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Financial Planning

Income Taxation of Trusts and Estates for Fortune 500 Employees and Retirees

 

How are trusts and estates taxed for purposes of the income tax?

Before discussing the tax implications of trusts and estates, we believe that all Fortune 500 employees and retirees should have a basic understanding of what trusts and estates are. You establish a trust when you (the grantor) transfer property to a trustee for the benefit of a third party. (The recipient). A decedent's estate comprises of his or her assets and liabilities. Similar to an individual, a trust and an estate are distinct, legal, tax-paying entities. Trust or estate revenue consists of income derived from the trust or estate property, such as rents collected from real estate.

How do trusts function within the taxation system? Is a query typically posed by Fortune 500 employees?

Who pays taxes on the income of a trust depends on who receives or retains trust benefits. (i.e., the trustee, beneficiaries, grantor, and power holder). Generally, trusts and estates are taxed similarly to individuals. The extent to which the same fundamental tax principles that apply to individuals also apply to trusts and estates has been a key factor in our Fortune 500 clients' tax-related strategic planning. A trust or estate is permitted to earn tax-free income and deduct certain expenses. A minor exemption is granted to each ($300 for a straightforward trust, $100 for a complex trust, and $600 for an estate). However, neither of these are eligible for a standard deduction. The income tax brackets for trusts and estates are substantially more condensed than those for individuals, which can result in higher taxes.

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Important Note: Fiduciary tax returns refer to trust and estate tax returns (Form 1041). This is because the fiduciary (executor or trustee) is frequently responsible for filing the tax return and paying any taxes owed. Trusts and estates may additionally be required to submit state income tax returns. Consult a lawyer or certified public accountant to ascertain your state's requirements.

What are the general rules regarding the taxation of trusts?

Generally, Trust Entities and Trust Beneficiaries Are Taxed on Income.

This inquiry is frequently posed by Fortune 500 employees. Income held by the trust is subject to taxation by the trust, while income distributed to beneficiaries is subject to taxation by the beneficiary. Consequently, either the trust or the beneficiary is taxed on trust income, but not both. This is the consequence of utilizing the concept of distributable net income (DNI).

Except Trusts of the Grantor-Type and Charitable Remainder Trusts

In order to educate and equip AT&T employees and retirees comprehensively, it is essential to note that the previously stated general rule has exceptions. There are two exceptions to the general norm. First, trust income is taxable to the grantor or powerholder if the grantor has retained an interest in the trust (e.g., right of revocation) or if another person has been granted a broad power of appointment over the income or principle of the trust. These are known as grantor-type trusts, and one example is a revocable trust in which the grantor is taxed on all income. Second, if the trust is a charitable remainder trust and the charity is tax-exempt, retained income is typically not taxable to the trust, whereas distributions are taxable to the beneficiaries.

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What are the general estate tax regulations?

The overwhelming majority of Fortune 500 customers' tax-related inquiries pertain to estate tax.

How Earnings Are Reported

  • Earnings of the decedent: If the decedent was a cash method taxpayer, any income received (actually or constructively) before death must be reported on their final Form 1040. If the decedent was an accrual taxpayer, the final Form 1040 must include income earned prior to death.

  • Profits from the estate: On the recipient's income tax return, income earned by the decedent but not paid previous to death is included. This income is known as the decedent's income. (IRD). IRD consists of uncollected wages, interest accrued on bank accounts, and declared but uncollected dividends. If the recipient of IRD is the decedent's estate, the executor must report it on Form 1041 (the federal tax return for fiduciaries). If the recipient is a beneficiary of an estate, the amount is deducted on Schedule B and reported on Schedule K-1 for inclusion on the recipient's tax return. Non-IRD income garnered by estate property after death and held by the estate is reported on the estate's tax return. (Form 1041). Other income (non-IRD) garnered by estate property after the decedent's death and paid to a beneficiary is deducted on Schedule B and reported on Schedule K-1 to the beneficiary for inclusion in the beneficiary's personal return.

  • Expenditure of the recipient: The beneficiary may obtain income (or income-producing property) directly from the decedent at the time of death. This income must be reported on the individual tax return of the recipient.

Which Deductions Are Permitted?

What deductions are permitted is a frequent concern raised by Fortune 500 employees regarding the estate tax. In general, estates have access to the same deductions available to individuals. Certain administration-related expenses may be deducted on either the estate tax return (Form 706) or the fiduciary return, but not both. Additionally, the personal representative may deduct a portion of an item on each return. The following deductions are allowed on Form 1040:

  • Court costs, bonds, and professional fees associated with the administration of an estate.

  • Expenses for selling estate property.

  • Property damage that is not covered by insurance

Tip: If administration expenses are deducted on Form 1041, attach two signed copies of a statement that lists those expenses and states, "These expenses have not been claimed as federal estate tax deductions, and the right to claim such deductions is waived." The waiver is irrevocable. Even if Form 706 is not required for the estate, this form must be filed.

Tip: The prohibition against double taxation does not apply to costs associated with a decedent. These expenses can be deducted on both Form 1041 and Form 706-E. Similarly, claims against the estate for amounts owed by the deceased at the time of death (such as state property taxes) may be deducted from both returns.

What Is Trust Income Regarding Income Taxes?

Given that trusts generate income, it is only natural that many of our Fortune 500 customers inquire about how this may affect their tax liability.

Accounting Income

Typically, trusts are created to provide an annual income to one beneficiary (the income beneficiary) while preserving the principal for another beneficiary. (The residual beneficiary). The income of the trust may include interest, dividends, ordinary income, or capital gain. The trust deed may specify which beneficiary will receive each revenue source.

Accounting income is used to determine the quantity that must be distributed to the income beneficiary. The income distribution deduction is used to calculate a beneficiary's taxable income. Accounting income impacts taxable income to the extent that it represents a limitation on the calculation of the income distribution deduction.

Accounting income is trust income that is allocated to the income beneficiary as opposed to the remainder beneficiary. Typically, a capital gain is added to the principal for the benefit of the remainder beneficiary. The accounting income of a trust may be specified in the trust deed; if not, it is governed by state law.

Example(s): The Jones Family Trust generates $10,000 in taxable interest income and $12,000 in capital gains in its first year. The trust's bookkeeping income is $10,000 (the taxable interest). $10,000 is mandated to be given to the recipient. The income distribution deduction for the trust is $10,000. The beneficiary's taxable income is $10,000. The $12,000 capital gain is retained by the trust, which will be taxed on it.

Tax-Exempt Income/Expense Allocation

Fortune 500 employees or retirees must be informed that, identical to an individual taxpayer, a trust can generate tax-exempt income. No deduction is available for expenses directly related to the generation of tax-exempt revenue. In contrast, all expenses directly related to the generation of taxable income are deductible. Allocation of indirect expenses to taxable and tax-exempt income. The calculation for this distribution is as follows: Non-deductible expenses as a percentage of taxable income equals gross tax-exempt income divided by gross accounting income. This aspect of trust tax has been essential to the tax strategies of many of Fortune 500's customers.

Gross Income

In terms of income tax, the gross income of a trust or estate is comparable to that of an individual. (including conventional income, capital gains, business income, and rental income). This may include funds to be delivered immediately or held for payment of expenses or future distributions; however, the beneficiary, trust, or estate may be taxed on the income.

Capital Gain

Many of our Fortune 500 customers understand the concept of capital gain tax, but are oblivious of its application to trusts. The capital gain is subject to taxation and must be reinvested or added to the principal. If the gain is distributed in reality, the recipient is taxed on it.

Caution: The gains from the sale or exchange of depreciable assets between related parties are categorized as ordinary income.

  • If losses exceed gains, the total loss is assigned to the trust. Capital losses may be subtracted from ordinary income (net loss or $3,000, whichever is less). Capital losses are able to be carried forward indefinitely. At the conclusion of the trust, any unused capital loss carryforwards may be transferred to the beneficiary.

Caution: A trust cannot deduct a loss from the sale or exchange of property between related taxpayers (such as the trustee and the grantor or the trustee and the beneficiary).

  • Basis: The basis (for gain or depreciation purposes) of property acquired by a trust or estate from a deceased person is the property's fair market value (FMV) on the date of death, unless an alternative valuation date was elected. Basis (for gain or depreciation purposes) of property acquired by a trust as a gift from the grantor is the adjusted basis of the grantor plus any gift taxes paid.

Caution: The basis of property acquired by a trust or estate in 2010 from a decedent who opted out of the federal estate tax would be modified rather than increased to FMV.

Which Tax Deductions May a Trust Claim?

Deductions Permitted

Numerous Fortune 500 employees with whom we interact inquire about allowable deductions. In general, fiduciaries have access to the same deductions as individuals.

These encompass:

  • State, local, and property taxes (frequently limited at $10,000)

  • Administrative costs (such as trustee fees)

  • Estate expenditures

Reductions Not Permitted

Unless a reserve exists, depreciation and depletion expenses generally follow income.

This cost must be divided between the trust and the beneficiary in the case of a trust. This is determined by the allocation of accounting income to each beneficiary, unless state law permits the trustee to maintain a reserve.

Deduction for charitable contributions: Charitable contributions paid from current trust income are only deductible if authorized by the trust deed or will. Donations from a trust's principal are not tax deductible.

Tip: A trust may choose to "push-back" a portion or the entire amount of a gift made with current-year income to the prior tax year. This election must be made by the filing deadline for the current year's tax return.

Tip: A small number of trusts qualify for the "set-aside" deduction. This means that a deduction can be claimed for funds set aside for charity but paid in a subsequent year.

What Is the Distribution of Income Deduction?

A trust may generally deduct an amount equal to the amount distributed to a recipient of income. This is known as the income distribution deduction. In particular, a trust's income distribution deduction is the lesser of the two quantities listed below:

  • Distributions minus tax-exempt income yields the distribution amount.

  • Distributable net income less tax-exempt income

Example(s): The Jones Family Trust received $10,000 in municipal bond income, $5,000 in CD interest, and $12,000 in capital gain in Year 1. The trust's tax-exempt income is $10,000. (interest accruing on municipal bonds). In addition, Fred received an additional $5,000 from the trust. The deduction for distributions of trust income is $5,000 ($15,000 - $10,000).

What Is Net Income Distributable (DNI)?

The distributable net income is a key factor when dealing with trust tax, and as a result, Fortune 500 employees and retirees find it to be of the utmost importance. The calculation of distributable net income (DNI) is used to allocate the income of a trust among its beneficiaries. DNI is utilized to limit a trust's ability to deduct payments made to a beneficiary. Beneficiaries are charged no more than their DNI.

Distributions in excess of DNI are classified as tax-free distributions of principal. Here is the DNI calculation:

  • Total quantity of trust income (taxable income excluded).

  • Fewer out-of-pocket expenses

  • In addition, expenses not included in the computation of taxable income and the portion used for charitable contributions reduce tax-exempt interest.

  • Plus capital gains if:

1. Income is recorded as profit

2. The trustee is required to distribute principal-allocated gain or routinely does so.

3. The principal's profit is donated or set aside for a charitable cause.

  • Capital losses are reduced if they are included in the calculation of any capital gain disseminated or required to be distributed.

A fundamental trust allocates and taxes DNI to the income beneficiaries. Taxable are only capital gains and other income remaining with the principal.

In a complex trust, DNI may exceed required current distributions if, for example, capital gains are included in DNI. First, DNI is allocated dollar-for-dollar to the current distribution of income recipients. The remainder of DNI is distributed proportionally to dividend and other payment recipients. To the extent of DNI, payments are considered to be derived from DNI. IRS regulations neither require nor allow the origin of a payment to be traced.

These restrictions are designed to prevent the trustee from manipulating distributions so that beneficiaries in higher tax brackets receive nontaxable distributions of principal while beneficiaries in lower tax brackets receive taxable income payments. Beneficiaries who receive distributions of principal may be required to report a portion of the payment as taxable income. Despite the appearance of double taxation, the capital gain tax is actually transferred to the beneficiaries.

Example(s): The Jones Family Trust received $10,000 in municipal bond income, $5,000 in CD interest, and $12,000 in capital gain in Year 1. The trust's taxable income and DNI total $17,000 ($5,000 plus $12,000). The trust's accounting income is $15,000 ($10,000 plus $5,000). In addition, the trust is required to distribute $5,000 plus 25% of the principal to Fred, 25% of the principal to Jack, and 50% of the principal to Sid on an annual basis.

Example(s): Fred receives $8,000 from the trust, while Jack receives $3,000 and Sid receives $6,000.

Example(s): Fred, the income recipient, is awarded the initial $5,000 in DNI. The remaining DNI is distributed in proportion to Fred, Jack, and Sid's respective shares.

For example, Fred's DNI of $8,000 is equal to $5,000 plus 25% of $12,000.

Jack (25 percent of $12,000) has a DNI of $3,000.

50 percent of $12,000 is $6000, so Sid will receive $6000.

Tip: Amounts required to be distributed are deductible in the current year, regardless of whether they were distributed. In contrast, discretionary distributions are typically only deductible in the year they are made. A trust may elect to treat distributions made during the first 65 days of the subsequent tax year as if they were made during the current tax year. (This is referred to as the 65-day norm).

What is the difference between simple and complex trusts, and how are they taxed?

A common misconception among many Fortune 500 customers is that all trusts are identical, but this is not the case. The two types of trusts are simple and complex, respectively.

Basic Trusts

 A straightforward trust is one that (1) is required to distribute and actually distributes all income in the same year it is received, (2) does not have a charitable beneficiary, and (3) does not distribute principal. A fundamental trust allocates and taxes DNI to the income beneficiaries. Taxable are only capital gains and other income remaining with the principal.

Example(s): Alan irrevocably transfers cash, securities, and bonds to the Alan B. Trust. The income interest in the trust provides Phoebe and Mona, Alan's children, with financial security. Alan's daughters receive an identical share of all interest and dividend income generated by the accounting department. The trust retains all capital gains realized. According to Alan's will, the trust will expire after twenty years, and the principal will be distributed to his two daughters and four grandchildren.

Multiple Trusts

A complex trust is one that is permitted to accumulate income, has a charitable beneficiary, or distributes principal. Estates are typically regarded as sophisticated trusts. DNI may exceed the instantaneous distribution requirement of a complex trust if, for instance, capital gains are included in DNI. First, DNI is allocated dollar-for-dollar to the current distribution of income recipients. The remainder of DNI is distributed proportionally to dividend and other payment recipients.

Example(s): Mary establishes an irrevocable trust for her only child, Adam (20 years old). The terms of the trust stipulate that the trust will retain all income until Adam reaches the age of 25. Adam will receive all existing income plus $150,000 in that year. The trust will continue to distribute all income to Adam until Mary's demise, at which time Adam will receive the principal.

Tip: A trust may be simple one year and complicated the next. The final year of a trust is complicated because the entire principal must be distributed upon termination. In years in which it actually distributes principal, a trust that is permitted but not required to do so is complex, whereas it is simple in years in which it does not. Even in years when no distributions are made, a trust that can either distribute or accumulate assets is always complex.

What are trusts of the grantor type and how are they taxed?

Numerous Fortune 500 employees have been affiliated with a Grantor Trust.

Trust with Grantor Retained Interest

A grantor trust is a trust in which the grantor retains control. The grantor is considered the proprietor of the trust's assets and is taxed on the income generated by the trust. If the grantor retains control over only a portion of the trust's assets, only those assets are attributed to the grantor, while income from other assets is taxed to the trust or beneficiaries. On Form 1041, the donor does not report taxable income. It is included on the grantor's Form 1040 individual tax return.

Supposedly, the grantor retains authority if he or she:

  • Insofar as the grantor receives benefits (directly or indirectly) from the trust, he or she is recognized as the owner of the income.

  • A revocable trust permits the grantor to revoke the trust in whole or in part. Within the scope of this authority, the grantor is recognized as the trust's owner.

  • Maintains control over pleasurable experiences: The trust's proprietor is a grantor who retains discretion over which beneficiaries receive income or principal.

  • The grantor could benefit from the trust if he or she has the authority to purchase principal for less than adequate consideration or to acquire funds without adequate collateral or interest. Within the scope of this authority, the grantor is considered the proprietor.

  • Retains a reversionary interest in either the income or principal: If the terms of the trust state that the trust "reverts back" to the grantor if the income or remainder beneficiary dies before the grantor, the grantor's income is taxable unless the value of the reversionary interest on the date of transfer is less than 5 percent of the trust.

  • A trustee can elect to pay tax on a qualified preneed funerary trust that would otherwise be considered a grantor trust. For a trust to qualify, it must be created through a contract with a professional funeral or burial service, and its primary purpose must be to hold and invest funds for such services.

Tip: A revocable trust may be included in the grantor's estate for that tax year upon the grantor's death. Prior to the due date of the estate's first income tax return, both the trustee and the estate representative must make this choice.

General Authority to Appoint

The holder of a general power of appointment over a trust is treated as the owner of the portion of the trust over which he or she holds the power, unless the grantor is treated as the owner under the grantor retained interest rules or the powerholder disclaims the power within a reasonable amount of time after discovering its existence.

How are they taxed?

We are aware that many Fortune 500 employees and retirees have charitable remainder trusts, so here is how these trusts are taxed differently. The income of a charity residual trust is ordinarily exempt from federal income tax, unless the trust includes unrelated business income, but taxable upon distribution to non-charitable beneficiaries. Special restrictions govern the income taxation of a charity remainder annuity trust (CRAT) and charitable remainder unitrust (CRUT). Any payments you receive as the income beneficiary of a CRAT or CRUT will be subject to income tax. While a CRAT or CRUT is exempt from paying capital gains tax on the sale of an asset, this benefit does not percolate down to you; you must pay income tax on any portion of the income allocated to you.

Recent changes in tax legislation have introduced a significant impact on the income taxation of trusts and estates, particularly for Fortune 500 employees and retirees. The Tax Cuts and Jobs Act (TCJA) of 2017 brought about several modifications, including adjustments to tax rates and brackets for trusts and estates. Under the TCJA, trust income is now subject to compressed tax brackets, with the highest tax rate of 37% being applicable at a much lower income threshold. This change has implications for the tax liability of trusts and estates, and it is crucial for individuals in this demographic to stay informed about the evolving tax landscape.

The degree of taxation depends on the nature of the payment, which is determined by a trust-specific method for calculating income tax. For determining the tax treatment of a beneficiary's income distribution, the IRS employs a four-tier accounting system, also known as the ordering principles. This accounting rule is represented by the abbreviation WIFO, which stands for "worst in, first out."

The following are the categories of distributions made by a trust:

  • Usual income consists of the current year's ordinary income plus any undistributed ordinary income from prior years (dividends and/or interest are examples of ordinary income).

  • Gain on capital: Gain on capital earned by the trust in the current year, in addition to any undistributed capital gains from prior years.

  • Nontaxable income is comprised of nontaxable income generated by the trust in the current year and any undistributed nontaxable income from prior years.

  • The Internal Revenue Service imposes the greatest rates of taxation on ordinary income. If the mandatory annual contribution cannot be covered by conventional income, capital gains are used as a substitute. If the payment cannot be made after depleting capital gains, it is made from tax-exempt income and, if necessary, from the principal of the trust.

Tip: In order to conduct these calculations, the trustee must keep track of all sales and gains realized by the trust, a laborious task that is typically handled by a computer tracking system.

Conclusion:

Managing the income taxation of trusts and estates can be likened to navigating a complex maze with shifting paths and hidden obstacles. Imagine you are an experienced explorer venturing through a labyrinth, representing the intricacies of the tax code. Each turn represents a different tax rule or provision, determining who is responsible for paying taxes and how income is allocated. The walls of the maze symbolize the various tax brackets and rates, which can be challenging to navigate. As a seasoned explorer, you must stay updated on the latest tax legislation, much like carrying a map that outlines the ever-changing tax landscape. By understanding the twists and turns of the maze, you can strategically plan your route to minimize tax liabilities and ensure that your hard-earned income is protected. Just as a skilled explorer relies on knowledge and careful planning to conquer the labyrinth, Fortune 500 employees and retirees must rely on expert advice and guidance to successfully navigate the complexities of trust and estate taxation. 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.

The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.

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