Tenth Annual Probate Administration

November 13, 2014

Chapter 10 2:00-2:30pm Estate Income Tax Issues Tiffany R. Gorton, Kutscher Hereford Bertram Burkart PLLC There is no PowerPoint for this Presentation Electronic format only:

1. Estate Income Tax Issues

Estate Income Tax Issues

Tiffany Gorton

I. Overview

Estates and trusts are treated as separate taxpaying entities. Subchapter J of the

Internal Revenue Code governs taxation of estates and trusts. The rules governing the

income taxation of estates and trusts are very complex. The basic issues are:

• What items should be taxed;

• What person should be taxed on such items; and

• How and when should they be taxed.

There is a conflict between the basic income tax principal that excludes gifts and

devises from taxation yet includes the income generated from such gifts and devises.

IRC Section 102(a) provides the general rule that the following transfers are NOT subject

to income tax of the recipient:

• Gifts

• Devises

• Bequests

• Inheritances

These fit within the general definition of gross income as “all income from whatever

source derived.” They qualify as “undeniable accessions to wealth, clearly realized and

over which the taxpayer has complete dominion.”1 However, IRC Section 102(a)

specifically excludes them from the income of the recipient. On the other hand, IRC

1 Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)

Section 102(b)(1) specifically provides that a person who receives income from a gift,

devise, bequest or inheritance generally must income that income in his or her gross

income for income tax purposes.

For example, mom gives daughter her rental house, which is worth $350,000. Daughter

does not include the value of the rental house in her gross income. Daughter receives

$12,000 in rental income from the tenant who rents the rental house. Daughter must

include the $12,000 rent in her gross income.

There are two important points to remember:

1) If property passes through an estate to a beneficiary pursuant to the decedent’s

will, the bequest or devise is not included in the recipient beneficiary’s

income.

2) If property held by an estate produces income, that income must be included

in the gross income of either the estate or the estate beneficiaries.

Trusts and estates are taxed, for the most part, in the same manner as individuals

except as provided by Subchapter J.2 Subchapter J essentially provides modifications or

exceptions to the rules of income taxation that govern individuals in order in order to

apply such rules to the taxation of trusts and estates. The major exception is that trusts

and estates are allowed a deduction for certain distributions made to beneficiaries,

making trusts and estate pass-through entities because the beneficiaries are required to

report as income the amount deductible as a distribution for the estate or trust. The result

is that sometimes trusts and estates are treated as taxable entities like individuals and

other times they are treated as pass-through entities like partnerships or S corporations.

2 IRC Section 641(b)

II. Income Taxation Rules for Estates and Trusts

A. Estate Defined

Subchapter J does not specify what constitutes a trust or estate. IRC Section 641

refers to:

• Income received by estates of deceased persons during the period of

administration or settlement of the estate,

• Income accumulated or held for future distribution under the terms of the

will, and

• Income which, in the discretion of the fiduciary, may either be distributed

to the beneficiaries or accumulated.

For purposes of Subchapter J a decedent’s estate includes an intestate estate as well as a

testate estate subject to administration. For income tax purposes, the decedent’s estate

only includes only property subject to probate administration. This is different than

property or interests included in the decedent’s estate for estate transfer tax purposes.

Estates come into existence for federal income tax purposes at the decedent’s

date of death, even though probate administration of the estate doesn’t begin until some

time later. The estate continues as a separate entity until the estate has been administered

and settled. The estate generally terminates for federal income tax purposes when the

final distribution of estate assets is complete.

B. Taxation of Complex Trusts and Estates

A complex trust is any trust that is not a simple trust. All estates are characterized as

complex trusts. The rules for complex trusts are found in IRC Sections 661 and 662. A

complex trust is a trust:

1) that is not required to distribute all of its income currently;

2) from which amounts other than income are paid, credited or required to be

distributed; or

3) from which amounts are paid, permanently set aside or used for the purposes

specified in IRC Section 642(c) (relating to charitable contributions)

C. Distributable Net Income (DNI)

Distributable Net Income (DNI) is a limitation on the amount the trust or estate can

deduct with respect to distributions to beneficiaries. DNI is calculated as follows:

Estate (Trust) Gross Income (includes all capital gains)

<Estate (Trust) Deductions>

Adjusted Total Income

+Adjusted Tax-Exempt Interest

<Capital Gains>

Distributable Net income (DNI)

DNI measures the taxable income that may be passed through to the trust or estate to the

beneficiary and also determines the character of the income received by the beneficiary.

D. Income Distribution Deduction

The income distribution deduction equals the lesser of 1) the actual distribution to the

beneficiaries and 2) DNI (less adjusted tax-exempt interest).

E. Taxable Income of Estates

Taxable income of an estate consists of gross income minus deductions and is

computed in the same manner as for individuals.3 If the deductions exceed the gross

income for the year, the excess deduction will be flow through to the beneficiaries if the

estate has terminated during that year. Otherwise, only capital loss carryovers and net

operating losses will be preserved and carried forward to the next year.4 Once taxable

income of an estate is determined, the income tax imposed under IRC Section 1(e) can be

computed.

Some of the items enumerated in IRC Section 61, which are included in gross

income and are common to estates include:

• Interest

• Dividends

• Royalties

• Gross income derived from business

• The distributive share of a partnership’s gross income

• Income from an interest in an estate or trust

• Income from life insurance and endowment contracts

• Gains derived from dealings in property

• Income in respect of a decedent

3 IRC Section 641(b) 4 IRC 642(h)

F. Deductions

Generally, an estate is entitled to the deductions allowed to individuals with

specific modifications. Some of the deductions allowed to an estate include expenses for

the following:

• Ordinary and necessary expenses incurred in a trade or business (IRC

Section 162)

• Expenses incurred for the production of income (IRC Section 212)

• Interest expense (IRC Section 163)

• Taxes (IRC Section 164)

• Losses (IRC Section 165)

• Bad debts (IRC Section 166)

• Depreciation and depletion (IRC Section 167, 168, 611 and 642(e))

• Charitable contributions (IRC Section 642(c))

• Net operating losses (IRC Section 172, 642(d))

• Special personal exemption for estates and trusts (IRC Section 642(b)

G. Annual Estate Income Tax

As stated above, estates come into existence upon the death of the decedent and

continue until final distributions are made. If an estate is complex or if there is litigation

involving the estate, it may remain open for several years after the decedent’s death.

During the time the estate is being administered, income is generated and expenses are

paid.

An estate reports income and deductions on the Form 1041, similar to the way an

individual reports his or her income on a Form 1040. An estate is required to file a Form

1041 when its annual income exceeds $600. Unlike with individuals, an estate does not

have a standard deduction. An estate may elect to have either a calendar year or a fiscal

year. The calendar year income tax return is due on April 15 of each year. A fiscal year

income tax return is due on the 15th day of the fourth month after year-end. Note that an

estate is exempted from making estimated tax payments for its first two tax years.

2014 Tax Rate Schedule Estates and trusts, if line 6 of the Estimated Tax Worksheet above is: Over— But not over— The tax is: Of the amount over— $0 $ 2,500 15% $0 $2,500 $5,800 $375 + 25% $2,500 $5,800 $8,900 $1,200 + 28% $5,800 $8,900 $12,150 $2,068 + 33% $8,900 $12,150 - - - - - - $3,140.50 + 39.6% $12,150