trusts and estates are not entities conduit theory of...

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MICKEY R. DAVISDAVIS & WILLMS, PLLC

HOUSTON, TEXASJULY 13, 2015

Trustsandestatesarenotentities◦ Taxlawstreatthemasthoughtheywere◦ RulesapplicabletoindividualsapplytotrustsandestatesexceptperSubchapterJ

Conduittheoryoftaxation:◦ Trustsandestatespaytaxonincometheyretain

◦ Theyreceive"distributiondeduction"fortaxableincomedistributedtobeneficiaries

◦ Beneficiariespaytaxondistributedincome◦ Characterremainsunchanged

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1. Simplevs.complextrusts,andestates2. Thecarry‐outof"distributablenetincome"3. Thecharitablededuction4. Thedeductibilityofinterestondeferredgifts5. Thetreatmentoftrustandestatenetlosses6. Recognitionofgainbyestatesandtrustswhen

appreciatedassetsaredistributed7. RecognitionofGainbybeneficiariesfrom

unauthorizednon‐proratadistributionsofassets8. “Incomeinrespectofadecedent"9. Thedeductibilityofadministrationexpensesfor

incomevs.estatetaxpurposes10. Thegrantortrustrules


Simpletrust:◦ Mustberequiredtodistributeall(fiduciaryaccounting)incomeatleastannually

◦ Nodistributionstocharities◦ Nocurrentdistributionsinexcessofincome

Truststhatarenotsimplearecomplex

Estatesaretaxedlikecomplextrusts


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Simpletrustsdeductamountsrequiredtobedistributed annually◦ Beneficiariesmustreportincomeinyearrequiredtobedistributed

◦ Characterofamountscarryouttobeneficiaries◦ Allowanceinlieuofpersonalexemption:$300

Estatesandcomplextrustdeductamountsrequiredorpermittedtobedistributed◦ Required(TierI)distributionscarryoutincomefirst◦ Permitted(TierII)distributionscarryoutanyremainingincometoextentofactualdistributions◦ Complextrustsallowance:$100;estates:$600


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GeneralRule:Aninheritanceisincome‐taxfree Exception:Beneficiariespaytaxonreceiptof"DNI" "DNI"isafundamentalconceptinSubchapterJ Usedtoprovideroughadjustmenttoconformnotionsoftaxableandfiduciaryaccountingincome

DNI=Taxableincome(beforeanydistributiondeductionorallowanceinlieuofpersonalexemption)◦ Lessnetcapitalgains◦ Plusnetexemptincome


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DNImeasuresamountsandtypesoftrustorestateincome

DistributionsaregenerallytreatedascomingfirstfromDNI,thenfromcorpus

DistributionstomultiplebeneficiariesgenerallycarryoutDNIprorata

EstatesandtrustsgettodeductamountoftaxableDNIdistributed(orrequiredtobedistributed)

Beneficiariesreportcorrespondingamountinincome

Distributionsaretreatedasthoughmadeonthelastdayoftheentity'staxyear◦ Estatesandcomplextrustscanelecttoapply"65‐dayrule"


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AandBarebeneficiariesof$1,000,000estate Executordistributes$200,000toA,$50,000toB Duringsameyear,estateearnsincomeof$100,000:◦ Amustreportincomeof$80,000 $100,000x($200,000/$250,000)◦ Bmustreportincomeof$20,000 $100,000x($50,000/$250,000)◦ Estategetsadistributiondeductionof$100,000

Ifdistributionswere$50,000toAand$25,000toB:◦ Awouldreportincomeof$50,000◦ Bwouldreportincomeof$25,000◦ Estatewouldreceive$75,000distributiondeduction◦ Estatewouldreportremaining$25,000asincomeontheestate'sincometaxreturn


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Specificpropertyandspecificsumsofmoneypaidinnotmorethanthreeinstallments◦ Requirementofascertainability◦ Formulabequests◦ Notifpaymentsonlyfromincome

Transfersofrealestatewhentitlevestsimmediately◦ E.g.,UNIF.PROB.CODE § 3‐101◦ Specificvs.generalbequests


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Amountsrequiredtobedistributed(TierI) Otheramountsproperlydistributed(TierII) TierIdistributionscarryoutDNIfirst◦ Computedwithoutregardtocharitablededuction◦ GenerallyprorataamongTierIdistributees

AnyremainingDNIcarriedouttoTierIIdistributees◦ Computedafterconsideringthecharitablededuction◦ Again,generallyprorataamongTierIIdistributees

Effect oftheserulesistotreatcharityasan"intermediateTier"betweenTierIandTierII

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Generalrule:DNIgetscarriedouttomultiplebeneficiaries(withineachtier,ifany)prorata

Exception:SeparateSharetreatmentappliesWhen the governing instrument of the trust or estate (e.g., the trustagreement, the will, or applicable local law) creates separate economicinterests in one beneficiary or class of beneficiaries such that theeconomic interests of those beneficiaries (e.g., rights to income orgains from specific items of property) are not affected by economicinterests accruing to another separate beneficiary or class ofbeneficiaries

AppliessolelyforallocatingDNIDNIallocatedbaseduponbeneficiaries'respectiveeconomicshares

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WillbequeathsIBMstocktoXandthebalanceoftheestatetoY

IBMstockpays$20,000ofpost‐deathdividendstowhichXisentitledunderlocallaw.Nootherincome

Executordistributes$20,000toXand$20,000toY Pre‐separatesharerule:DNIcarriedoutprorata(i.e.,$10,000toXand$10,000toY)

ButXhaseconomicinterestindividends;Ydoesnot SeparateShareRules:Distributionof$20,000toXcarriesoutalloftheDNItoX.NoDNIiscarriedouttoY


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Incomefrompropertyspecificallybequeathed◦ E.g.,Unif.Prin.&Inc.Act§ 201(1)◦ Beforeseparatesharerules,proratarulescausemismatchbetweeneconomicbenefitsandtaxrules

Interestonpecuniarybequests◦ E.g.,Unif.Prin.&Inc.Act§ 201(3) Interestpaymentsarenot"distributions"carryingoutDNI

Interestexpensetoestateortrust

Interestincometobeneficiary

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Distributionstocharitiesdon'tcarryoutDNI◦ Charityas"intermediatetier"isafictiondescribingeffectoftierrules

Instead,trustsandestatesgetcharitabledeductions◦ Availableforamountsofgrossincomepaidtocharities

◦ Estates(andpre‐'69trusts)candeductamounts"setaside"forcharity

Mayelectone‐year"look‐back" Notlimitedtoapercentageof"AGI"likeindividuals

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Interestonpecuniarybequests◦ E.g.,Unif.Prin.&Inc.Act§ 201(3)◦ Interestpaymentsarenot"distributions"carryingoutDNI

◦ Interestincometobeneficiary◦ Interestexpensetoestateortrust

Taxableasinterestincometobeneficiary "Personalinterest"isnotdeductible "Investmentinterest"canbededucted◦ Investmentinterestargument◦ Cf.Treas.Reg.§ 1.663(c)‐5,Ex.7

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Ifestateortrustdeductionsexceedincome:◦ Excessdeductionscan'tnormallybecarriedbackorforward◦ Exceptionfornetoperatinglosses NOLscanbecarriedback2yearsandforward20years◦ Exceptionfornetcapitallosses Non‐corporatetaxpayerscancarryforwardcapitallossesindefinitely

Specialruleinyearofestateortrusttermination◦ Excessdeductionscarriedouttobeneficiaries◦ Itemizeddeductionstobeneficiariesinyearentityterminates◦ Deductiblebybeneficiariesthatsufferloss


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DistributionsofassetscarryoutDNI(unlessageneralDNIexceptionapplies)

Amountdistributedislesserofasset'sfairmarketvalueorbasis(plusanygainrecognizedondistribution)

Distributionofappreciatedpropertysatisfyingbequestof"specificdollaramount"causesestateortrusttorecognizegains

"Specificdollaramount"notthesameas"specificsumofmoney"—mostformulabequestscauserecognition


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Executormayelect torecognizegainsondistributions◦ All‐or‐nothingelection;IRC§ 643(e)

Reasonforelection‐‐Example:◦ Dateofdeath:estateworth$1.8million◦ Stocks:$1.1million;Bonds:$700,000◦ Dateofdistribution:estateworth$2.1million◦ Stocks:$1.4million;Bonds:$700,000◦ Estatedividedamongthreekids—allbondstoone

Lossesgenerallynotrecognizedduetorelatedpartyrules

Exception:estatesfundingpecuniarybequests


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Formulagiftrequiresexecutortodistribute$400,000worthofproperty

Executorproperlyfundsbequestwithassetsworth$400,000atdateofdistribution

Date‐of‐deathvalue(andthereforecostbasis)ofassetofonly$380,000

Estaterecognizesa$20,000gain


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Generallynogainorlossrecognizedbybeneficiariesasaresultoftrustorestatedistributions

Exceptionforunauthorized non‐pro‐ratadistribution

Wheretofindauthority:◦ Statelaw◦ Languageinthegoverninginstrument


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EstatepassesequallytoAandB Twoassets:stock&farm,eachworth$120,000 Dateofdeathvalues(equalsbasis):◦ Stock:$100,000;Farm:$110,000

ExecutorgivesstocktoAandfarmtoB NeitherWillnorlocallawauthorizesnon‐proratadistributions

IRS: AandBeachreceivedone‐halfofeachasset◦ A"sold"herinterestinfarm(basisof$55,000)forstockworth$60,000:$5,000gaintoA.◦ B"sold"hisinterestinstock(basisof$50,000)foraone‐halfinterestinfarmworth$60,000:$10,000gaintoB

BothAandBare"disappointed"


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GeneralRule:Aninheritanceisincome‐taxfree

Exception:IncomeinRespectofaDecedent◦ Income"earned"bythedecedentbutnotproperlyreportedbyhimorher

Decedententeredintolegallysignificanttransaction

Decedentperformedsubstantivetasksrequired

Noeconomicallysignificantcontingencies

Decedentwouldhavereceivedpropertybutfordeath

MajorsourcesofIRD:◦ Retirementaccounts

◦ Installmentgainobligations


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Generalrule:Gainrecognizedwhenpaymentisactuallyreceived

DistributionofrighttoreceiveIRDtypicallydoesnotacceleraterecognition◦ SpecificbequestofIRDasset◦ ResiduarydispositionofIRDasset

IRDrecognitionwillbeacceleratedifestateortrustdistributesassetinmannergenerallycausinggainrecognition(SeeRule6)◦ Distributionsinsatisfactionofpecuniarybequest◦ Executormakes§ 643(e)electiontorecognizegain


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Xdieswith$8,430,000estateWillmakesformulamaritalgiftof$3,000,000tospouse,leavingtheresttoX'skids

IRDassetworth$3,000,000(butwithbasisof$0)isusedtofundmaritalgift

NOstep‐upinbasisforIRDassets Estaterecognizes$3,000,000gain Spousereceives$3,000,000worthofproperty Estate owesincometaxof$1,198,000 Kidsgetonly$4,232,000($8,430,000‐$3,000,000‐ $1,198,000)insteadof$5.43million


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Deductionsinrespectofadecedent("DRD") AnalogoustoIRD,butonexpenseside◦ Amountstillpayableatdateofdeath◦ Wouldhavebeenincome‐taxdeductiblebydecedentifpaid

Eligibleforestatetaxdeductionasdebt Eligibleforincometaxdeductionwhenpaid CommonExamples:◦ Accruedpropertytaxes◦ Accruedbusinessexpenses


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Executorcanelecttodeductadministrationexpensesonestatetaxreturnoronestate'sincometaxreturn

Doubledeductiondisallowed(exceptforDRD) Examples:◦ Executors'fees Attorneys'fees◦ Accountants'fees Appraisalfees◦ Courtcosts Otheradminexpenses

Dothemath:Compareestatetaxvs.incometaxsavings

Butalsoconsiderothereffects(equitableadjustment?)


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Deductionofexpensespaidfrommaritalorcharitablebequest onincometaxreturnmayreducethosedeductionsforestatetaxpurposes

Maydeductestate"managementexpenses"withnolossofestatetaxdeduction◦ Investmentfees Stockbrokeragecommissions◦ Custodialfees Interest

Cannotdeductestate"transmissionexpenses"withoutcorrespondinglossofestatetaxdeduction◦ Executors'fees Mostattorneyfees◦ Probatefees Courtcosts

Summaryofdeductibleexpenses—pages14‐15


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Notalltrustsaresubjecttothe"normal"rulesofSubchapterJ

Congressionalsetof"string"statutesresultinincometaxationoftrustincometograntoroftrust(orsomeonetreatedasgrantor)

Statutetreatsgrantorasownerofthatportionoftrustpropertyoverwhichspecifiedpowerisheld

Similar,butnotidentical,listof"string"statutesresultinestatetaxinclusionoftrustpropertyingrantor'sfederaltaxableestate

Statutorylistofincometax"strings"isexhaustive


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RightofReversion—§ 673 PowertoControlBeneficialEnjoyment—§ 674 CertainAdministrativePowers—§ 675 PowertoRevoke—§ 676 RetainedRighttoIncome—§ 677 RightinBeneficiarytoVestTrustinSelf —§ 678 TransferstoForeignTrusts —§ 679


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RightofReversion—§ 673 Trustthatultimatelyrevertstograntoristreatedasownedbygrantorunlessitoccursafter"safeperiod"

Pre‐1986,"safeperiod"was10years Current"safeperiod"ifactuarialvalueofreversionattimeoftrustcreationislessthan5%◦ Withverylowinterestrates,virtuallyallreversionsflunkthistest

◦ At2.2%7520rate,reversionafter60years=27%;reversionvaluedat<5%onlyafter138+years!

Reversionafterdeathofdescendant/beneficiarywhodiesbeforeage21isalsopermitted


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PowertoRevoke—§ 676 Sortoflikediscretionaryreversionandsame"safeperiod"applies

Alsoappliestopowerheldbynon‐adverseparty Manygrantorsrecreaterevocabletrustsfornon‐taxreason;theyareignoredfortaxpurposes

Defaultruleinmoststates:Trustisirrevocableunlesstrustinstrumentsaysotherwise

Notuniversallytrue,andtrustscanchangejurisdictions

Bestpractice:Explicitlystatewhethertrustisrevocableorirrevocable


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RetainedRighttoIncome—§ 677 Appliestotruststhatcanpayincometograntororspouse

Alsoappliesifincomecanbeaccumulatedforlaterdistributiontograntororspouse

Evenappliestoindirectuseoftrustincome:◦ Paymentsthatdischargelegalorcontractualobligations◦ Paymentofpremiumsofinsuranceonlifeofgrantororgrantor'sspouse

Paymentforsupportormaintenanceofsomeonegrantorlegallyobligatedtosupport?◦ Righttohavetrustsouseddoesn'tcauseautomaticgrantortrusttreatment

◦ Butgrantoristaxedtoextendincomeisactuallysoused


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PowertoControlBeneficialEnjoyment—§ 674 Section674(a):Grantortrustifsubjecttopowerofdispositionbygrantororanon‐beneficiarywithoutapprovalabeneficiary,BUT:◦ Section674(d):Butindependenttrusteecanhavefulldiscretion

◦ Section674(c):Anyoneotherthangrantorandspousecanhavepowerlimitedbyascertainablestandard(suchas"HEMS")

◦ Section674(b):Anyonecanhavelonglistofpermittedpower

Generally,exceptionsdonotapplyifsomeoneretainsthepowertounilaterallyaddbeneficiaries


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CertainAdministrativePowers—§ 675 Hodgepodgeofprohibitedpowers:◦ Righttodealwithtrustpropertywithoutfullandadequateconsideration

◦ Righttoborrowtrustpropertywithoutadequateinterestandsecurity(unlessindependenttrusteecansoloantoanyone),buteventhen,actualborrowingbygrantororspousecausesgrantortrusttreatmentuntilyearfollowingrepayment

◦ Righttovotecloselyheldstockownedbytrust◦ Righttoreacquiretrustassetsbysubstitutingassetofanequivalentvalue,exercisableinanon‐fiduciarycapacity

Thislastpowerisoftenemployedtointentionallymaketrustagrantortrust


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RightinBeneficiarytoVestTrustinSelf —§ 678 Treatssomeoneotherthanthegrantor asownerofthetrust'spropertyforincometaxpurposes

Appliestosomeoneholdingpowertovesttrustpropertyinhim/herself,exercisablesolelybyhim/herself◦ Commonexample:Crummeywithdrawalrights

Alsoappliestolapsedpowerif,treatingpowerholderasgrantor,grantortrusttreatmentwouldapplytotrust

Noexceptioninstatuteforpowerslimitedbyascertainablestandard,butcourtswouldprobablyapplyone


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Statesfrequentlyimposeincometaxontrustsifproper"nexus"exists

Statesestablishnexusbasedupon:◦ Residenceofgrantor(orplaceofgrantor'sdeath)◦ Residenceoftrustee◦ Situsofadministrationoftrust◦ Residenceoftrustbeneficiary

Incomeearnedwithinstateoftenformsindependentbasisofstateincometaxation

Trustsmayowetaxinmorethanonestate

Constitutionallimitsonnotionof"nexus"


trusts and estates are not entities conduit theory of...

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