Estates and nongrantor trusts must file income tax returns just as individuals do, but with some important differences. For one, their income is taxed at either the entity or beneficiary level depending on whether it is allocated to principal or allocated to distributable income, and whether it is distributed to the beneficiaries. And because their exemption amounts, tax brackets and related thresholds haven’t been indexed for inflation or modified for tax relief to the extent those for individuals have, they can be subject to higher tax rates at much lower levels of income. With the new Medicare tax on investment income on the highest tax brackets, estates and trusts pay still more taxes on incomes over $11,200, as opposed to $200,000 or $250,000 for individuals.
In this and other ways, the Patient Protection and Affordable Care and the Health Care and Education Reconciliation acts of 2010 (PL 111-148 and PL 111-152, respectively) affect trusts’ and estates’ income taxes and have introduced discrepancies that tax practitioners can review with their clients who administer trusts and estates. This article reviews some strategies for more tax-efficient allocation of income and principal by trusts and estates.
Income tax accounting for trusts and estates has received relatively little attention from tax professionals as well as lawmakers. This is not surprising because of the comparatively few taxpayers affected. In the 2008 tax year, approximately 3 million Forms 1041, U.S. Income Tax Return for Estates and Trusts, were filed, with an aggregate gross income of $188 billion. Aggregate taxable income and tax liability were $112 billion and $23 billion, respectively (IRS Statistics of Income, Fiduciary Returns–Sources of Income, Deductions, and Tax Liability). Compared with more than 142 million individual income tax returns (forms 1040, 1040A or 1040-EZ) reporting more than $8 trillion in gross income (IRS Statistics of Income, Individual Income Tax Returns, Preliminary Data, 2008), these are small numbers.
In addition, income taxation of estates and trusts does not generate much public interest—unlike the estate and gift tax, which has been subject to much debate within the professional community as well as in government and among the general public. As a consequence, practitioners and their clients may not be aware of several tax issues related to estates and trusts. However, as this article demonstrates, careful planning that takes these issues into account is no less important than for other types of returns and can reap significant tax benefits.
FIDUCIARY ACCOUNTING AND INCOME TAXES
Income of estates and nongrantor trusts is taxed at either the entity or the beneficiary level, depending on the answer to the following two questions:
Is each income, loss or deduction item part of the trust’s or estate’s distributable income, or is it part of a change in the principal?
Is the income, loss or deduction item distributed to the beneficiaries, or does the entity retain it?
Fiduciary accounting has been characterized as somewhat similar to governmental accounting because it deals with a fund (the trust principal) and income derived from the fund.
CASE STUDY: THE JSA TRUST
The hypothetical Jon and Susan Anders Family Trust (“JSA Trust”) reports the following income for 2010: rental income of $25,000; qualified dividend income of $12,000; municipal bond interest income of $5,000 (tax-exempt); and long-term capital gains of $60,000. Expenses are a trustee fee of $1,000; depreciation deductions of $2,000; tax return preparation fees of $450; and rental expenses of $6,250. Rental income, dividends and interest are considered trust income and will be included in accounting income (generally, all income as determined under the terms of the governing instrument and state law—IRC § 643(b)). Long-term capital gains, on the other hand, are part of the trust principal and are not included in accounting income. Thus, gross accounting income is $42,000 ($25,000 + $12,000 + $5,000).
The categorization of trustee fee and depreciation expenses depends on specifications in the trust instrument and state law. If the trust instrument is silent, state law prevails. If both are charged to the principal, net accounting income in our example is $35,300 ($42,000 + $450 + $6,250). Tax-exempt income is included in accounting income for purposes of allocating the trustee fee and depreciation deductions in determining taxable income but is excluded from taxable income.
The estate’s or trust’s taxable income is computed using the following formula:
Deductible trust expenses