14-1 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-2 INCOME TAXATION OF TRUSTS & ESTATES (1 of 2)  Basic concepts  Principles of fiduciary accounting  Formula for trust taxable income and tax liability  Distributable net income (DNI)  Determining a simple trust’s taxable income Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-3 INCOME TAXATION OF TRUSTS & ESTATES (2 of 2)  Determining taxable income for complex trusts and estates  Income in respect of a decedent  Grantor trust provisions  Tax planning considerations  Compliance and procedural considerations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-4 Basic Concepts  Inception of trusts  Inception of estates  Reasons for creating trusts  Basic principles of fiduciary taxation  Definitions Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-5 Inception of Trusts and Estates  Trust  Inter vivos  Created while person is alive or under direction of will following death  Testamentary  Created by decedent’s will  Estate  Upon death of person whose assets are being administered Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-6 Reasons for Creating Trusts  Tax saving aspects  Income splitting  Minimizing estate taxes  Nontax aspects  §2503 and Crummey trusts  Trustee manages assets for minor  Revocable trust  Reduces probate costs Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-7 Basic Principles of Fiduciary Taxation  Trusts and estates separate taxpayers  No double taxation  Deductions permitted for income distributed to beneficiaries  Conduit approach  Distributed income retains its character  Rules similar to individuals Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-8 Principles of Fiduciary Accounting Principal vs. Income  Principal or corpus  Initial assets transferred by grantor plus certain additions/deductions required by provisions of trust instrument  Income  Earnings derived from principal but certain gains, losses or deductions may be considered adjustments to principal Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-9 Principles of Fiduciary Accounting Relevant Parties (1 of 2)  Grantor  Party that transfers assets to a trust  Trustee  Party that administers a trust  Income Beneficiary  Party (or parties) who receives income when distributed by Trustee under provisions of trust instrument Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-10 Principles of Fiduciary Accounting Relevant Parties (2 of 2)  Remaindermen  Party (or parties) who eventually receives trust principal  Same person may receive both income and principal Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-11 Principles of Fiduciary Accounting Types of Trusts  Simple trust  Must distribute all income annually,  Does not distribute any principal AND  Makes no contributions to charities  Complex trust  Any trust that is not a simple trust Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-12 Formula for Trust Taxable Income & Tax Liability (1 of 3) Gross Income - Deductions for expenses - Personal exemption Taxable income before distribution - Distribution deduction Trust taxable income Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-13 Formula for Trust Taxable Income & Tax Liability (2 of 3) Trust taxable income x Tax rates in §§1(e) & 1(h) Tax on taxable income - Credits Net tax liability Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-14 Formula for Trust Taxable Income & Tax Liability (3 of 3)  Deductions for expenses  Parallel expenses for individuals  Trustee fees deductible similar to §212 exp  2% of AGI floor may apply to certain exp  Personal exemption  $600 for estates  $300 if annual distribution of all income required  $100 if current income may be retained Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-15 Distributable Net Income (DNI) Basic Concepts  DNI is maximum distribution deduction & income reportable by beneficiaries  No distribution deduction available for portion of distribution deemed to consist of tax-exempt income even though net tax-exempt income included in DNI Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-16 Distributable Net Income (DNI) Computation Taxable income before distributions + Personal exemption already deducted - Capital gains added to principal + Capital losses subtracted from principal + Tax exempt interest (net of expenses) Distributable Net Income Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-17 Distributable Net Income (DNI) Topic Review 2 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-18 Determining a Simple Trust’s Net Income (1 of 3)  Must distribute all of its net accounting income currently  Aggregate gross income reported by beneficiaries cannot exceed DNI  Income received by beneficiaries retains its character Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-19 Determining a Simple Trust’s Net Income (2 of 3)  Allocation of expenses to tax-exempt income Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall Tax-exempt income (net of exp. directly attributable thereto) X Accounting income (net of all direct exp) = Indirect expenses allocable to non-taxable income

14-20 Determining a Simple Trust’s Net Income (3 of 3)  Tax treatment of beneficiary if trust has > 1 beneficiary  Beneficiary’s share of gross income if DNI lower than net accounting income is fraction of DNI shown below Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall Income required to be distributed to such beneficiary Income required to be distributed to all beneficiaries

14-21 Determining Taxable Income for Complex Trusts & Estates (1 of 2)  Complex trusts permit the following activities  Making distributions < current earnings  Distributing principal  Making charitable contributions  Complex trust’s DNI  Impact on beneficiaries Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-22 Determining Taxable Income for Complex Trusts & Estates (2 of 2) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-23 Complex Trust’s DNI (1 of 2)  Complex DNI not reduced by charitable contribution deduction when determining maximum distribution for mandatory distributions Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-24 Complex Trust’s DNI (2 of 2)  DNI reduced when calculating deductible discretionary distributions  Distribution deduction is smaller of DNI or sum of mandatory and other amounts properly paid Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-25 Impact on Beneficiaries (1 of 2)  In general  Beneficiary includes distributions as gross income up to current DNI for the trust  Accumulation distribution or throwback rules attempt to tax individual as if distributions were made annually  Higher trust tax rates make accumulation less desirable Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-26 Impact on Beneficiaries (2 of 2)  Tax treatment of beneficiary if trust has > 1 beneficiary  Beneficiary’s share of gross income if total income required to be distributed exceeds DNI Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall Income required to be distributed currently to beneficiary Aggregate income required to be distributed to all beneficiaries currently

14-27 Income in Respect of a Decedent (IRD) (1 of 4)  Most individuals use cash basis  IRD is income constructively received, but not actually received before death  Interest on CDs, bonds, or savings  Salary, commissions, or bonus  Dividends received after date of death with record date before death Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-28 Income in Respect of a Decedent (IRD) (2 of 4)  IRD must be included  As gross income on estate’s income tax return AND  As part of the gross estate for transfer tax purposes Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-29 Income in Respect of a Decedent (IRD) (3 of 4)  Estate may claim an income tax deduction for the extra transfer tax due because these items were counted as part of the estate Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-30 Income in Respect of a Decedent (IRD) (4 of 4) §691(c) deduction for the year X Total §691(c) deduction = Net IRD included in gross inc for the year Total Net IRD Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-31 Grantor Trust Provisions (1 of 2)  Grantor does not give up enough control or economic benefit to be a completed transfer  Grantor taxed on some or all of trust’s income  Even if income distributed to beneficiaries Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-32 Grantor Trust Provisions (2 of 2)  Types of grantor trusts  Revocable trusts  Post-1986 Reversionary interest trusts  See Topic Review 4 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-33 Tax Planning Considerations (1 of 2)  Changes that reduced the benefit of using trusts to shift income  Tax rates for fiduciaries are very compressed  Children under 18 (and some > 18) are taxed at parents’ higher rate on unearned income even if from a trust or estate  Dividend income taxed at max of 15% Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-34 Tax Planning Considerations (2 of 2)  Timing of distributions  Sprinkling trusts maximize flexibility in timing of distributions to each beneficiary to maximize tax savings  Property distributions  Trustee may elect to recognize gain on appreciated property distributed  Estates are free to adopt any fiscal year Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14-35 Compliance and Procedural Considerations  Filing requirements  Form 1041 if gross income ≥$600  Due date 15 th day of 4 th month following year end  Form 7004 for automatic 5-mo extension Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall