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experience ideas // CPAs & ADVISORS FIDUCIARY TAX COMPLIANCE Kevin G. Horn, CPA

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  • experience ideas //

    CPAs & ADVISORS

    FIDUCIARY TAX COMPLIANCE

    Kevin G. Horn, CPA

  • PRESENTATION AGENDA

    General Terminology

    Types of Trusts

    Reporting for Grantor Trust

    Ficuciary Accounting Rules

    Reporting for a non-Grantor Trust

    Types of Income and additions to principal

    Types of deductions

    Estates and how they differ from trusts

    Revocable trusts and elections available to the estate Section 645

    IRD and DRD

    Passive Activities

    2 // experience ideas

  • GENERAL TERMINOLOGY

    Grantor (Settlor or Trustor)

    Irrevocable Trust

    Revocable Trust

    Beneficiary

    Income Beneficiary

    Remainder Beneficiary

    Fiduciary Income Tax Return (Form 1041)

    Distributable Net Income (DNI)

    Trust Accounting Income (TAI)

    Taxable Income

    Principal (Corpus)

    3 // experience ideas

  • TYPES OF TRUSTS

    Grantor

    Simple

    Complex

    Charitable

    4 // experience ideas

  • 5 // experience ideas

    CLASSIFYING THE TRUSTS

    Trust

    Non -Grantor

    Simple Complex

    Grantor

  • CHARACTERISTICS OF A GRANTOR TRUST

    Grantor (or person other than the grantor) retains substantial power over the trust.

    Statutory definitions 671-679.

    Income, deductions, and credits are reported on the grantors annual income tax return.

    Tax Return Filing Options

    No tax return is required.

    Reasons to file Form 1041

    Separate Tax Identification Number

    Avoid matching notices

    Respect trust for estate purposes

    1099 option

    6 // experience ideas

  • 7 // experience ideas

    GRANTOR TRUST TAX RETURNS

  • GRANTOR TRUST TAX RETURNS

    8 // experience ideas

  • K-1 DISCLOSURE ON GRANTOR LETTER

    9 // experience ideas

  • General Fiduciary Accounting Rules

    10 // experience ideas

  • WHO IS THE BENEFICIARY?

    Income beneficiaries

    Receive the income produced by the trust corpus (principal).

    Remainder beneficiaries

    Receive the corpus of the trust when the trust is terminated.

    11 // experience ideas

  • TYPES OF INCOME

    Taxable versus Nontaxable

    Taxable

    Dividends from corporate stock

    Interest on corporate and United States bonds

    Rents

    Capital gains

    Nontaxable

    Municipal bond interest

    12 // experience ideas

  • TRUST ACCOUNTING INCOME ILLUSTRATION

    13 // experience ideas

  • TRUST ACCOUNTING INCOME ILLUSTRATION

    14 // experience ideas

  • TRUST ACCOUNTING INCOME ILLUSTRATION

    15 // experience ideas

  • EXAMPLE #1 INCOME VERSUS PRINCIPAL

    16 // experience ideas

    The ABC Trust had the following income and expenses for 2015. Complete the allocation between income and principal.

    Received taxable interest income of $10,000

    Received municipal interest income of $10,000

    Received Qualified Dividends of $20,000

    Paid investment fees of $8,000

    Paid trustee fees of $4,000

    Sold investments resulting in a capital gain of $30,000

    Paid Arkansas income tax of $2,000

    State taxes were paid due to capital gains

  • INCOME VERSUS PRINCIPAL EXAMPLE SOLUTION

    17 // experience ideas

    Total Principal Income

    Interest $10,000 $10,000

    Muni-Interest $10,000 10,000

    Dividends $20,000 20,000

    Capital Gains $30,000 30,000 0

    Total Revenue $70,000 $30,000 $40,000

    Invest Fees $8,000 4,000 4,000

    Trustee Fees $4,000 2,000 2,000

    State Taxes $2,000 2,000 0

    Total Expense $14,000 8,000 6,000

    Excess $56,000 $22,000 $34,000

  • 18 // experience ideas

  • TYPES OF INCOME

    Trust accounting income and principal

    Who gets what

    Income: available to an income beneficiary

    Principal: available to current discretionary principal beneficiary or a remainder person.

    Refer to trust document and state Principal and Income Act.

    19 // experience ideas

  • ACCOUNTING INCOME OR PRINCIPAL?

    20 // experience ideas

    Generally

    Accounting Income Principal

    Dividends (taxable and non) Capital gains

    Interest (taxable and non)

    Rents

    Distributions from partnerships and s corporations

    Distributions from partnerships?

    Expenses Expenses

    Federal and State tax payments Federal and State tax payments

  • NON-GRANTOR TRUSTS

    21 // experience ideas

  • CLASSIFYING THE TRUST

    22 // experience ideas

    Trust

    Non -Grantor

    Simple Complex

    Grantor

  • WHAT IS A NON-GRANTOR TRUST?

    Treated as a separate taxpayer for income tax purposes

    See 641(b)

    Basic concept income taxed once

    23 // experience ideas

  • SIMPLE TRUSTS

    The trustee:

    Required to distribute all of the income currently

    Cannot make charitable contributions

    24 // experience ideas

  • POLLING QUESTION

    25 // experience ideas

    If a simple trust is required to distribute out all income, could the trust ever owe tax?

    A. Yes

    B. No

    C. Maybe

  • SIMPLE TRUSTS

    Example language:

    Commencing with my death and during the life of my wife, the trustee shallpay to her all the income from the ABC Trust in convenient installments, at least as often as quarterly. . .

    The trust may also allow for discretionary distributions of principal.

    Example Marital Trust

    26 // experience ideas

  • SIMPLE TRUST TAX RETURNS

    27 // experience ideas

  • COMPLEX TRUSTS

    Not a simple trust

    Accumulation of income

    Distributes principal during the taxable year

    Trustee may be authorized to make charitable contributions

    Final year of a trust

    28 // experience ideas

  • COMPLEX TRUSTS

    Example language:

    The trustee may, in its discretion, pay so much or all of the income or principal of the ABC trust to the beneficiary as the trustee determines to be necessary to maintain the beneficiaries standard of living. . .

    29 // experience ideas

  • 65 DAY RULE UNDER IRC 663(B)

    Applies to estate and complex trusts

    Allows fiduciary to treat distributions made within 65 days after year-end to be treated as if they were made as of December 31st of the prior year

    Limited to DNI reduced by distribution made during the year

    Election is made by the due date of the tax return

    Irrevocable

    Annual Election

    30 // experience ideas

  • HOW TO MAKE A 65 DAY ELECTION

    31 // experience ideas

  • FIDUCIARY INCOME TAX RETURN FORM 1041

    32 // experience ideas

  • COMPLEX TRUST TAX RETURNS

    33 // experience ideas

  • BASIC REQUIREMENTS

    When required to file?

    Any taxable income for the year, OR

    Gross income of $600 or more, regardless of the amount of taxable income

    Due dates

    Estates on or before the 15th day of the fourth month following the close of the estates taxable year

    Trusts April 15th

    Extensions

    Use Form 7004 for an automatic 5 1/2 month extension

    States?

    34 // experience ideas

  • Estates and trusts (other than grantor trusts) must make quarterly estimated tax payments

    Same provisions effective for individuals

    Different income thresholds

    Exceptions:

    First two tax years of an Estate

    Tax liability for the current year is less than $1,000

    No safe harbor available in initial year or year following a short year

    State requirements?

    Form 1041-T

    35 // experience ideas

    ESTIMATED PAYMENTS

  • DEDUCTIONS

    Exemptions

    Charitable

    Net Operating Loss

    Depreciation

    Miscellaneous Itemized Deduction

    Trustee fees

    Legal and accounting

  • A deduction granted to the estate or trust for amounts distributed to beneficiaries. This eliminates the possibility of double taxation.

    Lesser of:

    The aggregate of:

    Income required to be distributed currently, and

    Other amounts paid, credited, or required to be distributed; OR

    Distributable net income less tax-exempt income as adjusted.

    37 // experience ideas

    INCOME DISTRIBUTION DEDUCTION

  • DISTRIBUTABLE NET INCOME (DNI)

    DNI is taxable income computed with certain modifications:

    No income distribution deduction

    No exemption

    No capital gains and losses (generally)

    Look at trust document

    Final Year

    Includes tax exempt interest, adjusted for allocated expenses

    38 // experience ideas

  • INCOME DISTRIBUTION DEDUCTION

    39 // experience ideas

  • INCOME DISTRIBUTION DEDUCTION

    Shown on Form 1041, Page 1 Line 18

    40 // experience ideas

  • ALLOCATION OF EXPENSES

    Direct traced to a specific source of income.

    Indirect not specific to any type of income.

    41 // experience ideas

    TaxableTax

    Exempt

  • NET INVESTMENT INCOME TAX 1411

    3.8% Medicare surtax is imposed on the lesser of:

    Undistributed net investment income, or

    The excess of AGI over the threshold amount.

    The threshold amount for 2014 is $12,150 (income level at which the 39.6% rate applies)

    Material participation implications

    Form 8960 (same for individuals)

    42 // experience ideas

  • TAX RATES

    2016 Tax Rate Schedule

    If taxable income is:

    43 // experience ideas

    Over But no over Its tax is: Of the amount over

    $0 2,550 15%

    2,550 5,950 $382.50 + 25% 2,550

    5,950 9,050 1,232.50 + 28% 5,950

    9,050 12,400 2,100.50 + 33% 9,050

    12,400 3,206.00 + 39.6% 12,400

  • Exercise #1

    44 // experience ideas

  • EXERCISE #1 TAI VERSUS DNI

    The XYZ Trust had the following income and expenses in 2016. Figure TAI and DNI.

    45 // experience ideas

    Income Expenses

    Dividends $12,000 Trustee Fees $2,000

    CorporateInterest

    $8,000 Tax Prep Fees $1,000

    Municipal Interest

    $10,000 Real Estate Taxes

    $1,000

    LTCG $20,000 State Income Taxes

    $2,500

  • TAI VERSUS DNI EXAMPLE SOLUTION

    TAI DNI

    Dividends $12,000 $12,000

    Corp Interest 8,000 8,000

    Muni Interest 10,000 10,000

    Capital Gain 0 0

    Total Revenue $30,000 $30,000

    Trustee Fees 1,000 2,000

    Tax Prep Fees 500 1,000

    Real Estate Tax 1,000 1,000

    State Income Tax 2,500

    Total Expenses $2,500 $6,500

    Totals $27,500 $23,500

    46 // experience ideas

  • Estates

    47 // experience ideas

  • ESTATE BASICS

    Separate taxable entity which is created upon the death of a decedent.

    Limited existence which terminates upon distribution to heirs and designated beneficiaries.

    Period is usually no longer than three years after death.

    48 // experience ideas

  • DIFFERENCES FROM TRUSTS

    Exemption $600 versus $100 for complex trusts and $300 for simple trusts.

    Certain administration expenses or debts of the decedent may be deductible.

    Estate tax deduction.

    No estimated payment requirements in initial year

    Can have a fiscal year creating opportunity for income tax deferral

    49 // experience ideas

  • TRUSTS SOLELY FOR CHARITABLE RECIPIENTS

    Two Options

    Seek Exemption from taxation under Section 501(a) by filing Form 1023

    Do not seek exemption and pay income tax too

    Private Foundation Rules

    Distribute 5% to qualified charity

    No Self Dealing with donor and/or family

    File Form 990PF annually

    Tax on investment income at 2%

    50 // experience ideas

  • TRUSTS SOLELY FOR CHARITABLE RECIPIENTS

    Non-Exempt Charitable Trusts

    Section 4947(a)(1) governs

    Deduction was allowed to donor

    Still subject to Private Foundation Rules

    Since the trust is not exempt from income taxes

    Normal trust tax rules apply

    If there is taxable income, Form 1041 must be filed

    No Form 1041 filing requirement if no taxable income

    51 // experience ideas

  • 52 // experience ideas

  • REVOCABLE TRUSTS AND DEATH OF THE GRANTOR

    THE BEGINNING

    645 elections

    Income & deductions in respect of a decedent

    THE MIDDLE

    Allocating principal & income

    Passive activity rules

    THE END

    Termination

    645 elections

    53 // experience ideas

  • TO 645 OR NOT TO 645?

    What is it? Executor of estate & trustee of qualified revocable trust (QRT) created by decedent may elect for trust to be treated & taxed as part of estate for all tax years of estate ending after date of decedents death & before applicable date

    54 // experience ideas

  • DEFINITIONS FOR 645 ELECTION PURPOSES

    Qualified revocable trust (QRT): Trust treated as grantor trust because of right of revocation under 676

    Applicable date: Date on which QRT ceases to be treated & taxed as part of decedents estate under election

    Estate tax return is not required to be filed: Two years after date of decedents death (645(b)(2)(A)), or

    Estate tax return is required to be filed: Six months after date of final determination of estate tax liability (645(b)(2)(B))

    55 // experience ideas

  • DEFINITIONS FOR 645 ELECTION PURPOSES

    Date of final determination of estate tax liability:

    Six months after issuance by Service of estate tax closing letter,

    unless estate tax refund claim is filed within 12 months after

    issuance of letter

    Date of final disposition of refund claim that resolves estate tax

    liability, unless suit is initiated within 6 months after final

    disposition of claim

    Date of execution of settlement agreement with Service that

    determines estate tax liability

    56 // experience ideas

  • DEFINITIONS FOR 645 ELECTION PURPOSES

    Date of final determination of estate tax liability (cont.):

    Date of issuance of decision, judgment, decree or other order by court of competent jurisdiction resolving estate tax liability, unless notice of appeal or petition for certiorari is filed within 90 days after issuance, or

    Date of expiration of 6501 period of limitations for assessment of estate tax (Reg. 1.645-1(f)(2)(ii))

    57 // experience ideas

  • ADVANTAGES OF 645 ELECTION

    Availability of fiscal year (Reg. 1.645-1(e)(3)(i))

    Avoid need to make estimated payments for two years after decedents death (Reg. 1.645-1(e)(4))

    Ability to obtain charitable deduction for amounts permanently set aside for charity under 642(c)(2) (Reg. 1.645-1(e)(2)(iv))

    Ability to hold S corporation stock for duration of administration of estate (Reg. 1.645-1(e)(3)(i))

    Simplify number of tax returns

    58 // experience ideas

  • WHO IS ELIGIBLE S CORPORATION SHAREHOLDER

    Individual (except nonresident alien)

    Estate of deceased individual during period of administration (Reg. 1.641(b)-3(a))

    QRT electing 645

    Organizations exempt from tax under 501(a)

    Qualified retirement plan described in 401(a)

    Charitable organization described in 501(c)(3)

    Six specified trusts permitted under 1361(c)(2)(A)

    59 // experience ideas

  • WHO IS ELIGIBLE S CORPORATION SHAREHOLDER

    Certain trusts permitted as shareholders (1361(c)(2)(A))

    Grantor trust (671-679)

    Former grantor trust (two years post-death)

    Qualified subchapter S trust (QSST)

    Testamentary trust (two years post-funding)

    Electing small business trust (ESBT)

    Voting trust created to exercise voting power of stock

    Trust part of profit sharing or pension plan exempt under 401(a)

    60 // experience ideas

  • ADVANTAGES OF 645 ELECTION

    Avoidance of passive loss active participation requirement under 469 for two years after death (Reg. 1.645-1(e)(3)(i))

    Use of $600 personal exemption (Reg. 1.645-1(e)(2)(ii)(A))

    Deferral of payment of income tax on income earned after date of death until due date of estates fiduciary return (up to 11 months of deferral)

    61 // experience ideas

  • DISADVANTAGES OF 645 ELECTION

    May not be advisable with estates/trusts with significant assets & incongruent beneficiaries

    Potential complications with separate share rule

    State residency/situs considerations

    62 // experience ideas

  • MECHANICS OF 645 ELECTION

    How do you make election?

    Election must be made on estates first timely income tax return (including extensions) & once made is irrevocable.

    Election is made by filing Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate, with Form 1041.

    Box in Item G of Form 1041 (page 1) should be checked

    No provision for relief for late elections!

    63 // experience ideas

  • 64 // experience ideas

  • MECHANICS OF 645 ELECTION

    Employer Identification Number: Revocable living trust becomes different taxpayer after grantor dies (Rev. Rul. 57-51). Trustee of QRT must obtain new EIN for QRT upon death of decedent

    Form SS-4 (Application for Employer Identification Number):When applying for EIN for QRT, indicate trust will make election to be treated as estate under 645 as there is no penalty for later changing this decision

    65 // experience ideas

  • MECHANICS OF 645 ELECTION

    Which EIN to use?

    If there is probate estate, file under EIN of estate

    If trust is electing by itself without probate estate, file under EIN of QRT (Note: New EIN will be necessary on termination of 645 election). If there is no executor in this situation, trustee of trust files Form 8855

    66 // experience ideas

  • MECHANICS OF 645 ELECTION

    What happens at end?

    On close of last day of election period, i.e., applicable date, distribution is deemed to be made by combined electing trust &

    related estate (Reg. 1.645-1(h)(1))

    67 // experience ideas

  • 645 ELECTION CASE STUDY #1

    Decedent: Bob The Client

    Created Bob T. Client Revocable Trust on January 4, 2010, & transferred all outstanding shares of Clients Business, Inc. (S corporation) to trust

    Bob passed away November 15, 2010

    Date closing letter issued: June 30, 2013

    What is last day trust is eligible S corporation shareholder?

    68 // experience ideas

  • 645 ELECTION CASE STUDY #1 THE SOLUTION

    DOD: November 15, 2010

    Form 706 filed February 15, 2012

    Date closing letter issued: June 30, 2013

    645 election period: 11/15/2010 - 6/29/2014

    Plus: Two-year period under 1361(a)(1)

    June 29, 2016

    69 // experience ideas

  • IRD & DRD

    Income in respect of a decedent (IRD): Items of gross income not properly includible in decedents final/prior year return are taxed to decedents successors in interest when received by them (691(a))

    Items of IRD under 691 are not entitled to step-up in basis at decedents death (1014(c))

    Difficult to apply - requires us to consider Decedents method of accounting

    Whether item constitutes IRD

    Code does not define what constitutes item of IRD & regulations provide little guidance

    70 // experience ideas

  • IRD & DRD

    Three groups of items of IRD based on ways in which income is generated

    By providing use of property investment income, e.g., accrued interest & dividends declared but not paid

    By performing services, e.g., bonuses & other compensation or paid/payable following decedents death; IRAs & qualified benefit plans upon which decedent has not been taxed

    By disposition of property, e.g., unrecognized gain on installment obligation

    71 // experience ideas

  • IRD & DRD

    Income from flow-through entities

    Partnerships: Death of partner results in close of partnerships taxable year with respect to decedent partner (706(c)(2)(A). Decedent partners share of partnership income will be included on his or her final tax return & no part of successors share of partnerships distributive share will be IRD

    S corporations: Decedent shareholder in S corporation is required to include pro rata share of corporate income earned through date of death (1366(a)). Therefore, no part will be IRD

    72 // experience ideas

  • IRD & DRD

    Income from flow-through entities (cont.)

    Fiduciaries:

    Income actually distributed by fiduciary to cash method beneficiary before death is taxable to beneficiary on his or her final tax return, & any amount paid to beneficiarys estate is IRD (Reg. 1.652(c)-2 & 1.662(c)-2)

    If undistributed income passes to another beneficiary under terms of governing instrument, it will not constitute IRD

    73 // experience ideas

  • IRD & DRD

    Courts have employed two tests in deciding whether particular item triggers IRD upon receipt

    Casual connection test: Where decedents economic activities gave rise to post-death payment, payment is IRD upon receipt

    Right of income/entitlement test: Decedent must also have had right to that payment

    691(a)(3) provides that item of IRD shall have same character in successors hands as it would have had in decedents

    74 // experience ideas

  • IRD & DRD

    Deductions in respect of a decedent (DRD): 691(b) allows deduction on decedents successor in interest who liquidates decedents obligations, i.e., expenses accrued at date of death but paid after death

    Limited to expenses deductible under 162, 163, 212 & 611

    Items of DRD are allowable under 2053(a)(5) for estate tax purposes as claims against estate & are also allowed as DRD for income tax purposes to person/entity paying those expenses

    75 // experience ideas

  • IRD & DRD

    691(c) provides deduction for estate tax paid with respect to item of IRD

    Reason is to mitigate effects of double taxation, i.e., IRD represents property interest taxable in decedents gross estate for estate tax purposes

    Proportionate part of deduction is allowed to successor in interest for each period in which IRD is included in income

    Deduction is itemized deduction which is not subject to 2% floor under 67

    Only allows for deduction of federal estate tax paid; no deduction is allowed for state death tax paid

    76 // experience ideas

  • IRD & DRD CASE STUDY #1

    Jack Client died on 1/1/2015 with following assets & liabilities

    Installment note has zero basis. Mortgage is secured by real estate, & liability includes $25,000 of interest accrued to but unpaid at date of death. All assets pass as part of Jacks probate estate

    77 // experience ideas

    Cash $2,000,000

    Real estate 2,500,000

    Installment note 1,000,000

    Mortgage -500,000

    Total 5,000,000

  • IRD & DRD CASE STUDY #1

    Probate administration was completed on 9/1/2015. Upon closing estate, executor paid executor, attorney & accountant fees of $100,000 & interest on mortgage of $50,000. Executor also paid Illinois estate tax of $250,000. Residue of estate was distributed to Jacks daughter, Jill

    What are items of IRD & DRD?

    Is there deduction available under 691(c)?

    78 // experience ideas

  • IRD & DRD CASE STUDY #1 THE SOLUTION

    Installment note is taxable to Jill as item of IRD under 691(a) & is not entitled to step-up in basis

    Jacks estate is entitled to DRD deduction under 691(b) for $25,000 interest expense accrued through date of death but paid by estate (interest is 163 expense)

    No 691(c) deduction is available as there is no federal estate tax paid (despite $250,000 of Illinois estate tax paid!)

    79 // experience ideas

  • IRD & DRD CASE STUDY #2

    Jack Client died on 1/1/2015 with following assets (assume no liabilities)

    IRA has zero basis

    All assets (except IRA) pass under Jacks revocable trust agreement to Jacks daughter, Jill. Jacks ex-wife, Jackie, is beneficiary of IRA

    80 // experience ideas

    Cash $2,000,000

    IRA 2,000,000

    Real estate 2,500,000

    Total 6,500,000

  • IRD & DRD CASE STUDY #2

    Estate was not probated. Upon closing estate, executor paid executor, attorney & accountant fees of $100,000. Executor also paid Illinois estate tax of $498,929 & federal estate tax of $188,428. Jackie receives distribution of entire IRA in 2015

    What are items of IRD & DRD?

    Is there deduction available under 691(c)?

    81 // experience ideas

  • IRD & DRD CASE STUDY #2 THE SOLUTION

    IRA is taxable to Jackie as item of IRD under 691(a) & is notentitled to step-up in basis

    There are no items of DRD

    Jackie is entitled to deduction for federal estate tax paid under 691(c) in 2015

    82 // experience ideas

  • IRD & DRD CASE STUDY #2 THE SOLUTION

    691(c) deduction is calculated as follows

    1. Compute total FET value of all items of IRD

    $2,000,000

    2. Compute total amount of DRD for which deduction is claimed on Form 706

    $0

    3. Amount in (1) is reduced by amount in (2) to produce net value for FET purposes of all IRD items (691(c)(2)(B))

    $2,000,000

    83 // experience ideas

  • IRD & DRD CASE STUDY #2 THE SOLUTION

    691(c) deduction is calculated as follows (cont.)4. Compute FET attributable to net value (691(c)(2)(C))

    84 // experience ideas

    WITH WITHOUT

    Cash $2,000,000 $2,000,000

    IRA 2,000,000 - -

    Real estate 2,500,000 2,500,000

    Total gross estate 6,500,000 4,500,000

    Admin expenses -100,000 -100,000

    Tentative taxable estate 6,400,000 4,400,000

    State death tax deduction -498,929 -114,286

    Taxable estate 5,901,071 4,285,714

    Federal estate tax 188,428 - -

  • IRD & DRD CASE STUDY #2 THE SOLUTION

    691(c) deduction is calculated as follows (cont.)

    5. As IRD is received, proportionate part of FET determined in step (4) is deducted by recipient of IRD. Proportionate part is determined as follows under 691(c)(1)(A)

    IRD received x FET from step (4)

    Total IRD (FET value)

    For this purpose, IRD received is valued at lesser of actual amount received or its FET value.

    85 // experience ideas

  • IRD & DRD CASE STUDY #2 THE SOLUTION

    691(c) deduction is calculated as follows (cont.)

    IRD received x FET from step (4)

    Total IRD (FET value)

    $2,000,000 x $188,428 = $188,428

    $2,000,000

    86 // experience ideas

  • IRD & DRD CASE STUDY #3

    Jack Client died on 1/1/2015 with following assets/liabilities

    Installment note & IRA have zero basis. Mortgage liability includes $25,000 of interest accrued to but unpaid at date of death. All assets (except IRA) pass under Jacks revocable trust agreement to Jacks 2 daughters. Jacks ex-wife, Jackie, is beneficiary of IRA

    87 // experience ideas

    Cash $2,000,000

    IRA 2,000,000

    Real estate 2,500,000

    Installment note 2,000,000

    Mortgage -500,000

    Net 8,000,000

  • IRD & DRD CASE STUDY #3

    Estate was not probated. Upon closing estate, executor paid executor, attorney & accountant fees of $100,000 & interest on mortgage of $50,000. Executor also paid Illinois estate tax of $665,669 & federal estate tax of $711,732

    In 2015 & 2016, Jacks trust received payments on installment notes of $500,000 & $1,500,000, respectively. Jackie elected to receive distributions from IRA over 5 years

    What are items of IRD & DRD?

    Is there deduction available under 691(c)?

    88 // experience ideas

  • IRD & DRD CASE STUDY #3 THE SOLUTION

    Installment note is taxable to Jacks trust as item of IRD & is not entitled to step-up in basis

    IRA is taxable to Jackie as item of IRD & is not entitled to step-up in basis

    Jacks trust, as payor, is entitled to DRD under 691(b) for $25,000 interest expense accrued through date of death but paid by estate (interest is 163 expense) (note additional $25,000 of interest expense paid is deductible by trust)

    89 // experience ideas

  • IRD & DRD CASE STUDY #3 THE SOLUTION

    691(c) deduction is calculated as follows

    1. Compute total FET value of all items of IRD

    $4,000,000 ($2M IRA & $2M installment note)

    2. Compute total amount of DRD for which deduction is claimed on Form 706

    $25,000

    3. Amount in (1) is reduced by amount in (2) to produce net value for FET purposes of all IRD items (691(c)(2)(B))

    $3,975,000

    4. Compute FET attributable to net value (691(c)(2)(C))

    90 // experience ideas

  • IRD & DRD CASE STUDY #3 THE SOLUTION

    91 // experience ideas

    With Without

    Cash $2,000,000 $2,000,000

    IRA 2,000,000 - -

    Real estate 2,500,000 $2,500,000

    Installment note 2,000,000 - -

    Total gross estate 8,500,000 4,500,000

    Mortgage -500,000 -500,000

    Admin expenses -125,000 -100,000

    Tentative taxable estate 7,875,000 3,900,000

    State death tax deduction -665,669 - -

    Taxable estate 7,209,331 3,900,000

    Federal estate tax 711,732 - -

    Difference 711,732

  • IRD & DRD CASE STUDY #3 THE SOLUTION

    691(c) deduction is calculated as follows (cont.)

    5. As IRD is received, proportionate part of FET determined in step (4) is deducted by recipient of IRD. Proportionate part is determined as follows under 691(c)(1)(A)

    IRD received x FET from step (4)

    Total IRD (FET value)

    For this purpose, IRD received is valued at lesser of actual amount received or its FET value.

    92 // experience ideas

  • IRD & DRD CASE STUDY #3 THE SOLUTION

    691(c) deduction is calculated as follows (cont.)

    IRD received x FET from step (4)

    Total IRD (FET value)

    Jacks trust (2015): $475,000 x $711,732 = $85,050

    $3,975,000

    Jacks trust (2016): $1,500,000 x $711,732 = $268,578

    $3,975,000

    93 // experience ideas

  • IRD & DRD CASE STUDY #3 THE SOLUTION

    691(c) deduction is calculated as follows (cont.)

    IRD received x FET from step (4)

    Total IRD (FET value)

    Jackie (2015): $400,000 x $711,732 = $71,620

    $3,975,000

    94 // experience ideas

  • PROPER PLACE TO DEDUCT

    Final 1040:

    Unrecovered basis of annuity

    Itemized deduction paid before death

    Carryover (decedent)

    Capital loss

    Charitable

    NOL

    Investment interest

    PAL

    Investment tax credit

    95 // experience ideas

  • PROPER PLACE TO DEDUCT

    EITHER final 1040 OR 706:

    Medical expense of decedent paid within one year

    706:

    Funeral expense

    Claim against estate of personal, non-deductible nature

    Administrative expenses attributable to exempt income

    1041: Tax on estate income

    Real estate tax not accrued prior to death

    Interest accruing after death

    96 // experience ideas

  • PROPER PLACE TO DEDUCT

    EITHER 1041 OR 706:

    Estate administration expense (except attributable to TEI)

    Unreimbursed casualty & theft loss

    BOTH 1041 & 706: Trade or business, interest or tax expense accrued prior to

    death

    Expense incurred for management, conservation or maintenance of property held for production of income or in connection with determination, collection or refund of tax accrued prior to death

    Alimony & maintenance payment accrued at death

    97 // experience ideas

  • THE MIDDLE

    98 // experience ideas

  • THE PRINCIPAL QUESTION

    Income: Money or property fiduciary receives as current return from principal asset (2000 Revised Uniform Principal & Income Act Section 102(4))

    Principal: Property held in trust for distribution to remainder beneficiary when trust terminates (2000 Act Section 102(10))

    Property rights governed by state laws

    Determination Governing instrument

    State law

    If neither provide guidance: Item should be allocated to principal (2000 Act Section 103(a)(4))

    99 // experience ideas

  • THE PRINCIPAL QUESTION

    Disposition of property: Principal

    Including capital gains in DNI under Reg. 1.643(a)-3

    Allocated to income by governing instrument and state law or pursuant to reasonable impartial exercise discretion by fiduciary

    Treated consistently as part of distributions to a beneficiary

    Actually distributed or considered by fiduciary in determining distributions

    Usually contrary to grantors intent

    100 // experience ideas

  • THE PRINCIPAL QUESTION

    Insurance proceeds: Principal, unless purchased to protect trust from loss of income (2000 Act Section 407) or separate interest of income beneficiary

    Corporate distributions:

    Cash dividends: Income

    Liquidating dividends: Principal

    Extraordinary dividends: Principal

    101 // experience ideas

  • THE PRINCIPAL QUESTION

    Interest income: Income

    Exceptions

    IRD

    Tax-exempt

    Imputed interest under 1274

    Amortization of bond premiums & discounts: Principal

    Exceptions

    Zero-coupon bonds

    Obligation has maturity of less than one year

    102 // experience ideas

  • THE PRINCIPAL QUESTION

    Rental activities: Income

    Leaseholds, patents, copyrights & royalties subject to depletion

    90% Principal

    10% Income

    Retirement plans, IRAs & annuities

    DOD value or 90% Principal

    Post-death gain or 10% Income

    103 // experience ideas

  • THE PRINCIPAL QUESTION

    Pass-through entities: Based on distributions from entity rather than income allocated on Schedule K-1

    Earnings: Income

    Other assets: Principal

    Property other than money

    Money received for part or all of interest in entity

    Money received in total or partial liquidation of entity

    Capital gain dividends form RIC or REIT

    104 // experience ideas

  • PASSIVE ACTIVITY LOSSES (PALS)

    What is it? System to defer losses from passive activities

    Who does it apply to? Individuals, estates & trusts

    Closely held C corporations

    Personal service corporations

    What does it apply to? Passive activities under 469(c)

    Activity involving trade or business in which taxpayer does not materially participate

    Generally any rental activity

    Working interest in oil & gas property

    105 // experience ideas

  • PASSIVE ACTIVITY RULES UNDER 469

    Trade or business activities

    Reg. 1.469-4(b)

    Involve conduct of trade or business within meaning of 162

    Conducted in anticipation of commencement of trade or business

    Involve research or experimental activities under 174

    106 // experience ideas

  • PASSIVE ACTIVITY RULES UNDER 469

    Investment activities Reg. 1.469-5T(f)(2)(ii)

    Work as investor is not counted (unless directly involved on daily basis). Includes

    Studying & reviewing financial data

    Preparing/compiling summaries or analysis for individuals own use

    Monitoring finances/operations in non-manager capacity

    Not customarily done by owners

    Work of type not customarily done by owner

    Principal purpose for work is to avoid PAL rules

    107 // experience ideas

  • PASSIVE ACTIVITY RULES UNDER 469

    Material participation

    Involved in operations of activity on regular, continuous & substantial basis (469(h)(1))

    Seven tests under Reg. 1.469-5T

    Limited partner presumed not materially participating except under tests one, five & six (469(h)(2))

    108 // experience ideas

  • MATERIAL PARTICIPATION BY TRUSTS & ESTATES

    Grantor trust: Material participation is measured by participation of grantor (Temp. Reg. 1.469-1T(b)(2))

    QSST: Participation is measured by participation of deemed owner of trust (beneficiary under 1361(d)(1)(B))

    Estates & non-grantor trusts (including ESBTs)

    Reg. 1.469-8, and

    Temp. Reg. 1.469-5T(g)

    109 // experience ideas

  • MATERIAL PARTICIPATION BY TRUSTS & ESTATES

    There will be some degree of uncertainty for determining material participation of trusts & estates until clarifying regulations under 469 are issued by IRS

    Legislative history: An estate or trust is materially participating in any activityif an executor or fiduciary, in his capacity as such, is so participating." (S. Rep. No. 99-313, 99th Cong., 2d Sess. 735 (1986) (emphasis added)

    110 // experience ideas

  • MATERIAL PARTICIPATION BY TRUSTS & ESTATES

    Mattie K. Carter Trust v. United States (256 F. Supp. 2d 536):Texas District Court went beyond Senate report by concluding trust material participation is determined by reference to all persons who conduct business on trusts behalf, including employees as well as trustee

    Frank Aragona Trust v. Commissioner (142 T.C. No. 9): Tax Court held trust can be considered real estate professional under 469(c)(7) because personal services performed by individual trustees constituted personal services by trust. Court held services performed by individual trustees as employees count towards achieving material participation by trust

    111 // experience ideas

  • MATERIAL PARTICIPATION BY TRUSTS & ESTATES

    TAM 200733023: IRS concluded that sole means for trust to establish material participation was by its fiduciaries being involved in operations

    PLR 201029014: IRS held that trust materially participates in business only if trustee is involved in operations of entitys activities on regular, continuous & substantial basis

    TAM 201317010: IRS concluded that sole means for trust to establish material participation in relevant activities of trust-owned business is if fiduciaries, in their capacities as fiduciaries, are involved in operations of relevant activities of trust-owned business on regular, continuous & substantial basis

    112 // experience ideas

  • MATERIAL PARTICIPATION BY TRUSTS & ESTATES

    Dont like answer?

    Change trustee to someone who is active

    Add another fiduciary

    113 // experience ideas

  • PASSIVE ACTIVITY LOSS (PAL)

    Fiduciary accounting income principles determine whether limitations apply at estate, trust or beneficiary level

    State law controls if governing instrument is silent on allocation of loss to income or principal

    Simple trust with PAL chargeable to income for FAI purposes will be taxed to estate/trust

    114 // experience ideas

  • YOU ARENT MY PAL ANYMORE: FORMER ACTIVITIES

    Activity was passive in prior year

    Losses from when activity was passive may still offset income from that activity

    Excess losses remain passive

    115 // experience ideas

  • YOU ARENT MY PAL ANYMORE: DISPOSITION

    Fully taxable transaction: Current & suspended losses become fully deductible (469(g)(1))

    Beneficiaries are related parties (267(b))

    Distribute to beneficiary: Basis of interest immediately before distribution is increased by amount of any suspended passive activity losses allocable to interest; none of suspended loss is allowed as deduction (469(j)(12))

    Exception: Gain/loss is recognized on distribution in satisfaction of pecuniary bequest with appreciated or depreciated property

    116 // experience ideas

  • YOU ARENT MY PAL ANYMORE: DISPOSITION

    By death:

    Generally, if decedent has unused PALs at death, transfer of property due to death is considered disposition under 469(g)(1)

    BUT, under 469(g)(2), if basis of passive activity property to transferee exceeds decedents basis immediately before death, i.e., step-up in basis under 1014, suspended PAL is reduced & never used

    Permanently disallowed portion equals excess of

    Basis of passive activity interest in hands of transferee, over

    Decedents adjusted basis in interest immediately before death

    117 // experience ideas

  • THE END

    118 // experience ideas

  • YOU ARENT MY PAL ANYMORE: TERMINATION

    Losses are not generally passed through to beneficiaries except upon termination

    Only NOLs, capital losses & excess deductions allowed as deduction to beneficiary (642(h))

    PALs are not passed through to beneficiary during existence or termination of estate/trust

    Footnote all trust-related information necessary to prepare beneficiary individual income tax returns on Schedule K-1

    119 // experience ideas

  • 645 ELECTION CASE STUDY #2

    Decedent: A. Great Client

    Date of death: May 2, 2011

    Form 706 filed: August 1, 2012

    645 election made with initial Form 1041 filed January 7, 2013

    Fiscal year-end of April 30 selected

    Date closing letter issued: April 13, 2013

    120 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    When does 645 election period terminate?

    Election period began: May 2, 2011 (election filed 1/7/2013)

    Election period ended

    Issuance of estate tax closing letter: April 13, 2013

    Date of final determination of liability: October 13, 2013

    Plus 6 months

    April 12, 2014 (Reg. 1.645-1(f)(1))

    121 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    What are implications of termination to S corporation election of corporations whose shares are held by QRT?

    Termination of estates interest in corporation

    Corporations must allocate items of income/loss on pro rata basis absent election to terminate year

    122 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    What is impact of termination on Forms 1041?

    Combined estate & trust under 645 election

    5/2/2011 - 4/30/2012 Initial return; include Form 8855; report 2011 S corp. K-1

    5/1/2012 - 4/30/2013 Report 2012 S corp. K-1

    5/1/2013 - 4/12/2014 Report 2013 S corp. K-1; however, items of income are included in calculation of DNI of electing trust & treated as being distributed

    123 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    What is impact of termination on Forms 1041? (cont.)

    Estate

    4/12/2014 - 4/30/2014 Report income for estate only

    5/1/2014 - 4/30/2015.and so on until closed

    Trust

    4/12/2014 - 12/31/2014 Report 2013 K-1 from combined estate/trust; report 2014 S corp. K-1

    124 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    What needs to be done?

    Do nothing: Termination of S corporation election

    Evaluate options dont wait to act!

    Track deadline

    125 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    What is last day trust can make ESBT election?

    Two-year period beginning on day S corporation stock is deemed to be distributed: April 12, 2016

    Plus 2 months & 15 days.

    June 27, 2016

    But wait, theres more.

    126 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    Relief can be granted by IRS

    IRS has authority to treat late or unfiled S corporation election as being timely under 1362(b)(5) with reasonable cause for failure to timely file election

    IRS has authority to waive inadvertent invalid elections or terminations of S election caused by late or faulty S corporation election under 1362(f)

    127 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    Rev. Proc. 2013-30 allows relief to be approved without obtaining PLR in certain circumstances

    Covers all elections under subchapter S

    Request for relief must be filed within 3 years & 75 days after effective date of election

    Exception to 3-year rule for S corporation elections provided all returns have been filed as if S corporation status applied

    128 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    Relief for late ESBT election under Rev. Proc. 2013-30

    Requesting trust intended to be ESBT

    Trust requests relief within 3 years & 75 days after effective date

    of election

    Failure to qualify was solely because election was not timely filed

    by due date

    Failure to make timely election was inadvertent & trustee

    seeking relief acted diligently to correct mistake upon its

    discovery

    129 // experience ideas

  • 645 ELECTION CASE STUDY #2 THE SOLUTION

    To request relief for late election when requirements of Rev.

    Proc. 2013-30 are not met, entity must request Private Letter

    Ruling & pay user fee in accordance with Rev. Proc. 2016-1

    $2,200 for income under $250,000

    $6,500 for income between $250,000 & $1,000,000

    $28,300 for income above $1,000,000

    130 // experience ideas

  • THANK YOU

    FOR MORE INFORMATION // For a complete list of our offices and subsidiaries, visit bkd.com or contact:

    Kevin G. Horn// Arkansas Tax [email protected] // 501.372.1040