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Federal Fiduciary Income Tax Workshop

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This workshop helps attendees understand the income taxation of trusts and estates, identify sources of taxable income, calculate distributable net income, and apply the Alternative Minimum Tax.

Presenter: David Spence, Jennifer Han, Allison Kroeker, and Li (Fiona) Xu of Royse Law Firm.

Published in: Law
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Federal Fiduciary Income Tax Workshop

  1. 1. FEDERAL FIDUCIARY INCOME TAX WORKSHOP Royse Law Firm, P.C. www.rroyselaw.com 149 COMMONWEALTH DRIVE, SUITE 1001 MENLO PARK, CA 94025 650.813.9700
  2. 2. ROYSE LAW FIRM, P.C. – FACULTY C. David Spence Michael L. Zosky Jennifer Han Fiona Xu Allison Kroeker
  3. 3. INCOME TAXATION OF ESTATES Basic Concepts and Issues www.rroyselaw.com 149 COMMONWEALTH DRIVE, SUITE 1001 MENLO PARK, CA 94025 650.813.9700 C. DAVID SPENCE, ESQ. AND MICHAEL L. ZOSKY, ESQ. ROYSE LAW FIRM, PC d s p e n c e @ r roys e l aw. co m a n d m zo s k y @ r roys e law. co m
  4. 4. • A person having legal duty to act primarily for another’s benefit • Duties include: – Loyalty – Prudence – Impartiality – Diligence – Account – Others Duties WHAT IS A FIDUCIARY?
  5. 5. • Examples of Fiduciaries: –Executor or Administrator of an Estate –Trustee of a Trust –Conservator of an Estate –Certain other Persons Required by Agreement or by Law to act for and on behalf of other(s) • Spouse? • Agent? • Partner? WHAT IS A FIDUCIARY?
  6. 6. • Statute of Wills (enacted 1540) • Codified the private right to devise property by Will • Established early Will requirements –Signature and date –2 witnesses WHAT IS AN ESTATE?
  7. 7. CALIFORNIA ESTATE ADMINISTRATION • 1500+ Pages of Rules • Minimum Administration Period (in most California counties) of 8 months • More realistic expected time period is 12-18 months if no 706 filing requirement
  8. 8. INCOME DURING ADMINISTRATION • Report and pay tax on income realized during period of administration
  9. 9. • Based on Centuries Old English Common Law • Lord Blackstone’s Commentaries from 1765 liken a trust to a division of components of ownership like… WHAT IS A TRUST?
  10. 10. • Division of Ownership Characteristics • Division of: –Control over Disposition –Title –Benefit A BUNDLE OF STICKS?
  11. 11. • Generally, a Written Instrument Governs (except when state law pre-empts it): – Agreement – Declaration – Deed • Three Parties: – Settlor, Trustor, Grantor – Trustee – Beneficiary MODERN TRUSTS
  12. 12. • Begins on Date of Death of Individual Taxpayer • Ends on Date of Final Distribution of the Estate (sec 641(a)(3)) • Tax Computed in the Same Manner as an Individual— Except…[for a lot of exceptions] • One Level of Taxation—either at Estate Level or Beneficiary Level, not Both! ESTATES UNDER THE IRC From Death to Final Distribution
  13. 13. • Cash or accrual method of accounting • Election made on the first fiduciary income tax return • Does not have to be the same method of accounting used by the decedent Accounting Method Cash OR Accrual
  14. 14. • The first taxable year begins the day of the decedent’s death • Ends on the last day of a month not more than 12 months after the commencement date of the tax year – A short first and/or final tax year of the estate are permitted • The estate may use a fiscal year – If fiscal year not elected, assumption of calendar year – Practice Note: An entry on Form SS-4 indicating the closing month of an accounting year is not a fiscal year election Taxable Years
  15. 15. • Not required unless estate is open more than two years after decedent’s date of death – A short fiscal year counts as one tax year • Once obligated to make estimated tax payments, estate may become liable for penalties imposed on underestimations of estimated tax – 90%/100% Safe Harbor Rule Estimated Tax Payments
  16. 16. • Special rule when AGI exceeds $150,000 – Required percentage of the preceding year’s tax that must now be paid in a tax year to satisfy the safe harbor provisions is 110% • Final tax year, estimated tax payments may be allocated to the beneficiaries per an election by the executor (Form 1041-T) Estimated Tax Payments (Cont.)
  17. 17. • Domestic estate must file Form 1041 if it has: – Gross income in excess of $600.00 for the taxable year; or – A beneficiary who is a non-resident alien • Foreign estates file Form 1040NR Federal Filing Requirements
  18. 18. • Due date = fifteenth day of the fourth month following the close of the tax year – Generally, April 15 – for Calendar year • Automatic 5 ½ month extension of time to file Form 1041 (Form 7004) Federal Filing Requirements (Cont.)
  19. 19. • Practice Note: Consider California Filing Requirements Federal Filing Requirements
  20. 20. • Long-term capital gains and qualified dividends = 15% – 20% if taxable income exceeds $12,500 • 3.8% net investment income tax (“NIIT”) on net investment income applies if estate has undistributed net income in excess of $12,500 • AMT applies Federal Income Tax Rates (2017) Marginal Rate Income of Estate or Trust 15% 0-$2,550 25% $2,551-6,000 28% $6,001-9,150 33% $9,151-12,500 39.6% Over $12,500
  21. 21. We will now take a 15 minute break! BREAK
  22. 22. INCOME TAXATION OF TRUSTS Basic Concepts and Issues MICHAEL L. ZOSKY, ESQ. ROYSE LAW FIRM, PC mzosky@rroyselaw.com www.rroyselaw.com 149 COMMONWEALTH DRIVE, SUITE 1001 MENLO PARK, CA 94025 650.813.9700
  23. 23. • Settlor/Trustor/Grantor • Beneficiary • Trustee Parties to a Trust TRUSTEE BENEFICIARYSETTLOR Revocable Trust
  24. 24. • Commencement – Trusts – Grantor Trusts – Separate Trusts (separate tax payers) • Duration – Termination – • As specified in the trust • When there are no longer any assets of the trust – Trusts holding S corporation stock Commencement and Duration
  25. 25. • Trusts are taxed under Subchapter J of the Code • Trusts may be classified generally as either simple trusts, complex trusts, or grantor trusts – A trust may be deemed a simple trust one year and a complex trust in another year General
  26. 26. • S corporation eligible trusts: – Electing Small Business Trust (“ESBT”) (1361(e)) • Multiple beneficiaries – Qualified Subchapter S Trust (“QSST”) (1361(d)) • One beneficiary – Grantor trusts General
  27. 27. • General requirements in trust instrument: – 651-652 – All income is to be distributed currently; – No accumulation of trust income; – The trust does not permit amounts to be paid, permanently set aside, or used for charitable purposes; and – No trust principal is distributed in the current year • Annual exemption of $300.00 Simple Trusts
  28. 28. • General requirements in trust instrument: – 661-663 – Discretionary income distributions, including discretion to accumulate; – The trustee distributes principal, either pursuant to a discretionary power or a mandatory directive; and – May have charitable beneficiaries • Annual exemption of $100.00 Complex Trusts
  29. 29. • 671-679 • Grantor trusts – Revocable (living) Trusts – Certain retained rights/interests also cause grantor trust status • Grantor must report all trust income on his or her own Form 1040 • May need separate tax ID number and may need to file informational Form 1041 Grantor Trusts
  30. 30. • There are two alternative methods without a Form 1041: – The trustee may furnish the grantor’s tax information to each payor of income, and provide the grantor with a statement identifying each payor and showing income/deductions and credits. – The trustee may furnish the trust’s tax information to each payor. The trustee then file Form 1099s with the IRS showing the trust as the payor and the grantor as the recipient. Trustee provides the grantor with a statement identifying each payor and showing income/deductions and credits. • Both methods require Trustee must then advise grantor to report items on individual Form 1040 Grantor Trusts (Cont.)
  31. 31. • Importance of Grantor Trusts in 2017 Income Tax Planning – Estate, Gift and Income Tax Planning Grantor Trusts (Cont.) *Not all CLATs
  32. 32. • 671: Basic Grantor Trust Rules • 672: Definitions and Rules • 673: Reversionary Interests • 674: Power to Control Beneficial Enjoyment • 675: Administrative Powers • 676: Power to Revoke • 677: Income for Benefit of Grantor • 678: Person Other Than Grantor Treated as Substantial Owner • 679: Foreign Trusts having one or more U.S. Beneficiaries Grantor Trusts (Cont.)
  33. 33. • In general, calendar year • Limited exceptions: – Trusts exempt from taxation under Code Section 501(a)/charitable trusts – Charitable trusts described in Code Section 4947(a)(1)/split-interest trusts – Revocable trusts making Section 645 election – fiscal year of estate Taxable Years
  34. 34. • General rules require a trust to file a declaration and make estimated tax payments if the trust is expected to owe $1,000.00 or more in tax liability • Penalties – Same safe harbors as estates Estimated Tax Payments
  35. 35. • Form 1041 must be filed for a trust if it has: – Any taxable income for the tax year; – Gross income of $600.00 or more, regardless of taxable income; or – A non-resident alien beneficiary • Due 15th day of the 4th month following the end of the trust’s taxable year – Generally April 15 for Calendar year • Eligible for automatic 5 ½ month extension to file • Practice Note: Consider California Filing Requirements Federal Filing Requirements
  36. 36. • Tax Years Beginning in 2017: • Long-term capital gains and qualified dividends - 15% – 20% if taxable income exceeds $12,500 • NIIT applies • Consider State Income Taxation Federal Income Tax Rates (2017) If Taxable Income is: The Tax Is: Not over $2,550 15% of taxable income Over $2,550 but not over $6,000 $382.50 plus 25% of the excess over $2,550 Over $6,000 but not over $9,150 $1,245.00 plus 28% of the excess over $6,000 Over $9,150 but not over $12,500 $2,127 plus 33% of the excess over $9,150 Over $12,500 $3,232.50 plus 39.6% of the excess over $12,500
  37. 37. • What is Income? • What is Principal? • In California: Uniform Principal and Income Act Foundational Components
  38. 38. • Trust Accounting Income – This is income as determined under state trust law • I.e. Per the Agreement or State Probate Code • May or may not comport with GAAP • It is NOT a taxable income concept • It is NOT the same as state taxable income • Used to determine the appropriate allocation between principal and income • E.g., used to determine the amount of cash distributed when the trust requires “income” to be distributed Hint: Whenever Subchapter J of the IRC uses the term “income” without a modifier, it is referring to Trust Accounting Income. Foundational Components
  39. 39. • Trust Accounting Income – Examples of differences between TAI and Taxable Income: • Tax Exempt Income • Depreciation/Depletion Reserves • Investment management Fees and other deductions limited by tax law which may not be so limited for FAI purposes • Charitable Contributions • CAPITAL GAINS Foundational Components
  40. 40. • Trust Accounting Income –Capital Gains: • Gains on Sale of Principle Assets—historically allocable to Principal – Duty of Impartiality required balancing investments for “income” (e.g. bonds) with investments for “remainder” (non-dividend paying, growth investments) – Trust instrument always could define “income” differently from state law Foundational Components
  41. 41. • Trust Accounting Income – Capital Gains: • Modern Portfolio Theory has Necessitated Changes Made by UPIA – Allowing “Reallocation” of capital gains from principal to income – This may occur even if the trust instrument does not specifically allow it • Thus, the tax preparer should consult with the attorney for the trustee if there are any ambiguities about what constitutes income in any particular year – “Reallocation” policy is not necessarily consistent year-to- year Foundational Components
  42. 42. • Trust Accounting Income – Capital Gains: • Modern Portfolio Theory has Necessitated Changes Made by UPIA – Allowing “Reallocation” of capital gains from principal to income » This may occur even if the trust instrument does not specifically allow it – Unitrust distributions may also be used as an income proxy under UPIA » This is a specific percentage of principal regardless of receipts during the period • Thus, the tax preparer should consult with the attorney for the trustee if there are any ambiguities about what constitutes TAI in any particular year – “Reallocation” policy is not necessarily consistent year-to-year Foundational Components
  43. 43. Time For an Accountant Joke… Foundational Components
  44. 44. • Trust Accounting Principal –Property Contributed by the Settlor –Income From Prior Years Which Was Not Required to be Distributed, and Which was not in fact Distributed –Sometimes others, e.g.: • Realized Gains from Sale of Assets • Stock Dividends • Insurance Proceeds • IRD (discussed later) Foundational Components
  45. 45. • Distributable Net Income (DNI) –This is a tax-only concept –Think of it as applying tax concepts to trust accounting income –DNI is used to avoid Double Taxation Foundational Components
  46. 46. • Tax Calculation: –Gross Income “pours in” the bucket –DNI is “distributed” out –The net increase is Taxable Income Foundational Components
  47. 47. • Distributable Net Income (DNI) –Determines the Maximum Income Distribution Deduction for the Year –Determines the Maximum Amount of Income Taxable to the Beneficiaries for the Year –DNI is used to determine the Character of Income Distributed to Beneficiaries Foundational Components
  48. 48. • Distributable Net Income (DNI) • Taxable Income + Tax Exempt Income, Less: –Allocable Expenses, modified to exclude: • Deductions for distributions • Annual personal exemption • Cap gains allocable to corpus (and not required to be distributed) • Charitable distributions • Capital Losses (except as used to arrive at net capital gains) Foundational Components
  49. 49. • Distributable Net Income (DNI) ⁼ Taxable Income + Tax Exempt Income, Less: – Allocable Expenses, modified to exclude the following: • Deductions for distributions • Annual personal exemption • Cap gains allocable to corpus (and not required to be distributed) • Charitable distributions • Capital Losses (except as used to arrive at net capital gains) Foundational Components
  50. 50. • Distributable Net Income (DNI) Discussion Examples: –Specific Bequests of Property –Specific Bequests of Cash (not more than 3 installments) Foundational Components
  51. 51. • Distributable Net Income (DNI) Discussion Examples: –Reallocation of Principal to Income under state law: –“Safe Harbor”: allocations between 3%-5% deemed reasonable Reg. 1.643(b)-1 Foundational Components
  52. 52. We will now take a one hour lunch break! LUNCH
  53. 53. INCOME REPORTABLE BY FIDUCIARIES FIONA XU, ESQ. ROYSE LAW FIRM, PC fxu@rroyselaw.com www.rroyselaw.com 149 COMMONWEALTH DRIVE, SUITE 1001 MENLO PARK, CA 94025 650.813.9700
  54. 54. What income should be Taxed Section 61: Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including: interests, dividends, rents, royalties, gross income derived from businesses, the distributive share of a partnership’s gross income. Section 102(a): Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. Section 102(b): Subsection (a) shall not exclude from gross income— (1) the income from any property referred to in subsection (a); or (2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income. Any amount included in the gross income of a beneficiary under subchapter J shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property.
  55. 55. What income should be Taxed Section 641: The tax imposed by section 1(e) shall apply to the taxable income of estates or of any kind of property held in trust, including: For Estates,  “income received by estates of deceased persons during the period of administration or settlement of the estate,”  “income accumulated or held for future distribution under the terms of the will,” and  “income which, in the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated.” For Trusts,  “income which is to be distributed currently by the fiduciary to the beneficiaries,”  “income which, in the discretion of the fiduciary, may be either distributed to the beneficiaries or accumulated,” and  “income accumulated in trust for the benefit of unborn or unascertained persons or persons with contingent interests, and income accumulated or held for future distribution under the terms of the … trust.”
  56. 56. Fiduciary Accounting Income • Presumption of Receipt as Principal. Section 16335(a)(4) • Right of Independent Trustee To Make Adjustments. Section 16336 • Distribution from business entities, cash is income (unless it is part of a partial or full liquidation), while other assets distributed are principal. Section 16350 • All rents are income (unless a business). Section 16356 • Bond Premiums and Discounts. Interests are income, while amounts received on sale or redemption are Principal (other than those bought at a discount and maturing within a year). Section 16357 • If a trustee plans to make a large, unusual expenditure, the trustee can reduce income in order to reimburse principal or establish a reserve. Section 16373 California Principal & Income Law, as effective from Jan. 1, 2000
  57. 57. Taxed as an Individual • Example: An estate receives income items during its tax year: • interest income • Dividends • Rents • Royalties • short and long term capital gains All of the above items represent taxable income to the estate. ‒ If any of the interest income is tax-exempt pursuant to §103, such income also will be tax exempt to the estate. ‒ If any of the transactions that gave rise to capital gains would not be recognized for tax purposes by an individual because of the sections that permit or require non-recognition (for example, §1031 dealing with like-kind exchanges), such gain also would not be recognized by the estate.
  58. 58. Taxed as an Individual • Example: A trust owns a residence that is used by a beneficiary as her principal residence. The trust sells the residence for a gain. ‒ It is income to the trust! ‒ Because an estate or trust cannot have a principal residence, an estate or trust cannot take advantage of section 121. This is so even though the beneficiary would have qualified under this section.
  59. 59. Interests and Dividends • Interests ‒ Line 1, Form 1041 ‒ Form 1099 ‒ Tax-exempted Interests reported separately • Dividends ‒ Qualified Dividend 1. The dividend must have been paid by an American company or a qualifying foreign company. 2. The dividends are not listed with the IRS as those that do not qualify. 3. The required dividend holding period has been met. 4. Taxed at the same rate as capital gain. ‒ Allocation between beneficiary and the Estate Qualified dividends allocated to the beneficiaries is determined according to the following formula: (Total Income Distribution/Distributable Net Income) Total Qualified Dividends
  60. 60. Income in Respect of a Decedent (IRD) • What is IRD? ‒ Reg. §1.691(a)-1(b) : In general, the term “income in respect of a decedent” refers to those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent. • IRD can come from various sources: ‒ Unpaid salary, fees, commissions or bonuses, ‒ Distributions from traditional IRAs and employer-provided retirement plans, ‒ Deferred compensation benefits, and ‒ Accrued but unpaid interest, dividends and rent. • IRD retains the character it would have had in the deceased’s hands.
  61. 61. Income in Respect of a Decedent (IRD) Example: A is a cash basis individual, invested $100,000 in a 4%, one year certificate of deposit on October 1, 2010, with interest credited to his account on a monthly basis. A died on December 1, 2010. The CD matured, and the principal and interest were paid to his estate on October 1, 2011. The Form 1099INT reported the entire $4,000 interest income in 2011 to A, using his social security number. Since A was a cash basis taxpayer, but was in constructive receipt of the interest income earned up to the date of his death, $667 of the $4,000 interest income should be reported on his final Form 1040, whereas $3,333 is taxable to the estate in 2011. Variation: If the interest earned on the certificate of deposit was not credited to A’s account until the maturity date, none of the interest would be reported on his final Form 1040 because he was not in constructive receipt of the interest before then. The entire $4,000 interest income would be reported on the estate’s Form 1041. The $667 interest earned through A’s date of death is IRD.
  62. 62. Business Income • Schedule C or Schedule C-EZ ‒ Whether the trust/estate has a business or not? ‒ Deduction under section 162 and section 212 • No self-employment tax ‒ Section 1402(a) • Sale of business property ‒ Form 4797 ‒ Line 7 of Form 1041
  63. 63. Capital Gains • Schedule D • Short term vs. Long term • Form 8949 Sales and Other Dispositions of Capital Assets • IRD does not have step-up basis
  64. 64. Special Rules – Rental and Royalty Income • Decedent’s Former Residents – The tax reporting depends on how the property is used after the owner's death. – A dwelling unit used for personal purposes by the estate's or trust's beneficiaries will be treated as personal use property unless the beneficiaries pay the entity a fair rent. – If there is no personal use of the property by the beneficiaries, and the property is held for the production of income, any loss on the sale should be deductible by the beneficiaries.
  65. 65. Special Rules – Partnership Income • Allocation of tax between income and principal – Tax is paid from income to the extent of receipts from the entity allocable to income, with the balance paid from principal. – A Partnership's capital gain allocated to a trust are included in the income of the trust. • The deductibility of a loss must be considered in view of three possible limitations, considered in the following order: 1. tax basis, 2. at risk (section 465), and 3. passive activity rules (section 469).
  66. 66. Special Rules – Depreciation and Depletion • Who’s entitled to the Depreciation? ‒ The deduction is to be apportioned among “the estate and the heirs, legatees, and devisees on the basis of the income of the estate allocable to each.” Section 611(b)(4) ‒ The income referred to is fiduciary accounting income (FAI). Section 643(b) ‒ In the case of a trust, apportioned between the income beneficiaries and the trust in accordance with the pertinent provisions of the trust instrument. Section 611(b)(3) • A Depreciation Reserve ‒ The amount of the reserve will not necessarily be the same as the amount of the depreciation deduction for federal income tax purposes. ‒ If a reserve is established, the amount of the reserve will affect the extent to which the trustee is entitled to the depreciation deduction.
  67. 67. Special Rules – Depreciation and Depletion • Example: All of the income of a trust is to be distributed currently to B. No provision fundamentally departs from local law. The trust income for the year is $90,000. The trustee does not establish a depreciation reserve. B is entitled to all of the depreciation deduction. This is true regardless of the value of the depreciation deduction. • Example: A trust has gross income of $60,000 for the year before creating any depreciation reserve. The trustee is required to charge the income with an expense of $10,000 in order to create a depreciation reserve of $10,000. Thus, the trust's FAI is $50,000. The trustee distributes this $50,000 of income to B, the income beneficiary. If the depreciation deduction is $10,000 or less, the trust is entitled to the entire deduction. If the depreciation deduction is more than $10,000, the first $10,000 is allocated to the trustee, because of the depreciation reserve, and the balance is allocated to B, who received all the FAI. • Example: A trust has a net income of $30,000. The trustee is not allowed to establish a depreciation reserve. The trustee exercises its discretion and distributes one-half or $15,000 of the trust's income to B, one of the beneficiaries. If the allowable depreciation deduction is $10,000, $5,000 is allocated to the trust and $5,000 to B, because she received one-half of the trust income.
  68. 68. DEDUCTIONS AVAILABLE TO FIDUCIARIES MICHAEL L. ZOSKY, ESQ. ROYSE LAW FIRM, PC mzosky@rroyselaw.com www.rroyselaw.com 149 COMMONWEALTH DRIVE, SUITE 1001 MENLO PARK, CA 94025 650.813.9700
  69. 69. • Deductions Generally: – Trusts and estates are entitled to many of the same deductions as are allowed to individuals General Rules
  70. 70. • Allocation and Reduction of Deductions When Tax-Exempt Income is Present – A portion of otherwise allowable deductions may have to be allocated to tax-exempt income, and are consequently rendered non-deductible – “Disallowance ratio” – Expressed as a fraction as follows: • The amount of tax-exempt income The income included in DNI (generally not capital gains) General Rules (Cont.)
  71. 71. • No standard deduction nor credit or deduction for dependents • Exemption: – Estates: $600 – Simple Trusts: $300 – Complex Trusts: $100 Exemptions and Standard Deductions
  72. 72. • Double Deductions Are Generally Prohibited – Estate Tax Return (Form 706) vs. 1041 • Certain Deductions Are Not Allowed on Form 1041 – Ex. Funeral expenses – Ex. Medical expenses Double Deductions
  73. 73. • Limited Exceptions to the Prohibition on Double Deductions – “Deductions in Respect of the Decedent” – Some items which constitute deductible debts of a decedent on Form 706 and also constitute deductible expenses on Form 1041 when paid by the fiduciary after the decedent’s death. Ex.: • Business expenses • Interest expenses • Certain state or local taxes owed at time of death and paid after death Double Deductions
  74. 74. • The Income Distribution Deduction • Depreciation • Required Association of Expense Items with Related Income Items – Items of deduction that are directly attributable to a specific type of income must be deducted from that income Deductions
  75. 75. • Line 10, Form 1041 • In general, may deduct interest like an individual • Interest payments made in connection with a deferred payment of federal estate tax per Code Section 6166 are not deductible on Form 1041 Deduction – Interest Expenses
  76. 76. • Line 11, Form 1041 • Federal taxes are not deductible – Note - Generation-skipping transfer tax on taxable income distributions is deductible – A special exception to this general rule may be invoked when an item is subject to double taxation as income in respect of a decedent (Ex. IRA) • State and local taxes (other than inheritance and estate taxes) are deductible Deduction – Taxes
  77. 77. • Line 12, Form 1041 • Special deduction for trusts and estates • May not be deducted on Form 1041 if previously deducted on Form 706 Deduction – Fiduciary Fees
  78. 78. • Line 13 and Schedule A, Form 1041 • Unlimited charitable deduction against their gross income • Not available for simple trusts Deduction – Charitable Deductions
  79. 79. • Actually paid or permanently set aside for a charitable purpose • Amounts contributed to charity must be paid from gross income • Special (irrevocable) election for charitable contributions made after close of taxable year Deduction – Charitable Deductions (Cont.)
  80. 80. • Line 14, Form 1041 • Form 706 vs. Form 1041 – When claimed on Form 1041, not subject to 2% AGI limitation • If incurred in the entity’s final year, may rise to excess deductions which are indicated on Schedule K-1 and carried to beneficiaries’ personal income tax returns as excess deductions – a miscellaneous itemized deduction subject to 2% AGI limitation Deduction – Attorney, Accountant, Return Preparer Fees
  81. 81. • Deductions for “costs which are paid or incurred in connection with the administration of the estate or trust… would not have been incurred if the property were not held in such trust or estate.” Section 67(e)(1). Examples include: – Appraisal fees – Probate fees – Fiduciary bonds – Fees to prepare fiduciary accountings Deduction – Other Deductions
  82. 82. • Investment Advisor Fees and Similar Expenditures – Controversial – Final Regs. – expenses “commonly” or “customarily” incurred by individuals as well as trusts and estates should be subject to the 2% floor Deduction – Other Deductions (Cont.)
  83. 83. • Investment Advisor Fees and Similar Expenditures (Cont.) – Ownership costs: Subject to the 2% floor • Expenses for real estate taxes or “ordinary and necessary” trade or business expenses are not subject to the 2% floor; however, and are generally fully deductible – Tax preparation fees • Fiduciary income tax returns and the decedent’s final income tax return not subject to 2% Floor – Investment advisory fees: Subject to the 2% floor – Appraisal fees: Generally fully deductible – Certain fiduciary expenses: Generally fully deductible Deduction – Other Deductions (Cont.)
  84. 84. • “Bundled” fees – Single fiduciary fee that might include investment advisor fees (or other fees subject to 2% floor) – Allocation of fees – “Reasonable Method” Deduction – Other Deductions (Cont.)
  85. 85. • Line 15b Form 1041 • Only available when the trade or business is actually conducted within the fiduciary entity – Two year carryback, 20 year carryforward – Unused NOLs may be passed through to beneficiaries in final year of trust or estate Deduction - Net Operating Loss Deductions
  86. 86. • Line 18, Form 1041 • Unique to Fiduciary Income Taxation – Deduction for income distributed to beneficiaries – Deduction cannot exceed DNI • Distributions Carry Out DNI-with exceptions – Specific bequests of property or specific bequests of a specified sum of money payable in not more than three installments – Payments of required bequests to charity Deduction – Income Distribution Deduction
  87. 87. • Distributions in excess of DNI • Character of Income to Beneficiaries • Beneficiary Income Reporting Deduction – Income Distribution Deduction (Cont.)
  88. 88. • Distributions of Simple Trusts – Deduction = Amount required to be distributed, whether or not actually distributed • Distributions of Complex Trusts – Deduction = income required to be distributed currently plus any other amounts of income properly paid, credited or required to be distributed – The 65-Day Rule for Distributions Deduction – Income Distribution Deduction (Cont.)
  89. 89. • Determining Income Distribution Deduction - Schedule B of Form 1041 (Simplified) – Lesser of: – FAI – DNI – MODIFIED DNI (FAI less tax exempt income and associated deductions, which means net tax exempt income) – MODIFIED FAI (DNI less tax exempt income and associated deductions, which means net tax exempt income) Deduction – Income Distribution Deduction (Cont.)
  90. 90. • Line 19, Form 1041 • Income in respect of a decedent (IRD) • Difference between estate’s actual federal estate tax liability and the federal estate tax that would have been paid if the IRD item(s) had been excluded from the estate tax calculation: – IRD Item x Estate Tax Paid Total Estate Assets • Not subject to the 2% of AGI floor Deduction – Estate Tax Deduction
  91. 91. • Line 20, Form 1041 • Annual exemptions as follows: – Estate: $600.00 – Simple Trust: $300.00 – Complex Trust: $100.00 – Grantor Trust: No exemption allowed • No annual exemption is permitted for the final year of an entity Deduction – Exemption
  92. 92. • Payments are not deductible as alimony expenses • To the extent paid from income, payments may be deducted as an income distribution deduction • Do carry out DNI Deduction – Alimony Deduction
  93. 93. • Net Operating Loss Issues • Related Party Loss Issues Deduction – Losses
  94. 94. We will now take a 15 minute break! BREAK
  95. 95. Chapter 8 Tax Calculations, Credits, Payments and Special Rules JENNIFER HAN, ESQ. ROYSE LAW FIRM, PC jhan@rroyselaw.com www.rroyselaw.com 149 COMMONWEALTH DRIVE, SUITE 1001, MENLO PARK, CA 94025 650.813.9700
  96. 96. • Where to Calculate the Income Tax Liability. – Taxable income present - Schedule G of Form 1041. – No long-term capital gains or qualified dividends - Tax Rate Schedule – Long-term capital gains and qualified dividends - Part V of Schedule D. – If qualified dividends, section 1250 gain or 28% gain are present - Form 1041 Instructions or Instructions to Schedule D of Form 1041. How to Handle Taxable Income Realized by the Trust or Estate
  97. 97. • Lump-sum distributions from qualified retirement plans - Form 4972 • Alternative minimum tax – Calculation - Schedule I – Report - Schedule G. • Net investment income tax – Form 8960 Other Taxes
  98. 98. • General rule: Credits are apportioned between the entity and its beneficiaries on the basis of the income allocated to the entity and its beneficiaries. • Income distributed to the beneficiaries carries out the credits that correspond to that income. (a) The foreign tax credit: • Calculation - Form 1116 • Report - Line 2a of Schedule G of Form 1041. (b) “General Business Credit” • Report - Line 2b of Schedule G • More than one Credit - Form 3800, General Business Credit • See list on pg 79-80 Credits Available
  99. 99. (c) Paid alternative minimum tax in a previous year – Attach Form 8801 – Report - Line 2c of Schedule G (d) Holding a tax credit bond – Attach Form 8912, Credit to Holders of Tax Credit Bonds – Included in interest income; – Report - Line 2d of Schedule G (e) Qualified Zone Academy Bond Credit as an S corporation shareholder – Calculation – Form 8860 – Report - Line 2(e) of Schedule G with notation “QZAB”. (f) Clean Renewable Energy or Gulf Tax Credit Bond Form 8912; Line 2e with either “CREB” or “GTCB” inserted on the dotted line – Attach 8912 – Report – Line 2e with either notation “CREB” or “GTCB” • Sum of all credits totaled on Line 2e • Amount of total credits (Line 2e) subtracted from the total tax liability (Line 1d) – Final amount reported on Line 3 of Schedule G. • Line 4 to Schedule G of Form 1041 – Report amount of net investment income tax (Line 21 of Form 8960) Credits Available (Cont.)
  100. 100. Specific recapture taxes (Line 5 of Schedule G) (a) Form 4255 - Investment credit recapture (b) Form 8611 - Low-income housing credit recapture tax (c) Qualified electric vehicle recapture tax – Line 5 – notation “LIHCR” (d) Form 8845 - The Indian Employment Credit – Line 5 – notation “IECR” (e) Form 8882 - Employer-Provided Child Care Facilities – Line 5 – notation “ECCFR” (f) New markets recapture tax (IRC 45D(g)) – Line 5 – notation “NMCR” (g) Form 4255 - Recapture of investment tax credit – Line 5 – notation “ICR” Recapture Taxes
  101. 101. • Household employee – Schedule H of Form 1040; – Report - Line 6 of Schedule G. • Triggering Circumstances (IRS Publication 926) (a) Pay any one household employee cash wages of $2,000 or more during 2016 ($2000 - 2017) (the FICA threshold); or (b) Withheld federal income tax; or (c) Paid total cash wages of $1000 or more in any calendar quarter during 2016/2017 (the FUTA threshold) Household Employment Tax
  102. 102. Certain other taxes that may be applicable • Line 7 of Schedule G • Add reported amount of tax to reach the total tax due These include: (a) Form 4970 - Tax due on an accumulation distribution from a trust (b) Form 5329 - Excise tax due if the trust or estate fails to receive the minimum required distribution from a qualified retirement plan or Individual Retirement Account (c) Interest due on an outstanding deferred tax liability arising from the installment sale or real property. Code Section 453A(c). (d) Form 8697 - Interest due under the look-back method of accounting for certain long term contracts. Code Section 460(b)(2). (e) Form 8866 - Interest due under the look-back method for property depreciated under the income forecast method (f) Tax due on the portion of an Electing Small Business Trust (ESBT) consisting of stock in one or more S Corporations Additional Special Situation Taxes
  103. 103. • Line 7 of Schedule G  Line 23, pg 1, Form 1041 • Various possible prepayments: (a) Estimated tax payments (Form 1041-ES) or overpayments – report on Line 24a (b) Estimated tax payments made by an individual prior to death - final Form 1040 - If this results in a refund, file Form 1310 (c) Treating estimated taxes paid by the entity as paid by beneficiaries (Code Section 643(g)) - Report - Line 24b of Form 1041 - Election - Form 1041-T –file by 65th day after close of entity’s taxable year - Line 24b  Line 13A of Schedule K-1 of beneficiary (d) Amount of tax paid with the Extension Request Form (Form 7004) - Report - Line 24d of Form 1041 (e) Tax withheld for any reason - Report - Line 24e - Attach appropriate W-2, 1099, etc. forms to Form 1041 - No withheld income taxes (except backup withholding) may be passed through to beneficiaries via Schedule K-1 or Form 1041-T. (f) The refundable tax credits for taxes paid on undistributed capital gains by regulated investment companies (Form 2439)(Line 24f) and for Federal excise taxes on certain fuels (Form 4136) (Line 24g) - Totaled on Line 24h. Prepayment of Tax
  104. 104. Form 2210 – Utilized to determine the existence of a penalty (or the availability of an exception to an otherwise applicable penalty) – Indicate amount on Line 26 Underpayment of Estimated Tax
  105. 105. • The total tax due, less payments made, plus any penalties due for underpaying estimated taxes – calculated on Line 27 and 28 to indicate either a balance due or an overpayment. • Overpayment – refunded or credited to the estimated tax due for the following tax year – Line 29 of Form 1041 Balance Due or Overpayment
  106. 106. • IRS Center indicated in the instructions for Form 1041 • Filing location = the location of the trust or estate • Check or money order: – “United States Treasury” – “[Entity’s federal identification number]” – “ [TAX YEAR], Form 1041” • Payment should accompany the completed Form 1041 • Different zip codes to be used for returns with payment versus return without payment Where to File Form 1041
  107. 107. • Form 1041, Page 2 • Preparer must be certain that the nine questions appearing under “Other Information” have been answered Addressing the “Other Information” Questions and Elections
  108. 108. Question 1: Total the tax-exempt interest income received and exempt-interest dividends received from a mutual fund – Any allocation of expenses to the tax exempt income is calculated and submitted on an attached sheet – Necessary to compute the income distribution deduction Addressing the “Other Information” Questions and Elections (Cont.)
  109. 109. Question 2: Entity’s receipt of an individual’s earnings via a contract assignment or similar arrangement Question 3: Foreign bank accounts (broader inquiry) • “Yes” - estate or trust had an interest in/ signature /other authority over a bank, securities or other account in a foreign country. – Must note foreign country/countries and file FinCen Form 114 » Filed electronically with the Department of Treasury by April 15th. • “No” - value of the accounts maintained by the trust or estate was less than $10,000 for the whole year. Addressing the “Other Information” Questions and Elections (Cont.)
  110. 110. Question 4: Any relationship with a foreign trust, including as a grantor, distributee or transferor to such a trust. - If answered “Yes” - Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts Addressing the “Other Information” Questions and Elections (Cont.)
  111. 111. Question 5: Qualified residence interest • If “yes”: – attachment must provide the name, address and identifying number of the person to whom qualified residence interest was paid, or from whom it was received. Addressing the “Other Information” Questions and Elections (Cont.)
  112. 112. Question 6: Sec. 663(b) election to treat payments made to a beneficiary within 65 days of the end of the entity’s taxable year as made in the prior year Addressing the “Other Information” Questions and Elections (Cont.)
  113. 113. Question 7: Section 643(e) (3) election • treat a noncash distribution of property as a sale to the beneficiary at FMV and recognize gain accordingly (no loss deductions available -Section 267) – General rule: an in-kind distribution of property by an estate or trust to its beneficiaries does not result in the recognition of gain or loss to the distributing entity. Code Section 643(e). • The distribution is valued at the lower of the basis of the property in the hands of the entity or its FMV on the date of distribution. – Recipient beneficiary takes the distributed property with a carryover basis from the entity. Section 643(e)(1). – A special election is available to enable the estate or trust to: • treat distribution as sale at FMV, • recognize the gain at the trust/estate level • No election on asset-by asset basis. • Election applies to all of the distributions during the taxable year. Section 643(e)(3). Addressing the “Other Information” Questions and Elections (Cont.)
  114. 114. Question 7 continued… – If the election is made, beneficiary takes a basis equal to the adjusted basis of the entity, plus any gain recognized on the distribution, i.e., typically FMV of property on date of disposition – The distribution of property carries out DNI to the beneficiaries. • If election: DNI carried out = FMV of distributed property. • If no election: DNI carried out = lesser of FMV of the distributed property OR basis of property – If basis is carryover basis, tacking on of holding period of transferring entity • If not, when election is made and transaction deemed a sale, transferee must begin a new holding period – If value of property has declined, fiduciary cannot recognize a loss on distribution to beneficiary, since the transaction is treated as a sale to a related party. Section 267(b). • The only exception: Loss can be deducted when the estate is funding a pecuniary bequest and realizes a loss. Section 267(b)(13). – To make the election: check “Section 643(e) election” box on page 2 of Form 1041 • deemed sale of the property reported by entity - Schedule D, Form 1041 • Annual election; can only be revoked with the consent of the IRS Addressing the “Other Information” Questions and Elections (Cont.)
  115. 115. Planning: When to Make a Section 643(e) Election: • Ideally when estate or trust has large capital losses, and the election will result in a gain at the entity level that will be offset by the available losses. • If property depreciable, be careful of ordinary income recapture • Generally, election should not be made if: – beneficiary in a lower tax bracket than entity, or – if beneficiary will likely retain the property and not sell it for a long time, or hold the property until death – step-up basis for beneficiary’s heirs Addressing the “Other Information” Questions and Elections (Cont.)
  116. 116. Question 8: If estate has been open for more than two years and, if so, requests an explanation for the delay in closing the estate. - Exception: Estates continuing to hold S corporation stock during the period that the estate is paying estate tax in installments pursuant to Section 6166 is not considered to be using an unreasonably prolonged time to keep the estate open. PLR 200226031. - If estate kept open “too long”, potential recharacterization as a trust, with the calendar year filing requirement, reduced exemption, etc. requirements imposed. Addressing the “Other Information” Questions and Elections (Cont.)
  117. 117. Question 9: Beneficiaries who are “skip persons” • beneficiaries who are part of a generation that is two or more generations younger than the transferor of property. • Potential liability for the generation-skipping transfer tax when certain transfers are made from the trust or estate. Addressing the “Other Information” Questions and Elections (Cont.)
  118. 118. Question 10: Whether trust was a specified domestic entity required to file Form 8938 for the tax year • appears for the first time in the 2016 Form 1041 • if the trust held foreign financial assets of $50,000 on the last day of its tax year, or $75,000 at any time during its tax year, attach to Form 1041 Addressing the “Other Information” Questions and Elections (Cont.)
  119. 119. • Extension of time to file ≠ no accrual of interest • Late filing penalty – 5% of the tax due for each month or part of a month that the return is late, maximum 25%. – reasonable cause available • Late payment penalty – ½ of 1% of the unpaid amount of tax for each month or part of a month that payment remains outstanding; maximum is 25% of the unpaid tax Interest and Penalties
  120. 120. The Separate Share Rule Applied to Trusts and Estates Trust Beneficiary S1 BeneficiaryBeneficiary S2 S3 Single Trust with more that one beneficiary, each beneficiary has separate and independent shares and distinct economic interest, shares treated as separate trusts solely for purpose of determining amount of DNI allocable to each beneficiary. Section 663(c); Treas. Reg. 1.663(c)- 1(a) and (c)-4(a).
  121. 121. • The beneficiary of a separate share may not be taxed on more than his or her pro rata share of DNI. • It does not require separate identifying numbers, additional trust income return filings, or separately maintained accounts, nor does it permit additional personal exemptions • Separate share treatment is not elective. The Separate Share Rule Applied to Trusts and Estates (Cont.)
  122. 122. Application to Estates – 1997 Act • Substantially separate and independent shares of different beneficiaries in an estate having more than one beneficiary • Separate share rule will be applied to determine the estate’s deduction for distributions to beneficiaries and the income taxable to the estate and to such beneficiaries. • Similar to the case with trusts, the application of these rules to estates is mandatory. • Effect: limit the application of Code Section 661 and 662 to distributions to beneficiaries so that no beneficiary is subjected to income tax on more than his or her pro rata share of the entity’s DNI. – promote fairness among the beneficiaries and to prevent manipulation of the entity’s taxable income The Separate Share Rule Applied to Trusts and Estates (Cont.)
  123. 123. The Separate Share Rule Applied to Trusts and Estates (Cont.) Estate B1 B2 B3 TI: $3,000 Absent Separate Share Rule $2,000 Distribution 1) A reports $2,000 income (B&C report nothing) 2) Estate reports $1,000 TI (after claiming $2,000 income distribution deduction)
  124. 124. The Separate Share Rule Applied to Trusts and Estates (Cont.) Estate B1 B2 B3 TI: $3,000 Applying Separate Share Rule $2,000 Distribution 1) A treated as receiving and reports $1,000 income (A’s 1/3 share of $3,000) 2) A also treated as receiving principal distributions of $1,000 3) B&C treated as receiving nothing and report nothing 4) Estate reports $2,000 TI (after claiming $1,000 income distribution deduction)
  125. 125. System for the allocation of DNI • “Separate economic interests” exist where the economic interests of the beneficiaries are not interdependent. • DNI is calculated separately for each separate share, and the estate’s gross income is allocated in accordance with the income to which each share is entitled under the governing instrument or applicable state law. Treas. Reg. 1.663(c)-2(a) and (b). – Income earned on assets allocated to one share, or the appreciation or depreciation of assets in one separate share has no effect on any other share. Treas. Reg. 1.663(c)-4(a). – A qualified revocable trust will always be deemed a separate share, regardless of whether the Section 645 election is made. • Such trust may itself be further divided into additional separate shares. Treas. Reg. 1.663(c)-4(a). The Separate Share Rule Applied to Trusts and Estates (Cont.)
  126. 126. – Specific bequests are not classified as separate shares - not the basis for allocation of DNI. Treas. Reg.1.663(c)-4(a). – However, earnings from specific bequests of property, if included as part of the bequest, may be treated as separate shares. Treas. Reg. 1.663(c)- 1(b)(3); 1.663(c)-5. – Rights to items of income in respect of a decedent (IRD) are allocated among the various separate shares that could potentially be funded with the IRD amounts, whether or not such shares otherwise participate in income. • allocation is pro rata, based on the relative value of each share. Treas. Reg. 1.663(c)-2(b)(3). • allocation of IRD could shift income tax liability to trusts otherwise protected from estate tax or generation-skipping transfer tax by the use of the decedent’s exemptions (language should be specifically drafted to limit the possible recipients of IRD items) – The Regulations will allow directions in the governing instrument to override the requirements regarding allocation among potential recipients. Treas. Reg. 1.663(c)-5, Example 10. The Separate Share Rule Applied to Trusts and Estates (Cont.)
  127. 127. • Income allocated to charities – rules of Section 642(c), not separate share rules (See Chapter 7, section II.D.) • Show separate share calculations and attach to Form 1041. The Separate Share Rule Applied to Trusts and Estates (Cont.)
  128. 128. TRUST AND ESTATE DISTRIBUTIONS Special Issues and Situations _______________________________________ ALLISON KROEKER, ESQ. ROYSE LAW FIRM, PC akroeker@rroyselaw.com www.rroyselaw.com 149 COMMONWEALTH DRIVE, SUITE 1001, MENLO PARK, CA 94025 650.813.9700 EXT. 211
  129. 129. • Pro rata allocation of tax items at termination • NOLs and capital losses continue to carry forward • Excess deductions on termination are miscellaneous itemized deductions and subject to the 2% floor  Use it or lose it  They won’t be back, baby  All losses reported on the beneficiary’s Schedule K-1 Distributions in the Year of Termination
  130. 130. Suspended Passive Losses  Suspended passive losses do not become available as a deduction to the beneficiaries  Suspended passive losses may be used to increase the income tax basis of the passive activity property immediately before distribution § 469(j)(12) Passive Losses at Termination
  131. 131. Certain deductions to which a trust or estate may otherwise be entitled do not survive the entity: The fiduciary may not claim a personal exemption And the amount of such exemption may not be added to the excess deduction available to beneficiaries in the year of termination • Excess charitable contributions Consider making the election to treat a charitable contribution as made in the prior tax year Investment interest expense carryovers Excess percentage depletion carryovers Retired Deductions
  132. 132. • Kenan Rule  A distribution of non-cash assets by a fiduciary in satisfaction of a pecuniary obligation triggers realization of gain by the estate or trust, see Treas. Reg. § 1.661(a)-2(f); Kenan v. Comm’r, 114 F. 2d 217 (2d Cir. 1940) • Application of the Kenan Rule  Two factor test: (1) Obligation to pay a specific amount of money or to transfer specific property; and (2) satisfaction of that obligation by the transfer of other property - The residue of an estate/share of an entity’s assets (by fraction or by formula) is not a “specific amount of money” under the Kenan Rule • Hypothetical Sale  Beneficiary takes basis equal to the distributed property’s fair market value at distribution; entity may recognize gain or loss Distributions in Kind
  133. 133. Accumulation Distributions • Throwback Rules: A beneficiary receiving an accumulation distribution (i.e., a distribution that exceeds current income) is taxed as if the trust made the distribution in the year of accumulation  Prior to 1993, these rules were in place to limit the possibility that accumulated income in a trust would be taxed at lower rates than those rates applicable to trust beneficiaries  After tax law changes in 1993, high marginal tax rates at low levels of trust income made these rules unnecessary • Substantial Repeal under the Taxpayer Relief Act of 1997  Distributions to trust beneficiaries from “qualified trusts” are computed without regard to any previously undistributed income (effective for distributions made after Aug. 5, 1997) • What is a “qualified trust?” – Generally, any domestic trust that has never been treated as a foreign trust
  134. 134. Accumulation Distributions Non-Qualified Trusts  Any foreign trust  Any domestic trust that was previously treated at any time as a foreign trust  Any trust created for the purpose of tax avoidance before March 1, 1984 Calculating Tax Liability  The trustee completes Schedule J of Form 1041 to calculate an accumulation distribution which indicates the amounts to be “thrown back”  Form 4970 is used to calculate the beneficiary’s tax liability on this amount  Beneficiaries may offset their tax liability for taxes paid by the trust on the accumulated income in prior tax years  No refund or credit is available to the beneficiary if there was an excess tax payment made by the trust
  135. 135. Exempt Accumulation Distributions There are several important exceptions to the imposition of the throwback rules where they remain applicable:  Estates are not subject to the throwback rules  Distributions of amounts paid, credited, or required to be distributed in a taxable year in which it qualifies as a simple trust  Distributions from a trust representing income accumulated before the birth of a beneficiary or before such beneficiary is 21  Gifts or bequests of a specific sum of money or specific property so long as it is paid all at once or in not more than three installments and not exclusively from trust income  Amounts paid, permanently set aside, or credited to a charitable organization within Section 642(c)
  136. 136. Distributions in Excess of DNI How is income allocated when distributions are made to multiple beneficiaries in excess of distributable net income (DNI)? • Tier 1: Beneficiaries having a direct, nondiscretionary right to income are allocated DNI on a priority basis – If Tier 1 distributions use all of the entity’s DNI, any remaining distributions are made from the principal • Tier 2: Distributions from estates, required distributions of corpus, and discretionary distributions of income and corpus from a complex trust – These distributions only decrease DNI to the extent that there is remaining DNI after the full absorption of DNI by Tier 1 payments  A beneficiary being charged with a proportionate share of DNI may not trace the distribution to its actual source to claim it is a distribution of principal instead of a distribution of income, see Section 662(a)(2)(B); Harkness v. U.S., 469 F. 2d 310 (1972)
  137. 137. Distributions in Excess of DNI Example: Grantor creates a trust for the benefit of A, B, and C. The trust terms require annual income payments to A of $20,000. Any remaining income may either be paid to A, B, C, or accumulated at the discretion of the trustee. Assume the trust has total DNI of $60,000 for the current tax year. The trustee distributes an additional $25,000 (beyond the $20,000 distribution to A) to each of A, B, and C for a total distribution of $95,000 for the current tax year. DNI $60,000 Tier 1 Distributions A: $20,000 Tier 2 Distributions A: $25,000 B: $25,000 C: $25,000
  138. 138. Distributions in Excess of DNI Example DNI for the year $60,000 Tier 1 distribution to A - $20,000 Remaining DNI balance $40,000 Tier 2 distributions to A, B, and C A: 25,000/75,000 x 40,000 = 13,333 B: 25,000/75,000 x 40,000 = 13,333 C: 25,000/75,000 x 40,000 = 13,333 $40,000 DNI distributed $35,000 principal distributed (the amount in excess of DNI) A has taxable income of $33,333 (the tier 1 distribution + the tier 2 distribution) B and C each have taxable income of $13,333 (the tier 2 distribution) A, B, and C each have accumulation distributions of $11,667 (the amount in excess of DNI) These accumulation distributions may be subject to the throwback rules §§ 665-68 DNI for the year $60,000 Tier 1 distribution to A - $20,000 Remaining DNI balance $40,000 Tier 2 distributions to A, B, and C A: 25,000/75,000 x 40,000 = 13,333 B: 25,000/75,000 x 40,000 = 13,333 C: 25,000/75,000 x 40,000 = 13,333 $40,000 Remaining DNI balance -0-
  139. 139. Alternative Minimum Tax (AMT) The AMT is a separate calculation of income tax liability that disallows many of the exclusions and deductions available in the taxable income base of the regular tax The AMT rules have been applicable to trusts and estates since January 1, 1987 The general intent of these AMT rules are to assure that all trusts and estates which have income in excess of the AMT exemption ($24,100 for 2017) that is not distributed in full to the beneficiaries of the entity will pay some tax, notwithstanding the various deductions which may be allowed for regular income tax purposes Policy Debates • AMT increases progressivity of the tax system • Rule complexity raises administrative and compliance costs • Disproportionately affects taxpayers who live in high-tax states • The two most important tax preferences for investment income in the Code are not disallowed for purposes of the AMT – Long-term capital gains – Qualified dividend income • Trump’s tax plan and the GOP blueprint both propose to repeal the AMT and most tax preferences under the Code
  140. 140. AMT Calculation AMT Adjustments Disallow deductions allowed for regular tax purposes Income Distribution Deduction Calculate the distribution deduction for AMT purposes AMT Exemption Undistributed income is not taxable until it is in excess of the AMT exemption, which is indexed for inflation ($23,900 for 2016; $24,100 for 2017) Tentative Minimum Tax If the entity’s minimum taxable income exceeds the AMT exemption, it calculates a tentative minimum tax AMT Liability If the tentative minimum tax is higher than the regular tax liability, then the entity must pay AMT
  141. 141. Net Investment Income Tax (NIIT) As part of the Affordable Care Act, a 3.8% Net Investment Income Tax (also called the “Medicare Tax” or “Obamacare Tax”) applies to net investment income if MAGI of an individual taxpayer is over the $200k single/$250k married threshold Tax based upon the lesser of the taxpayer’s net investment income or the excess of the taxpayer’s MAGI over the threshold amounts Not indexed for inflation
  142. 142. Application of NIIT to Trusts and Estates The NIIT applies to the investment income received by estates and trusts along with its application to individuals § 1411(a)(2) An estate or trust will pay the NIIT on investment income based on the lesser of the estate or trust’s undistributed net investment income, or the excess of the estate or trust’s adjusted gross income as determined under Section 67(e) over the dollar amount threshold at which the estate or trust is taxed at the highest marginal tax rate for the tax year § 1.1411-3 $12,400 for 2016; $12,500 for 2017 Adjusted annually for inflation
  143. 143. NIIT Considerations for Trusts and Estates • It is fair to assume that most of the income realized by trusts and estates is net investment income • Where applicable, the Form 8960 computes the NIIT and should be attached to the Form 1041 • There is likely increased pressure on fiduciaries to distribute the net investment income to beneficiaries with MAGI below the threshold (where discretion to do so exists) • The NIIT follows the same rules as the “regular” tax on trusts and estates, i.e., income will be taxed once— either to the entity if it retains the income, or to the beneficiary to the extent it is distributed
  144. 144. And Now, The Test… Just Kidding
  145. 145. ROYSE LAW FIRM, P.C. WEALTH STRATEGIES AND TAX TEAM C. David Spence Michael L. Zosky Jennifer Han Fiona Xu Allison Kroeker

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