taxation of trusts & estates circular 230 disclosure: to ensure compliance with requirements...

Taxation of Trusts & Estates

Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication, including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. If you would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us.

Stephen J. Bigge, CPAKeebler & Associates, LLP

420 S. Washington St.Green Bay, WI 54301

Phone: (920) 593-1702E-mail: [email protected]

mailto:[email protected]

Taxation of Trusts & Estates

© 2015 Keebler & Associates, LLPAll Rights Reserved 2

• Foundational concepts• Tax-sensitive planning

Foundational Concepts

3© 2015 Keebler & Associates, LLPAll Rights Reserved

OverviewFoundational Concepts


• General tax rules• Types of trusts• Types of income• Distributable Net Income (DNI)• Tier rules• Separate share rule• 65-day rule (IRC §663(b))• Charitable deductions (IRC §642(c))• Income in Respect of a Decedent (IRD)• 3.8% Net Investment Income Tax (NIIT)• Other issues



General Tax Rules

• Trusts and estates are separate taxable entities– Receive income and pay expenses

• Taxable income computed similar to individuals– Exemption

○ $100 complex trust○ $300 simple trust○ $600 estate

• Method of tax accounting– Trusts – Calendar year (i.e. Jan. 1st – Dec. 31st)– Estates – Fiscal or calendar year



General Tax Rules

• Income taxed to either the trust/estate or the beneficiary– If income is accumulated, then the income is taxed to the

trust/estate

– If income is distributed, then the trust/estate gets an income tax deduction and beneficiaries report taxable income



Types of Trusts

• Simple trusts– Required to distribute accounting income annually– Cannot make principal distributions– Cannot make distributions to charity

• Complex trusts– May accumulate income– May make either discretionary or mandatory distributions of

income and/or principal– May make distributions to charity



Types of Trusts

• Grantor trusts– Trust and grantor treated as one taxpayer

– Income taxed to grantor

• Charitable trusts– Split-interest trusts consisting of an income beneficiary and a

remainder beneficiary○ Charitable Lead Trust (CLT) – charity is the income beneficiary

○ Charitable Remainder Trust (CRT) – charity is the remainder beneficiary

− Last for a term of years or life



Types of Income

• Fiduciary accounting income– Governed by state law and the trust instrument

– Determines the amount that may or must pass to the trust’s or estate’s beneficiaries

• Tax accounting income – Governed by the federal income tax law

– Determines who is taxed on the income



Types of IncomeTypical Types of Fiduciary Income

• Interest– Taxable– Tax-exempt

• Dividends• Rents (net of expenses)• Royalties



Types of IncomeTypical Types of Fiduciary Principal

• IRA value as of date of death

• Increases in asset value (i.e. growth)

• Realized long-term capital gain

• Realized short-term capital gain

• Proceeds from covered call writing


Assume that a complex trust had the following sources of income and deductions during the current tax year:

Interest income $3,000Tax-exempt interest income 1,000Dividend income 6,000Rental income 10,000Royalty income 5,000Long-term capital gains 15,000

Taxes 3,000Trustee fees 3,000Attorney/accountant fees 1,000

All indirect expenses


Types of IncomeFiduciary Income vs. Taxable Income Example

Fiduciary Accounting

IncomeTaxable Income

Interest income 3,000$ 3,000$ Tax-exempt interest income 1,000 - Dividend income 6,000 6,000 Rental income 10,000 10,000 Royalty income 5,000 5,000 Long-term capital gains - 15,000 Gross income 25,000$ 39,000$ Less: Taxes (1,875) (2,925) Less: Trustee fees (1,875) (2,925) Less: Attorney/accountant fees (625) (975) Less: Exemption - (100) Net Income 20,625$ 32,075$


NOTE 1: Trust expenses (for fiduciary accounting purposes) were apportioned on a pro-rata basis between income and principal.NOTE 2: Under IRC §265, the trust’s deductible expenses (for income tax purposes) must be reduced for the portion that are allocable to tax-exempt income.


Types of IncomeFiduciary Income vs. Taxable Income Example (cont.)



Distributable Net Income (DNI)

• Determines the amount of the trust’s or estate’s income distribution deduction

• Determines how much the beneficiaries must report as income on their tax returns

• Determines the character (e.g. interest, dividends, etc.) of the taxable income in beneficiaries’ hands


DNI

Trust/EstateDNI acts as a ceiling

for purposes of the allowable deduction

BeneficiaryDNI acts as a ceiling for the total amount of income the beneficiary must report on his/her tax return




Taxable income+ Income distribution deduction+ Exemption+ Net tax-exempt income+ Capital losses*< Capital gains* >< Extraordinary/stock dividends >= Distributable Net Income (DNI)

* Except in the year of termination






• Normally, capital gains and losses are trapped at the trust or estate level– However, in the year of termination, the capital gain/loss

passes out to the beneficiaries

• Specific bequests do not carry out DNI to the beneficiaries– Not taxable to trust/estate or beneficiaries– Requirements

o Paid at once ORo Paid in not more than 3 installments


Assume that a complex trust had the following sources of income and deductions during the current tax year:

Interest income $15,000Dividend income 10,000Rental income 5,000Long-term capital gains 20,000

Taxes 2,500Trustee fees 3,500Attorney/accountant fees 2,000


Distributable Net Income (DNI)DNI Example

Interest income 15,000$ Dividend income 10,000 Rental income 5,000 Long-term capital gains 20,000 Total Income 50,000$ Less: Taxes (2,500) Less: Trustee fees (3,500) Less: Attorney/accountant fees (2,000) Adjusted Gross Income (AGI) 42,000$ Less: Exemption (100) Taxable Income 41,900$

Taxable Income 41,900$ Add-In: Exemption 100 Less: Long-term capital gains (20,000) Distributable Net Income (DNI) 22,000$



Distributable Net Income (DNI)DNI Example (cont.)



Tier Rules

• Apply to estates and complex trusts

• Two tiers– First tier beneficiary

o Required distribution of income on a current basis

– Second tier beneficiaryo Receives any amount remaining (at the discretion of the

trustee/executor)


Mandatory distributionsof income

Complex Trust

First Tier Beneficiary

DNI carries out to thisbeneficiary only to the extent that income exceeds the distributionmade to the first tier beneficiary

Second Tier Beneficiary

Discretionarydistributions

of income and/or principal

DNI carries out to this beneficiary first


Tier Rules



Separate Share Rules

• Applies to estates and complex trusts

• Treats multiple beneficiaries of an estate or single trust as if each were the sole beneficiary

• Determines how DNI carries out to each beneficiary– DNI is computed separately for each share



Separate Share RulesSeparate Share Example

Assumptions• Complex trust• Two equal beneficiaries (S & D)• Distributable Net Income (DNI) in 2015 = $30,000• Distributable Net Income (DNI) in 2016 = $10,000• Trust distributes $20,000 to S and $5,000 to D in 2015• Trust distributes $15,000 to D in 2016

2015 Tax Year

2016 Tax Year

Son $15,000 $0

Daughter 5,000 5,000

Trust 10,000 5,000

Total $30,000 $10,000



Separate Share RulesSeparate Share Example (cont.)



65-Day Rule (IRC §663(b))

• Applies to estates 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 distributions made during the

prior year)

• Election must be made by the due date of the tax return– Election is irrevocable– Annual election


20162015

12/31

65 days

Distributions for the 2015 tax year made during this period will be treated as have been made as of 12/31/2015

(if a timely election is made)


65-Day Rule (IRC §663(b))



Charitable Deduction (IRC §642(c))

• Requirements– Paid from gross income– Paid pursuant to the governing document

• Must be actually be paid in the current year– Exception – pre-1969 trusts

• Unlimited in amount• Taken as a deduction in computing adjusted gross

income (AGI)

Income in respect of a decedent (IRD) – is all items of gross income in respect of a decedent which were not properly included as taxable income in a tax period falling on or before a taxpayer’s death and are payable to his/her estate and/or another beneficiary



Income in Respect of a Decedent (IRD)



Income in Respect of a Decedent (IRD)Types of IRD

• IRAs and other qualified retirement plans• Unpaid salaries/wages at the time of death• Dividends and interest earned, but not taxed, prior

to death• Unrecognized capital gain on an installment note

at the time of the seller’s death• Net Unrealized Appreciation (NUA) on employer

securities



Income in Respect of a Decedent (IRD)IRC §691(c) Deduction

• To the extent that a decedent’s taxable estate includes items of IRD and a federal estate tax is assessed, the estate and/or its beneficiaries are entitled to an income tax deduction for the estate tax attributable to IRD– This deduction is a miscellaneous itemized deduction NOT

subject to the 2% AGI limitation



Income in Respect of a Decedent (IRD)IRC §691(c) Deduction

• The income tax deduction computation for estate taxed paid on IRD is determined on a “with and without” basis– In essence, the total deduction allowed is the difference

between: (a) the estate tax liability with all items of IRD included in the taxable estate and (b) the estate tax liability without the IRD included in the taxable estate

Non-IRD IRDCash & money market 15,000$ -$ Accrued interest - 100 Marketable securities (non-qualified) 750,000 - Accrued interest & dividends - 9,900 IRA - 1,500,000 Primary Residence 350,000 - Cottage 150,000 - Personal property 50,000 - TOTALS 1,315,000$ 1,510,000$

On July 1, 2015, Jackie passed away leaving the following assets:



Income in Respect of a Decedent (IRD)IRC §691(c) Deduction Example

With IRD Without IRDGross Estate 2,825,000$ 1,315,000$ Less: Exemption (2,000,000) (2,000,000) Taxable Estate 825,000$ -$

Estate Tax 371,250$ -$

Gross IRC §691(c) Deduction 371,250$ (Difference between estate tax with and without IRD)

Subsequent to her death, the personal representative withdrew $50,000 from Jackie’s IRA. Accordingly, the IRC §691(c) attributable to the $50,000 distribution would be as follows:



Income in Respect of a Decedent (IRD)IRC §691(c) Deduction Example (cont.)

IRD

Allocable IRC §691(c) Deduction

Interest - Cash & money market 100$ 25$ Interest & dividends - Brokerage account 9,900 2,434 IRA 1,500,000 368,791 TOTAL 1,510,000$ 371,250$

Gross IRA distribution 50,000$ IRC §691(c) apportionment percentage (i.e. $368,791/$1,500,000) 24.586%IRC §691(c) deduction 12,293$



Income in Respect of a Decedent (IRD)IRC §691(c) Deduction Example (cont.)



3.8% X the lesser of

1. Undistributed “net investment income” for such taxable year

OR

2. The excess (if any) of—- “Adjusted Gross Income” (as defined

in Section 67) for such taxable year, over the dollar amount at which the highest tax bracket in section 1(e) begins for such a taxable year

3.8% Net Investment Income Tax (NIIT)



Does NOT Include:

•Salary, wages, or bonuses

•Distributions from IRAs or qualified plans

•Any income taken into account for self-employment tax purposes

•Gain on the sale of an active interest in a partnership or S corporation

•Items which are otherwise excluded or exempt from income under the income tax law, such as interest from tax-exempt bonds, capital gain excluded under IRC 121, and veterans benefits

Includes:

•Interest

•Dividends

•Annuity Distributions

•Rents

•Royalties

•Income derived from passive activity

•Net capital gain derived from the disposition of property




Mary Ann – Deceased•Estate/Trust•$0 employment income•Undistributed $225,000 net investment income

Excess of: MAGIThresholdSubtotal

$ 225,000 $ 11,950 $213,050

3.8% NIIT would apply

to$213,050





3.8% NIIT would not

apply

Wages are not subject to NIIT

Jerry – Deceased•Estate•$100,000 salary (IRD)•$0 net investment income




Anita Jones Trust•$100,000 investment income•$50,000 of IRA Income•A distribution of $90,000 or 60% of AGI•DNI Reduction of $60,000•$40,000 is trapped and subject to NIIT

3.8% NIIT would apply

Residual taxable to the trust, but

potentially to the beneficiaries



Other IssuesTrust/Estate Termination

• In the year of termination, all Net Operating Losses (NOLs), capital losses and “excess deductions” pass to the beneficiaries– Only applies in the year of termination

– NOLs subject to carryback/carryover rules that apply to individual taxpayers

– No time limit on beneficiaries to use capital loss carryovers



Other IssuesExcess deductions

• “Excess deductions” occur when trust/estate expenses exceed income in the year of termination– Deduction passes to the beneficiaries– Deductible as a “miscellaneous itemized deduction” (subject

to the 2% AGI floor)



Other IssuesAdministrative Expenses

• Consist of a attorney/accountant fees, fiduciary fees, filing fees, appraisal fees, taxes, etc.

• May be deducted on either the estate tax return (Form 706) or the income tax return (Form 1041)– Only applies to estates– Fiduciary may elect where to take the expenses (IRC §642(g))

• May or may not be subject to 2% AGI floor– To the extent that the expenses would not otherwise been incurred if the

property were not held in an estate or trust, then the deduction is not subject to the 2% AGI floor (i.e. expenses must be unique to the estate or trust)


Tax-Sensitive Planning



Interest Income

Taxable

Capital Gain Income

Taxable

Roth IRA &

Insurance

Tax Free

Real Estate, Oil & Gas

Tax Preferential

Pension & IRA

Income

Tax Deferred

• Money market

• Corporate bonds

• US Treasury bonds

Attributes• Annual

income tax on interest

• Taxed at highest marginal rates

• Equity Securities

Attributes• Deferral

until sale• Reduced

capital gains rate

• Step-up basis at death

• Real Estate• Depreciation

tax shield• 1031

exchanges• Deferral on

growth until sale

Oil & Gas• Large up

front IDC deductions

• Depletion allowances

• Pension plans

• Profit sharing plans

• Annuities

Attributes• Growth

during lifetime

• RMD for IRA and qualified plans

• No step-up

Tax- Exempt Interest

Tax Free

• Equity securities

Attributes• Qualified

dividends at LTCG rate

• Return of capital dividend

• Capital gain dividends

• Bonds issued by State and local Governmental entities

Attributes• Federal tax

exempt• State tax

exempt

Roth IRA•Tax-free growth during lifetime•No 70½ RMD•Tax-free distributions out to beneficiaries life expectancy

Life Insurance•Tax-deferred growth•Tax-exempt payout at death

Income Types

Dividend Income

Taxable



• Taxable investment accounts – income generated within the account (i.e. interest, dividends, capital gains, etc.) are taxed each year to the account owner

• Tax-deferred investment accounts (e.g. traditional IRAs, traditional qualified retirement plans, non-qualified annuities, deferred compensation) – income generated within the account is not taxed until distributions are taken from the account

• Tax-free investment accounts (e.g. Roth IRAs, life insurance) – income generated within the account is never taxed when distributions are made (provided certain qualifications are met)

Account Types


Tax-Sensitive PlanningAsset Location

When tax planning for an estate/trust, one must take into consideration where to place certain types of investments (i.e. “asset location”). The key here is to place ordinary income producing assets in tax-deferred accounts (e.g. traditional IRAs, traditional 401(k) plans) while placing tax-exempt and growth investments in either taxable investment accounts or tax-free accounts (e.g. Roth IRAs).



Traditional IRA

Taxable Investment

Account

Retirement investment income•Interest (ordinary income)•Tax-exempt interest (tax-exempt)•Ordinary dividends (ordinary income)•Qualified dividends (long-term capital gain)•Short-term capital gains (ordinary income)•Long-term capital gains (long-term capital gain)•Annuities (ordinary income)•Rents (ordinary income)•Royalties (ordinary income)

Roth IRA

Taxed based on character of income (i.e. ordinary,

long-term capital gain, etc.)

100% taxable as ordinary income

100% tax-free (provided certain requirements are

met)



• Traditional IRAs– Ordinary income – retains character – Long-term capital gain – converts to ordinary income– Tax-exempt income – converts to ordinary income

• Taxable investment accounts– Ordinary income – creates “tax drag” on annual return– Long-term capital gains – creates “tax drag” on annual return– Tax-exempt income – no impact


Tax-Sensitive Planning“Tax Drag”

• “Tax drag” is simply the reduction in the annual rate of return on an investment as a result of the income tax liability paid on the income generated

• “Tax drag” by income character:– Ordinary income – 10%, 15%, 25%, 28%, 33%, 35%, 39.6%– Long-term capital gain – 0%,15%, 20%– Tax-exempt income – 0%



• Assume a $10,000 bond is generating 6% interest• Assume that the taxpayer is in the 25% tax bracket• Given these facts, the “tax drag” on the annual return

would be 1.5% (6% x 25%), thus reducing the after-tax rate of return to 4.5%

• When compared against a tax-deferred investment account (e.g. traditional IRA) or a tax-free investment account (e.g. Roth IRA), the long-term results are significant

“Tax Drag”Example


Tax-Sensitive Planning“Tax Drag”

Example (cont.)

Yr

Taxable Investment

Account

Tax-Deferred Investment

Account Difference %1 10,450$ 10,600$ 150$ 1.44%5 12,462$ 13,382$ 920$ 7.39%10 15,530$ 17,908$ 2,379$ 15.32%15 19,353$ 23,966$ 4,613$ 23.84%20 24,117$ 32,071$ 7,954$ 32.98%25 30,054$ 42,919$ 12,864$ 42.80%30 37,453$ 57,435$ 19,982$ 53.35%


Tax-Sensitive PlanningManaging Capital Gains & Losses

• In generating capital losses to offset capital gains (so as to reduce “tax drag”), it is important as to how the capital losses are matched up against the capital gains

• In general, capital losses are more tax effective if they can be used to offset income taxed at higher tax rates (e.g. short-term capital gains and ordinary income)– Thus, long-term losses used against short-term gains are

more tax-efficient than short-term losses being used against long-term capital gains


Tax-Sensitive PlanningManaging Capital Gains & Losses

Short-Term Gain Long-Term Gain

Short-Term Loss

NEUTRAL INEFFECTIVE

Long-Term Loss EFFECTIVE NEUTRAL


Tax-Sensitive PlanningImplementing Asset Location

• Best assets for tax-deferred investment accounts (e.g. traditional IRAs and other qualified retirement plans)– Taxable bonds– High-yield equities (producing primarily ordinary dividends)– High-turnover equities (i.e. short-term capital gain)– High-turnover mutual funds (i.e. short-term capital gain)– Annuities



• Best assets for tax-free investment accounts (e.g. Roth IRAs)– High-yield equities (producing primarily qualified dividends)– High-growth equities– Index funds– Hedge funds– Investment partnerships



• $500,000 of bonds and $500,000 of stock both generate a 7% pre-tax rate of return

• The capital gains on stock are deferred until the time of sale, then taxed as long-term capital gains

• The amount of any tax savings from a deductible IRA contribution is invested in a taxable investment account earning the same yield as the IRA

• The values shown for the IRA include the value of the taxable investment account

• The client is in the 25% ordinary income tax bracket (15%* for capital gains purposes)

Implementing Asset LocationExample #1



• Orange = position the investor would be at under the original 50% stock / 50% bond investment mix

• Blue = additional $63,890 of additional growth the investor would achieve by placing 100% bonds in IRA

Implementing Asset LocationExample #1 (cont.)

1,800,000

2,050,000

2,300,000

2,550,000

2,800,000

10 11 12 13 14 15

Option A - 100% Bonds in IRA

Option B - 50/50 Mix in IRA$63,890 of additional assets (2.6% increase)



• $100,000 beginning cash to invest and 28% tax bracket (15% long-term capital gains bracket)

• Options: – Corporate bonds (6% annual interest)– Municipal bonds (4.5% annual interest)– Stocks (1% annual non-qualified dividends, 5% growth

[100% asset turnover])

Implementing Asset LocationExample #2



Example #2 (cont.)

$-

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

1 3 5 7 9 11 13 15 17 19 21 23 25

Stock (50% Turnover) Stock (100% Turnover)

Municipal Bonds Corporate Bonds



Ordinary Income

Short-Term

Capital Gains

Long-Term

Capital Gains

Tax-Exempt

Taxable Investment Account 3 3 1 1

Traditional IRA 1 1 3 N/A

Roth IRA 2 2 2 2

Implementing Asset LocationSummary

To be added to our IRA update newsletter, please email

[email protected]


taxation of trusts & estates circular 230 disclosure: to ensure compliance with requirements...

Documents

income tax deduction

expensestaxable income

beneficiaryif income

cpakeebler associates

taxrelated penalties

charityfoundational

lifefoundational concepts

incomefoundational concepts