Chapter 14. Trusts and Estates

1. Chapter 14.Trusts and Estates Howard Godfrey, Ph.D., CPA Professor of Accounting

2. Note:You may want to print the two slides with the Code Sections – 2 slides per page. Top of page 5.

3. The student should be able to: 1. Understand the basic concepts concerning trusts and estates. (Pg. 2) 2. Distinguish between the accounting concept of principal and income. (Pg. 4) 3. Calculate the tax liability of a trust or estate. (Pg. 7) 4. Understand the significance of distributable net income. (Pg. 10) 5. Determine the taxable income of a simple trust. (Pg. 13) 6. Determine the taxable income of a complex trust. (Pg. 19) 7. Recognize the significance of income in respect of a decedent. (Pg. 27) 8. Explain the effect of the grantor trust provisions. (Pg. 30) 9. Recognize the filing requirements for fiduciary returns. (Pg. 35)

4. 1. Understand the basic concepts concerning trusts and estates. (Pg. 2)

5. INTRODUCTION Trusts and estates are taxable entities subject to tax rules in Subchapter J of the Internal Revenue Code (§§ 641 through 692). Trusts and estates are called fiduciary taxpayers and the trustee or executor is a fiduciary. Grantor trusts, a type of trust not recognized as a taxable entity and therefore not subject to the rules of Subchapter J.

6. ESTATES-1 An estate as a legal entity comes into existence upon the death of an individual. While the decedent's legal affairs are being settled, assets owned by the decedent are managed by an executor or administrator of the estate. After all legal requirements have been satisfied, the estate terminates and ownership of all estate assets passes to the decedent's beneficiaries or heirs.

7. ESTATES-2 A decedent's estate is a taxable entity that files a tax return and pays Federal income taxes on any “taxable” income earned. An estate is a transitional entity that bridges the brief gap in time between the death of an individual and the distribution of the assets to relatives, etc. Estates may continue in existence for many years if there is controversy over distributions of the assets (multiple wills, questionable modifications to the will, etc.)

8. Trust - 1 A trust is a contract in which an individual, the grantor, transfers legal ownership of assets to one party, the trustee, and the legal right to enjoy and benefit from those assets to a second party, the beneficiary (or beneficiaries). A trust is often used to provide protection for the beneficiary. Often trust beneficiaries are minor children or family members incapable of competently managing the assets themselves.

9. Trust - 2 The terms of the trust, the duties of the trustee, and the rights of the various beneficiaries are specified in a legal document, the trust instrument. The assets put into trust are referred to as the trust corpus, or principal.

10. Trust - 3 The trustee is a fiduciary -- required to act in the best interests of the trust beneficiaries rather than for his or her own interests. The position of trustee is usually filled by the professional trust department of a bank or a competent friend or family member. Professional trustees receive an annual fee to compensate them for services rendered.

11. Trust - 4 The purpose of a trust is to protect and conserve trust assets for the sole benefit of the trust beneficiaries, not to operate a trade or business. A trust that becomes involved in an active, profit-making business activity runs the risk of being classified as an association for Federal tax purposes, with the unfavorable result that it will be taxed as a corporation rather than under the rules of Subchapter J.

12. Fiduciary Income Tax Rates-2005 • 15% on $0 - $2,000 • 25% on $2,001 - $4,700 • 28% on $4,701 - $7,150 • 33% on $7,151 - $9,750 • 35% over $9,750 Because beneficiaries are usually in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower taxes overall

13. FIDUCIARY ACCOUNTING INCOME-1 There is no standard accounting system that applies to fiduciaries. Accounting income of an estate or trust is determined by reference to the decedent's valid will or the trust instrument. These documents can specify how fiduciary receipts, disbursements, and other transactions affect income, principal, or both. Every fiduciary may have its own unique set of rules for computing accounting income, and the executor or trustee must refer exclusively to this income number in carrying out his or her duties.

14. FIDUCIARY ACCOUNTING INCOME-2 If a will or trust instrument is silent concerning the impact of a particular transaction on accounting income, such impact must be determined by reference to controlling state law. Most states have enacted a version of the Revised Uniform Principal and Income Act.

15. Annie and Ann (Mom) Annie sends money to her mother (Ann) each month to supplement Ann’s social security payments which are her only source of income. Ann lives alone in a house that she owns.

16. Annie is concerned that her mother (Ann) might not have enough income to pay her monthly bills if Annie were to die before Ann.

17. Annie Sets Up Trust-1 Annie owns corporate bonds with a face value of $100,000, paying 11% interest ($11,000) per year.

18. Annie Sets Up Trust-2 Annie puts bonds in a trust. Trustee will charge $1,000 per year for services, filing tax returns, etc. Trust document states that net income will be distributed (paid) each year to Ann (Mom). Simple Trust. Pg 14

21. Thought Question Would it have been just as good for Annie to put the bonds in a corporation and give the corporate stock to Ann, with Ann receiving dividends each year in the amount of $10,000?

22. Annie Limits Distribution Annie wants Ann to have greater income in the future – to cover inflation. Trust agreement states that 90% of trust net income will be paid to Ann each year. Ten percent of income is reinvested each year. Trust is a complex trust. Pg. 14

24. Lets learn 16 important things from the Internal Revenue Code – Subchapter J. Instructor will explain the 16 items shown on next two slides.

27. [Pg. 4] Income of trusts and estates is: a. Subject to double taxation similar to corporate income b. Taxed one time--either to the fiduciary or beneficiary  c. Not subject to income tax 

28. Types of Trusts Simple trust – must distribute all of its accounting income annually to its beneficiaries and cannot make charitable contributions Complex trust – not a simple trust • Not required to distribute all their accounting income each year allowing trust principal to accumulate • Can take tax deduction for making charitable contributions

29. 2. Distinguish between the accounting concept of principal and income. (Pg. 4)

30. Income (less related expenses) can be distributed to income beneficiaries. Income allocated to corpus is reinvested and kept so that the assets will ultimately go to the remainderman. Payments that will benefit the remainderman are charged against corpus. Capital gains are often allocated to corpus to protect the remainderman from erosion due to inflation. Depreciation may be deducted from income so that funds are available to replace depreciated assets.

31. [Pg. 6] The Martin Trust consisted primarily of various income-producing real estate properties. In 2006, the trustee incurred these charges. • Depreciation. • Principal payments on various mortgages. • Street assessment. Which would be a proper allocation of these items? a. All to income, except the street assessment. b. All are to be allocated equally between principal & income.  c. All to principal.   d. All to principal, except depreciation. (CPA Exam) 

32. 3. Calculate the tax liability of a trust or estate. (Pg. 7)

33. Which of the following items is not included in the gross income of an estate on Form 1041, U.S. Fiduciary Income Tax Return? a. Dividends b. Life insurance proceeds c. Gain from sale of property d. Interest e. Income received from a trust (Source IRS Exam)  

34. See first slides for Annie, the trust, and Ann. Now suppose Annie died and left those bonds to Ann. During the period of the estate administration, the trust had interest income of $11,000, executor fees of $1,000, and made distributions of $10,000 to Ann. Or distributed $9,000, etc.

35. 4. Understand significance of distributable net income. (Pg. 10)

36. DNI Distributable net income (DNI) is the current increase in value available for distribution to income beneficiaries • DNI determines the fiduciary’s maximum distribution deduction • DNI determines beneficiary’s maximum taxable income • Character is retained- Beneficiaries do not pay tax on tax-exempt income portion of DNI

37. [Pg. 11, 15] Trust B has distributable net income of $60,000, which includes $5,000 of tax-exempt income. The trustee distributed $75,000 to the trust’s sole beneficiary. What amount is included in income of beneficiary? a. $55,000. b. $60,000. c. $70,000. d. $75,000. [IRS-03-3#80] What is the distribution deduction?

38. 5. Determine the taxable income of a simple trust. (Pg. 13)

39. The Bob Trust is a Simple Trust. How much taxable income is passed through to the beneficiaries? Taxable interest $1,000  Tax exempt interest $1,000  Fiduciary fee $400  a. $1,600 b. $600 c. $800 d. $1,800 What is the taxable income of the Trust? Hint: Simple trust must distribute DNI.

43. Lessons from previous slides. • Like individuals, trusts and estates do not include municipal interest, etc. in income. • Expenses are allocated to tax-free income and to other income – no deduction allowed for expenses related to tax-free income. [One-half of expenses are non-deductible here and one-half are deductible.] • A distribution to beneficiary is deductible only to extent it is made from taxable types of income (50% in this case). Same would be true if we had a charitable contribution. • Exemption for a trust is $300 or $100.

44. 6. Determine the taxable income of a complex trust. (Pg. 19)

45. [Pg. 19] The Tom Trust did not make a distribution to its beneficiary in the current year (complex trust). Taxable interest $1,000 Tax exempt interest 1,000 Fiduciary fee 400 What is trust taxable income? a. $700 b. $200 c. $500 d. $1,000 IRS-2004

49. Lessons from previous slides. • Like individuals, trusts and estates do not include municipal interest, etc. in income. • Expenses are allocated to tax-free income and to other income – no deduction allowed for expenses related to tax-free income. [One-third of expenses are non-deductible here and two-thirds are deductible.] • A distribution to beneficiary is deductible only to extent it is made from taxable types of income (two-thirds in this case). Same would be true for a charitable contribution. • Exemption for a trust is $300 or $100.