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Income Taxation of Estates and Trusts
Solutions to Problem Materials DISCUSSION QUESTIONS
25-1 To describe a fiduciary as a conduit of income implies that income earned and accounted for by the fiduciary "flows through" the fiduciary and is taxed to the beneficiaries of the fiduciary rather than the fiduciary itself. Under this conduit principle, the character of the income is not changed as it flows through the fiduciary. A fiduciary functions as an income conduit only to the extent cash or property distributions are made to the beneficiaries. (See p. 25-13 and 651, 652, 661, and 662.) 25-2 Trusts are useful in situations in which it is desirable or necessary to separate the legal ownership and control of property from the beneficial enjoyment of the property. Such situations could occur when the beneficial enjoyment of property is to be given to a number of individuals (as opposed to one individual), a minor, or an incompetent or incapacitated individual. (See p. 25-2.) A trust cannot exist unless there is a separation of legal ownership and beneficial ownership. No such separation exists if the trustee and sole beneficiary are the same person. (See p. 25-2.) If the income beneficiaries and remaindermen of a trust are different individuals, the grantor may want both types of beneficiaries to bear a portion of the cost of the trust administration. (See p. 25-3.) Congressional tolerance may be due to the fact that estates, unlike trusts, are not intentionally created and that an estate usually exists as a separate taxable entity for a very short period of time. (See pp. 25-1 and 25-5.) The concept of fiduciary income as defined by the trust instrument or applicable state law may differ from the concept of fiduciary taxable income as defined in the Internal Revenue Code. Therefore, a distribution of 100% of fiduciary income may not represent a distribution of 100 percent of taxable income. [See p. 25-3 and 643(b).] Administrative expenses (or any portion thereof) may be claimed as a 2053 deduction from the gross estate or a 212 expense for fiduciary income tax purposes. No double deduction is allowed. [See pp. 25-6 and 25-8 and 642(g).] Per rules governing individual taxation, a fiduciary may deduct an annual maximum of $3,000 of net capital loss; and excess capital loss is carried forward [See p. 25-10 and 641(b).] 25-3 25-4 25-5 25-6 25-7 25-8 25-1 25-2 Chapter 25 Income Taxation of Estates and Trusts 25-9 25-10 Operating losses of a fiduciary do not "flow through" to be deducted by beneficiaries; rather, they are subject to carryback or carryforward at the fiduciary level. [See p. 25-10 and 642(d).] From the point of view of the fiduciary, the taxable portion of DNI is the maximum amount deductible for distributions to beneficiaries. For beneficiaries, the taxable portion of DNI represents the maximum amount of fiduciary income for which they may be taxed. [See pp. 25-14 through 25-16 and 651(b), 652(a), 661(c), and 662(a).] When a beneficiary receives a distribution from a fiduciary, the distribution is considered nontaxable to the same extent, or in the same proportion, that the fiduciary DNI is nontaxable. [See Example 12, p. 25-14, and 652(b) and 662(b).] Unlike charitable contributions made by individual taxpayers, charitable contributions made from fiduciary gross income are deductible without limitation. Also, a fiduciary may elect to deduct a charitable contribution in the year paid or in the preceding taxable year. [See p. 25-9 and 642(c)(1).] Such property distribution may represent a distribution of estate taxable income, unless it is a specific property bequest. [See Example 9, p. 25-13, and 663(a)(1).] In the year of termination, all trusts distribute trust corpus to the appropriate beneficiaries. A trust that distributes corpus, by statutory definition, is a complex trust. [See p. 25-16 and 651(a), last sentence.] Such a cash reserve economically replaces the decline in value of depreciable trust corpus. Thus, the ultimate recipient of the trust corpus is protected against the economic decline or deterioration of his property during the existence of the trust. (See p. 25-3.) When a beneficiary receives a distribution from a fiduciary exceeding DNI, the distribution may represent corpus or previously accumulated fiduciary income. Such amounts are nontaxable. (See p. 25-17.) Fiduciaries may want to avoid accumulating income since it may be taxed at very high rates. Because DNI may not be known until after the close of the year, a trustee may not know the amount of the current distributions needed to avoid accumulation. Under the 65-day rule, this problem can be avoided since it allows the fiduciary to treat distributions after the year end as made in the prior year. (See p. 25-24.) 25-11 25-12 25-13 25-14 25-15 25-16 25-17 PROBLEMS
25-18 Dividend income Tax-exempt interest Taxable interest Less: 60% of $5,000 trustee fee Fiduciary accounting income $38,000 18,900 12,400 $69,300 (3,000) $66,300 Each beneficiary will receive one-third of $66,300 for a distribution of $22,100. (See Example 1 and pp. 25-3 and 25-4.) 25-19 a. b. There is no income to M because he receives the stock as a specific bequest. [See 663(a)(1).] The trust must recognize a capital gain of $4,000. M's basis in the stock is $11,000. [See Example 11, p. 25-14, and Reg. 1.661(a)-2(f)(1).] $7,000 of trust income (basis of the distributed shares) is taxable income to M. Trust T will recognize no gain on the distribution and will use the $7,000 basis of the stock as its deduction for distributions to beneficiaries. M will have a $7,000 basis in the 100 shares. [See Example 10, p. 25-13, and 643(e)(1) and (2).] $11,000 of trust income (FMV of the distributed shares) is taxable income to M. Trust T will recognize a $4,000 gain on the distribution and will use $11,000 as its deduction for distributions to beneficiaries. M will have an $11,000 basis in the 100 shares. [See Example 10, p. 25-13, and 643(e)(1) and (3).] c. Solutions to Problem Materials 25-3 25-20 a. b. Per Reg. 1.167(h)-1(b), allowable depreciation is allocated to the trustee to the extent the governing trust instrument or local law requires a reserve for depreciation. Therefore, all $2,000 is allocated to the trust and none to the beneficiaries. The above-cited regulation specifies that to the extent allowable depreciation exceeds the amount of any required reserve, such excess is allocated on the basis of trust income allocable to trustee and beneficiaries. Allowable depreciation Allocated based on trust reserve Allocated to 100% income beneficiaries $ 7,000 (3,000) $ 4,000 (See Example 5 and p. 25-9.) 25-21 Rents Dividends Capital loss ($7,000 but limited to $3,000) Less: Rent expense ($70,000 but limited to rent income) Trustee fee Exemption (complex trust) Trust taxable income $62,000 12,000 (3,000) $71,000 (62,000) (4,000) (100) $ 4,900 The $8,000 excess of rent expense over rent income is a passive activity loss that may not be deducted against the trust's dividend income. Note that the $25,000 loss allowance is not available for trusts. This passive activity loss will be carried forward by the trust. (See p. 25-10 and 469.) 25-22 a. The $19,900 legal and accounting fees and the $6,100 executor's fee may be deducted either on the estate tax return (Form 706) or on the estate income tax return (Form 1041) but not both. The executor may allocate a portion of the expenses to each return in order to maximize the tax benefit of the deduction. In the case of Decedent L, the estate's marginal income tax rate on $60,000 of income is 35 percent (2011), whereas the marginal estate tax rate on a $1,700,000 taxable estate is zero percent. Therefore, the entire $26,000 of expenses should be deducted on the estate's income tax return. The $4,800 funeral expenses may only be deducted on the estate tax return (Form 706). [See p. 25-7 and 642(g).] In this case, L's taxable estate is zero because of the unlimited marital deduction of 2056. Therefore, the executor should deduct all the administrative expenses on the estate's income tax return. [See p. 25-7 and 642(g).] $4,000 $10,000 distribution $20,000 taxable DNI $50,000 DNI b. 25-23 a. (See Example 12, p. 25-15.) b. $4,000. [See Example 12, p. 25-14, and Reg. 1.661(c)-1.] Note that whatever amount is deducted by the trust is taxable to the beneficiaries. 25-4 Chapter 25 Income Taxation of Estates and Trusts 25-24 a. $6,000 $10,000 charitable donation $60,000 taxable trust income $100,000 trust income [See Example 4, p. 25-8, and Reg. 1.642(c)-3(b)(1).] b. $3,000 $55,000 trustee fee $60,000 taxable trust income $100,000 trust income [See Example 3, p. 25-7, and Reg. 1.652(b)-3(b).] c. 25-25 a. $6,500 rent expense (all allocable to taxable rent). [See p. 25-6 and Reg. 1.652(b)-3(a).] Taxable interest Rents $25,000 11,000 $36,000 Less: Rent expense Deductible trustee fee* (2,400) (900) $32,700 [$1,000 fee $36,000 taxable trust gross income $40,000 trust gross income Plus: Net nontaxable interest ($4,000 $100 trustee fee allocable to nontaxable trust income) DNI 3,900 $36,600 [See Example 13, pp. 25-14 and 25-15, and 643(a).] b. Taxable interest Rents LTCG (taxable even though not distributable) $25,000 11,000 9,000 $45,000 Less: Rent expense Deductible trustee fee Deduction for distribution to beneficiaries (taxable DNI) Exemption (simple trust) Trust taxable income (See Example 13 and pp. 25-14 and 25-15.) (2,400) (900) (32,700) (300) $ 8,700 Solutions to Problem Materials 25-5 c. $960 (at 2011 tax rates). Because the entire $8,700 of taxable income represents LTCG, the trust's 2011 tax liability equals 0% capital gain rate of the first $2,300 of taxable income (the amount of taxable income subject to the 15% rate), $0, plus 15% capital gains tax on the remaining $6,400 of income ($8,700 $2,300) or $960. Taxable dividends Rents $10,000 30,000 $40,000 25-26 a. Less: Rent expense Deductible trustee fee* Taxable DNI *$5,000 fee $40,000 taxable trust gross income $50,000 trust gross income (7,500) (4,000) $28,500 Plus: Net nontaxable interest ($10,000 $1,000 trustee fee allocable to trust nontaxable income) DNI 9,000 $37,500 [See Example 13, pp. 25-13 through 25-16, and 643(a).] b. Dividends Rents LTCG $10,000 30,000 15,000 $55,000 Less: Deductible trustee fee Rent expense Deduction for distribution to beneficiaries Exemption (complex trust) Trust taxable income (4,000) (7,500) (22,800)* (100) $20,600 *$30;000 distributions (See Example 16 and p. 25-16.) c. Beneficiary C: Beneficiary D: (See Example 16 and p. 25-17.) $28,500 taxable DNI $37,500 DNI $20,000 distribution $10,000 distribution $28,500 taxable DNI $15,200 taxable income $37,500 DNI $28,500 taxable DNI $7,600 taxable income $37,500 DNI 25-6 Chapter 25 Income Taxation of Estates and Trusts 25-27 a. b. Because total current distributions of $70,000 are less than DNI, each beneficiary is required to report the amount of the distribution representing taxable DNI in his or her gross income. Therefore, E must report $60,000 of taxable DNI and G must report $10,000 of taxable DNI. The trust's deduction for distribution to beneficiaries is $70,000. (See Example 15, p. 25-17.) The required first-tier distribution to E is $42,500, 50 percent of the trust accounting income of $85,000. The additional $37,500 distributed to E and the $40,000 distributed to G are discretionary second-tier distributions. The first $42,500 of DNI is allocated to the first-tier distribution. The remaining $42,500 of DNI is allocated proportionately to the second-tier distributions as follows: $37,500 E's second-tier distribution $42,500 $20,565 $77,500 total second-tier distributions $40,500 G's second-tier distribution $42,500 $21,935 $77,500 total second-tier distributions Therefore, E must report taxable DNI of $63,065 ($42,500 $20,565), and G must report taxable DNI of $21,935. The trust's deduction for distributions to beneficiaries is $85,000. [See Examples 15, 16 and 17, p. 25-18, and 662(a)(1) and (2).] 25-28 Beneficiary S: First-tier distribution of $60,000 is taxable to the extent of $75,000 taxable DNI $60,000 $45,000 $100,000 DNI Beneficiary T and U: Second-tier distributions are taxable to the extent of remaining taxable DNI: DNI First-tier distribution Remaining DNI $100,000 (60,000) $ 40,000 75% $30,000 Taxable DNI allocable to second-tier distributions T: $40,000 distribution $30; 000 $17,143 taxable to beneficiary T $70,000 total second-tier distributions U: $30,000 distribution $30,000 $12,857 taxable to beneficiary U $70,000 total second-tier distributions [See Example 17, p. 25-18, and 662(a).] 25-29 The beneficiaries pay tax on taxable DNI of $33,000. The balance represents previously taxed income and is not subject to tax. [See p. 25-17.] Solutions to Problem Materials 25-7 25-30 a. b. Because the uncollected $14,500 income that K earned before his death could not be included in his final cash basis individual income tax return, it must be classified as income in respect of a decedent and taxed to K's estate when it is received. The $1,600 debt to K's attorney is a personal debt that would not have resulted in a business deduction when paid by K. Therefore, the payment of the debt by K's executor does not result in a deduction in respect of a decedent. (See pp. 25-11 and 25-12 and 691.) If K had been an accrual basis taxpayer, the $14,500 earned income would have been properly reported on K's final income tax return even though the receivable was not collected prior to K's death. The subsequent receipt of $14,500 cash by the executor would have no income tax consequence. (See pp. 25-11 and 25-12 and 691.) Because Z is a cash basis taxpayer and did not receive an interest payment prior to her death, no amount of capital gain or interest income is includible on her final income tax return. [See pp. 25-11 and 25-12 and 691(a).] The amount of $18,000 interest income, accrued as of the date of Z's death, represents income in respect of a decedent (IRD) and is taxable to the estate under 691(a). The remainder of the interest ($1,700) was earned by the estate and is taxable under the general rule of 61. The receipt of the $20,000 principal payment triggers recognition of $15,000 of capital gain under 453(c). $150,000 gross profit on sales of land 75% gross profit percentage $200,000 contract price Principal payment Gross profit percentage Capital gain $20,000 75% $15,000 25-31 a. b. The $15,000 capital gain is taxed to the estate as IRD. [See pp. 25-11 and 25-12 and Reg. 1.691(a)-5.] c. IRD collected by the estate totals $33,000. The total IRD included in Z's taxable estate is $168,000 ($18,000 accrued interest plus $150,000 deferred capital gain on the installment sale). $33,000 $10,000 estate tax attributable to total IRD $1,964 $168,000 Therefore, the estate may deduct $1,964 under 691(c). [See Example 8, p. 25-12 and Reg. 1.691(c)-1.] TAX RETURN PROBLEMS
A completed 2010 Form 1041, Schedule D, and Schedule K-1 for the MKJ Problem (25-32) are contained in the Instructor's Resource Guide and Test Bank for 2012. TAX RESEARCH PROBLEMS
Solutions to the Tax Research Problems (25-33) are contained in the Instructor's Resource Guide and Test Bank for 2012. ...
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- Spring '11