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:
From these distinctive aspects of estates and trusts, three basic questions arise:
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).
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.
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:
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:
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:
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
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:
DNI can generally be thought of as accounting income from an 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.
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:
2. Complex Trusts, IRC 661 and 662:
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:
Grantor trusts are broken down into several common types:
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:
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:
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:
Functions of Estate:
Estate is Liable For Tax On:
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:
The Internal Revenue Code authorizes several types of trusts which address specific situations, and therefore have individualized rules. Some of these are the following: