Decedent, Estate, and Trust Income Tax Returns PDF

1 STUDY UNIT EIGHTEEN DECEDENT, ESTATE, AND TRUST INCOME TAX RETURNS 18.1 Decedent’s Final Income Tax Return....................................... 1 18.2...

1 STUDY UNIT EIGHTEEN DECEDENT, ESTATE, AND TRUST INCOME TAX RETURNS 18.1 Decedent’s Final Income Tax Return....................................... 1 18.2 Income in Respect of a Decedent (IRD)..................................... 3 18.3 Income Taxation of Estates and Trusts..................................... 6 18.4 Fraudulent Trusts...................................................... 17 This study unit addresses different kinds of income taxes. Estates and trusts (also called fiduciaries) are legal entities defined by the assets they hold. These assets produce income. The entities are subject to tax on that income. This is referred to as fiduciary income taxation. The formula for computing this fiduciary tax is the individual income tax formula, modified for the distribution deduction and other special rules. Furthermore, the beneficiaries of these fiduciary entities, rather than the fiduciary, are personally subject to income tax on certain fiduciary income. 18.1 DECEDENT’S FINAL INCOME TAX RETURN The final individual income tax return is due at the same time the decedent’s return would have been due had death not occurred. Inclusions in Income 1. The decedent’s income includible on the final return is generally determined as if the person were still alive except that the taxable period ends on the date of death. a. Cash-method taxpayers include only the income that was actually received or constructively received before the date of death, that is, income that was made available for use by the decedent without restriction. b. Accrual-method taxpayers include any amounts earned and accrued before death. c. For partnership income, the death of a partner does not generally close the partnership’s tax year. 1) For partnership tax years ending on or before a partner’s death, the distributive share should be included on the final return. 2) For partnership tax years ending after the date of death, the partner’s distributive share before death is included on the final tax return. 3) These rules apply for cash- and accrual-method taxpayers in all situations except for self-employment tax purposes. d. The person who is required to file the final income tax return of the decedent can elect to include all interest earned on bonds transferred as a result of death if the cash-method decedent had chosen not to report the interest each year. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 18: Decedent, Estate, and Trust Income Tax Returns 2. Deductions and Credits a. A full standard deduction may be taken unless deductions are itemized. b. If deductions are itemized, medical expenses paid before death by the decedent are deductible. 1) This includes amounts paid for the decedent, the decedent’s spouse, and the decedent’s dependents. 2) If medical expenses are paid out of the estate during the 1-year period beginning with the day after death, an election may be made to also deduct them on the return for the year incurred. 3) Any medical expenses claimed on the decedent’s final income tax return may not be claimed on the estate tax return. c. A decedent’s deduction for NOLs from business must be taken on the final return. 1) Any deduction for capital losses must be taken on the final return. a) The capital loss deduction is limited to $3,000 in any year. 2) There are no carryforwards of unused losses and deductions, and the limitations on losses and deductions still apply in this situation. d. Any credits, taxes, and payments that the decedent would have applied had (s)he not died during the year are applied in full in the final return. Self-Employment Tax 3. Self-employment income for a decedent includes income actually or constructively received or accrued, depending on the decedent’s accounting method. a. For self-employment tax purposes only, the decedent’s self-employment income includes the decedent’s distributive share of a partnership’s income or loss through the end of the month in which death occurred. 4. The return should only be signed by the personal representative and/or an individual who prepares the return for pay. a. If an individual prepares the return free of charge, (s)he should not sign the return. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 3 18.2 INCOME IN RESPECT OF A DECEDENT (IRD) IRD is all amounts to which a decedent was entitled as gross income but that were not properly includible in computing taxable income on the final return. The person had a right to receive it prior to death, e.g., salary was earned, or a sale contract was entered into. 1. Not includible on the final income tax return of a cash-method (CM) taxpayer are amounts not received. Not includible on the final income tax return of an accrual-method (AM) taxpayer are amounts not properly accrued. Items of Income in Respect of a Decedent IRD Not IRD Salary earned prior to, but not received before, Salary earned and accrued by AM taxpayer death of a CM taxpayer Collection after death of A/R of CM taxpayer Collection of A/R by AM taxpayer Gain on sale of property by CM taxpayer Gain on sale of property received before death received not before death Rent accrued but not received before death by Rent received before death CM taxpayer Interest on installment debt accrued before Interest on installment debt accrued after death by CM taxpayer death by AM taxpayer Installment income recognized after death on Installment contract income recognized contract entered into before death before death 2. IRD is reported by the person receiving the income as if the recipient were the decedent. a. The cash method applies to income once designated IRD. b. IRD received by a trust or estate is fiduciary income. 3. A right to receive IRD has a transferred basis. The basis is not stepped-up to FMV on the date of death, as is generally the case for property acquired from a decedent. EXAMPLE 18-1 Right to Receive IRD -- Transferred Basis Mrs. Hart earned 2 weeks’ salary of $2,000 that had not been paid when she died. As a cash-method taxpayer, her basis in the right to receive the $2,000 was $0. When her estate received the income, it had $2,000 of ordinary income because its basis in the right to receive it was also $0. Note that the $2,000 is not reported on Mrs. Hart’s final return. 4. IRD has the same character and tax status it would have had in the hands of the decedent. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 18: Decedent, Estate, and Trust Income Tax Returns 5. IRD is taxable as income to the recipient and is includible in the gross estate. Double tax is mitigated by deductions. a. Deductions in respect of a decedent. 1) 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. a) They are deductible on the return of the taxpayer reporting the IRD (Form 1041). b) They are also deductible on the estate tax return (Form 706). b. Deduction for estate tax. 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). 1) Administrative expenses and debts of a decedent are deductible on the estate tax return [Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return]. Some of them may also be deductible on the estate’s income tax return (Form 1041, U.S. Income Tax Return for Estates and Trusts). a) Double deductions are disallowed. b) The right to deduct the expenses on Form 706 must be waived in order to claim them on Form 1041. 2) 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. c. The tax returns that would report IRD include, but are not limited to, the following: 1) The decedent’s estate, Form 1041, if the decedent’s estate receives right to the income. 2) The beneficiary’s Form 1040, if the right to income arising out of the decedent’s death is passed directly to the beneficiary and is never acquired by the decedent’s estate. 3) The Form 1040 of any person to whom the decedent’s estate properly distributes the income. NOTE: The decedent’s final Form 1040 would not include IRD. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 5 EXAMPLE 18-2 IRD -- Return Presentation Frank Johnson owned and operated an apple orchard. He used the cash method of accounting. He sold and delivered 1,000 bushels of apples to a canning factory for $2,000, but did not receive payment before his death. The proceeds from the sale are income in respect of a decedent. When the estate was settled, payment had not been made and the estate transferred the right to the payment to his widow. When Frank’s widow collects the $2,000, she must include that amount in her return. The amount is not reported on the final return of the decedent or on the return of the estate. EXAMPLE 18-3 IRD -- Recognized Income Assume the same facts as in Example 18-2, except that Frank used the accrual method of accounting. The amount accrued from the sale of the apples would be included on his final return. Neither the estate nor the widow would realize income in respect of a decedent when the money is later paid. EXAMPLE 18-4 IRD -- Recognized Gain On February 1, George High, a cash-method taxpayer, sold his tractor for $3,000, payable March 1 of the same year. His adjusted basis in the tractor was $2,000. George died on February 15, before receiving payment. The gain to be reported as income in respect of a decedent is the $1,000 difference between the decedent’s basis in the property and the sale proceeds. In other words, the income in respect of a decedent is the gain the decedent would have realized had he lived. EXAMPLE 18-5 IRD -- Recognized Income Assignment Cathy O’Neil was entitled to a large salary payment at the date of her death. The amount was to be paid in five annual installments. The estate, after collecting two installments, distributed the right to the remaining installments to the beneficiary. The payments are income in respect of a decedent. None of the payments were includible on Cathy’s final return. The estate must include in its income the two installments it received, and the beneficiary must include in income each of the three installments as the installments are received. EXAMPLE 18-6 IRD -- Recognized Income Assignment Paige inherited the right to receive renewal commissions on life insurance sold by her father before his death. Paige inherited the right from her mother, who acquired it by bequest from Paige’s father. Paige’s mother died before she received all the commissions she had the right to receive, so Paige received the rest. The commissions are income in respect of a decedent. None of these commissions were includible on Paige’s father’s final return. The commissions received by Paige’s mother were included in her income. The commissions Paige received are not includible in Paige’s mother’s income, even on her final return. Paige must include them in her income. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 18: Decedent, Estate, and Trust Income Tax Returns 18.3 INCOME TAXATION OF ESTATES AND TRUSTS Tax is imposed on taxable income of a trust or estate at the following rates for 2023: Fiduciary Taxable Income Brackets Applicable Rate $ 0 – $ 2,900 10% > 2,900 – 10,550 24% (+ $290) > 10,550 – 14,450 35% (+ $2,126) > 14,450 37% (+ $3,491) Fundamentals 1. Following are some basic definitions and a discussion of filing requirements: a. A simple trust is formed under an instrument having the following characteristics: 1) Requires current distribution of all its income 2) Requires no distribution of the res (i.e., principal) 3) Provides for no charitable contributions by the trust b. A complex trust is any trust other than a simple trust. A complex trust can 1) Accumulate income, 2) Provide for charitable contributions, and 3) Distribute amounts other than income. c. 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. 1) A trust is considered a grantor trust when the grantor retains a greater than 5% reversionary interest. 2) Under Sec. 677(a), a grantor is treated as the owner of a trust, the income of which may be distributed or accumulated for the grantor’s spouse (without the approval or consent of an adverse party). 3) The grantor is also taxed on income from a trust in which the income may be applied for the benefit of the grantor. a) Use of income for the support of a dependent is considered the application of income for the benefit of the grantor. b) Under Sec. 677(b), however, the 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. 4) The grantor or other owners with substantial interests have not given up complete dominion and control over the trust property. The trust is not considered a separate legal entity for tax purposes. 5) All revocable trusts are grantor trusts. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 7 d. The rules for classifying trusts are applied on a year-to-year basis. e. An estate with gross income greater than or equal to $600 is required to file a tax return. A trust is required to file a return if it has either any taxable income or more than $600 of gross income. 1) The trustee, executor, or administrator must file the return no later than the 15th day of the 4th month after the close of the entity’s tax year. 2) Form 1041, U.S. Income Tax Return for Estates and Trusts, must be used. 3) If a domestic estate has a beneficiary who is a nonresident alien, the representative must file a return regardless of income. 4) Estate gross income includes the gain from the sale of property (not gross proceeds). 2. An estate may adopt any tax year ending within 12 months after death. a. Most trusts must adopt a calendar tax year. b. Tax-exempt and wholly charitable trusts may qualify to use a fiscal tax year. c. A beneficiary includes his or her share of trust income in his or her return for his or her tax year in which the trust’s tax year ends. 1) When distributions are made is irrelevant. 3. Any permissible accounting method may be adopted. 4. The alternative minimum tax applies to trusts and estates. It is determined in the same manner as for individuals. Principal vs. Income 5. Tax is imposed on taxable income (TI) of trusts and estates, not on items treated as fiduciary principal. a. State law defines principal and income of a trust or estate for federal income tax purposes. 1) Many states have adopted the Revised Uniform Principal and Income Act, some with modifications. a) The act and state laws provide that the trust instrument controls designations of fiduciary principal and interest components. b) The act and state laws also provide default designations. b. Generally, principal is property held eventually to be delivered to the remainderman (the person who inherits or is entitled to inherit the property). 1) Income is return on, or for use of, the principal. It is held for or distributed to the income beneficiary. a) Principal is also referred to as the corpus or res. 2) Change in form of principal is not taxable income. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 18: Decedent, Estate, and Trust Income Tax Returns Allocation of Fiduciary Receipts and Disbursements Principal Income Receipts Consideration for property Business income (e.g., gain on sale) Insurance proceeds for lost profits Replacement property Interest Nontaxable stock dividends Rents Stock splits Dividends (taxable) Stock rights Extraordinary dividends Liquidating dividends Taxable stock dividends Depletion allowance Depletion allowance (natural resource property) - (natural resource property) - Royalties (90%) Royalties (10%) Disbursements Principal payments on debt Business (ord. & nec.) expenses Capital expenditures (e.g., interest expense) Major repairs Production of income expenses Modifications (e.g., maintenance or repair, Fiduciary fees (e.g., insurance, rent collection fee) management of principal) Tax on fiduciary income Tax on principal items Depreciation (e.g., capital gains) Fiduciary fees (e.g., probate court fees and costs) Income Tax Formula 6. TI of a trust or an estate is computed similarly to that of an individual. a. Gross income is computed as for individuals. 1) It includes dividends, interest, rents, royalties, gain from the sale of property, and income from business, partnerships, trusts, and other sources. b. Life insurance proceeds are generally includible in the value of the gross estate but are not considered income of the estate. c. Income in respect of a decedent is also taxed as income if it is received by the estate. d. Capital gains are taxed to the estate; then the gain must be added to the principal of the estate. e. Losses from a passive activity owned by the estate or trust cannot be used to offset portfolio income (interest, dividends, royalties, annuities, etc.) of the estate or trust in determining taxable income. f. AGI does apply to fiduciaries for purposes of computing deduction limits. 1) The standard deduction is not allowed. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 9 g. Deductions. Deductions generally follow those allowable to an individual. Trustee, or administrator, fees and tax return preparation fees are deductible in full if not deducted on the estate tax return. 1) Depreciation. In default of a trust instrument designation, the act charges depreciation to income. a) Absent provisions in the estate instrument apportioning the deduction, the allowable amount must be allocated between the estate and each beneficiary in proportion to the amount of fiduciary income taxable to each party. b) Trusts. The trust may deduct depreciation only to the extent a reserve is required or permitted under the trust instrument or local law, and income is set aside for the reserve and actually remains in the trust. i) Any part of the deduction in excess of the trust income set aside for the reserve is then allocated between the parties according to the trust instrument. ii) If the instrument is silent, allocation of the excess between the trust and each beneficiary is in proportion to the amount of fiduciary income taxable to each. 2) Fiduciary NOLs are computed without regard to charitable contributions or distribution deductions. Carryover by the fiduciary is permitted. a) Pass-through for deduction on personal returns of beneficiaries is allowed only in the year the trust or estate terminates. b) Pass-through NOLs and capital loss carryovers are used to calculate the beneficiary’s AGI and taxable income. c) Estates can claim a deduction for an NOL. The NOL is calculated in the same manner as an individual taxpayer’s deduction, except that an estate cannot deduct any distributions to beneficiaries or charitable contributions in arriving at the NOL or NOL carryover. d) An unused NOL in the final year of the estate may carry over to the beneficiaries succeeding to the property of the estate. 3) A fiduciary may deduct a capital loss to the extent of capital gains plus $3,000. Carryover is permitted. 4) Charitable contributions are deductible only if the governing instrument (e.g., trust) authorizes them. Deductions are not subject to limits based on AGI. 5) Expenses attributable to tax-exempt income are not deductible. 6) Personal exemption. A deduction is allowable but not for the year the trust or estate terminates. The amount is $600 for an estate, $300 for a simple trust, and $100 for a complex trust. h. Credits. Gross regular tax of a fiduciary is offset by most of the same credits available to individuals. 1) Certain “personal” credits are unavailable. a) A fiduciary, for example, has no dependents. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 18: Decedent, Estate, and Trust Income Tax Returns Distribution Deduction 7. The deduction for distributions allocates TI of a trust or estate (gross of distributions) between the fiduciary and its beneficiaries. a. Simple trust. The deduction is the lesser of the amount of the distributions (required) minus net tax-exempt income or distributable net income (DNI) minus tax-exempt interest. Calculating Income Distribution Deduction of Trusts Figure 18-1 Visual Memory Aid: For candidates who are visual learners, the figure above and the description below can aid in recalling how the trust distribution deduction is calculated. Trusts can have mighty high tax rates. That is why it is advantageous to calculate the income distribution deduction, so the income is taxed at the individual rate, which is lower. The trust fund baby illustrated above is receiving income via the vacuum cleaner with the word “deduct” on it. If the baby receives the money, the baby will pay tax on that income. The distribution deduction will be the lesser of the items on the scale: The distributable net income (DNI) versus the required distribution (RD). The image above is © Dugger Corcoran Illustrations, LLC. Reprinted with permission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 11 1) Generally, DNI is current net accounting income of the fiduciary reduced by any amounts allocated to principal. Calculating Net Income of Simple Trusts Figure 18-2 Visual Memory Aid: For candidates who are visual learners, the figure above and the description below can aid in recalling how net income is calculated for simple trusts. Distributable net income (DNI) = Taxable income – Capital gains + Tax-exempt income The fisherman illustrated above is hauling in “net” income. Taxable income and tax-exempt income are “stuck” in the net and are included in net income. However, a fish escapes with a capital gain “cap” and dives into the body of water. Remember to subtract capital gains when calculating DNI for simple trusts. The body of water should remind you of “corpus” (i.e., body or principal) of the trust instrument. If capital gains are allocable to the corpus, they are excluded from DNI calculation. The image above is © Dugger Corcoran Illustrations, LLC. Reprinted with permission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 12 SU 18: Decedent, Estate, and Trust Income Tax Returns b. Estates and complex trusts. The deduction is the lesser of DNI (minus tax-exempt interest) or distributions. 1) The amount distributed is the lesser of the FMV of the property or the basis of the property in the hands of the beneficiary. 2) The trustee(s) of a complex trust may elect to treat distributions made during the first 65 days of the (trust’s) tax year as if they were made on the last day of the preceding tax year. 3) Specific bequests distributed or credited to a beneficiary in no more than three installments are not included as amounts distributed. 4) The fiduciary recognizes no gain on distribution of property unless an estate executor so elects. 5) A fiduciary’s basis in distributed property is transferred, along with adjustments for any gain recognized, to the beneficiary. Every $1 of value distributed is treated as if (first) from any current DNI. a) The instrument might allocate the $1 to current income, accumulated income, or principal. b) Principal (after DNI) is distributed tax-free. Distributable Net Income (DNI) 8. DNI is the maximum deductible at the fiduciary level for distributions and the maximum taxable at the beneficiary level. It is taxable income of the fiduciary (trust or estate), adjusted by the following items: TI of fiduciary (before the distribution deduction) + Personal exemption deduction ($600 estate, $300 simple trust, $100 complex trust) + Capital gain allocated to beneficiaries + Tax-exempt interest minus any related expenses + Charitable deduction adjustment, Form 1041 Schedule A + Capital losses allocated to principal – Capital gains allocated to principal – Taxable stock dividends allocated to principal – Extraordinary dividends allocated to principal = DNI a. Expenses directly related are allocated first (e.g., interest expense allocated to taxable and exempt interest income). The remaining balance is used to allocate indirect expenses to all income. b. No adjustment to fiduciary TI is made for the following: 1) Dividends, other than as previously noted 2) NOL deductions 3) Depreciation, if a reserve is established and all income is not distributable 4) Certain expenditures charged to principal, such as trustee fees a) They reduce income taxable to the beneficiary. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 13 9. Beneficiary’s Taxable Income Simple Trust a. A beneficiary of a simple trust is taxed on the lower of the two amounts listed below. 1) Trust income required to be distributed (even if not distributed) 2) The beneficiary’s proportionate share of the trust’s DNI Estates and Complex Trusts b. A beneficiary of an estate or a complex trust is taxed on amounts of fiduciary income required to be distributed plus additional amounts distributed to the beneficiary. 1) The taxable amount is limited to the beneficiary’s share of DNI. Character c. The character of the income in the hands of the beneficiary is the same as in the hands of the trust or estate. EXAMPLE 18-7 Tax-Exempt Income from a Simple Trust A simple trust distributes all its $10,000 income to its sole beneficiary. Its DNI is also $10,000. Included in the trust income was $1,000 of tax-exempt income. The beneficiary treats $1,000 of the income from the trust as tax-exempt interest and excludes it from his or her personal gross income. Schedule K-1 d. Schedule K-1 (Form 1041) is used to report the beneficiary’s share of income, deductions, and credits from a trust or an estate. The income is reported on the beneficiary’s tax return for the year in which the trust or estate year ends. 1) Schedule K-1 also contains detailed content that is required for the taxpayer to calculate the qualified business income deduction. 10. Trusts and estates are required to remit payments of estimated tax. The required amount and due dates of installments are determined in the same manner as for individuals. a. An estate is not required to pay estimated tax for its first 2 tax years. b. A trustee may elect to treat any portion of an estimated tax payment by the estate as made by the beneficiary. 1) The amount would also be treated as paid or credited to the beneficiary on the last day of the tax year. c. An estate of a domestic decedent or a domestic trust that had no tax liability for the full 12-month preceding tax year is not required to make estimated tax payments in the current year. 11. Most estate and trust income tax returns are due on April 15. An extension of up to 5 1/2 months may be granted. Penalties Failure to Provide K-1 to Beneficiaries Late Filing or Recipients of Property Distribution 5% (of tax), per month up to 25% $310 (per failure) up to $3,783,000 15%, per month up to 75% if fraudulent ($1,261,000 for small businesses with More than 60 days late, minimum gross receipts ≤ $5 million) per year equals lesser of $485 or tax due Greater of $630 or 10% of reportable items, without any limit if failure is intentional Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 14 SU 18: Decedent, Estate, and Trust Income Tax Returns 12. In general, the U.S. owner of a foreign trust is taxed on the income of that trust. a. A U.S. person is treated as the owner of a foreign trust under the grantor trust rules, which include someone who transfers assets to a foreign trust that has a U.S. beneficiary of any portion of the trust. 1) Each U.S. owner should receive a Foreign Grantor Trust Owner Statement (Form 3520-A), which includes information about the foreign trust income (s)he must report. b. In general, the U.S. beneficiary of a foreign trust will report his or her share of foreign trust income to the extent it is not reported by the transferors to the trust under the grantor trust rules. 1) The U.S. beneficiary should receive a Foreign Grantor Trust Beneficiary Statement (Form 3520-A) or a Foreign Non Grantor Trust Beneficiary Statement, which includes information about the taxability of distributions the beneficiary has received and foreign trust income the beneficiary must report. c. Gain on certain transfers of appreciated assets to a foreign trust must be recognized. Net Investment Income Tax (NIIT) 13. Under PPACA, estates and trusts are subject to the NIIT, at a rate of 3.8%, if they have undistributed net investment income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins ($14,450 for 2023). a. Net investment income includes interest, dividends, capital gains, rental and royalty income, and nonqualified annuities. EXAMPLE 18-8 NIIT -- Return of Principal As beneficiary, a taxpayer chooses to receive $100,000 of life insurance proceeds in 10 annual installments of $11,000. Each year, the taxpayer can exclude from his or her income $10,000 ($100,000 ÷ 10) as a return of principal. The balance of the installment, $1,000, is taxable as interest income. EXAMPLE 18-9 NIIT -- Interest Income The face amount of a policy is $200,000, and as beneficiary a taxpayer chooses to receive annual installments of $12,000. The insurer’s settlement option guarantees the taxpayer this amount for 20 years based on a guaranteed rate of interest. It also provides that extra interest may be credited to the principal balance according to the insurer’s earnings. The excludable part of each guaranteed installment is $10,000 ($200,000 ÷ 20 years). The balance of each guaranteed installment, $2,000, is interest income to the taxpayer. The full amount of any additional payment for interest is income to the taxpayer. EXAMPLE 18-10 NIIT -- Reportable Gross Income Under the terms of the will of Gerald Peters, $5,000 is to be paid to his widow each year and $2,500 is to be paid to his daughter each year out of the estate’s income during the period of administration. There are no charitable contributions. For the year, the estate’s DNI is only $6,000. The DNI is less than the currently distributable income, so the widow must include in her gross income only $4,000 [($5,000 ÷ $7,500) × $6,000], and the daughter must include in her gross income only $2,000 [($2,500 ÷ $7,500) × $6,000]. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 15 EXAMPLE 18-11 NIIT -- Reportable Gross Income Henry Frank’s will provides that $500 be paid to the local Community Chest out of income each year. It also provides that $2,000 a year is currently distributable out of income to his brother, Fred, and an annuity of $3,000 is to be paid to his sister, Sharon, out of income or corpus. Capital gains are allocable to corpus, but all expenses are to be charged against income. Last year, the estate had income of $6,000 and expenses of $3,000. The personal representative paid $500 to the Community Chest and made the distributions to Fred and Sharon as required by the will. The estate’s DNI (figured before the charitable contribution) is $3,000. The currently distributable income totals $2,500 ($2,000 to Fred and $500 to Sharon). The income available for Sharon’s annuity is only $500 because the will requires that the charitable contribution be paid out of current income. The $2,500 treated as distributed currently is less than the $3,000 DNI (before the contribution), so Fred must include $2,000 in his gross income and Sharon must include $500 in her gross income. EXAMPLE 18-12 NIIT -- Reportable Gross Income Assume the same facts from Example 18-11, except the estate has an additional $1,000 of administration expenses, commissions, etc., chargeable to corpus. The estate’s DNI (figured before the charitable contribution) is now $2,000 ($3,000 – $1,000 additional expense). The amount treated as currently distributable income is still $2,500 ($2,000 to Fred and $500 to Sharon). The $2,500 treated as distributed currently is more than the $2,000 DNI, so Fred has to include only $1,600 [($2,000 ÷ $2,500) × $2,000] in his gross income and Sharon has to include only $400 [($500 ÷ $2,500) × $2,000] in her gross income. Fred and Sharon are beneficiaries of amounts that must be distributed currently, so they don’t benefit from the reduction of distributable net income by the charitable contribution deduction. 14. If no charitable contribution is made during the tax year, distributions should be treated as consisting of the same proportion of each class of items entering into the computation of DNI as the total of each class bears to the total DNI. EXAMPLE 18-13 NIIT -- Gross Income Allocation Steve’s estate has DNI of $3,000, consisting of $1,800 in rents and $1,200 in taxable interest. There is no provision in the will or local law for the allocation of income. The personal representative distributes $1,500 each to Jim and Ted, beneficiaries under Steve’s will. Each will be treated as having received $900 in rents ($1,800 × 50%) and $600 of taxable interest ($1,200 × 50%). EXAMPLE 18-14 NIIT -- Gross Income Allocation Assume that the will from Example 18-13 provides for the payment of the taxable interest to Jim and the rental income to Ted and that the personal representative distributed the income under those provisions. Jim is treated as having received $1,200 in taxable interest and Ted is treated as having received $1,800 of rental income. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 16 SU 18: Decedent, Estate, and Trust Income Tax Returns 15. If a charitable contribution is made by an estate and the terms of the will or local law provide for the contribution to be paid from specified sources, that provision governs. If no provision or requirement exists, the charitable contribution deduction must be allocated among the classes of income entering into the computation of the income of the estate before allocation of other deductions among the items of distributable net income. EXAMPLE 18-15 NIIT -- Reportable Gross Income The will of Harry Thomas requires a current distribution from income of $3,000 to his wife, Betty, each year during the administration of the estate. The will also provides that the personal representative may distribute the balance of the current earnings either to Harry’s son, Tim, or to one or more designated charities. Last year, the estate’s income consisted of $4,000 of taxable interest and $1,000 of tax-exempt interest. There were no deductible expenses. The personal representative distributed the $3,000 to Betty, made a contribution of $2,500 to the local heart association, and paid $1,500 to Tim. The DNI for determining the character of the distribution to Betty is $3,000. The charitable contribution deduction to be taken into account for this computation is $2,000 ($5,000 estate income – $3,000 currently distributable income). The $2,000 charitable contribution deduction must be allocated as follows: $1,600 [($4,000 ÷ $5,000) × $2,000] to taxable interest and $400 [($1,000 ÷ $5,000) × $2,000] to tax-exempt interest. Betty is considered to have received $2,400 ($4,000 – $1,600) of taxable interest and $600 ($1,000 – $400) of tax-exempt interest. She must include the $2,400 in her gross income. She must report the $600 of tax-exempt interest, but it is not taxable. The entire charitable contribution must be taken into account to determine the amount to be included in Tim’s gross income. The currently distributable income is greater than the estate’s income after taking into account the charitable contribution deduction, so none of the amount paid to Tim must be included in his gross income for the year. EXAMPLE 18-16 NIIT -- Income Distribution Deduction An estate has DNI of $2,000, consisting of $1,000 of dividends and $1,000 of tax-exempt interest. Distributions to the beneficiary total $1,500 {$750 of dividends [$1,500 distribution × ($1,000 dividends ÷ $2,000 DNI)] and $750 of tax-exempt interest [$1,500 distribution × ($1,000 tax-exempt interest ÷ $2,000 DNI)]}. The income distribution deduction is limited to $750, because no deduction is allowed for the tax- exempt interest distributed. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 18: Decedent, Estate, and Trust Income Tax Returns 17 18.4 FRAUDULENT TRUSTS 1. All trusts must comply with the tax laws as set forth by the Congress in the Internal Revenue Code (IRC), Secs. 641-685. a. Trusts established to hide the true ownership of assets and income or to disguise the substance of financial transactions are considered fraudulent trusts. b. Abusive techniques used to reduce income taxes include 1) Depreciating personal assets (such as a home); 2) Deducting personal expenses; 3) Splitting income over multiple entities, often filed in multiple locations; 4) Underreporting income; 5) Avoiding filing returns; 6) Wiring income overseas and failing to report it; and 7) Attempting to protect transactions through bank secrecy laws in tax haven countries. c. Violations of the IRC may result in civil penalties and/or criminal prosecution. 1) Civil sanctions can include a fraud penalty up to 75% of the underpayment of tax attributable to the fraud in addition to the taxes owed. 2) Criminal convictions may result in fines up to $250,000 for individuals ($500,000 for corporations) and/or up to 5 years in prison for each offense. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].