EA2 Study Unit 18.1-18.4 - Decedents, Estates, and Trust Tax Returns

Decedent's Final Income Tax Return

• The final individual income tax return is due when it would have been due had death not occurred.

Inclusions in Income

• Income includible on the final return is generally determined as if the person were still alive, but the taxable period ends on the date of death.
• Cash-method taxpayers include only income actually or constructively received before death.
• Accrual-method taxpayers include amounts earned and accrued before death.
• The death of a partner usually does not close the partnership's tax year.
• For partnership tax years ending on or before a partner's death, the distributive share is on the final return.
• For partnership tax years ending after death, the partner's distributive share before death is on the final return.
• These rules apply for cash- and accrual-method taxpayers in all situations except for self-employment tax.
• The person filing the final return can elect to include all interest earned on bonds transferred as a result of death if the cash-method decedent had not reported the interest each year.

Deductions and Credits

• A full standard deduction may be taken unless deductions are itemized.
• For itemized deductions, medical expenses paid before death are deductible.
• Medical expenses include amounts paid for the decedent, the decedent's spouse, and the decedent's dependents.
• If paid out of the estate during the 1-year period after death, medical expenses can be deducted on the return for the year incurred via election.
• Medical expenses claimed on the final income tax return cannot be claimed on the estate tax return.
• A decedent's NOLs from business must be taken on the final return.
• Deduction for capital losses is limited to $3,000 in any year.
• Carryforwards of unused losses and deductions are not permitted, and limitations still apply.
• Any credits, taxes, and payments the decedent would have applied are fully applied on the final return.

Self-Employment Tax

• Self-employment income includes income actually or constructively received or accrued, depending on the accounting method.
• For self-employment tax purposes only, the decedent's self-employment income includes the distributive share of a partnership's income or loss through the end of the month in which death occurred.

Signing the Return

• The return should be signed by the personal representative, and/or an individual who prepares the return for pay.
• If an individual prepares the return free of charge, they should not sign.

Income in Respect of a Decedent (IRD)

• IRD includes amounts a decedent was entitled to as gross income but that were not properly includible in computing taxable income on the final return.
• The person had a right to receive income prior to death. Note salary was earned, or a sale contract was entered into.
• Amounts not received by a cash-method (CM) taxpayer are not includible on their final income tax return.
• Amounts not properly accrued by an accrual-method (AM) taxpayer are not includible on their final income tax return.
• IRD is reported by the person receiving the income as if the recipient were the decedent.
• Cash method applies to income once designated IRD.
• IRD received by a trust or estate is fiduciary income.
• A right to receive IRD has a transferred basis, not stepped-up to FMV on the date of death.
• IRD has the same character and tax status it would have had in the hands of the decedent.
• IRD is taxable as income to the recipient and is includible in the gross estate, but double tax is mitigated by deductions.

Deductions in Respect of a Decedent

• Expenses accrued before death, but not deductible on the final return because the decedent used the cash method, are deductible when paid if otherwise deductible.
• They are deductible on the return of the taxpayer reporting the IRD (Form 1041) and also deductible on the estate tax return (Form 706).
• Estate taxes attributable to IRD included in the gross estate are deductible on the recipient's income tax return and the fiduciary income tax return (Form 1041).
• Administrative expenses and debts of a decedent are deductible on the estate tax return like Form 706, United States Estate.
• Some may also be deductible on the estate's income tax return (Form 1041).

Double Deductions

• Double deductions are disallowed.
• The right to deduct the expenses on Form 706 must be waived in order to claim them on Form 1041.
• A deduction (on Form 1041) is allowed for any excess of the federal estate tax over the amount of the federal estate tax if the IRD had been excluded from the gross estate.
• Returns report IRD include:
  • The decedent's estate (Form 1041) if the estate receives the right to the income.
  • The beneficiary's Form 1040, if the right to income arising out of the decedent's death is passed directly to the beneficiary.
  • Form 1040 of any person to whom the decedent's estate properly distributes the income.
• The decedent's final Form 1040 would not include IRD.

Income Taxation of Estates and Trusts

• Tax is imposed on taxable income of a trust or estate at the following rates for 2023:
  • $0 - $2,900: Tax rate is 10%
  • > $2,900 - $10,550: Tax rate is 24% (+ $290)
  • > $10,550 - $14,450: Tax rate is 35% (+ $2,126)
  • > $14,450: Tax rate is 37% (+ $3,491)

Fundamentals

• A simple has the following characteristics:
  • Requires current distribution of all its income.
  • Requires no distribution of the res (i.e., principal).
  • Provides for no charitable contributions by the trust.
• A complex trust is any trust other than a simple trust and can:
  • Accumulate income.
  • Provide for charitable contributions.
  • Distribute amounts other than income.
• A grantor trust is any trust to the extent the grantor is the effective beneficiary; income attributable to a trust principal that is treated as owned by the grantor is taxed to the grantor. The trust is disregarded.
• A trust is considered a grantor trust when the grantor retains a greater than 5% reversionary interest.
• A grantor is treated as the owner of a trust, the income from which may be distributed or accumulated for the grantor's spouse (without the approval or consent of an adverse party) under Sec. 677(a).
• The grantor is also taxed on income from a trust in which the income may be applied for the benefit of the grantor.
• Use of income for the support of a dependent is considered the application of income for the benefit of the grantor.
• Under Sec. 677(b), income of a trust that may be applied for the support of a dependent is not taxable to the grantor if it is not actually used.
• The grantor/owners with substantial interests must give up control for the trust property to be considered a separate legal entity for tax purposes; all revocable trusts are grantor trusts.
• Rules for classifying trusts are applied on a year-to-year basis.
• An estate with gross income ≥ $600 must file taxes; a trust must file if it has any taxable income or gross income > $600.
• The trustee, executor, or administrator must file the return by the 15th day of the 4th month after the entity's tax year close, using Form 1041.
• If a domestic estate has a nonresident alien beneficiary, the representative must file irrespective of income.
• Estate gross income includes gain from property sales (not gross proceeds).
• An estate may adopt any tax year ending within 12 months after death, while most trusts must adopt a calendar tax year.
• Tax-exempt and wholly charitable trusts may qualify to use a fiscal tax year.
• A beneficiary includes their share of trust income in their tax return for the tax year the trust's tax year ends (when distributions are made is irrelevant).
• Any permissible accounting method may be adopted; the alternative minimum tax applies to trusts and estates in the same manner as for individuals.
• Tax is imposed on taxable income of trusts/estates, not on items treated as fiduciary principal defined by state law (Revised Uniform Principal and Income Act).
• State and acts provide that the trust instrument controls designations of fiduciary principal and components; they also provide default designations.
• Principal is property eventually delivered to the remainderman, while income is return on/for principal, held for or distributed to the income beneficiary (change in form of principal is not taxable income).
• Gross income is computed as for individuals like dividends, interest, rents, royalties, and gain from the sale of property.
• Life insurance proceeds are generally included in the value of the gross estate but are not considered income of the estate.
• Income in respect of a decedent is also taxed as income if received by the estate.
• Capital gains are taxed to the estate, then the gain must be added to the principal of the estate.
• Losses from a passive activity cannot offset the portfolio income of the estate or trust in determining taxable income.
• AGI does apply to fiduciaries for purposes of computing deduction limits.
• The standard deduction is not allowed.
• Deductions generally follow individual allowances; trustee fees and tax return preparation fees are fully deductible if not deducted on the estate tax return.

Depreciation

• In default, the act charges depreciation to income. Absent provisions apportioning the deduction, the allowable amount is allocated between the estate and each beneficiary based on the fiduciary income taxable to each.
• Trusts may deduct depreciation only to the extent a reserve is required/permitted and income is set aside for the reserve; any excess is allocated between parties according to the trust instrument, or proportionally if silent. -fiduciary NOLs are computed without considering charitable contributions or distribution deductions, and carryover is permitted. Pass-through for deduction on personal returns of beneficiaries is allowed only when the trust/estate terminates; pass-through NOLs/capital loss carryovers are used to calculate AGI and taxable income. An estate can also claim a deduction for an NOL and the NOL carryover.
• Estates can claim a deduction for an NOL, calculated the same as an individual's deduction An unused NOL in the final year of the estate may carry over to the beneficiaries succeeding to the property of the estate.
• A fiduciary may deduct a capital loss up to capital gains plus $3,000, with carryover permitted; charitable contributions are only deductible if authorized, without AGI limits.
• Expenses attributable to tax-exempt income are non-deductible.
• A personal exemption applies but not in the year of termination.
• The amount is $600 for an estate, $300 for a simple trust, and $100 for a complex trust.
• Gross regular tax of a fiduciary is offset by most of the credits available to individuals (certain "personal" credits like credits for dependents are unavailable).
• Pass-through for deduction on personal returns of beneficiaries is allowed only when the trust/estate terminates; pass-through NOLs/capital loss carryovers are used to calculate AGI and taxable income.
• The deduction for distributions allocates taxable income of a trust or estate between the fiduciary and its beneficiaries.
• For simple trusts, the deduction is the lesser of the amount of distributions (required) minus net tax-exempt income or distributable net income (DNI) minus tax-exempt interest.
• For estates and complex trusts, the deduction is the lesser of DNI (minus tax-exempt interest) or distributions.
• The amount distributed is the lesser of the FMV of the property or the basis of the property in the hands of the benficiary
• Distributions for the tax year needs to be paid within 65 days
• Specific bequests distributed or credited to a beneficiary are not included
• No gain on distribution can be recognized if an executor does not elect
• Value can allocate to current income

Distributable Net Income (DNI)

• DNI is generally current net accounting income of the fiduciary reduced by any amounts allocated to principal.
• DNI is the maximum deductible at the fiduciary and taxable at the beneficiary level
• DNI adjustment may be made for dividends
• FORM 1041 is used to report the beneficiaries share of income, deductions and credits from the trust or estate.
• Trusts are required to remit payments of estimate tax
• Estates are not required to pay estimated tax for its first 2 tax years
• Estimated tax payment by the estate may be made by the beneficiary
• Not required to make estimated tax payments in the current year if estate of domestic decedent or trust has no tax liability
• Income tax returns are due in April.

Fraudulent Trust Penalties

• Late filing
  • 5% of tax per month up to 25%
• Fraudlent late fee
  • 15% per month up to 75% if fraudlent
• Minimum excess is $485 or tax due
• $310 if failure exists to the beneficiaries
• $630 or 10% if reportable issues exist

Foreign Trust

• U.S Owner is texas on the income of that trust
• Each U.S owner should receive a foreign grantor from Texas's owner Statement FORM 3520-A,
• U.S. Beneficiary has a foreign trust
• Gain on certain transfers of appreciated assets to a foreign trust must be recognized
• Under PPACA , income from a foreign trust that is over $14,450 is subject to NIIT, at a rate of 3.8%
• Net Investment income includes interest, dividends, capital gains, and non qualified

Fraudulent Trust

• All trust must comply with the tax laws that are set forth by Congress in the Internal Revenue Code
• Abusive techniques used to reduce the amount of income taxes

Violations of the IRS:

Result: may result in civil penalties or criminal prosecution

• Civil Sanctions can include a fraud penalty up to 75% of the underpayment Civil Sanctions can include a fraud penalty up to 75% of the underpayment Criminal: Convictions may result in fines up to $250,000-$500,000

This covers tax implications related to a deceased person's final income tax return. Topics include reporting interest, standard deduction, medical expenses, loss deductions, self-employment tax, and who should sign the return.