Subchapter J Federal Income Taxation of Estates and Trusts
By: Richard M. Colombik, JD, CPA
Bruce Willey, JD, CPA
Federal taxation of estates, trusts and the beneficiaries thereof present unique and complex circumstances which are not addressed by the three existing systems of federal taxation – individual, corporate, or partnership. The three aspects of estates and trusts that contribute to this complexity are:
- Generally, gifts and devises are not subject to federal income tax.
- Income from a gift or devise is subject to income tax for the beneficiaries.
- Estates and trusts are unique forms of property ownership under individual state laws, not federal law.
From these distinctive aspects of estates and trusts, three basic questions arise:
- who should be taxed;
- what should be taxed;
- when should the estate or trust be taxed
The issue of what items should be taxed incorporates the basic tenet that a gift or devise should not be taxed, but that the income derived from the gift or devise should be taxed. The issue of who should be taxed on distributions from an estate or trust involves several choices. For an estate, there are two choices: the estate or the estate?s beneficiaries.. For a trust, there are three choices; the grantor, the trust, or the beneficiaries of the trust. The issue of how and when taxation should occur involves general tax considerations, such as realization and characterization of income, as well as state law considerations.
Accordingly, Subchapter J of the Internal Revenue Code (26 USC §641 – §685) was drafted to provide special rules for taxing estates, trusts and their beneficiaries. The hybrid methodology of Subchapter J generally treats the estate or trust as a taxable entity, much like an individual, but it also allows for pass through items of income and deductions to the beneficiaries. The major exception is that an estate or trust is allowed a deduction for certain distributions it makes to beneficiaries. This deduction makes the estate or trust a pass-through entity because its beneficiaries are required to report as income the amount of the distribution deductible by the estate or trust.
Part I of Subchapter J (26 USC §641 – §685), outlines the income tax requirements for certain estates and trusts, and addresses the taxation of the estate?s or trust?s beneficiaries. . Part I does not apply to organizations which are not classified as a trusts under IRC §§ 301.7701-2, 301.7701-3, and 301.7701-4 of Chapter 26 (Regulations on Procedure and Administration). The six subparts of Part I of subchapter J are as follows:
Subpart A: General rules for taxation of estates and trusts.
Subpart B: Specific rules relating to trusts which distribute current income only.
Subpart C: Estates and trusts which may accumulate income or which distribute corpus.
Subpart D: Treatment of excess distributions by trusts.
Subpart E: Grantors and other persons treated as substantial owners.
Subpart F Miscellaneous provisions regarding limitations on charitable deductions, income of an estate or trust in case of divorce, and taxable years to which the provisions of subchapter J are applicable.
Subparts A through D relate to taxation of estates and trusts and their beneficiaries, but not to the trust corpus or income which is regarded by the Internal Revenue Code as being owned by the grantor or others.
Subpart E generally addresses rules for treatment of any portion of a trust where the grantor, or another person, is treated as the substantial owner.
Part II of subchapter J addresses the treatment of income in respect of decedents (not including employee trusts subject to subchapters D and F, chapter 1 of the Code, and common trust funds subject to subchapter H, chapter 1 of the Code).
Who Should Be Taxed?
General Rule: IRC § 641(a) imposes a tax on the income of estates and trusts. IRC §641(b) directs that this tax is to be computed in the same manner as that of an individual except as otherwise provided, and that such tax is to be paid by the trust?s or estate?s fiduciary.
Exception: If the grantor of a trust, or another party, holds an ownership interest or power over a trust described in IRC §671 ? §679, he or she is treated as the owner of the portion of the trust property over which the interest or power operates. To the extent the grantor is treated as the owner, the trust is not considered a taxable entity. Instead, the grantor takes into account the trust income, deductions, and credits, whether or not the grantor has the right to receive distributions from the trust. Although the trust must file a fiduciary income tax return, it is essentially an information return, rather than a return for a separate taxable entity. If the trust is treated as a disregarded entity, however, it is not required to file a separate income tax return, and such information is reported by the owner of such income.
What Should Be Taxed?
General Rule: IRC §641(b) directs that ?taxable income of an estate or trust shall be computed in the same manner as in the case of an individual, except as provided in this part.?
Initial Determination: As with the taxation of an individual, it must be determined whether or not the receipt of income is taxable income to the individual. If the answer is yes, then it is income to the estate or trust. If the receipt of income, would not be recognized by an individual or would be exempt from individual income inclusion, then the same treatment applies to the estate or trust, providing that the estate or trust meets the requirements for the non-recognition or exemption for such income.
Common Types of Taxable Income: Typically, gross income for estates and trusts consists of the following types of receipts:
- business income
- income from an interest in another estate or trust
- income from life insurance contracts
- property sales or transactions
- income in respect of a decedent.
Computation of Taxable Income: After an estate or trust?s gross income is calculated, excluding items otherwise excluded by the Code, the next step is to determine the proper deductions, as would be done with an individual taxpayer. IRC §642 is the primary Code section outlining the credits and deductions for estates and trusts. Gross income less allowable deductions produces the taxable income of the estate or trust. If the deductions exceed the gross income for the year, the excess deduction will flow through to the beneficiaries, but only if the estate or trust terminated during that year. Only capital loss carryovers and net operating losses will be preserved and carried forward to the next year, See Section 642(h).
Common Types of Deductions for Estates and Trusts:
- Trade or business expenses
- Relating to income producing activities and investments
- Interest paid or accrued on loans or indebtedness
- Net operating loss
- Administrative expenses
- Fees paid for professional services and advice
- Theft or casualty losses
- Depreciation, depletion, amortization
- Bad debt expense
- Charitable contributions, if authorized pursuant to the creation of the estate or trust
- Taxes paid by the estate or trust
When Is It Taxed?
Estates: An estate?s initial tax year begins on the date of the decedent?s death. The fiduciary, may elect to treat the first tax year as a short year ending on December 31. Alternatively, the fiduciary may opt to treat the first tax year as a full 12 month year. Either way, the tax year is selected by the fiduciary when the first return is filed.
Trusts: IRC §644(a) mandates that that trusts subject to Subtitle J adopt a calendar year tax year, with the exception of charitable trusts under IRC §501(a) of Section 4947(a)(1). However, grantor trusts will use the same taxable year as it?s grantor See, IRC §671.
Form: Form 1041 is the income tax return which estates and trust file with the Internal Revenue Service.
Requirement to File: Form 1041 only need be filed if:
- Estates: have $600 or more gross income, or, have any nonresident alien beneficiaries
- Trusts: have $300 for a trust required to distribute all income currently, whether a simple or complex trust, and $100 for all other trusts, or any trusts that have any nonresident alien beneficiaries
Filing Deadline: Calendar year estates and trusts must file Form 1041 by April 15 following the close of the tax year. Fiscal year estates and trusts must file Form 1041 by the 15th day of the fourth month following the close of the tax year.
Tax Rates: The 2006 rate schedule for estate and trust taxable income is:
If 2006 taxable income is: The tax is:
Not over $2,050 15% of taxable income
Over $2,050 but not over $4,850 $307.50 plus 25% of excess over $2,050
Over $4,850 but not over $7,400 $1,007.50 plus 28% of excess over $4,850
Over $7,400 but not over $10,050 $1,721.50 plus 33% of excess over $7,400
Over $10,050 $5,596.00 plus 35% of excess over $10,050
The Concept Of Distributable Net Income
As discussed above, taxable income earned by an estate or trust is taxable either to the estate or trust, or, to it?s beneficiary. The estate or trust is then allowed a corresponding deduction for income distributions made to its beneficiaries See, IRC §§§ 651, 652, and 661.
Distributable Net Income (DNI) is a relatively new concept in the tax code and serves the purpose of allocating income between the entity and it?s beneficiaries. In other words, DNI attempts to approximate the actual economic benefit received by the income beneficiaries, and is consequently the maximum amount upon which an income beneficiary can be taxed, even if distributions exceed the amount of DNI . Distributions to a beneficiary in excess of DNI are typically treated as tax free distributions of corpus, principal.
DNI is defined by IRC §643(a) as the taxable income of an estate or trust computed with the following modifications:
- No deduction for distributions taken under §§ 651 or 661.
- No deduction for personal exemptions under IRC §642(b).
- Capital Gains or Losses are excluded if allocated to corpus and not paid, credited, or required to be distributed to any beneficiary and not paid or permanently set aside for charitable purposes.
- Extraordinary dividends and taxable stock dividends allocable to corpus are excluded.
- Tax-exempt interest is included, but reduced by deductible amounts for disbursements See, IRC §§§103, 212, and 265.
- Foreign Trusts must include income from sources within the United States.
DNI can generally be thought of as accounting income from an estate or trust:
- Regardless of whether the income is taxable or tax-exempt,
- That is distributable to beneficiaries,
- Less estate and trust expenses and deductions.
- For which the beneficiaries receive the tax character as held by the estate or trust
Insufficient DNI: If DNI is less than the income required to be distributed to the beneficiaries, then the available DNI is distributed proportionally to the beneficiaries according to each person?s share of the estate or trust.
An accrual for a cash based estate or Trust
The 65 Day Rule: Under IRC §663(b), estates and trusts have the option of using the first 65 days of the subsequent tax year to distribute to beneficiaries amounts payable from the prior tax year, while still receiving the allowable deduction for the distribution in the prior tax year. This is equivalent to allowing an accrual for distributions made to a beneficiary, 65 days after the year ends, even though such distribution was not made in the current year.
Types Of Trusts And Their Taxation
Trusts are not specifically defined by the Code. However, treasury regulations do recognize that the general purpose of a trust is to protect and foster the growth of the trust property for the beneficiaries. Treas. Reg. §301.7701-4(a).
Whether or not a trust itself is taxed under Subchapter J, or passes all of its income through to its beneficiaries, depends on the elements of the trust. The Internal Revenue Code sets out the guidelines for this determination by differentiating between what are commonly referred to as Simple and Complex Trusts See, IRC §651 and §661.
1. Simple Trusts, IRC §651:
- All income is required to be distributed and taxed to the beneficiaries to the extent of DNI.
- Have no taxable income.
- Have no charitable beneficiaries.
- IRC §652 addresses how the DNI and deductions of the Simple Trust are included in the gross income of the simple trust beneficiaries
- Income generally retains same character in hands of beneficiary as that of the Trust.
2. Complex Trusts, IRC §661 and §662:
- Any trust that does not qualify as a Simple Trust.
- Deductions allowed for the sum of any income required to be distributed currently and any other amounts properly paid or credited or required to be distributed.
- Deduction is limited to DNI computed without the charitable contribution deduction for first tier beneficiaries.
- The deductible amount is considered to consist of the same proportion of each class of items entering into the computation of DNI as the total of each class.
- Charitable contributions decrease taxable income in arriving at DNI only for second tier beneficiaries.
- IRC §662 addresses inclusion of income by beneficiaries of complex trusts, and income generally retains same character in hands of beneficiary as that of the Trust.
Regardless of whether a trust is Simple or Complex, it can be further broken down into two categories, Grantor or Non-Grantor Trusts.
1. Grantor Trusts: These are the most well-known type of trusts. These trusts are valid legal entities under state law, but because the degree of control retained by the grantor, they are not recognized as entities separate from their beneficiaries for income tax purposes. However, grantor trusts at times are required to file an informational fiduciary income tax return, Form 1041. Generally, a grantor trust is one that:
- Distributes all or part of its income to the grantor,
- Requires the trust property be returned to the grantor at trust termination,
- The Grantor can revoke at his or her sole option, or
- Otherwise gives the grantor sufficient control over the trust so that he or she is considered its owner for income tax purposes.
Grantor trusts are broken down into several common types:
- Trusts with prohibited powers held by the grantor or spouse IRC §672.
- Reversionary trusts – the grantor or spouse retains a reversionary interest that enables him to recover the possession or enjoyment of property transferred if at the inception of the trust, the value of that reversionary interest exceeds 5% of the trust’s value. IRC §673.
- Grantor Controlled Trusts – the grantor retains control of the beneficial enjoyment of trust income or principal or retains certain administrative powers usable for his benefit. IRC §674 & §675.
- Revocable Trusts – the grantor reserves the power to terminate the trust and take back the trust principal. IRC §676.
- Income Benefit Trusts – the grantor or spouse can or does benefit from the trust income. IRC § 677.
- Trusts controlled by persons other than the grantor – the trustee, beneficiary or other person has the power to take the trust principal or income or use it to pay his legal obligation for support or maintenance. IRC §678.
- Certain foreign trusts – the corpus of a foreign trust is transferred, in part or in whole, by a US person and the trust has a US beneficiary. The US transferor is taxed currently on the foreign trust’s income when the funds are being accumulated for a US beneficiary. IRC §678.
2. Non-Grantor Trusts: A trust under which the grantor does not retain significant control or benefits, will be taxed as a separate entity under Subchapter J. Common types of these trusts are:
- Business Trust – the beneficiaries created a trust to conduct a business activity which typically would have conducted through a corporation or a partnership. Treas. Reg. §301.7701-4(b).
- Land or Real Estate Trust – primary purpose is to own and manage real property.
- Investment Trust – a trust that ?facilitate(s) direct investment in the assets held by the trust? or a trust that is ?substantially equivalent to undivided interests? in the corpus. Treas. Reg. §301.7701-4(c)(2) The regulations state that an ?investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate holders.? Treas. Reg. §301.7701-4(c)(1).
- Liquidating Trust – a trust ?organized for the primary purpose of liquidating and distributing the assets transferred to it.? Treas. Reg. §301.7701-4(d). The entity will be taxed as a separately ?if its activities are all reasonably necessary to, and consistent with, the accomplishment of that purpose.? Treas. Reg. §301.7701-4(d).
- Environmental Remediation Trust – a trust created for environmental cleanup of land which is currently in need of clean up. Treas. Reg. §301.7701-4(e)(1).
- Escrow Accounts and Settlement Funds – generally, money held in an escrow account in contemplation of a land purchase, or settlement of a lawsuit, is not treated as trust. However, if the person or entity managing this money is performing functions customary to those of a trustee, then the IRS may deem that a trust exists. See generally, IRC §468B.
Note Single Trust vs. Multiple Trusts: An individual may create more than one trust during the course of his or her life. If multiple trusts are created, then IRC §643(f) determines whether the trusts will be respected individually for tax purposes or combined into one tax paying entity. IRC §643(f) may treat multiple trusts as one tax paying entity if any of the following factors are met:
- The trusts have ?substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries,? or,
- If ?a principal purpose of such trusts is the avoidance of the tax imposed by this chapter.?
- Note, that a husband and a wife are treated as one person, be it one grantor or one beneficiary.
Income Taxation Of Estates
Like trusts, estates are legal entities that are created to manage property for a specific purpose. Per IRC §641(a)(3), Subchapter J only applies to estates of deceased persons. Therefore, bankruptcy estates, guardianships, conservatorships, UTMA accounts, and the like are not subject to Subchapter J.
Elements of Estate Subject to Subchapter J:
- Legal entity separate from deceased,
- Existence begins on the date of death,
- Holds only property of deceased which is subject to probate,
- Terminates when all such probate property is completely distributed to the beneficiaries.
Functions of Estate:
- Organize and ascertain probatable assets of deceased,
- Pay debts and taxes of deceased,
- Distribute assets of deceased,
- Account for assets of deceased.
Estate is Liable For Tax On:
- All Income earned on the deceased probatable assets during the time that the assets were held by the estate, regardless of its source. This may include but is not limited to interest, business income, wages earned before death, rental proceeds, pension or retirement payments, etc.
- Capital gains (or losses) from sale/exchange of capital asset held by estate. Gains and losses are automatically long term.
Election to Treat Revocable Trust as Part of Estate: IRC §645 allows a deceased?s qualified revocable trust (QRT) to be treated as part of the estate, according to the following guidelines:
- Both executor of estate and trustee of QRT trust must agree on election
- Election Form 8855 must be filed by due date of first Form 1041
- Trust must have clearly been a QRT, (grantor/deceased had power to revoke)
Specific Rules For Income Taxation If Estates And Trusts
The Internal Revenue Code authorizes several types of trusts which address specific situations, and therefore have individualized rules. Some of these are the following:
- Alaska Native Settlement Trusts: IRC §646 contains very specific provisions and guidelines for qualifying trusts which elect to be treated within this section.
- Charitable Remainder Trust: Addressed by IRC §664, this is a split-interest trust that provides income to the grantor or other non-charitable beneficiaries, while granting the remainder interest to charity.
- Pooled Income Fund: Is a trust within IRC §642, which is maintained by a public charity. The trust maintains property donated by multiple contributors in a single fund, while donors retain life income interests and the charity receives an irrevocable remainder interest in the donated assets.
- Qualified Disability Trust: A trust which provides financial assistance to disabled beneficiaries without disqualifying them from medical assistance. General trust tax rules apply although qualifying trusts are allowed an exemption amount equal to the exemption amount for unmarried individuals. See, IRC §642(b)(2)(C).
- Electing Small Business Trust: Under IRC §641(c), some trusts can qualify to own Subchapter ?S? stock by electing to be treated as a small business trust. The ?S? portion of the trust is treated as a separate trust and taxed at the highest trust rate with no exemption.
- Foreign Trust with at Least One US Beneficiary: IRC §679 directs that United States citizens who transfer property to a trust based in a foreign country, are still treated as the owner of the contributor?s share of the trust, as long as the trust has at least one United States beneficiary.