1. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comprehensive Volume 1 Chapter 28 Income Taxation of Trusts and Estates

2. The Big Picture (slide 1 of 3) Anna Jiang is the main breadwinner in her family, which includes her husband Tom, a social worker, and two children, Bobby, age 8, and Sally, age 13. Anna has accumulated about $2 million in after-tax investment accounts, largely made up of growth stocks that do not regularly pay dividends.

3. The Big Picture (slide 2 of 3) Anna has addressed the problem of probate costs through joint property ownership, life insurance policies, and beneficiary arrangements for her retirement plans. She and Tom update their wills every five years or so.

4. The Big Picture (slide 3 of 3) There is a history of Alzheimer’s disease in Anna Jiang’s family. –She wants to make certain that Tom and the children will have adequate cash flow from the $2 million of investment assets if she becomes unable to work. One of Anna’s colleagues suggests that she set up a trust to take care of her family in case a medical problem ever arises. Read the chapter and formulate your response.

5. What Is a Trust? Not defined in Code –Usually refers to an arrangement created by a will or by inter vivos (lifetime) declaration –Trustee takes title to property for purpose of protecting or conserving it for beneficiary –Used to achieve various financial and other goals

6. Creation Of A Trust Typically, involves at least three parties: –The grantor - transfers selected assets to the trust entity Sometimes referred to as the settlor or donor –The trustee - charged with the fiduciary duties associated with the trust Usually is either an individual or a corporation –The beneficiary - designated to receive income or property from the trust

7. Common Motivations for Creating a Trust (slide 1 of 5) Life Insurance Trust –Holds life insurance policies on the insured –Removes proceeds of policies from gross estate (if irrevocable trust) –Safeguards against receipt of proceeds by young or inexperienced beneficiary

8. Common Motivations for Creating a Trust (slide 2 of 5) “Living” (revocable) Trust –Manages assets –Reduces probate costs –Provides privacy for asset disposition –Protects against medical or other emergencies, and –Provides relief from the necessity of day-to-day management of the underlying assets

9. Common Motivations for Creating a Trust (slide 3 of 5) Trust for minors –Provides funds for college education –Shifts income to lower-bracket taxpayers –Allows parents to retain some control over children’s use of assets

10. Common Motivations for Creating a Trust (slide 4 of 5) “Blind” trust –Holds assets of grantor without his/her input or influence (e.g., while grantor holds political office or some other sensitive position) Retirement trust –A special tax-exempt trust that manages asset contributions under a qualified retirement plan

11. Common Motivations for Creating a Trust (slide 5 of 5) Divorce trust –Manages assets of an ex-spouse and ensures they will be transferred on a prescribed schedule to named beneficiaries Liquidation trust –Manages assets and final dissolution of a corporation undergoing a complete liquidation

12. Structure of Typical Trust

13. What Is an Estate? Created upon the death of every individual –Collects and conserves an individual’s assets, satisfies all liabilities, and distributes the remaining assets to heirs

14. Structure of Typical Estate

15. Nature of Trust and Estate Taxation In general, taxable income of trusts or estates is taxed to the entity or to its beneficiaries to the extent that each has received the accounting income of the entity –Whoever receives the accounting income of the entity, or some portion of it, is liable for the income tax that results

16. Filing Requirements Fiduciary must file a Form 1041, U.S. Income Tax Return For Estates and Trusts, in the following situations: –For an estate with gross income > $600 –For a trust that either has any taxable income or, if no taxable income, has gross income of $600 or more Due date is 15th day of fourth month following year-end

17. Tax Accounting Periods, Methods, and Payments (slide 1 of 2) Tax year –Estates can use calendar year or fiscal year –Trusts must use a calendar year

18. Tax Accounting Periods, Methods, and Payments (slide 2 of 2) Estimated tax payments –Trusts and estates are required to make quarterly estimated tax payments using same schedule as individuals Applies to estates and grantor trusts only for tax years ending two or more years after date of decedent’s death Charitable trusts and private foundations are exempt from making estimated tax payments

19. Tax Rates for Estates and Trusts Taxable Income Tax is: But Not Of Amount Over Over Over $ -0-$2,300 15%$ -0- 2,300 5,450$ 345.00 + 25% 2,300 5,450 8,300$1,132.50 + 28% 5,450 8,300 11,350$1,930.50 + 33% 8,300 11,350........$2,937.00 + 35%11,350 Note: tax on dividend income and net long-term capital gains of fiduciary is limited to 15%

20. Personal Exemptions Estates$600 Simple trusts(generally)$300 All other trusts (primarily complex trusts)$100

21. Alternative Minimum Tax May apply to an estate or trust in any year –AMTI calculation is generally the same as for individuals –Annual exemption = $22,500, with phaseout –Rate = 26% on first $175,000 AMTI, 28% thereafter

22. Accounting Income, DNI and Taxable Income of the Entity and Beneficiaries

23. Entity Accounting Income Accounting income is based on the controlling document –Either the document or state law determines whether amounts are allocated to corpus or current income –If the entity distributes income currently, that income should generally correspond to accounting income

24. Common Allocations: Income or Corpus Allocable to IncomeAllocable to Corpus -Ordinary and operating net-Depreciation on business assets income from trust assets-Casualty gain/loss on -Interest, dividend, rent, and income-producing assets royalty income-Insurance recoveries on -Stock dividends income-producing assets -One-half of fiduciary fees/-Capital gain/loss on investment commissions assets -Stock splits -One-half of fiduciary fees/ commissions

25. Taxation of Estates and Trusts (slide 1 of 2) Generally, estates and trusts act as conduits for income received, and taxation is at beneficiary level –This is codified through allowance of a distribution deduction

26. Taxation of Estates and Trusts (slide 2 of 2) Exceptions: –Complex trusts accumulate income for specified times (e.g., until beneficiary is age 30) –Estates are not always required to make current distributions In these cases, or other cases where the entity is not required to distribute current income, the entity itself is taxed

27. Property Distributions (slide 1 of 2) Generally, entity does not recognize gain or loss –Beneficiary takes same basis in asset as it had in the estate or trust –Distribution absorbs distributable net income (DNI) and qualifies for a distribution deduction to extent of the lesser of: Basis to beneficiary FMV on date of distribution

28. Property Distributions (slide 2 of 2) Property distributions (cont’d) –Trustee or executor can elect to recognize gains and losses on assets distributed in kind Beneficiary’s basis in asset would be FMV Distribution absorbs distributable net income (DNI) and qualifies for a distribution deduction equal to FMV on date of distribution

29. The Big Picture – Example 7 Property Distributions Return to the facts of The Big Picture on p. 28-2. Assume that Anna has established the Jiang Family Trust. –The trust distributes a painting, basis of $40,000 and fair market value of $90,000, to beneficiary Sally. –Sally’s basis in the painting is $40,000. The distribution absorbs $40,000 of the Jiang Trust’s DNI, and the trust claims a $40,000 distribution deduction relative to the transaction

30. The Big Picture – Example 8 Property Distributions Assume the same facts as in Example 7, except that the Jiang Trust’s basis in the painting is $100,000. –Sally’s basis in the painting is $100,000. The distribution absorbs $90,000 of the Jiang Trust’s DNI, and the trust claims a $90,000 distribution deduction.

31. Deductions Allowed (slide 1 of 3) Deductions are allowed for ordinary and necessary expenses for: –A trade or business –Production of income –Management, conservation, or maintenance of property –Determination, collection, or refund of any tax

32. Deductions Allowed (slide 2 of 3) Other deductions –No deduction is allowed for expenses related to the production or collection of tax-exempt income –Cost recovery deductions are allocated proportionately to the recipients of accounting income –Deductions are allowed for casualty or theft losses and NOLs –Wash sale and related party rules apply

33. Deductions Allowed (slide 3 of 3) Other deductions (cont’d) –May be eligible for the domestic production activities deduction Computation of qualified production activities income (QPAI) is made at the entity level Each beneficiary receives, as a pass-through from the entity, his or her share of QPAI and the W–2 wages paid, based on the proportion of entity accounting income received –Charitable contribution deduction is allowed to the extent of amounts included in gross income for the year Deemed to be made proportionately from each of the income elements of entity accounting income

34. The Big Picture – Example 17 Charitable Contribution Deduction (slide 1 of 2) Return to the facts of The Big Picture on p. 28-2. Again assume that Anna has established the Jiang Family Trust. The trust has 2011 gross rent income of $80,000, expenses attributable to the rents of $60,000, and tax-exempt interest from state bonds of $20,000.

35. The Big Picture – Example 17 Charitable Contribution Deduction (slide 2 of 2) Under the trust agreement, the trustee is to pay 30% of the annual trust accounting income to the United Way, a qualifying organization. –Accordingly, the trustee pays $12,000 to the charity in 2012. 30% X $40,000. –The charitable contribution deduction allowed for 2011 is $9,600. ($80,000/$100,000) X $12,000.

36. The Big Picture – Example 18 Charitable Contribution Deduction Assume the same facts as in Example 17, except that the trust instrument also requires that the contribution be paid from the net rent income. The agreement controls, and the allocation formula need not be applied. –The entire $12,000 is allowed as a charitable deduction.

37. Distributable Net Income (slide 1 of 3) Entity is allowed a deduction for distributions to beneficiaries –Distributable net income (DNI) is used to compute the amount of the deduction Maximum amount beneficiaries pay tax on –The character of income in DNI is preserved to the beneficiaries Maximum amount of distribution deduction

38. Distributable Net Income (slide 2 of 3) Calculating DNI –Step 1: Determine entity’s taxable income before the distribution deduction Includes all of entity’s income, deductions, gains, losses and exemption

39. Distributable Net Income (slide 3 of 3) Calculating DNI (cont’d) –Step 2: Make the following adjustments to entity’s taxable income to determine distributable net income: Add back: –Personal exemption –Net tax-exempt interest –Net capital losses Subtract net capital gains allocable to corpus

40. Distribution Deduction –For estates and complex trusts, distribution deduction is the lesser of: Deductible portion of DNI, or The taxable amount actually distributed –For a simple trust, full distribution is always assumed

41. Entity Taxable Income Entity taxable income is calculated as follows: Entity taxable income before the distribution deduction Less: Distribution deduction Entity taxable income

42. Allocation of DNI (slide 1 of 6) Each type of DNI must be allocated proportionately to income beneficiaries –This prevents manipulation of tax liabilities by assigning, for example, tax-exempt income to high bracket taxpayers, and taxable income to low bracket taxpayers

43. Allocation of DNI (slide 2 of 6) Amount taxable to beneficiaries –For a simple trust DNI is the maximum taxable amount May be less if DNI includes tax-exempt interest If more than one income beneficiary, apportion elements of DNI ratably

44. Allocation of DNI (slide 3 of 6) Amount taxable to beneficiaries (cont’d) –For estates and complex trusts Use a two-tier system –Income required to be distributed is categorized as a first-tier distribution –All other amounts properly paid, credited or required to be distributed are second-tier distributions

45. Allocation of DNI (slide 4 of 6) Amount taxable to beneficiaries (cont’d) –If only first-tier distributions are made and those amounts exceed DNI, use the following formula to allocate DNI among beneficiaries First-tier dist. to beneficiary × DNI First-tier dist. to all beneficiaries = Beneficiary’s Share of DNI

46. Allocation of DNI (slide 5 of 6) Amount taxable to beneficiaries (cont’d) –If first and second-tier distributions are made and first-tier distributions exceed DNI, use the previous formula to allocate first-tier distributions –Second-tier distributions are not taxed since all DNI has been allocated

47. Allocation of DNI (slide 6 of 6) Amount taxable to beneficiaries (cont’d) –If first and second-tier distributions are made and first- tier distributions do not exceed DNI, use the following formula to allocate DNI among beneficiaries 2nd-tier dist. to beneficiary × Remaining 2nd-tier dist. to all beneficiaries DNI = Beneficiary’s share of DNI

48. Character of Income Various classes of income retain their character and flow through to beneficiaries –If all DNI is distributed and there are multiple beneficiaries, must allocate various classes of income Distributions are treated as consisting of the same proportion as the items that enter into the computation of DNI

49. Trust Taxation Example (slide 1 of 9) The Alto Family Trust has the following income and expenses: Interest income$8,000 Tax-exempt income$6,000 Capital gain income$4,000 Fiduciaries fees$2,000 The trust agreement allocates fiduciaries fees to trust income. Capital gains are allocated to trust corpus.

50. Trust Taxation Example (slide 2 of 9) 1. Accounting income is as follows and is distributed to Sue, the sole beneficiary, at the end of the year: Interest income$ 8,000 Tax-exempt income 6,000 Fiduciaries fees (2000) Accounting income$12,000

51. Trust Taxation Example (slide 3 of 9) Fiduciary fees are allocated between interest income and tax- exempt income before calculating trust taxable income: Interest income × Fees = $ 8,000 × $2,000 =$1,143 Total income$14,000 Tax-exempt inc. × Fees = $ 6,000 × $2,000 =$ 857 Total income$14,000

52. Trust Taxation Example (slide 4 of 9) 2. Taxable income of the trust, before the distribution deduction, is as follows: Capital gain$ 4,000 Interest income 8,000 Less: fiduciaries fees related to interest income (1,143) Less: exemption ( 300) Taxable income before distribution deduction$10,557 Net tax exempt income is $6,000 less $857, or $5,143.

53. Trust Taxation Example (slide 5 of 9) 3. Calculate Distributable Net Income (DNI) and the distribution deduction as follows: DNI: Taxable income before DNI$10,557 Plus: Exemption 300 Plus: Tax-exempt income (total) 6,000 Net of: Expenses allocated to tax-exempt income( 857) Less: Capital gains allocated to corpus( 4,000) DNI$12,000 In this case, since no expenses were allocated to corpus, DNI is the amount actually distributed to the beneficiary.

54. Trust Taxation Example (slide 6 of 9) Distribution Deduction The distribution deduction is the lesser of the amount actually distributed ($12,000) or DNI net of tax-exempt income (less expenses): DNI $12,000 Less: tax-exempt income( 6,000) Plus: expenses related to tax-exempt income 857 Distribution deduction$ 6,857

55. Trust Taxation Example (slide 7 of 9) 4. Determine trust taxable income after distribution deduction Taxable income before distribution deduction$10,557 Distribution deduction( 6,857) Taxable income$ 3,700 Note: tax is limited to 15% since income is from capital gains

56. Trust Taxation Example (slide 8 of 9) 5. Allocate DNI and its character to the beneficiaries. DNI to Sue is $12,000, consisting of the following: InterestTax-Exempt Income Income Total. Gross income$8,000 $6,000$14,000 Allocable fees 1,143 857 2,000 Net income, per category$6,857 $5,143$12,000

57. Trust Taxation Example (slide 9 of 9) Sue received a distribution of $12,000 from the trust. She pays tax on $6,857, which corresponds to tax on trust’s $8,000 of interest income, and a deduction for a portion of the trustee’s fees. She lost deductions of $857 for fees allocated to tax-exempt income.

58. Refocus On The Big Picture (slide 1 of 4) Anna Jiang and her family should consider the creation of one or more trusts. One suggestion for the family might be: 1. Anna transfers some or all of the $2 million assets to the Jiang Family Trust, with quarterly income payable to Tom and the children. –Recipients would be designated by the trustee, but all of the entity’s accounting income must be distributed. –In this way, the income could be directed to the beneficiary most in need (e.g., to pay for education expenses or to start a new business). –The children could be named first-tier beneficiaries, with Tom as a second-tier income beneficiary.

59. Refocus On The Big Picture (slide 2 of 4) 2.While Anna is still healthy and earning a regular salary, the trustee could accumulate the accounting income and allow the corpus to build up. –Alternatively, the trustee could make gifts to charity or fund education plans for Bobby and Sally. 3.Anna should provide clear instructions to the trustee as to her preferences on how the trust corpus should be invested and specify which of Tom’s and the children’s expenses should and should not be covered. 4.The children should be named as remainder beneficiaries of the Jiang Family Trust. –In case the trust corpus exceeds the estate tax bypass amount, other remainder beneficiaries could be named in order to avoid any generation-skipping tax (see Chapters 18 and 19). 5. Amendments to the trust document should be considered whenever Tom and Anna update their wills.

60. Refocus On The Big Picture (slide 3 of 4) What If? If Anna remains healthy, the Jiang Family Trust might be terminated when the children reach the age of majority, as the need for financial support will have diminished. However, if Tom is unable or unwilling to take over the management of the assets, the trust should continue. –In this event, the trustee might shift the focus to funding long-term care for the couple, making charitable gifts, or financing the education needs of grandchildren.

61. Refocus On The Big Picture (slide 4 of 4) What If? The controlling trust document should be worded to provide flexibility as to the purposes and termination date of the trust. The trustee should be chosen from family members or business associates who know Anna and Tom well and are familiar with the couple’s objectives.

62. © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 62 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta