2. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 15 Income Taxation of Trusts and Estates Slide 15-1

3. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trusts Created when a donor transfers property to a fiduciary or trustee for the benefit of one or more beneficiaries Trust property is called corpus or principal Two ways trusts may be created  Donor may create during his or life (inter vivos trust)  May be created by will (testamentary trust) Slide 15-2

4. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc 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

5. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trusts Donor control  May be irrevocable  Donor gives up control over property  May be revocable  Donor may revoke trust and take back property  Result is incomplete gift for gift and estate tax purposes  Treated as grantor trust with donor taxable on all income even if trust is not revoked Slide 15-4

6. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trusts Simple trust  Trust required to distribute all of its accounting income  Makes no charitable contributions  No distributions out of corpus Complex trust  Any trust that is not a simple trust Slide 15-5

7. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Taxation of Trust and Estates (Overview) Modified conduit approach Trusts and estates are allowed a deduction for income distributed and taxed to their beneficiaries Trusts and estates are taxable on any income not distributed Slide 15-6

8. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trust Taxable Income Calculation Step 1: Calculate trust accounting income Step 2: Calculate trust taxable income before income distribution deduction Step 3: Compute distributable net income (DNI) and the distribution deduction Step 4: Subtract the distribution deduction from the amount in step 2 to determine trust taxable income Slide 15-7

9. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trust Taxable Income Calculation (continued) Step 5: Calculate trust tax liability Step 6: Allocated DNI and the distribution deduction to the beneficiaries to determine the amount and character of income taxed to each beneficiary Slide 15-8

10. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trust Accounting Income Importance: determines which items are allocated to income and distributable to beneficiaries and which items are allocated to principal If trust document is silent on allocation, state law controls Slide 15-9

11. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Common Allocations Slide 15-10 IncomePrincipal Interest, dividends, rents, royalties Capital gains and losses on investments Operating incomeCasualty losses and insurance recoveries Operating expenseExtraordinary repairs Taxes levied on incomeTaxes levied on principal

12. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trust Taxable Income Computed in a manner similar to individual taxable income  No adjusted gross income concept  No standard deduction Slide 15-11

13. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Depreciation May be deductible by trust, beneficiaries or allocated between them Trust document controls If document silent, depreciation apportioned based on share of trust accounting income  In such a situation a simple trust would allocate all depreciation to beneficiaries Slide 15-12

14. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Other Expenses Slide 15-13 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

15. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Exemptions All trusts entitled to a personal exemption except in final year Trusts required to distribute all income annually receive an exemption of $ 300 Other trusts receive $ 100 exemption Slide 15-14

16. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Distributable Net Income Defines the maximum possible income distribution deduction and maximum possible income from trust taxable to beneficiaries Slide 15-15

17. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Distributable Net Income Calculation Start: Taxable income before distribution deduction Add: Personal exemption Subtract: Capital gains allocated to principal Add: Capital losses allocated to principal Add: Tax-exempt interest Subtract: Expenses allocated to tax-exempt income Slide15-16

18. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trust Tax Liability Tax rates are steeply progress reaching the maximum rate of 38.6% with only $ 9,200 of taxable income Often beneficiaries in lower rate brackets Slide 15-17

19. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Taxation of Trust Beneficiaries Income taxable to trust beneficiaries in total is limited to DNI Beneficiaries of simple trusts and beneficiaries of first tier distributions from complex trust taxed proportionately on share of income distributed Second tier distributions only taxable to beneficiaries if first tier does not exceed DNI Slide 15-18

20. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Character of Income If more than one type of income is distributed from a complex trust, it must be allocated proportionately amount income beneficiaries Slide 15-19

21. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Separate Share Rule Slide 15-20 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

22. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc 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 Slide 15-21

23. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc 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 Slide 15-22

24. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Trust Filing Requirements All trusts must use a calendar year end All trusts must file if over $ 600 of gross income or any taxable income Slide 15-23

25. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Income Taxation of Estates Slide 15-24 Basically same rules as for taxation of trusts Distributions allocated between principal and income based upon will or state law

26. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Income in Respect of a Decedent Income earned before death of decedent but not properly reportable on final income tax return Items are subject to both income tax and estate tax Related expenses are referred to as deductions in respect of a decedent Deductions in respect of a decedent are deductible for both income and estate tax Slide 15-25

27. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Estate Administration Expenses May be claimed as deductions against estate tax return or income tax return but not both  To claim on income tax return, personal representative must file election not to claim as deductions on estate tax return Slide 15-26

28. McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc Estate Exemptions and Filing Requirements $600 exemption May utilize a fiscal year No estimated payments required for two years after decedent’s death Slide 15-27