1. 14-1 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

2. 14-2 INCOME TAXATION OF TRUSTS & ESTATES (1 of 2)  Basic concepts  Principles of fiduciary accounting  Formula for trust taxable income and tax liability  Distributable net income (DNI)  Determining a simple trust’s taxable income ©2010 Pearson Education, Inc. Publishing as Prentice Hall

3. 14-3 INCOME TAXATION OF TRUSTS & ESTATES (2 of 2)  Determining taxable income for complex trusts and estates  Income in respect of a decedent  Grantor trust provisions  Tax planning considerations  Compliance and procedural considerations ©2010 Pearson Education, Inc. Publishing as Prentice Hall

4. 14-4 Basic Concepts  Inception  Reasons for creating trusts  Basic principles of fiduciary taxation  Definitions ©2010 Pearson Education, Inc. Publishing as Prentice Hall

5. 14-5 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

6. 14-6 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

7. 14-7 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

8. 14-8 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

9. 14-9 Principles of Fiduciary Accounting (2 of 4)  Grantor  Party that transfers assets to a trust  Trustee  Party that administers a trust  Income Beneficiary  Party (or parties) who receives income when distributed by Trustee under provisions of trust instrument ©2010 Pearson Education, Inc. Publishing as Prentice Hall

10. 14-10 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

11. 14-11 Principles of Fiduciary Accounting (4 of 4)  Complex trust  Any trust that is not a simple trust ©2010 Pearson Education, Inc. Publishing as Prentice Hall

12. 14-12 Formula for Trust Taxable Income & Tax Liability (1 of 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

13. 14-13 Formula for Trust 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

14. 14-14 Formula for Trust Taxable Income & Tax Liability (3 of 3)  Deductions for expenses  Parallel expenses for individuals  Trustee fees deductible similar to §212 exp  2% of AGI floor may apply to certain exp  Personal 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

15. 14-15 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

16. 14-16 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 2 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

17. 14-17 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

18. 14-18 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

19. 14-19 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

20. 14-20 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

21. 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

22. 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

23. 14-23 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

24. 14-24 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

25. 14-25 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

26. 14-26 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

27. 14-27 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

28. 14-28 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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

29. 14-29 Grantor Trust Provisions (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 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

30. 14-30 Grantor Trust Provisions (2 of 2)  Types of grantor trusts  Revocable trusts  Post-1986 Reversionary interest trusts  See Topic Review 4 ©2010 Pearson Education, Inc. Publishing as Prentice Hall

31. 14-31 Tax Planning Considerations (1 of 2)  Changes that reduced the benefit of using trusts to shift income  Tax rates for fiduciaries are very compressed  Children 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

32. 14-32 Tax Planning Considerations (2 of 2)  Timing of distributions  Sprinkling trust maximize flexibility in timing of distributions to each beneficiary to maximize tax savings  Property distributions  Trustee may elect to recognize gain on appreciated property distributed  Estates are free to adopt any fiscal year ©2010 Pearson Education, Inc. Publishing as Prentice Hall

33. 14-33 Compliance and Procedural Considerations  Filing requirements  Form 1041 if gross income ≥$600  Due date 15 th day of 4 th month following year end  Form 7004 for automatic 5-mo extension ©2010 Pearson Education, Inc. Publishing as Prentice Hall

34. 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 14-34 ©2010 Pearson Education, Inc. Publishing as Prentice Hall