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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 grantor’s 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?

½ Expenses ½ 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 estate’s 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 decedent’s 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 decedent’s estate under election

⁻ Estate tax return is not required to be filed: Two years after date of decedent’s 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 decedent’s 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 estate’s 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 estate’s 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 Client’s 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 decedent’s final/prior year return are taxed to decedent’s successors in interest when received by them (§691(a))

• Items of IRD under §691 are not entitled to “step-up” in basis at decedent’s death (§1014(c))

• Difficult to apply - requires us to consider⁻ Decedent’s 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 decedent’s 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 partnership’s taxable year with respect to decedent partner (§706(c)(2)(A). Decedent partner’s share of partnership income will be included on his or her final tax return & no part of successor’s share of partnership’s 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 beneficiary’s 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 decedent’s 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 successor’s hands as it would have had in decedent’s


IRD & DRD

• Deductions in respect of a decedent (DRD): §691(b) allows deduction on decedent’s successor in interest who liquidates decedent’s 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 decedent’s 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 Jack’s 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 Jack’s 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

• Jack’s 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 Jack’s revocable trust agreement to Jack’s daughter, Jill. Jack’s 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 Jack’s revocable trust agreement to Jack’s 2 daughters. Jack’s 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, Jack’s 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 Jack’s 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

• Jack’s 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.






Jack’s trust (2015): $475,000 x $711,732 = $85,050

$3,975,000

Jack’s 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 grantor’s 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 individual’s 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 activity…if 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 trust’s 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 entity’s 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



• Don’t 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 AREN’T 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 AREN’T 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 AREN’T 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 decedent’s 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

» Decedent’s adjusted basis in interest immediately before death


THE END


YOU AREN’T 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 estate’s 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 – don’t 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, there’s 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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