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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

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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)


TYPES OF TRUSTS

Grantor

Simple

Complex

Charitable



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



GRANTOR TRUST TAX RETURNS

K-1 DISCLOSURE ON GRANTOR LETTER


General Fiduciary Accounting Rules


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.


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


TRUST ACCOUNTING INCOME ILLUSTRATION


EXAMPLE #1 INCOME VERSUS PRINCIPAL


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


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

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.


ACCOUNTING INCOME OR PRINCIPAL?


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


CLASSIFYING THE TRUST


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


SIMPLE TRUSTS

The trustee:

Required to distribute all of the income currently

Cannot make charitable contributions


POLLING QUESTION


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


SIMPLE TRUST TAX RETURNS


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


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. . .


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


HOW TO MAKE A 65 DAY ELECTION


FIDUCIARY INCOME TAX RETURN FORM 1041


COMPLEX TRUST TAX RETURNS


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?


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


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.


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



Shown on Form 1041, Page 1 Line 18


ALLOCATION OF EXPENSES

Direct traced to a specific source of income.

Indirect not specific to any type of income.


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)


TAX RATES

2016 Tax Rate Schedule

If taxable income is:


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


EXERCISE #1 TAI VERSUS DNI

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


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


Estates


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.


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


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%


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


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


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


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))



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



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))


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


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)


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)


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)


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


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!



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



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



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))


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?


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


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


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


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


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


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


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


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


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


Cash $2,000,000

Real estate 2,500,000

Installment note 1,000,000

Mortgage -500,000

Total 5,000,000


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)?


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!)



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


Cash $2,000,000

IRA 2,000,000


Total 6,500,000


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





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



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



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


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 - -


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.






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

$2,000,000



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


Cash $2,000,000

IRA 2,000,000


Installment note 2,000,000

Mortgage -500,000

Net 8,000,000


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





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)



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))




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



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)



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






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

$3,975,000


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



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



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


THE MIDDLE


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))



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



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



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



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



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


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


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



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



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))


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)



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)



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



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



Dont like answer?

Change trustee to someone who is active

Add another fiduciary


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


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


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


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


THE END


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


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



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))



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



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



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



What needs to be done?

Do nothing: Termination of S corporation election

Evaluate options dont wait to act!

Track deadline



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.



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)



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



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



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


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

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