Income Taxation of Trusts & Estates

How Are Trusts and Estates Taxed for Income Tax Purposes

When you, the grantor, give something to a trustee for the benefit of another person (the beneficiary), a trust is established. The possessions and debts a person leaves behind after death make up their estate. Like any people, a trust and an estate are distinct, legitimate, and tax-paying entities. revenue received by the estate or trust, such as rents from real estate, is considered revenue earned by the trust or estate.

Depending on who benefits from the trust (i.e., the grantor, the powerholder, the beneficiaries, or the trust entity), different people may be responsible for paying taxes on the money the trust earns. Depending on how the income is classified—that is, whether it was generated by the decedent, the estate, in respect of the decedent, or transferred to beneficiaries—who is responsible for paying taxes on the money received by the estate. Estates and trusts are generally subject to individual taxation.

Estates and trusts are subject to the same general tax laws as people. Tax-exempt income can be earned by a trust or estate, and some expenses can be written off. Everybody is entitled to a modest exemption ($600 for an estate, $100 for a complex trust, and $300 for a simple trust). But neither is entitled to a typical deduction. When compared to individual tax brackets, the income taxable to a trust or estate has significantly more compressed brackets, which may lead to greater taxes.

Technical Note: Fiduciary tax returns are income tax returns (Form 1041 ) for trusts and estates. This is so because submitting the return and paying any taxes due are often the responsibilities of the fiduciary, who is the trustee or estate representative. It can also be necessary for trusts and estates to file a state income tax return. To find out what is required in your state, speak with an accountant or attorney.

What Are The General Income Tax Rules for Trusts?

Generally, Income Is Taxable to Trust Entity or Trust Beneficiaries

Trust income retained by the trust is taxed to the trust, while distributed income is taxed to the beneficiary who receives it. Thus, trust income is taxable to the trust or to the beneficiary but not to both. This result is obtained though the use of the distributable net income (DNI) concept.

Except Grantor-Type Trusts or Charitable Remainder Trusts

The general rule is not applicable to these two cases. First, trust income is taxable to the grantor or powerholder if they have retained an interest in the trust (such as the right of revocation) or if another individual has been granted a wide power of appointment over the trust income or principle. These are referred to as grantor-type trusts; a revocable trust in which the grantor is subject to all income taxes is one example. Second, retained trust income is usually not taxable to the trust if the trust is a charitable residual trust due to the charity's tax exemption; nonetheless, any distributions are taxable to the beneficiaries.

Tip: In computing tax liability, multiple trusts are treated as one trust and their incomes are aggregated if they have substantially the same grantors and/or beneficiaries.

What Are The General Income Tax Rules for Estates?

How Income Is Reported

1.  Income of the decedent: If a decedent was a cash method taxpayer, income received (actually or constructively) by the decedent prior to death is reported on the decedent's final 1040. If the decedent was an accrual taxpayer, income accrued prior to death is reported on the final 1040.

2.  Income of the estate: Income earned by the decedent but not paid before death is reported on the income tax return of the recipient of the income. This income is called income in respect of the decedent (IRD). Examples of IRD include uncollected wages, accrued interest on bank accounts, and dividends declared but not collected. If the recipient of IRD is the decedent's estate, it is reported on Federal Form 1041 (the fiduciary tax return) by the estate representative. If the recipient is an estate beneficiary, it is deducted on Schedule B and reported to the beneficiary on Schedule K-1 for inclusion on the beneficiary's personal return. Other income (non-IRD) earned by estate property after death and retained by the estate is reported on the estate's tax return (Form 1041). Other income (non-IRD) earned by estate property after death and distributed by the estate to a beneficiary is deducted on Schedule B and reported to the beneficiary on Schedule K-1 for inclusion on the beneficiary's personal return.

3.  Income of the beneficiary: The beneficiary may receive income (or income-producing property) directly from the decedent at the time of death. The beneficiary must include this income on his or her individual tax return.

What Deductions Are Allowed

Generally, the same deductions allowed for individuals are allowed for estates. Some expenses for administering an estate can be deducted on either the estate tax return (Form 706) or the fiduciary return but not both. The personal representative may also elect to split an expense and deduct a portion on each return. The following deductions are allowed on Form 1041:

1.  Probate expenses, such as court costs, bonds, and professional fees

2.  Expenses for selling estate property

3.  Uninsured casualty losses

Tip: Make sure you include two copies of a statement signed by the estate's personal representative that lists all administration expenses and states, "These expenses have not been claimed as deductions for federal estate tax purposes, and all rights to claim such deductions are waived," if you deduct them on Form 1041. This waiver cannot be revoked. It is necessary even in cases when Form 706 filing by the estate is not needed.

Tip: The rule against double taxation does not apply to expenses in respect of a decedent. Such expenses can be deducted on both the estate tax return and Form 1041. Similarly, claims against the estate for amounts owed by the decedent at the time of death (e.g., state property taxes) may be deducted on both returns.

What Is Trust Income for Income Tax Purposes?

Accounting Income

Generally speaking, trusts are designed to preserve the principle for one beneficiary (the remaining beneficiary) and distribute income to another (the income beneficiary) on a yearly basis. The trust may receive interest, dividends, regular income, or capital gains as its source of income. whatever beneficiary will receive whatever kind of revenue can be specified in the trust agreement.

The amount that must be given to the income beneficiary is calculated using accounting income. The income distribution deduction establishes the amount of taxable income allotted to a beneficiary. Accounting income has an impact on taxable income to the extent that it limits how the income distribution deduction is calculated.

Trust income that is assigned to the income beneficiary rather than the remainder beneficiary is referred to as accounting income. For the advantage of the beneficiary who will get the remainder, for instance, a capital gain is typically added to the principle. The trust agreement may specify the accounting income of the trust; if not, state law will apply.

Example(s): In Year 1, the Jones Family Trust earns $10,000 in taxable interest and realizes a $12,000 capital gain. The trust's accounting income is $10,000 (the taxable interest). The amount required to be distributed to the beneficiary is $10,000. The income distribution deduction to the trust is $10,000. The beneficiary's taxable income is $10,000. The $12,000 capital gain remains in the trust and is taxable to the trust.

Tax-Exempt Income/Allocation of Expenses

Like any individual taxpayer, a trust may receive income that is exempt from taxes. It is not possible to deduct costs that are directly associated with the creation of tax-exempt income. On the other hand, costs directly associated with generating taxable income are entirely deductible. The allocation of all indirect costs is made between taxable and exempt revenue. Here's how this allocation is determined: The proportion of expenses not deducted from taxable income is equal to gross tax-exempt income / gross accounting income.

Example(s): In Year 1, the Jones Family Trust earns $10,000 in interest on municipal bonds, $5,000 in interest on CDs, and realizes a $12,000 capital gain. The trust's accounting income is $15,000 ($10,000 + $5,000). The trust's tax-exempt income is $10,000 (interest on municipal bonds). Thus, the percentage of indirect expenses not deductible is 67 percent ($10,000 divided by $15,000).

Gross Income

A trust or estate's gross income (i.e., ordinary income, capital gains, and business and rental income) is comparable to an individual's for income tax purposes. Income that is to be distributed now, kept to cover expenses, or set aside for future distributions may fall under this category; nonetheless, the beneficiary, the trust, or the estate may be responsible for paying taxes on the income.

Capital Gain

Capital gain is taxed to the trust where the gain must be or is added to the principal. If the gain is actually distributed, it is taxed to the beneficiary.

Caution: Gain from the sale or exchange of depreciable property between related parties is treated as ordinary income.

 Losses: If losses exceed gains, all losses are allocated to the trust. Capital losses can be deducted against ordinary income (lesser of net loss or $3,000). Excess capital losses may be carried forward indefinitely. Unused capital loss carryovers can be passed through to the beneficiary at the termination of the trust.

Caution: A trust may not deduct a loss from the sale or exchange of property between related taxpayers (e.g., trustee and grantor, trustee and beneficiary).

 Basis: Basis (for the purpose of gain or depreciation) of property acquired by a trust or estate from a decedent is its fair market value (FMV) at the date of death, unless the alternate valuation date was elected. Basis (for the purpose of gain or depreciation) of property acquired by a trust as a gift from the grantor is the grantor's adjusted basis plus gift taxes paid.

Caution: The basis for property that a trust or estate purchases from a deceased individual who chose not to file for federal estate tax in 2010 will be changed rather than increased to FMV.

What Deductions Can a Trust Take?

Deductions Allowed

Generally, deductions allowed to individuals are also allowed on fiduciary returns.

These include:

1.  State, local, and real property taxes (generally limited to $10,000)

2.  Administrative expenses (e.g., trustee fees)

3.  Estate expenses

Deductions Not Allowed

Depreciation and depletion: Depreciation and depletion expenses generally follow income unless there is a reserve.

However, in the case of a trust, this expense must be apportioned between the trust and the beneficiary. This is done on the basis of accounting income allocated to each unless state law allows the trustee to maintain a reserve.

Example(s): Edna Smith receives 50 percent of the accounting income from the John Smith Trust and the trust retains the other 50 percent. The property in the trust that generates the income depreciates $1,000 in Year 1. The John Smith trust is allowed to deduct $500 (50 percent of $1,000) on the fiduciary tax return, while Edna is allowed to deduct $500 (50 percent of $1,000) on her personal income tax return.

Charitable deduction: Charitable contributions paid from current trust income are deductible only if the will or trust agreement authorizes such payments. Charitable contributions from trust principal are not deductible.

Tip: The trust can elect to 'push-back' part or all of a contribution made with current-year income to the immediately preceding tax year. This election must be made by the due date of the current year's tax return.

Tip: A few trusts are allowed a 'set-aside' deduction. That means that the deduction is allowed in the current year for amounts set aside for charity but actually paid in a later year.

What Is The Income Distribution Deduction?

In general, a trust may set aside an amount equal to what is given to the income recipient. The income distribution deduction is the name given to this. The income distribution deduction for a trust is specifically the smaller of:

1.  Distributions less tax-exempt income, or

2.  Distributable net income less tax-exempt income

Example(s): In Year 1, the Jones Family Trust earns $10,000 in interest on municipal bonds, $5,000 interest on CDs, and realizes a $12,000 capital gain. The trust's tax exempt income is $10,000 (interest on municipal bonds). Additionally, the trust distributed $15,000 to Fred. The trust's income distribution deduction is $5,000 ($15,000 - $10,000).

What Is Distributable Net Income (DNI)?

A formula called distributable net income (DNI) is used to divide trust revenue among beneficiaries. The maximum deduction that a trust is permitted to take for beneficiary distributions is limited by the DNI. Beneficiaries only pay taxes up to the DNI amount.

Over DNI distributions are considered tax-free principal distributions. This is how the DNI is calculated:

 Total trust income (excluding tax-exempt income)

 Less deductible expenses

 Plus tax-exempt interest reduced by expenses not allowed in the computation of taxable income and the portion used to make charitable contributions

 Plus capital gains if:

1. Gain is allocated to accounting income

2. Gain allocated to principal is required to be distributed or is consistently and repeatedly distributed by the trustee

3. Gain allocated to principal is paid or set aside for charity

Less capital losses if they enter the calculation of any capital gain distributed or required to be distributed

In a simple trust, DNI is apportioned and taxed to the income beneficiaries. The trust pays taxes only on capital gains and other income remaining with the principal.

If DNI includes capital gains, for instance, it may surpass the income that must be distributed at this time under a complex trust. First, the beneficiaries who receive the revenue that needs to be given right now get DNI allocated to them dollar for dollar. Beneficiaries who receive additional payments or discretionary disbursements split the remaining DNI proportionally. To the extent of DNI, payments are deemed to have been made from DNI. The real source of payment cannot be tracked down or is not required under IRS regulations.

These regulations aim to stop the trustee from faking distributions such that beneficiaries in lower tax brackets receive distributions of taxable income and beneficiaries in higher tax brackets receive nontaxable distributions of principle. Recipients of main distributions might have to disclose a portion of the payout as taxable income. In actuality, the tax on the capital gain is being transferred from the trust to the beneficiaries, despite the fact that this sounds like double taxation.

Example(s): In Year 1, the Jones Family Trust earns $10,000 in interest on municipal bonds, $5,000 interest on CDs, and realizes a $12,000 capital gain. The trust's taxable income and DNI is $17,000 ($5,000 + $12,000). The trust's accounting income is $15,000 ($10,000 + $5,000). Additionally, the trust is required to distribute $5,000, plus 25 percent of the principal, to Fred annually, 25 percent of the principal to Jack, and 50 percent of the principal to Sid.

Example(s): The trust distributes $8,000 to Fred, $3,000 to Jack, and $6,000 to Sid.

Example(s): The first $5,000 of DNI is allocated to Fred, the income beneficiary. The remaining DNI is allocated to Fred, Jack, and Sid according to their shares of the remaining distributions.

Example(s): Fred $5,000 + (25 percent of $12,000) = $8,000 DNI

Example(s): Jack (25 percent of $12,000) = $3,000 DNI

Example(s): Sid: (50 percent of $12,000) = $6,000 DNI

Tip: Whether or not amounts that must be dispersed are actually distributed is irrelevant; they are deductible in the current year. Generally speaking, though, discretionary payments are only deductible in the year they are made. The 65-day rule allows a trust to choose to treat distributions made within the first 65 days of the following tax year as if they were made during that year.

What Are Simple And Complex Trusts and How Are They Taxed?

Simple Trusts

A simple trust is one that: (1) does not have a charitable beneficiary; (2) does not distribute principal; and (3) is required to distribute all income in the year it is received and actually does so. DNI is distributed and taxed to the income beneficiaries in a basic trust. Only capital gains and other income that stays with the principle are taxed by the trust.

Example(s): Alan makes an irrevocable transfer of cash, stocks, and bonds to the Alan B. Trust. The trust provides financial security for Alan's daughters, Phoebe and Mona, by giving them an income interest. All accounting income from interest and dividends are split equally and distributed to Alan's daughters. All capital gains are retained by the trust. At the end of 20 years, the trust will end and the principal will be distributed to the two daughters and Alan's four grandchildren under the terms of his will.

Complex Trusts

A complex trust is one that disburses principle, has a charitable beneficiary, or is permitted to generate income. Generally speaking, an estate is handled like a complex trust. If DNI includes capital gains, for instance, it may surpass the income that must be distributed at this time under a complex trust. First, the beneficiaries who receive the revenue that needs to be given right now get DNI allocated to them dollar for dollar. Beneficiaries who receive additional payments or discretionary disbursements split the remaining DNI proportionally.

Example(s): Mary sets up an irrevocable trust for her only son, Adam (age 20). Under the terms of the trust, the trust is to retain all income until the year Adam turns 25. In that year, the trustee is to distribute all current income plus $150,000 to Adam. The trust will continue to distribute all income to Adam until Mary dies, at which time the principal will be distributed to Adam.

Tip: A trust may be simple one year and complex the next. All trusts are complex in their final year because all principal must be distributed when the trust ends. A trust that is permitted but not required to distribute principal is complex in the years it actually does distribute but is simple in the years it does not. A trust that can either distribute or accumulate income is always a complex trust even in the years it does not actually make distributions.

What Are Grantor-Type Trusts and How Are They Taxed?

Grantor Retained Interest Trust

A trust is deemed to be a grantor trust if the grantor does not give up authority over it. The trust's assets are regarded as belonging to the grantor, who is also subject to taxation on trust income. Income from other assets is taxed to the trust or the beneficiaries if the grantor keeps control of only a portion of the trust. In this scenario, the grantor is regarded as the owner of the assets under their control. Income that is subject to grantor taxation is not disclosed on Form 1041. Form 1040, the grantor's personal income tax return, has a report on it.

The grantor is said to retain control if he or she:

1.  Derives benefits from the income: The grantor is treated as the owner of income to the extent that he or she receives a benefit (directly or indirectly) from the trust.

2.  Retains the power to revoke the trust: A revocable trust gives the grantor the power to end all or part of the trust. The grantor is treated as the owner of the trust to the extent of that power.

3.  Retains power over beneficial enjoyment: A grantor who retains the power to control which beneficiaries will receive income or principal is treated as the owner of the trust.

4.  Is able to exercise certain administrative powers over the trust's operation: If the grantor has the power to purchase principal for less than adequate consideration or to borrow funds without adequate security or interest, he or she could benefit from the trust. The grantor is considered the owner to the extent of that power.

5.  Retains a reversionary interest in either the income or principal: If the terms of the trust provide that the trust 'reverts back' to the grantor if the income or remainder beneficiary dies before the grantor, income will be taxable to the grantor unless the value of the reversionary interest on the date of transfer is not more than 5 percent of the trust.

Tip: On a qualifying preneed funeral trust, which is otherwise classified as a grantor trust, a trustee may choose to pay tax. A trust's only function must be to store and invest monies for professional funeral or burial services; it must be created as a result of a contract with such a service.

Tip: Revocable trusts may be included in the grantor's estate for that tax year upon the grantor's passing. The trustee and the estate representative must make this choice by the deadline for the estate's first income tax return, if not earlier.

General Power of Appointment

Unless the grantor is regarded as the owner under the grantor retained interest rules, or the powerholder disclaims the power within a reasonable time after learning of its existence, the holder of a general power of appointment over a trust is considered the owner of that portion of the trust over which the power is held.

What Are Charitable Remainder Trusts and How Are They Taxed?

Unless the trust has unrelated business revenue, charitable remainder trust income is generally not taxed. However, upon distribution, the trust's income is taxable to any noncharitable beneficiaries. The income taxation of a charitable remainder unitrust (CRUT) and charitable remainder annuity trust (CRAT) is subject to special regulations. You will be responsible for paying income tax on any payments you get if you are a CRAT or CRUT income beneficiary. Therefore, even though a CRAT or CRUT avoids paying capital gains tax when they sell an asset, you are still required to pay income tax on any portion of the revenue that is given to you.

The nature of the payment, which is ascertained using a particular income tax computation technique for trusts, determines how much of the payment is taxable. To ascertain the tax nature of the income distribution to the beneficiary, the IRS employs a four-tier accounting process referred to as the ordering rules. This accounting principle is known by its abbreviation, WIFO, which stands for worst in, first out.

The amounts distributed by a trust are classified as follows:

1.  Ordinary income: Ordinary income earned by the trust in the current year, along with any undistributed ordinary income from prior years (ordinary income includes dividends and/or interest).

2.  Capital gain: Capital gain earned by the trust in the current year, along with any undistributed capital gain from prior years.

3.  Nontaxable income: Nontaxable income earned by the trust in the current year, along with any undistributed nontaxable income from prior years.

4.  Principal: The IRS imposes the highest taxes on ordinary income. If the required annual payment cannot be paid out of ordinary income, it is then paid from capital gains. If the payment still cannot be met after exhausting capital gains, it is paid from tax-exempt income and finally, if necessary, from the principal of the trust.

Tip: The trustee must keep track of all sales made and gains realized by the trust to make these calculations — a difficult task that a computer tracking system frequently completes.

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