2. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved.

3. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Chapter Income Taxation of Trusts and Estates 16

4. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-3 Trusts 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)

5. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-4 Trusts - Nontax Purposes 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

6. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-5 Common Trusts Blind trust Bypass trust Crummey trust Life insurance trust Living (revocable) trust Retirement trust

7. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-6 Trusts 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

8. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-7 Grantor Trusts Powers that will not cause trust to treated as a grantor trust: Power to allocate principal or income to charities Power to invade principal on behalf of designated beneficiary Power to withhold income from minor or disabled beneficiary Power to allocate between principal and income Unused power to distribute income to dependents

9. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-8 Trusts 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

10. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-9 Taxation of Trust and Estates (Overview) 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

11. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-10 Trust Taxable Income Calculation 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 2 to determine trust taxable income

12. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-11 Trust Taxable Income Calculation (continued) 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

13. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-12 Trust Accounting Income 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

14. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-13 Common Allocations IncomePrincipal Interest, dividends, rents, royalties Capital gains and losses on investments Operating incomeCasualty losses and insurance recoveries Operating expenses and depreciation related to trust assets Extraordinary repairs and capital improvements Taxes levied on accounting income Taxes levied on items allocated to principal

15. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-14 Trust Taxable Income Computed in a manner similar to individual taxable income No adjusted gross income concept No standard deduction

16. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-15 Depreciation 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

17. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-16 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

18. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-17 Exemptions 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

19. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-18 Distributable Net Income Defines the maximum possible income distribution deduction and maximum possible income from trust taxable to beneficiaries

20. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-19 Distributable Net Income Calculation 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

21. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-20 Trust Tax Liability Tax rates are steeply progress reaching the maximum rate of 35% with only $9,550 of taxable income Often beneficiaries in lower rate brackets

22. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-21 Taxation of Trust Beneficiaries 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

23. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-22 Character of Income If more than one type of income is distributed from a complex trust, it must be allocated proportionately amount income beneficiaries

24. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-23 Separate Share Rule 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

25. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-24 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

26. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-25 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

27. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-26 Trust Filing Requirements All trusts must use a calendar year end All trusts must file if over $600 of gross income or any taxable income

28. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-27 Income Taxation of Estates Basically same rules as for taxation of trusts Distributions allocated between principal and income based upon will or state law

29. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-28 Income in Respect of a Decedent 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

30. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-29 Estate Administration Expenses 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

31. McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 16-30 Estate Exemptions and Filing Requirements $600 exemption May utilize a fiscal year No estimated payments required for two years after decedent’s death