Income Tax Accounting for Trusts and Estates Tax Filing
Estates and non-grantor trusts must file income tax returns just as individuals do, but with some important differences. For one, their income is taxed at either the entity or beneficiary level depending on whether it is allocated to principal or allocated to distributable income, and whether it is distributed to the beneficiaries. Income tax accounting for trusts and estates has received relatively little attention from tax professionals as well as lawmakers. This is not surprising because of the comparatively few taxpayers affected. In addition, income taxation of estates and trusts does not generate much public interest—unlike the estate and gift tax, As a consequence, practitioners and their clients may not be aware of several tax issues related to estates and trusts. Careful planning that takes these issues into account is no less important than for other types of returns and can reap significant tax benefits. While trusts exist in many forms, this article principally concerns the most commonly encountered type of non-grantor trust. Other trusts that may be of interest to practitioners include those often used in conjunction with a small business, principally electing small business trusts (ESBTs) and qualified subchapter S trusts (QSSTs).
FIDUCIARY ACCOUNTING AND INCOME TAXES
Income of estates and non-grantor trusts is taxed at either the entity or the beneficiary level, depending on the answer to the following two questions.
- Is each income, loss or deduction item part of the trust’s or estate’s distributable income, or is it part of a change in the principal?
- Is the income, loss or deduction item distributed to the beneficiaries, or does the entity retain it?
Fiduciary accounting has been characterized as somewhat similar to governmental accounting because it deals with a fund (the trust principal) and income derived from the fund. The estate’s or trust’s taxable income is computed using the following formula:
|Less||Deductible trust expenses|
|Less||Personal exemption amount|
|Equals||Taxable income before distribution deduction|
|Times||Applicable tax rates|
Note: Trusts will reach the top marginal tax rate faster than individuals because of the depressed progressive tax schedule. Distribution deduction. To prevent double taxation on their income, estates and trusts are allowed to deduct the lesser of distributable net income (DNI) or the sum of the trust income required to be distributed and other amounts “properly paid or credited or required to be distributed” to the beneficiaries. DNI is calculated based on accounting income less any tax-exempt income net of allocable expenses. The accounting method and period of the estate or trust determine when the deduction may be claimed; the beneficiary’s tax year is not relevant. Note: Because the tax rates of estates and trusts are likely higher than the tax rates of the individual beneficiaries, it is advisable (if possible) to retain the tax-exempt income and distribute taxable income only. The tax calculation for estates and trusts with regard to long-term capital gains rates is the same as for individuals. Thus, just as for individuals, long-term capital gains and qualified dividends are currently taxed at 15% and, for trusts and estates in the 15% tax bracket.
DIFFERENT INCOME TYPES AT THE BENEFICIARY LEVEL
The character of the trust income at the beneficiary level is determined based on the actual distribution amount and DNI unless the trust instrument or state law specifies otherwise. Direct expenses must be allocated to the respective incomes (for example, rental expenses must be deducted from rental income). Indirect expenses, such as trustee fees, must be allocated between taxable and tax-free income.
NEW LAWS AFFECTING ESTATES AND TRUSTS
The recently enacted health care legislation affects not only individuals and businesses but also the income of trusts and estates, Trusts and estates will be subject in 2013 and subsequent tax years to a 3.8% “unearned income Medicare contribution” tax on the lower of their undistributed net investment income or the amount by which their adjusted gross income (AGI) exceeds the amount where the highest tax bracket begins. Note: Since the threshold for individuals is much higher than for estates and trusts (and since most, if not all, trust income will be considered investment income), taxpayers may want to distribute more (or all) of the trust income to limit the amount subject to the 3.8% extra tax. Note that certain trusts will not be subject to this additional tax. Furthermore, simple trusts and grantor trusts are also likely to be exempt. A simple trust must distribute all current income; thus all income taxes apply at the beneficiary level, and it does not have any undistributed net investment income. A grantor trust is not considered a taxable entity because the grantor (or possibly some other person such as the beneficiary) is presumed to be the owner of the trust. The trust income is therefore taxed at the grantor level.
- Income taxation of estates and trusts may not receive the same attention as individual income taxes or estate taxes. This article describes some of the general income tax rules of these entities, such as the different rules for allocation of income and deduction items between principal and distributable income, between tax- exempt and taxable income, and between trusts/estates and beneficiaries.
- These allocations are prescribed either by the trust instrument, state law or the Internal Revenue Code. In some cases, taxpayers have flexibility. Generally, it is advisable to “push” the taxable income and the income taxed at higher rates to the beneficiary, because the tax rate schedule for trusts and estates is depressed, with the highest bracket.
- Pushing income to beneficiaries may become still more important if lower tax rates under the Economic Growth and Tax Relief Reconciliation Act.
- Also, since income from estates and trusts is mostly investment income, the new 3.8% unearned income Medicare contribution tax will apply to most, if not all, of the trust’s income falling in the highest tax bracket. Individuals are not subject to this tax until their modified AGI reaches $250,000 (married filing jointly and surviving spouses) or $200,000. Thus, distributing trust income to beneficiaries can lower the amount subject to this extra tax.