1. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company1 General Scheme of Taxation: Trusts or estates pay income tax on the amount retained and beneficiaries pay income tax on the amount of income actually distributed to them, so that income is taxed only once DNI (Distributable Net Income): –Ensures the trust or estate receives a deduction for the amount distributed and provides a limit for the deduction –Sets the limit on the portion of distributions taxable to beneficiaries –“Conduit theory” ensures the character of distributions to beneficiaries remains the same as in the hands of the trust or estate Income Taxation Of Trusts & Estates

2. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company2 Trust earns $10,000 of distributable net income. Trustee distributes $6,000 to the beneficiary, receives a $6,000 deduction, and retains the remaining $4,000 as undistributed net income on which trustee must pay income taxes at tax rates. $4,000 of undistributed net income (UNI) taxed at trust rates Beneficiary Reports $6,000 of income on individual tax return DNI $10,000 earned income Trust Corpus $6,000 Distribution DNI Example 1

3. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company3 Trust earns $10,000 of distributable net income. Trustee distributes $12,000 to the beneficiary, receives a $10,000 deduction, and the trust has no tax liability. The beneficiary will have to pay taxes on the $10,000 as ordinary income, but the $2,000 from trust corpus will be tax free to the beneficiary. DNI Example 2 Assume $0 UNI Beneficiary Reports $10,000 of income as taxable and $2,000 as return of principal on individual tax return DNI $10,000 earned income Trust Corpus $10,000 Distribution $2,000 Distribution

4. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company4 Interest income $10,000 Trust distributions retain the character of the income earned in the trust when they are distributed to the beneficiary. For example, if a Charitable Remainder Trust makes a distribution of $50,000, the beneficiary will be taxed according to the “income first rule”: Capital gain income $30,000 Income Taxation of Trusts Beneficiary Reports income based on the character of the trust distribution. All income received by the beneficiary will be taxed as ordinary income to the extent the trust earns ordinary income, then capital gain, then tax free. Trust Corpus $1,000,000 $10,000 taxed as ordinary income $2,000 tax free return of principal Tax-free income $8,000 $30,000 taxed as capital gain $8,000 tax free

5. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company5 Basic Question: Who will be taxed on the trust income? The beneficiary, the trust or the grantor? Multiple Trust Rule: If trusts have the same: –Grantor(s) –Beneficiaries and –The principal purpose of the trust is avoidance of federal income tax the trusts are treated as one trust and their incomes aggregated in computing federal income tax liability Income Taxation Of Trusts

6. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company6 Tax on.Tax Lower.Rate on Taxable IncomeAmountExcess $0to$2,300$015% 2,300to5,450345.0025% 5,450to8,3001,132.5028% 8,300to11,3501,930.5033% 11,350to -------2,937.0035% Income Taxation Of Trusts & Estates (2011)

7. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company7 Simple Trust: Trust agreement requires –All trust income to be distributed currently to beneficiaries –Trust may not make distributions from amounts other than current income –Principal may not be distributed –No charitable gifts can be made by this type of trust or it will be deemed a complex trust for that year –Personal exemption $300 Complex Trust: Any trust which is not a simple trust –Allowed deduction for actual income distributions –Taxed at trust rates on income retained –Personal exemption $100 Simple vs. Complex Trust

8. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company8 Grantor is taxed on the trust income whether or not grantor actually receives the income IRC Sections 671 - 677 Grantor Trust Rules

9. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company9 Grantor under this rule is the owner only for income tax purposes, the estate tax exclusion must be tested under estate tax rules Grantor deemed recipient of trust income and allowed deduction to extent of trust expenses or credits Sec. 671 Substantial Owner Rules

10. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company10 For income tax purposes, the grantor is treated as the owner of that portion of the trust: –In which the grantor or grantor’s spouse hold a reversionary interest in corpus or income –The reversionary interest exceeds 5% of the value of the property in which the reversionary interest is retained at time of inception or addition Sec. 673 Reversionary Interest Rules

11. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company11 Where grantor of a trust, a nonadverse party, or both can control beneficial enjoyment of a trust, the grantor is taxed as the owner of the trust for income tax purposes Sec. 674 Beneficial Interest Rules

12. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company12 Retention by grantor, or a nonadverse party, of the following administrative powers can cause the grantor to be deemed the owner of the corpus of a trust for income tax purposes: –Powers that enable the grantor to purchase, exchange, or otherwise deal with or dispose of the corpus or income of the trust for less than adequate consideration in money or money’s worth; –Powers that allow the grantor to borrow trust corpus or income without adequate interest or security; Sec. 675 Administrative Power Rules

13. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company13 Retention by grantor, or a nonadverse party, of the following administrative powers can cause the grantor to be deemed the owner of the corpus of a trust for income tax purposes (cont’d): –Powers of administration exercisable in a nonfiduciary capacity by any person without the consent or approval of any person in a fiduciary capacity such as: Power to vote stock of a corporation in which grantor or the trust has a significant voting interest Power to control investment of trust funds Power to reacquire the trust corpus by substituting other property of an equivalent value Sec. 675 Administrative Power Rules

14. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company14 If grantor can revoke the trust either acting alone or with a nonadverse party, the grantor is treated as the owner of that portion of the trust for income tax purposes Sec. 676 Power To Revoke Rules

15. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company15 Grantor treated as owner of a trust for income tax purposes if income from the trust is or may: –At the discretion of the grantor, a nonadverse party, or both, be: Distributed to the grantor Held or accumulated for future distribution to the grantor, or Applied to payment of premiums on life insurance policies on life of the grantor or grantor’s spouse Sec. 677 Income For Benefit of Grantor Rules

16. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company16 Grantor treated as owner of a trust for income tax purposes if income is: –Distributed to the grantor’s spouse –Held or applied for future distribution to the grantor’s spouse, or –Applied to payment of premiums on life insurance policies on life of the grantor’s spouse Sec. 677 Income For Benefit of Grantor Rules

17. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company17 If a person other than the grantor has the power, exercisable solely by himself, to vest corpus or income in himself, such a person is treated as the owner of the corpus, so that trust income will be taxable to that individual Sec. 678 Person Other Than Grantor Rules

18. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company18 Decedent’s Final Return –Must be filed on the regular due date, April 15 th, of the following year –Executor or administrator responsible for filing decedent’s individual return and the estate income tax return Income Taxation of Estates

19. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company19 Cash-basis vs. accrual taxpayers Income received after decedent’s death is taxed to the recipient of the payments in the same manner it would have been taxed to the decedent No step-up in basis for IRD income Estate or beneficiary that includes an IRD item is entitled to a deduction on the same income tax return for the amount of additional federal estate tax attributable to inclusion of that item in decedent’s federal estate tax return Sec. 691 Income In Respect Of A Decedent (IRD)

20. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company20 The estate is a separate taxable entity that must pay tax on its income at the compressed trust and estate tax rates Taxation Of The Estate

21. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company21 Estate income tax deductions: –Reasonable administrative costs including executor’s fees, legal fees in connection with administration of the estate, expenses of preparing the income tax return of the estate Note: Executor must decide whether it is more advantageous to take these expenses as income or estate tax deductions –$600 personal exemption –Deduction for amounts distributed to beneficiaries Note: “Income first rule” applies to distributions so that no matter which property the executor pays the income from, the distribution will be deemed to have come from ordinary income first then principal Taxation Of The Estate

22. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company22 What Basis Is & Why It Is Important –Basis is what a person or other taxpayer “paid” for the property –Basis is used to determine how much gain (or loss) is incurred upon a sale of property –Gain = Amount realized – Adjusted basis Note: Higher the basis  Lower the gain –Basis is the key factor in determining the allowable depreciation deduction taken on buildings and other business investments Note: High basis advantageous Basis Determination

23. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company23 No Step-Up If Decedent Acquired Property By Gift Within A Year Of Death If Property Left To Donor Or Donor’s Spouse - if decedent received gift of appreciated property during the 1-year period ending on date of death and - property acquired from decedent by (or passes from decedent to) donor of property (or donor spouse) Basis of that property hands of donor (or donor spouse) is decedent’s adjusted basis of property immediately before death.

24. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company24 Effect Of Step-up Basis Rules On Stock Redemption & Cross Purchase Agreements Stock includable in decedent’s estate receives new basis equal to either - value at death - alternative valuation date (if selected) Usually close to redemption value Typically, little to no gain recognized by estate or other seller of stock upon redemption

25. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company25 Overall Effect If low income tax basis in relation to market value, have incentive to hold property until death so estate can sell without income tax on appreciation in value If expect inflation, future increase in value, and potential increase in death taxes, have incentive for current sale If asset value falls below basis, consider sale and recognize loss

26. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company26 EGTRRA 2001 Provides replacement of stepped-up basis with modified carryover basis system for one year for property acquired from decedent dying in 2010 Property receives basis equal to lesser of –Adjusted basis of decedent (plus limited step-up amount) –Fair market value of porperty on decedent date of death

27. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company27 EGTRRA 2001 Executor of decedent’s estate may increase basis transferred assets up to total of $1.3 million Property passing to decedent’s spouse may be stepped-up an additional $3 million Step-up in basis for property acquired from nonresident non-citizen decedent cannot exceed $60,000 Basis of any property cannot be stepped up above fair market value

28. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company28 2010 Tax Act Repealed modified carryover basis rules for 2011 and 2012 For 2010, the rules apply unless the executor elects to subject the estate to the post 2010 estate tax rules

29. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company29 Issues in Community Property States Property held by spouses in a community property state as the separate property of one spouse will be included in that spouse’s estate and receive a new basis at death Entire property can go to surviving spouse under the marital deduction rules and will not be subject to tax

30. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company30 Issues in Community Property States Important to distinguish between property held by decedent as separate property and property held by decedent and spouse as community property –In both cases, property will receive step-up (or step-down) to fair market value for federal estate tax purposes –Value of community property will be lower because each spouse owns only 50% of the property

31. Federal Income Tax Issues Chapter 19 Tools & Techniques of Estate Planning Copyright 2011, The National Underwriter Company31 Basis Adj. for Taxable Distribution or Direct Skips Fair market value of transferred property$1,000,000 Adjusted basis before GST transfer$600,00 GST imposed on transfer (35% in 2011) $350,000 Net appreciation [$1,000,000 - $600,000] $400,000 Basis increase [$35,000,000 x ($400,000 / $1,000,000)] $140,000 Transferee’s basis [$600,000 + $140,000] $740,000