Time and again, CPAs and other accounting and tax professionals are faced with the unique income tax provisions related to trusts and estates. Aside from summarizing the general rules related to the income taxation of estates and trusts, this article highlights the impact of different legal authorities applicable to trusts. Further, it discusses issues related to some special trust and estate entities, namely, grantor trusts, pooled income funds, qualified subchapter S trusts (QSSTs), electing small business trusts (ESBTs), bankruptcy estates, and foreign trusts.
Understanding the uses of trusts generally requires an understanding of their purpose. Some trusts are formed for tax purposes, but others are formed to achieve specific wealth management goals. The first step in appreciating the difference is to examine their general principles of fiduciary income tax liabilities. Because trusts generally have much lower deductions, compressed marginal tax rates, and a much lower threshold for the net investment income tax, they may incur higher income taxes than individuals, especially if they retain current income.
TAXATION OF TRUSTS AND ESTATES
In general, estates' and nongrantor trusts' income is taxed in a manner analogous to that of individual taxpayers, with the following main differences:
- Trusts and estates (other than bankruptcy estates) do not get a standard deduction.
- These trusts and estates get an exemption, but only $100, $300, or $600, compared with the personal and dependency exemptions available to individual taxpayers (and bankruptcy estates) of $4,050 in 2017.
- Trusts and estates do get a deduction for trust income distributed to the beneficiaries, which is computed based on the actual distribution amount, distributable net income (DNI), and net accounting income (the latter two concepts are unique to trusts and estates and rely on an understanding of fiduciary accounting).
- Trusts and estates do have the same progressive tax rates as individuals, with the exception of the lowest 10% rate bracket, which exists only for individual taxpayers. However, compared with those of individual taxpayers, the tax brackets are very compressed, with the highest marginal tax rate of 39.6% starting at $12,500 in taxable income for 2017.
- Complex trusts and estates do not have a limitation for charitable contribution deductions from gross income. (Simple trusts cannot make charitable contributions.)
- The net investment income tax applies to trusts and estates based on a threshold at the highest tax bracket and not on a fixed dollar amount. Thus, in 2017, the net investment income tax for trusts and estates is levied on the lesser of net investment income or taxable income above the $12,500 threshold. (For individuals, the threshold is $250,000 for married couples filing jointly ($125,000 if married filing separately) or $200,000 for other taxpayers.)
- The top rate of 20% for net long-term capital gains and qualified dividends applies when income reaches the top marginal bracket for ordinary income of 39.6%; due to the relatively compressed brackets, this means the 20% rate goes into effect if taxable income of trusts and estates exceeds $12,500 in 2017. For individuals, the highest long-term capital gains rate does not apply for incomes below $235,350 (for married taxpayers filing separately) up to below $470,700 (joint filers).
Details of these differences and accounting for trusts and estates have been discussed in prior editions of the JofA (see "Income Tax Accounting for Trusts and Estates," JofA, Oct. 2010, and "Avoiding the Squeeze: Trusts, Estates, and the New ATRA Tax Regime," JofA, April 2014). Due to the compressed tax brackets and the net investment income tax, marginal rates can quickly reach 40% or greater. The progressivity for individual taxpayers, regardless of filing status, extends over much larger dollar amounts. Thus, reasons for creating trusts often go beyond tax strategies and involve asset protection, charitable contribution planning, and supporting minors (or other individuals not considered capable of making financial decisions). However, as discussed below, several trusts have been employed for some strategic tax planning.
LAWS GOVERNING TRUSTS
One of the more confusing items when dealing with estates and trusts is the impact of different laws aside from the federal income tax provisions. Generally, trusts are governed by a local version of the Uniform Trust Code (2000) (UTC) as adopted by the jurisdiction indicated in the trust or (if there is no designation) the jurisdiction with the most significant relationship to the matter at issue. In addition, a treatise published by the American Law Institute (Restatement of the Law Third, Trusts), as well as the Uniform Principal and Income Act (UPIA), may apply. State versions of the UTC and the UPIA are statutory; Restatement of the Law, Trusts, provides a summary of common law as it applies to trusts, as well as guidance when the laws in different jurisdictions conflict or when the local statutory law does not address a particular issue. Trusts must also follow the specifications laid out in their trust agreement. (Note: Oral trusts are possible, but in most states that adopted the UTC, they are recognized only if there is clear and convincing evidence supporting their creation.)
In most cases the trust agreement should be consulted first to determine how income and principal should be handled (and therefore accounted for and taxed). If the trust agreement is silent, state law (some form of either the UTC or the UPIA) applies. Thus, it is important to establish the situs of the trust, which is determined either by a provision in the agreement or by considering various factors such as the trustee's principal place of business or where the trust is (mostly) administered. As stated above, if the statutory local law is silent or unclear, one may want to research the issue via the Restatement of the Law, Trusts.
The interaction of different laws can be illustrated by contrasting language between a typical grantor trust agreement and a Nevada statute on trustee accounts. Grantor trust agreements frequently state, "Except to the extent required by law, the Trustee is not required to file accountings in any jurisdiction." Nev. Rev. Stat. Section 165.1207(1) requires the trustee to furnish an account to each beneficiary "[t]o the extent the trust instrument does not provide otherwise." In other words, an agreement could specify no filings, and since the statute defers to the trust agreement if it provides for no filings, in that case, no filings would be required in the state of Nevada.
Another issue introducing confusion and complexity are the various trust types. Besides situs, trusts can also be distinguished based on purpose or applicable law. For purposes of income tax accounting, the following distinctions are significant: simple versus complex trust, grantor versus nongrantor trust, and domestic versus foreign trust. Further, the tax law provides rules for special trusts such as ESBTs, pooled income funds, QSSTs, bankruptcy estates, and qualified revocable trusts (QRTs).
SIMPLE VERSUS COMPLEX TRUSTS
A trust qualifies as a simple trust if the trust instrument requires all income to be distributed currently, does not provide for any charitable contributions, and does not distribute amounts allocated to the trust corpus. Under Sec. 651(a), simple trusts get a deduction for the amount of income that must be distributed in the current year. The beneficiaries of a simple trust must include in their gross income the amount of the income required to be distributed currently, whether or not it is actually distributed.
If a trust does not qualify as a simple trust (i.e., accumulates income, makes distributions to charitable organizations, or distributes corpus (in addition to trust income)), the trust is no longer considered a simple trust, and the Sec. 661 rules concerning complex trusts apply.
GRANTOR VERSUS NONGRANTOR TRUSTS
Under grantor trust rules, trust income is taxed to the person creating and/or funding the trust if he or she retains power over trust corpus and/or income, such as determining the allocation of income or revoking the trust. This means that all trust income is reported on the grantor's tax return and not the trust income tax return. Most grantor trusts file Form 1041, U.S. Income Tax Return for Estates and Trusts, containing the basic trust information (name, address, taxpayer identification number); the amount that must be reported by the deemed owner of the trust is presented in a grantor tax information letter. In some situations, the grantor trust may file a Form 1099 instead of a Form 1041, which may simplify tax reporting if the trust does not have many types of income.
Compared with a nongrantor trust, a grantor trust offers several tax advantages, such as:
- Lower taxes due to the less compressed income tax brackets for individuals compared with those of trusts.
- If the grantor trust is considered owned by a U.S. taxpayer, it is eligible to be an S corporation shareholder.
- Any gain from the sale of a personal residence may qualify for the Sec. 121 exclusion.
Note that, due to the retained power and control, grantor trusts generally are included in the grantor's gross estate. However, since (in most cases) cumulative taxable transfers of less than $5.49 million (or $10.98 million for married couples) are excluded from wealth transfer taxes, this may not be as big a concern as when the exclusion was lower. However, tax planners should check the state inheritance and estate tax rules to determine possible state inheritance and wealth transfer tax consequences to the grantor.
POOLED INCOME FUNDS
Under Sec. 642(c)(3), a trust meeting the requirements of a pooled income fund (as defined in Sec. 642(c)(5)) gets a charitable contribution deduction for long-term capital gains earned in the current year and put aside for a future contribution to the charity receiving the remainder interest. This type of trust is created when several donors contribute an irrevocable remainder interest of property to a public charity or for charitable use, while retaining an income interest for the life of one or several individual beneficiaries.
The property contributed, which may not include tax-exempt securities, is commingled ("pooled") with similar property contributed by other donors. Pooled income funds must be maintained by the charity receiving the remainder interest. Any income distributions to beneficiaries terminate with their respective deaths. Income allocated to beneficiaries is based on the trust's rate of return for the current year and must be distributed in the current tax year (or within 65 days following its close).
QUALIFIED SUBCHAPTER S TRUSTS
The main benefit of a QSST is that it is treated as a grantor trust and therefore considered an eligible S corporation shareholder. To qualify, the QSST income beneficiary must make a proper and timely election, and the trust must distribute all income to a single individual beneficiary who is a U.S. citizen or resident. If the trust also distributes corpus, it must be allocated to the same income beneficiary. The interest terminates when the trust terminates or the beneficiary dies, and at that point principal and income must be distributed to the beneficiary (or the beneficiary's estate). The trust instrument must be specific and ensure that the QSST requirements are met when it becomes effective and cannot be violated in the future.
Depending on the type of transaction between the S corporation and the QSST holding the S corporation stock, either the beneficiary or the trust is considered the S corporation shareholder. For example, for purposes of the tax treatment of trust income, distributions, and basis adjustments, the beneficiary is treated like an S corporation shareholder. The beneficiary will report all S corporation income on the individual income tax return even if not all of it is distributed to the trust. On the other hand, if the QSST sells the S corporation shares, the QSST election terminates, and the trust (not the beneficiary) recognizes the gain or loss on the sale.
ELECTING SMALL BUSINESS TRUSTS
Similar to a QSST, an ESBT can be a shareholder of an S corporation if certain requirements are met. The main difference between an ESBT and a QSST is that an ESBT may have multiple income beneficiaries, and the trust does not have to distribute all income. Unlike with the QSST, the trustee, rather than the beneficiary, must make the election. To qualify as an ESBT, the trust must meet the following requirements:
- The beneficiaries must be either individuals, estates, or public charities;
- The trust cannot acquire the S corporation stock by purchase (it must be contributed to the trust);
- It cannot be a QSST;
- It cannot be a tax-exempt trust; and
- It cannot be a charitable remainder annuity trust or charitable remainder unitrust.
For purposes of the trust's meeting S corporation shareholder requirements, all potential current income beneficiaries of the ESBT count toward the maximum number of allowable shareholders.
For ESBTs that have assets other than S corporation stock, tax on each portion of ESBT income is determined separately for the "S" and the "regular trust" income. The S portion of the ESBT is treated like a separate trust, and its income is reported on a separate attachment to the return. S corporation income must be modified and does not allow for the exemption amount when determining alternative minimum taxable income and net capital losses. The S portion is taxed at the trust level, not the beneficiary level. The tax on the income is the highest rate for ordinary income or long-term capital gains, depending on the type of income. If the trustee does not materially participate in the S corporation activities, the net investment income tax also applies.
The non-S ESBT part is treated like normal trust income and reported on Form 1041. Distributions to beneficiaries are deductible for purposes of determining trust taxable income of the non-S part but only to the extent of DNI of the non-S part. If the distribution exceeds DNI and includes income that stems from the S corporation stock, this part of the income is not taxable to the beneficiaries. Note that these rules do not apply for ESBTs that meet the grantor trust rules.
When an individual taxpayer files a petition under either Chapter 7 (liquidation) or Chapter 11 (reorganization) of the Bankruptcy Code, a separate taxable entity, the "bankruptcy estate," is created. It is administered by a trustee (Chapter 7) or the debtor-in-possession (Chapter 11) and must file Form 1041 if it reaches a certain gross income threshold ($10,400 for single debtors in 2017). The administrator generally is in charge of the tax filings and must ensure that the estate receives its own employer identification number (the debtor's Social Security number is not acceptable).
Taxable income of the bankruptcy estate is determined using the same rules as for individual taxpayers (Sec. 1398(c)) and generally uses the same thresholds and phaseout amounts applicable to married taxpayers filing separately. The income that must be included in the estate, according to the Bankruptcy Code (11 U.S.C. Sections 541 and 1115), is income recognized during the period after the beginning and before the closing (or dismissal) of the bankruptcy case. It comprises:
- In Chapter 11 cases, but not in Chapter 7 cases, self-employment income and wages earned from services performed;
- Income generated from property of the estate that must be included in the bankruptcy estate; and
- Gains from the sale of bankruptcy property.
Note that income earned from property not included in (or dismissed from) the bankruptcy estate is not part of this entity's taxable income. Further, under Sec. 108(a), gain from debt forgiveness is not included in the bankruptcy estate's gross income. However, tax attributes to which the debtor succeeds after the termination of the bankruptcy estate are reduced by the amount of excluded gain in the following order: net operating losses, general business tax credit carryovers, minimum tax credit, capital losses, basis in depreciable and nondepreciable assets, passive activity loss and credit carryovers, and foreign tax credits.
Tax on the bankruptcy estate is assessed using the same tax rate schedule that is used for married taxpayers filing separately; if the estate does not itemize deductions, it gets a standard deduction of $6,350 (in 2017). The personal exemption is $4,050 (in 2016 and 2017).
SOME FOREIGN TRUST RULES
Any trust that is not a domestic trust (and therefore not subject to primary supervision of a court within the United States) is considered a foreign trust (Sec. 7701(a)(31)(B)). A trust is a domestic trust if (1) a court within the United States is able to exercise primary supervision over its administration, and (2) one or more U.S. persons have the authority to control all its substantial decisions.
If a foreign trust has a U.S. person as a beneficiary for any portion of the trust, any U.S. person directly or indirectly funding the trust will be treated as an owner or partial owner of the trust, and the grantor trust rules apply. The U.S. grantor will have to include in gross income the trust income attributable to the portion deemed owned. Grantor trust rules also apply if the U.S. transferor retains certain powers over the trust property and/or income.
However, if no U.S. taxpayer creates and/or funds the foreign trust, income could be distributed to U.S. beneficiaries tax-free if it were not for special rules in Sec. 672(f). These provisions were enacted to ensure that U.S. taxpayers who benefit from income earned in offshore accounts or from offshore assets pay an appropriate amount of U.S. tax. Under these rules, inbound trusts are treated as nongrantor trusts, and distributions of income to the U.S. beneficiaries are taxable to them. In addition, nonresident aliens who become U.S. residents within five years of funding a foreign trust directly or indirectly will generally be treated as making the transfer on their residency starting date.
If a nongrantor foreign trust earns U.S.-source or effectively connected income, it is required to file Form 1040NR, U.S. Nonresident Alien Income Tax Return, instead of Form 1041. If the foreign trust has a U.S. owner, it also must file Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner.
OTHER SPECIAL RULES RELATED TO TRUSTS
As CPAs and other tax professionals familiarize themselves more with the intricacies of estates and trusts, several other items may come to their attention.
- Under Sec. 645(c), a QRT that becomes irrevocable at the grantor's death can be included with the estate's income tax return, which reduces the number of Forms 1041 that need to be filed. (To make this election, the executor must file Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate, by the due date of the estate's first Form 1041 or the extended due date, if an extension is granted.)
- When trusts have a different tax year from the beneficiary, the beneficiary must include in income the trust income that was paid or distributed (or required to be distributed) during the estate's tax year or years ending within the beneficiary's tax year (Sec. 662(c)).
- A helpful tax planning tool is provided by Sec. 663(b), which allows the trustee to treat any amount distributed (or credited) to the beneficiary in the first 65 days of the trust's tax year as distributed in the previous tax year.
If a beneficiary dies, only income actually distributed would be included in the beneficiary's final Form 1040, U.S. Individual Income Tax Return. Any amount required to be distributed but actually paid after the decedent's death would go on the estate's income tax return as income in respect of a decedent.
These and other planning opportunities arise from optimal use of trusts for wealth management, tax planning, and other goals. Knowing the particular circumstances in which each type of trust is best employed allows CPAs to provide their clients with the legal, financial, and tax advantages of these versatile instruments.
About the author
Sonja E. Pippin (firstname.lastname@example.org) is an associate professor in the Department of Accounting and Information Systems at the University of Nevada—Reno.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
- The CPA's Guide to Financial and Estate Planning (#PPF1404D, online access)
- Estate & Trust Primer—Tax Staff Essentials (#157753, online access)
- Form 1041: Income Taxation of Estates and Trusts (#736952, text)
- Income Taxation of Trusts: Minimizing Your Clients' Taxes (#164990, online access)
- Conference on Tax Strategies for the High-Income Individual, June 12—15, Las Vegas
For more information or to register or make a purchase, go to aicpastore.com or call the Institute at 888-777-7077.
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