 26 © 2015 Keebler & Associates, LLP All Rights Reserved 65-Day Rule (IRC §663(b))

Foundational Concepts 27 © 2015 Keebler & Associates, LLP All Rights Reserved Charitable Deduction (IRC §642(c)) Requirements –Paid from gross income –Paid pursuant to the governing document Must be actually be paid in the current year –Exception – pre-1969 trusts Unlimited in amount Taken as a deduction in computing adjusted gross income (AGI)

Income in respect of a decedent (IRD) – is all items of gross income in respect of a decedent which were not properly included as taxable income in a tax period falling on or before a taxpayer’s death and are payable to his/her estate and/or another beneficiary Foundational Concepts 28 © 2015 Keebler & Associates, LLP All Rights Reserved Income in Respect of a Decedent (IRD)

Foundational Concepts 29 © 2015 Keebler & Associates, LLP All Rights Reserved Income in Respect of a Decedent (IRD) Types of IRD IRAs and other qualified retirement plans Unpaid salaries/wages at the time of death Dividends and interest earned, but not taxed, prior to death Unrecognized capital gain on an installment note at the time of the seller’s death Net Unrealized Appreciation (NUA) on employer securities

Foundational Concepts 30 © 2015 Keebler & Associates, LLP All Rights Reserved Income in Respect of a Decedent (IRD) IRC §691(c) Deduction To the extent that a decedent’s taxable estate includes items of IRD and a federal estate tax is assessed, the estate and/or its beneficiaries are entitled to an income tax deduction for the estate tax attributable to IRD –This deduction is a miscellaneous itemized deduction NOT subject to the 2% AGI limitation

Foundational Concepts 31 © 2015 Keebler & Associates, LLP All Rights Reserved Income in Respect of a Decedent (IRD) IRC §691(c) Deduction The income tax deduction computation for estate taxed paid on IRD is determined on a “with and without” basis –In essence, the total deduction allowed is the difference between: (a) the estate tax liability with all items of IRD included in the taxable estate and (b) the estate tax liability without the IRD included in the taxable estate

On July 1, 2015, Jackie passed away leaving the following assets: Foundational Concepts 32 © 2015 Keebler & Associates, LLP All Rights Reserved Income in Respect of a Decedent (IRD) IRC §691(c) Deduction Example

Subsequent to her death, the personal representative withdrew $50,000 from Jackie’s IRA. Accordingly, the IRC §691(c) attributable to the $50,000 distribution would be as follows: Foundational Concepts 33 © 2015 Keebler & Associates, LLP All Rights Reserved Income in Respect of a Decedent (IRD) IRC §691(c) Deduction Example (cont.)

Foundational Concepts 34 © 2015 Keebler & Associates, LLP All Rights Reserved Income in Respect of a Decedent (IRD) IRC §691(c) Deduction Example (cont.)

Foundational Concepts 35 © 2015 Keebler & Associates, LLP All Rights Reserved 3.8% X the lesser of 1.Undistributed “net investment income” for such taxable year OR 2. The excess (if any) of— -“Adjusted Gross Income” (as defined in Section 67) for such taxable year, over the dollar amount at which the highest tax bracket in section 1(e) begins for such a taxable year 3.8% Net Investment Income Tax (NIIT)

Foundational Concepts 36 © 2015 Keebler & Associates, LLP All Rights Reserved Does NOT Include: Salary, wages, or bonuses Distributions from IRAs or qualified plans Any income taken into account for self-employment tax purposes Gain on the sale of an active interest in a partnership or S corporation Items which are otherwise excluded or exempt from income under the income tax law, such as interest from tax-exempt bonds, capital gain excluded under IRC 121, and veterans benefits Includes: Interest Dividends Annuity Distributions Rents Royalties Income derived from passive activity Net capital gain derived from the disposition of property 3.8% Net Investment Income Tax (NIIT)

Foundational Concepts 37 © 2015 Keebler & Associates, LLP All Rights Reserved Mary Ann – Deceased Estate/Trust $0 employment income Undistributed $225,000 net investment income Excess of: MAGI Threshold Subtotal $ 225,000 $ 11,950 $213, % NIIT would apply to $213, % Net Investment Income Tax (NIIT)

Foundational Concepts 38 © 2015 Keebler & Associates, LLP All Rights Reserved 3.8% Net Investment Income Tax (NIIT) 3.8% NIIT would not apply Wages are not subject to NIIT Jerry – Deceased Estate $100,000 salary (IRD) $0 net investment income

Foundational Concepts 39 © 2015 Keebler & Associates, LLP All Rights Reserved 3.8% Net Investment Income Tax (NIIT) Anita Jones Trust $100,000 investment income $50,000 of IRA Income A distribution of $90,000 or 60% of AGI DNI Reduction of $60,000 $40,000 is trapped and subject to NIIT 3.8% NIIT would apply Residual taxable to the trust, but potentially to the beneficiaries

Foundational Concepts 40 © 2015 Keebler & Associates, LLP All Rights Reserved Other Issues Trust/Estate Termination In the year of termination, all Net Operating Losses (NOLs), capital losses and “excess deductions” pass to the beneficiaries –Only applies in the year of termination –NOLs subject to carryback/carryover rules that apply to individual taxpayers –No time limit on beneficiaries to use capital loss carryovers

Foundational Concepts 41 © 2015 Keebler & Associates, LLP All Rights Reserved Other Issues Excess deductions “Excess deductions” occur when trust/estate expenses exceed income in the year of termination –Deduction passes to the beneficiaries –Deductible as a “miscellaneous itemized deduction” (subject to the 2% AGI floor)

Foundational Concepts 42 © 2015 Keebler & Associates, LLP All Rights Reserved Other Issues Administrative Expenses Consist of a attorney/accountant fees, fiduciary fees, filing fees, appraisal fees, taxes, etc. May be deducted on either the estate tax return (Form 706) or the income tax return (Form 1041) –Only applies to estates –Fiduciary may elect where to take the expenses (IRC §642(g)) May or may not be subject to 2% AGI floor –To the extent that the expenses would not otherwise been incurred if the property were not held in an estate or trust, then the deduction is not subject to the 2% AGI floor (i.e. expenses must be unique to the estate or trust)

43 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning

44 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Interest Income Taxable Capital Gain Income Taxable Roth IRA & Insurance Tax Free Real Estate, Oil & Gas Tax Preferential Pension & IRA Income Tax Deferred Money market Corporate bonds US Treasury bonds Attributes Annual income tax on interest Taxed at highest marginal rates Equity Securities Attributes Deferral until sale Reduced capital gains rate Step-up basis at death Real Estate Depreciatio n tax shield 1031 exchanges Deferral on growth until sale Oil & Gas Large up front IDC deductions Depletion allowances Pension plans Profit sharing plans Annuities Attributes Growth during lifetime RMD for IRA and qualified plans No step-up Tax- Exempt Interest Tax Free Equity securities Attributes Qualified dividends at LTCG rate Return of capital dividend Capital gain dividends Bonds issued by State and local Governmental entities Attributes Federal tax exempt State tax exempt Roth IRA Tax-free growth during lifetime No 70½ RMD Tax-free distributions out to beneficiaries life expectancy Life Insurance Tax-deferred growth Tax-exempt payout at death Income Types Dividend Income Taxable

45 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Taxable investment accounts – income generated within the account (i.e. interest, dividends, capital gains, etc.) are taxed each year to the account owner Tax-deferred investment accounts (e.g. traditional IRAs, traditional qualified retirement plans, non- qualified annuities, deferred compensation) – income generated within the account is not taxed until distributions are taken from the account Tax-free investment accounts (e.g. Roth IRAs, life insurance) – income generated within the account is never taxed when distributions are made (provided certain qualifications are met) Account Types

46 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Asset Location When tax planning for an estate/trust, one must take into consideration where to place certain types of investments (i.e. “asset location”). The key here is to place ordinary income producing assets in tax-deferred accounts (e.g. traditional IRAs, traditional 401(k) plans) while placing tax-exempt and growth investments in either taxable investment accounts or tax-free accounts (e.g. Roth IRAs).

47 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Asset Location Traditional IRA Taxable Investment Account Retirement investment income Interest (ordinary income) Tax-exempt interest (tax-exempt) Ordinary dividends (ordinary income) Qualified dividends (long-term capital gain) Short-term capital gains (ordinary income) Long-term capital gains (long-term capital gain) Annuities (ordinary income) Rents (ordinary income) Royalties (ordinary income) Roth IRA Taxed based on character of income (i.e. ordinary, long-term capital gain, etc.) 100% taxable as ordinary income 100% tax-free (provided certain requirements are met)

48 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Asset Location Traditional IRAs –Ordinary income – retains character –Long-term capital gain – converts to ordinary income –Tax-exempt income – converts to ordinary income Taxable investment accounts –Ordinary income – creates “tax drag” on annual return –Long-term capital gains – creates “tax drag” on annual return –Tax-exempt income – no impact

49 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning “Tax Drag” “Tax drag” is simply the reduction in the annual rate of return on an investment as a result of the income tax liability paid on the income generated “Tax drag” by income character: –Ordinary income – 10%, 15%, 25%, 28%, 33%, 35%, 39.6% –Long-term capital gain – 0%,15%, 20% –Tax-exempt income – 0%

50 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Assume a $10,000 bond is generating 6% interest Assume that the taxpayer is in the 25% tax bracket Given these facts, the “tax drag” on the annual return would be 1.5% (6% x 25%), thus reducing the after- tax rate of return to 4.5% When compared against a tax-deferred investment account (e.g. traditional IRA) or a tax-free investment account (e.g. Roth IRA), the long-term results are significant “Tax Drag” Example

51 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning “Tax Drag” Example (cont.)

52 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Managing Capital Gains & Losses In generating capital losses to offset capital gains (so as to reduce “tax drag”), it is important as to how the capital losses are matched up against the capital gains In general, capital losses are more tax effective if they can be used to offset income taxed at higher tax rates (e.g. short-term capital gains and ordinary income) –Thus, long-term losses used against short-term gains are more tax-efficient than short-term losses being used against long-term capital gains

53 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Managing Capital Gains & Losses Short-Term GainLong-Term Gain Short-Term Loss NEUTRALINEFFECTIVE Long-Term LossEFFECTIVENEUTRAL

54 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Implementing Asset Location Best assets for tax-deferred investment accounts (e.g. traditional IRAs and other qualified retirement plans) –Taxable bonds –High-yield equities (producing primarily ordinary dividends) –High-turnover equities (i.e. short-term capital gain) –High-turnover mutual funds (i.e. short-term capital gain) –Annuities

55 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Implementing Asset Location Best assets for tax-free investment accounts (e.g. Roth IRAs) –High-yield equities (producing primarily qualified dividends) –High-growth equities –Index funds –Hedge funds –Investment partnerships

56 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning $500,000 of bonds and $500,000 of stock both generate a 7% pre-tax rate of return The capital gains on stock are deferred until the time of sale, then taxed as long-term capital gains The amount of any tax savings from a deductible IRA contribution is invested in a taxable investment account earning the same yield as the IRA The values shown for the IRA include the value of the taxable investment account The client is in the 25% ordinary income tax bracket (15%* for capital gains purposes) Implementing Asset Location Example #1

57 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Orange = position the investor would be at under the original 50% stock / 50% bond investment mix Blue = additional $63,890 of additional growth the investor would achieve by placing 100% bonds in IRA Implementing Asset Location Example #1 (cont.) $63,890 of additional assets (2.6% increase)

58 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning $100,000 beginning cash to invest and 28% tax bracket (15% long-term capital gains bracket) Options: –Corporate bonds (6% annual interest) –Municipal bonds (4.5% annual interest) –Stocks (1% annual non-qualified dividends, 5% growth [100% asset turnover]) Implementing Asset Location Example #2

59 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Implementing Asset Location Example #2 (cont.)

60 © 2015 Keebler & Associates, LLP All Rights Reserved Tax-Sensitive Planning Ordinary Income Short- Term Capital Gains Long- Term Capital Gains Tax- Exempt Taxable Investment Account3311 Traditional IRA113N/A Roth IRA2222 Implementing Asset Location Summary

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