1. Principles of Taxation: Advanced Strategies
Slide 15-1
Chapter 15
Income Taxation of Trusts and Estates
McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc

2. Trusts
Slide 15-2
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)
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3. Trusts – Nontax Purposes
Slide 15-3
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
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4. Trusts Donor control May be irrevocable
Slide 15-4
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
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5. Trusts
Slide 15-5
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
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6. Taxation of Trust and Estates (Overview)
Slide 15-6
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
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7. Trust Taxable Income Calculation
Slide 15-7
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 w to determine trust taxable income
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8. Trust Taxable Income Calculation (continued)
Slide 15-8
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
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9. Trust Accounting Income
Slide 15-9
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
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10. Common Allocations Income Principal
Slide 15-10
Income
Principal
Interest, dividends, rents, royalties
Capital gains and losses on investments
Operating income
Casualty losses and insurance recoveries
Operating expense
Extraordinary repairs
Taxes levied on income
Taxes levied on principal
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11. Trust Taxable Income
Slide 15-11
Computed in a manner similar to individual taxable income
No adjusted gross income concept
No standard deduction
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12. Depreciation
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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
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13. Slide 15-13
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
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14. Exemptions
Slide 15-14
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
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15. Distributable Net Income
Slide 15-15
Defines the maximum possible income distribution deduction and maximum possible income from trust taxable to beneficiaries
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16. Distributable Net Income Calculation
Slide15-16
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
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17. Trust Tax Liability
Slide 15-17
Tax rates are steeply progress reaching the maximum rate of 39.6% with only $ 8,900 of taxable income
Often beneficiaries in lower rate brackets
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18. Taxation of Trust Beneficiaries
Slide 15-18
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
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19. Character of Income
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If more than one type of income is distributed from a complex trust, it must be allocated proportionately amount income beneficiaries
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20. Separate Share Rule
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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
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21. Trust Property Distributions
Slide 15-21
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
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22. Trust Property Distributions
Slide 15-22
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
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23. Trust Filing Requirements
Slide 15-23
All trusts must use a calendar year end
All trusts must file if over $ 600 of gross income or any taxable income
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24. Income Taxation of Estates
Slide 15-24
Income Taxation of Estates
Basically same rules as for taxation of trusts
Distributions allocated between principal and income based upon will or state law
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25. Income in Respect of a Decedent
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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
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26. Estate Administration Expenses
Slide 15-26
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
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27. Estate Exemptions and Filing Requirements
Slide 15-27
$ 600 exemption
May utilize a fiscal year
No estimated payments required for two years after decedent’s death
McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc