INCOME TAXATION OF TRUST

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INCOME TAXATION OF TRUST ESTATES

• SUBCHAPTER J
• WILLIAM A. SNYDER
• NICHOLAS E. CHRISTIN

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CHAPTER 1Introduction to Subchapter J
Calculation of FAI
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ROADMAP

• This presentation should enable you to
  understand
• In basic terms, how a simple trust, complex trust
  and estate are taxed
• How to allocate receipts and disbursements to
  income or principal
• Basic considerations in selecting a tax year for
  estates and trusts
• How will a beneficiary be taxed on a distribution
  from a trust or estate

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ROADMAP

• Strategies to fully utilize deductions
• Tax consequences on funding various trusts with
  appreciated property and
• When a beneficiary receives appreciated assets
  what are tax consequences in terms of gain
  recognized and basis to the beneficiary.

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HYBRID TAXATION

• Income will be taxed to either Fiduciary or
  Beneficiary
• EITHER/OR model of Taxation
• No income will be double taxed

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TAX RATES

• Prior to 1986, estates and trusts reached their
  highest marginal income tax bracket at or about
  the same level as single taxpayers.
• For 2010, estates and trusts reach their highest
  marginal bracket at 11,200 of taxable income,
  whereas taxpayers filing joint returns reach
  their highest marginal bracket at 373,650.

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Section 641(b)

• Computation Payment
• The taxable income of an estate or trust shall
  be computed in the same manner as in the case of
  an individual, except as otherwise proved in this
  part

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FIDUCIARY ACCOUNTING INCOME (FAI)
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DEFINITION OF INCOME

• 643(b)
• For purposes of this subpart and subparts B, C,
  and D, the term income, when not preceded by
  the words taxable, distributable net,
  undistributed net, or gross, means the amount
  of income of the estate or trust for the taxable
  year determined under the terms of the governing
  instrument and applicable local law.

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Section 643(b)

• Section 643(b) directs us first to
• GOVERNING INSTRUMENT LOCAL LAW.
• The presentation will focus on FLORIDA law, but
  out-of-state-ers will substitute their applicable
  state law here.
• In FLORIDA we look to the
• UNIFORM PRINCIPAL AND INCOME ACT
• (Codified in Chapter 738)
• HOWEVER

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GOVERNING INSTRUMENT TRUMPS!

• For Allocation of Income Principal ALWAYS look
  to governing instrument first, even before STATE
  LAW
• If Fiduciary granted discretion in instrument,
  discretion trumps state law.

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Section 643(b)

• IF there is no discretionary power and no
  provisions in the governing instrument, then the
  UNIFORM PRINCIPAL INCOME ACT applies in
  Florida.
• If there is no rule in the UNIFORM PRINCIPAL
  INCOME ACT that pertains to a receipt or charge,
  then the DEFAULT allocation is to PRINCIPAL.

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UNIFORM PRINCIPAL INCOME ACT

• Used to calculate FAI
• Tells us HOW to characterize the RECEIPTS and
  EXPENDITURES of the estate or trust as INCOME or
  PRINCIPAL.
• Trusts are unique in that they have both INCOME
  and PRINCIPAL beneficiaries.
• IF a receipt is determined to be income, the
  income beneficiary will benefit to the detriment
  of the principal beneficiary.

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INCOME VS. PRINCIPAL
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ITEMS ALLOCATED TO PRINCIPAL

• ITEMS allocated to Principal
• 1. To the extent not allocated to income under
  the UPIA, assets received from a transferor
  during the transferors lifetime, a decedents
  estate, a trust with a terminating income
  interest, or a payor under a contract naming the
  trust or its trustee as a beneficiary.
• 2. Money or other property received from the
  sale, exchange, liquidation, or change in form of
  a principal asset, including realized profit
• EXPENSES allocated to Principal
• 1. Commissions on sale of an asset
• 2. Cost of capital improvements

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ITEMS ALLOCATED TO INCOME

• For FAI Income is a NET amount
• INCOME
• 1. interest from bonds
• 2. certificates of deposit
• 3. cash dividends from stock
• 4. rental income from real estate
• 5. items of ordinary income
• EXPENSES
• 1. income taxes, property taxes
• 2. maintenance costs

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SPLIT ALLOCATION

• FIDUCIARY FEES and ADMINISTRATION EXPENSES for
  trusts are typically SPLIT equally between Income
  Principal, unless specifically allocated by
  State law or the governing instrument.

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CHAPTER 2Calculation of Gross Income
Tentative Taxable Income
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TAXABLE YEARS OF TRUSTS ESTATES

• Election under 645 with respect to Qualified
  Revocable Trusts (QRT)
• Factors to consider when selecting an estates
  year end

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TENTATIVE TAXABLE INCOME

• TTI TAXABLE INCOME DISTRIBUTION DEDUCTION
• TTI is an intermediate step in calculating DNI
• Section 63(a) says
• TAXABLE INCOME
• GROSS INCOME DEDUCTIONS

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ITEMS EXCLUDED FROM GROSS INCOME

• SECTION 102 (a)
• GROSS INCOME does NOT include property acquired
  by gift.
• SECTION 102(b)
• Once property starts to generate income,
• then it will be taxed.
• ALSO excluded from gross income
• 1. Life insurance proceeds
• 2. Tax-exempt interest
• 3. Other items listed in code Section 103-139A

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DEDUCTIONS

• SECTION 63 STANDARD DEDUCTION
• There is NO standard deduction for a trust. ?
• SECTION 642 - PERSONAL EXEMPTION
• 100 - Complex Trust
• 300 - Simple Trust
• 600 - Estate

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DEDUCTIONS

• SECTION 642(C ) CHARITABLE DEDUCTION
• 642( C) is not as limited as 170
• Charitable Deduction is
• allowable up to the amount
• of GROSS INCOME.

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DEDUCTIONS

• SECTION 642(C ) CHARITABLE DEDUCTION
• Donation MUST be distributed pursuant to terms
  of the governing instrument
• No deduction allowed for distreibututions
  of amounts other than gross income,
  such as tax exempt income or corpus.

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DEDUCTIONS

• SECTION 212 DEDUCTION
• EXPENSES INCURRED IN THE PRODUCTION OF INCOME
• I.E. Basic Administrative Expenses
• Unlike 162 for trade or business expenses,
• 212 expenses in excess of income
• do NOT create a net operating loss
• and are WASTED in a non-final year.

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DEDUCTIONS

• SECTION 167 DEPRECIATION DEDUCTION
• Section 167 is governed by the Regulations
• GENERAL RULE
• DEPRECIATION FOLLOWS
• INCOME.

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DEDUCTIONS

• SECTION 67(e) KNIGHT V. COMMISSIONER
• QUESTION TO SUPREME COURT
• Are investment advisory fees incurred
• to administer a trust deductible without
• regard to the 2 floor?
• ANSWER NO! They are not unique
• to trusts and are subject to the 2 floor.

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DEDUCTIONS

• PROPOSED REGULATIONS UNDER 67(e)
• UNIQUE OR NOT UNIQUE?
• Under the proposed Regs, Trustees must separate
  trust administration expenses into those that are
  unique to trusts and those that are not
• Referred to as UNBUNDLING

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DEDUCTIONS

• EXPENSES ALLOCABLE TO TAX-EXEMPT INTEREST
• Deductions that would be allowable to an estate
  or trust are DISALLOWED to the extent they are
  attributable or apportioned to
• TAX-EXEMPT INCOME

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DEDUCTIONS

• Section 642(g)
• DISALLOWANCE OF DOUBLE DEDUCTION
• NO DOUBLE DIPPING!

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DEDUCTIONS

• DIRECT INDIRECT EXPENSES
• ALLOCATION OF DEDUCTION RULES
• All deductible items directly attributable to one
  class of income are allocated thereto.
• Deduction that are not directly attributable to a
  specific class of income may be allocated to any
  item of income.

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DEDUCTIONS

• HUBERT REGULATIONS
• Treasury Regulation 20.2056(b) 4
• Used to determine the deductibility of
  transmission expenses that may be charged to
  the marital bequest if its a residuary bequest.
• MANAGEMENT vs. TRANSMISSION EXPENSES

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ILLUSTRATIONFOR CHAPTER 2

• SEE PAGE 19 OF MATERIALS

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CHAPTER 3Distributable Net Income
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DISTRIBUTABLE NET INCOME (DNI)

• DNI - the KEY to Subchapter J!

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DISTRIBUTABLE NET INCOME (DNI)

• DNI is both a QUANTITATIVE QUALITATIVE
  measurement
• QUANTITATIVE limitation of the deduction for the
  amount distributed to beneficiary
• QUALITATIVE characterization of the distributions
  (i.e. ordinary income or tax exempt)

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DISTRIBUTABLE NET INCOME (DNI)

• STEP ONE Find TTI
• STEP TWO Apply modifications in 643 to TTI to
  reach DNI.
• SIMPLIFIED CALCULATION
• TTI XXXX
• 643(a)(2)
• 643(a)(3 lt gt
• 643(a)(5) Tax Exempt Int.
• lt265 Exp.gt

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DISTRIBUTABLE NET INCOME (DNI)

• NO 651 or 661 DEDUCTION
• Because DNI serves as a QUANTITATIVE limit on
  the distribution deduction, DNI does NOT take
  into account the 651 distribution deduction for
  simple trusts, nor the 661 distribution
  deduction for complex trusts or estates.

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DISTRIBUTABLE NET INCOME (DNI)

• NO 642 PERSONAL EXEMPTION
• In order to prevent use of 2 personal exemptions
  (one for the Trust and one for the beneficiary),
  the Trusts personal exemption under 642 is not
  taken into account when calculating DNI.

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DISTRIBUTABLE NET INCOME (DNI)

• EXCLUSION OF CAPITAL GAINS
• GENERAL RULE capital gains and losses will be
  excluded from DNI.
• HOWEVER, like every general rule there is an
• EXCEPTION included in DNI if
• Capital gains are allocated to FAI, allocated to
  corpus, and paid, credited, or required to be
  distributed to any beneficiary, or allocated to
  corpus and paid, permanently set aside for
  charitable purposes under 642(c)

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DISTRIBUTABLE NET INCOME (DNI)

• ADD BACK NET TAX-EXEMPT INTEREST
• Net tax-exempt interest is tax exempt
  interest reduced by any amounts which
  would be deductible in respect of
  disbursement allocable to such interests but for
  the provisions of 265 (relating to disallowance
  of certain deductions).

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ILLUSTRATION FOR CHAPTER 3

• SEE PAGE 23 OF MATERIALS

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CHAPTER 4Simple Trusts
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WHAT IS A SIMPLE TRUST?

• THREE REQUIREMENTS
• Trust instrument must require ALL trust income be
  distributed currently
• Trust must make NO distributions from principal
  in the taxable year of the trust
• Trust must make no disbursements deductible as
  charitable contributions under 642(c)

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WHAT IS A COMPLEX TRUST?

• A Any trust that fails one of the simple trust
  requirements!
• A trust may be a simple
• trust one year and a
• complex trust in the
• next year, depending on
• whether it meets the
• three simple trust requirements.

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SIMPLE TRUSTS

• 651 Distribution Deduction
• Simple Trusts get a 651 Distribution Deduction
  for the FAI that the governing instrument
  requires it to distribute.
• LIMITATIONS on deduction
• 1. 651 Deduction limited by DNI
• 2. No deduction allowed for tax-exempt income

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SIMPLE TRUSTS

• 651 DISTRIBUTION DEDUCTION
• If FAI exceeds DNI, then the deduction shall be
  limited to DNI. For this purpose, the
  computation of DNI shall not include tax-exempt
  income and the deductions allocable thereto.

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SIMPLE TRUSTS

• 651 DISTRIBUTION DEDUCTION
• SIMPLIFIED CALCULATION
• 651(a) Starting Point FAI (See 643(b))
• 651(b) Limit DNI (See 643(a))
• 651(b) Adjust lesser of DNI or FAI by removing
  net items of tax exempt income.

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SIMPLE TRUSTS

• 652 POTENTIAL GROSS INCOME (GI) OF BENEFICIARY
• 652 determines the potential GI of a beneficiary
  which is the amount of income required to be
  distributed to a beneficiary.
• If FAI exceeds DNI, and there is only 1 income
  beneficiary, then beneficiary includes all of the
  DNI in GI.
• If there are multiple beneficiaries, the total GI
  includable by all beneficiaries is limited to DNI
  and the amount is prorated among the
  beneficiaries.

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CHARACTER RULES

• 652 (b) Characterization Rules
• Amounts reported in beneficiaries Gross Income
  shall have the same character in the hands of the
  beneficiary as in the hands of the trust.
• Beneficiaries are treated as receiving their pro
  rata shares of the NET items of DNI.

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CHARACTER RULES - 2

• SIMPLIFIED CALCULATION
• 652(a) of each bene X DNI 652(a) amount
  Total 652(a)
• 652(a) amount x Each Item of DNI/DNI

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NET TAXABLE AMOUNT TO BENEFICIARIES

• Once we know the character of each item of income
  under 652(b), we can determine the net amount
  taxable to beneficiaries.
• TAXABLE AMOUNT TAX-EXEMPT INCOME
• NET TAXABLE AMOUNT

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ILLUSTRATIONFOR CHAPTER 4

• SEE PAGE 30 OF MATERIALS

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CHAPTER 5Complex Trusts
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COMPLEX TRUSTS

• Q WHAT IS A COMPLEX TRUST?
• A ONE THAT IS
• NOT A SIMPLE TRUST!
• i.e. A trust that fails one
• of the three simple trust requirements

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COMPLEX TRUSTS

• Section 661 - Distribution Deduction for
  Complex Trusts Estates
• 661(a) gives the amount of the deduction
• 661(b) gives the amount of tax exempt interest
  in the amount distributed
• 661(c ) gives a limitation on the deduction by
  removing the amount of net tax exempt interest
  distributed

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COMPLEX TRUSTS

• 661 (a) creates a TIER system for beneficiaries.
  The total distribution deduction equals the sum
  of 661 (a) (1) amount and the 661 (a) (2)
  amount.
• TIER ONE BENEFICIARIES
• 661 (a) (1) amount is the amount that TIER ONE
  beneficiaries receive. The first TIER
  beneficiaries are beneficiaries who receive
  distributions of income required to be
  distributed currently. The first TIER
  distributions are deductible to the extent of
  DNI. They receive priority DNI allocations
  proportionally based on their share of FAI.

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COMPLEX TRUSTS

• TIER TWO BENEFICIARIES
• 661(a)(2) tells us that the second TIER
  beneficiaries receive any other amount properly
  paid or credited or required to be distributed
  for such taxable year. This includes
  discretionary distributions of income or corpus
  and mandatory distributions of corpus.
• The distributions to TIER TWO beneficiaries are
  also deductible to the trust to extend of DNI.
• They share pro-rata any left over DNI
• Any amount they receive in excess of DNI a
  102(a) tax-free GIFT!

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COMPLEX TRUSTS

• TAXABLE INCOME FOR COMPLEX TRUSTS
• is very similar to Simple Trust calculation
• TAXABLE INCOME
• TTI - 661 DISTRIBUTION DEDUCTION

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COMPLEX TRUSTS

• 662 Potential Gross income of Beneficiaries
• Beneficiaries are taxed on distributions ONLY to
  the extent that distributions carry out DNI.
• I.E. the upper limit of the taxable amount to the
  beneficiaries is DNI.

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COMPLEX TRUSTS

• 662(b) Character of Beneficiary Amounts
• As with Simple Trusts, the amounts from 662(a)
  will have the same character in the hands of the
  beneficiaries as they had in the estate or trust.
  
• 662(a) x each item of DNI
• DNI

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COMPLEX TRUSTS

• NOTE 65 DAY ELECTION
• Under 663(b), a trustee can elect to treat
  distributions made within the first 65 days of
  the taxable year of a complex trust as paid in
  the preceding year.

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ILLUSTRATIONFOR CHAPTER 5

• SEE PAGE 40 OF MATERIALS

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CHAPTER 6SPECIFIC BEQUESTS 663(a)
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SPECIFIC BEQUESTS 663(a)

• 663(a) EXCEPTION
• Under 663(a), distributions of specific sums of
  money or specific property are NOT considered
  amounts properly paid to beneficiaries for
  purposes of 661 or 662.
• Specific distributions are NEITHER deductible by
  the trust NOR taxable to the beneficiary.

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4 REQUIREMENTS OF 663(a)

1. The amount must be properly paid or credited as a
   gift or bequest
2. The gift or bequest must be specific (if in
   money, a specific sum of money, or if in
   property, specific property)
3. The fiduciary must in fact pay or credit the
   amount or property at once or in not more than
   three installments and
4. The gift or bequest must not be payable, pursuant
   to the terms of the governing instrument, only
   from the income

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ILLUSTRATIONFOR CHAPTER 6

• SEE PAGE 46 OF MATERIALS

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CHAPTER 7DISTRIBUTIONS IN KIND KENAN ISSUES
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DISTRIBUTIONS IN KIND

• KENAN V. COMMISSIONER
• A distribution of appreciated non-cash assets by
  a fiduciary in satisfaction of a pecuniary
  obligation triggers realization of GAIN by the
  trust or estate.
• I.E. included in gross income and tentative
  taxable income of the trust!
• I.E. In certain instances a distribution of
  property is treated as a sale or exchange
• HOWEVER . . .

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KENAN FRACTIONAL SHARES

• HOWEVER,
• If a formula gift or bequest (whether fixed under
  the terms of the document or ascertainable by
  formula) consists not of an amount of money, but
  instead a SHARE of all the entitys assets, Kenan
  does NOT apply.

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TWO-PART KENAN TEST

• TWO REQUIREMENTS FOR KENAN
• There must be an obligation
• to pay a specific amount of
• money or to transfer a specific
• property and
• 2. There must be a satisfaction of that
• obligation by a transfer of OTHER property

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KENAN CONSISTENT WITH EITHER/OR TAXATION SCHEME

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ILLUSTRATIONFOR CHAPTER 7

• SEE PAGE 49 OF MATERIALS

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CHAPTER 8643(e)(3) ELECTIONPULLING THE
TRIGGER
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643(e)(3) Election

• PULLING THE TRIGGER Prof. Calfee

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643(e)(3) Election

• GENERAL RULE When a Fiduciary distributes
  property in kind, this is generally NOT a
  realization event.
• EXECPTION Under 643(e)(3) a fiduciary CAN
  elect to treat an in-kind distribution (not in
  satisfaction of a pecuniary amount or in place of
  another assets) as a realization event, i.e. can
  elect to recognize gain to the trust or estate.

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643(e)(3) Election

• IN SUMMARY, 643(e)(3) does 3 things
• Determines amount of gain or loss to the entity
  recognized upon distribution to beneficiary
• Tells the amount distributed for purposes of 661
  deduction and 662 inclusion and
• Tells the basis of the property in the hands of
  the beneficiary.

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NO 643(e)(3) Losses

• Unlike in Kenan situations, 267 does NOT allow
  entities to trigger a 643(e) loss.
• ONLY gains may be recognized under
  643(e)

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643(e)(3) DNI

• AS A GENERAL, LOGICAL RULE
• Elective gains under 643(e)(3) do NOT enter
  into computation of DNI, because gain is taxed to
  the entity NOT the beneficiary.

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643(e)(3), 663(a) and Kenan

• If 663(a) applies,
• then 643(e)(3) does NOT apply.
• KENAN gains and losses are MANDATORY, while
  643(e)(3) gains are ELECTIVE.

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STRATEGY PLANNING WITH 643(e)(3)
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ILLUSTRATIONFOR CHAPTER 8

• SEE PAGE 55 OF MATERIALS

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CHAPTER 9TERMINATION
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PLAN AHEAD FOR EXCESS LOSSES AND DEDUCTIONS IN
YEAR OF TERMINATION
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642(h)

• Under 642(h), when an estate or trust terminates
  at a time when it has unused net operating losses
  or capital loss carryovers, or when it deductions
  
• exceed its gross income
• for the taxable year, unused
• deductions can be transferred
• to the Beneficiaries!

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SUMMARY ILLUSTRATION1

• SEE PAGE 59 OF MATERIALS