Tax compliance issues for fiduciary entities are sometimes confusing to practitioners because many lack experience in the area of trusts and estates. Certain entities that are created for planning purposes exist separate and apart from individuals or businesses, and income in these entities needs to be accounted for and taxed if held within the entity itself.
This post discusses the basic definitions of estates, trusts, distributable net income and deductions. It also provides an overview of Subchapter J of the Internal Revenue Code (IRC), which deals with taxation of estates, trusts, beneficiaries and decedents. This information is essential for tax practitioners to properly fill out the Form 1041 to ensure tax compliance for clients who are fiduciary entities.
Estates Law Varies by State
Both state and federal law apply to estates. Federal Form 1041 – the U.S. Income Tax Return for Estates and Trusts, which is filed by a fiduciary to report the estate or trust’s income to the IRS – is prepared for an estate based on the applicable state definition of an estate.
“For state purposes, an estate is a legal entity established at the instance of death to protect and preserve all probate assets until the probate assets can be distributed to the individuals or entities who have a proper right to it,” according to taxation attorney Arthur Werner, in his recent webinar for Eli Financial on Form 1041.
“For federal purposes, the estate is the total of all assets owned or controlled by a decedent valued at their highest and best use” according to Internal Revenue Code § 2031, said Werner. IRC § 2033 includes in the gross estate all probate assets, and IRC §§ 2034-2044 include in the gross estate all non-probate assets. State law determines what is considered probate and non-probate, so this will vary by your location.
Classification of Trusts
A trust is a right of property, real or personal, held by one party for the benefit of another. A trust allows the bifurcation of an asset into legal title and equitable title: The trust holds the legal title to the asset, while the beneficiary holds the equitable title to the asset, according to Werner.
To understand the purpose of a trust and when and why to use one, practitioners must first understand the different types of trusts. All trusts can be specifically defined and classified by asking three specific questions of them, which are:
- How is the trust created?
- Inter-vivos (a separate legal document)
- Testamentary (within a last will and testament)
- Can the trust be changed, altered, amended or revoked?
- Yes (trust is revocable)
- No (trust is irrevocable)
- For federal income tax purposes, how is the trust classified?
Grantor, Simple and Complex Trusts
Under applicable state law, the grantor trust is a legal trust not recognized as a separate taxable entity for income tax purposes, and all income in this trust is taxed to the trustor or grantor and reported on the trustor’s Form 1040. All revocable trusts and some irrevocable trusts – which fall within IRC §§ 671-679 – are grantor trusts.
A simple trust instrument “requires that all income must be distributed currently and does not provide that any amounts are to be paid, permanently set aside, or used for charitable purposes and does not distribute amounts allocated to the corpus of the trust” according to the IRS.
A complex trust is a “trust that is not defined as a simple trust or a grantor trust under the Internal Revenue Code” according to the IRS.
Distributable Net Income (DNI)
“The income distribution deduction allowable to estates and trusts for amounts paid, credited, or required to be distributed to beneficiaries is limited to distributable net income (DNI),” according to the IRS, and “this amount is used to determine how much of an amount paid, credited, or required to be distributed to a beneficiary will be includable in his or her gross income.”
The income required to be distributed currently is income that is required under the terms of the governing instrument and applicable local law to be distributed in the year that it is received. The governing document language trumps local law. Only if the governing document is silent does local law control, according to Werner.
Checklist for Filing the Form 1041
Tax practitioners need to keep in mind the following requirements for filing Form 1041:
- When filing a Form 1041, estates may elect a fiscal year
- Trusts must adopt a calendar year except for:
- Certain charitable trusts (IRC § 501(a))
- Certain charitable trusts (IRC § 4947(a)(1)
- Grantor trusts (IRC §§ 671-679))
- A trust making the IRC § 645 election
- Every estate or trust required to file a Form 1041 is required to have a separate Employer Identification Number (EIN)
- Grantor trusts where the trustor and the trustee are the same may use the trustor’s Social Security Number as an identifying number; no 1041 is required
Taxation and Character of Income, and Deductions for Estates and Trusts
A general rule for income taxation is that income, if taxable at all, is only taxed once:
- To the trustor (if the trust is a grantor trust); or
- To the trust (or estate) itself; or
- To the beneficiary
A general rule with regard to the character of income is that the entity does not change the character of the income within it when the income leaves the entity:
- Tax-free income remains tax-free
- Ordinary income remains ordinary income
- Capital gains remain capital gains
Deductions are generally similar to those of individual income taxation with a few differences:
- Allocation of deductions to non-taxable income
- No standard deduction
- Loss carry-forwards will pass to beneficiaries at final return
In fiduciary accounting, the governing instrument is the key. When the governing instrument is silent, then state law applies, and if state law cannot address the issue, then common law controls, as per Werner. That requires a lot more research.
Distribution deductions are unique to income taxation of estates and trusts. Any amount of income that is properly distributed from an estate or a trust is deducted from the entity and is included as taxable income (in its character) to the beneficiary. The deduction is computed on Schedule B of Form 1041 and is limited to the lower of accounting income, taxable income or the actual distribution itself, said Werner.
Taking into account all these issues, tax practitioners should be able to handle basic trusts and estates tax work, but keep in mind: Your results will vary by state, and of course by your clients’ situations. Check out more resources for tax practitioners at Eli Financial.