To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 20 INCOME TAXATION OF TRUSTS AND ESTATES SOLUTIONS TO PROBLEM MATERIALS Question/ Problem 10 11 12 13 14 15 16 17 18 19 20 *21 22 *23 24 *25 *26 27 28 29 Learning Objective Topic LO LO LO LO LO LO LO Creating a trust Parties to a fiduciary entity Fiduciary tax terminology Fiduciary tax terminology Pass-through entities: incidence of tax Fiduciaries and the AMT Simple versus complex trust; personal exemptions LO Determining taxable income: five-step approach LO Distributions of appreciated property LO Disallowance of § 212 deductions LO Cost recovery deductions of a fiduciary LO Charitable contributions of a fiduciary LO Functions of DNI LO 2, Tax exempt income beneficiary LO 2, 3, Terminating a fiduciary entity LO Fiduciaries and education planning LO Grantor trust rules LO 1, Fiduciary tax compliance LO Fiduciary tax planning LO Fiduciary tax planning LO Attributes of simple and complex trusts LO Fiduciary tax formula LO Fiduciary AMT computations LO Entity accounting income LO Computing entity accounting income LO 1, 2, Attributes of trusts and estates LO Income in respect of a decedent LO Charitable contributions LO Entity cost recovery Status: Present Edition Q/P in Prior Edition New New Modified New Modified New Unchanged Unchanged Modified Modified Modified Modified Unchanged Modified Unchanged Unchanged Unchanged Unchanged Unchanged Unchanged Modified Modified Modified Unchanged Modified Unchanged Modified Modified Unchanged 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Instructor: For difficulty, timing, and assessment information about each item, see p 20-3 20-1 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-2 Question/ Problem *30 31 32 *33 *34 *35 *36 37 38 39 40 2012 Corporations Volume/Solutions Manual Learning Objective LO 2, LO 2, LO LO LO LO 2, LO LO LO LO LO 2, Topic Computing DNI, taxable income Computing DNI, taxable income Separate share rule Tier distributions Constitution of DNI Computing DNI, taxable income Income in respect of a decedent Grantor trust rules Termination year losses Income shifting Lifetime gift planning Status: Present Edition Q/P in Prior Edition Unchanged Unchanged Modified Modified Modified Unchanged Unchanged Unchanged Unchanged Modified Unchanged 30 31 32 33 34 35 36 37 38 39 40 *The solution to this problem is available on a transparency master Instructor: For difficulty, timing, and assessment information about each item, see p 20-3 Tax Return Problem Topic Status: Present Edition Income taxation of trusts and estates (Form 1041) Income taxation of trusts and estates (Form 1041) Modified Modified Income in respect of a decedent Grantor trust income Divorce trusts Internet activity Internet activity Internet activity Internet activity Internet activity Internet activity New Unchanged Unchanged New Modified Unchanged Unchanged Unchanged Unchanged Q/P in Prior Edition Research Problem 9 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates Difficulty Est’d completion time Medium 10 Easy Easy Easy Easy Easy Medium Easy Easy 10 5 5 10 10 10 Medium 10 11 Easy 12 13 Easy Medium 10 14 Medium 10 15 Medium 10 16 Medium 10 17 Medium 15 18 19 Easy Easy 10 20 Medium 10 21 22 23 24 Medium Medium Medium Medium 10 10 10 10 25 Medium 15 26 Medium 10 27 Easy 28 Medium 10 29 Medium 10 Question/ Problem 5 20-3 Assessment Information AICPA* AACSB* Core Comp Core Comp FN-Measurement | FNReporting FN-Reporting FN-Reporting FN-Reporting FN-Reporting FN-Reporting FN-Reporting FN-Measurement FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Reporting FN-Measurement | FNReporting FN-Reporting FN-Measurement | FNReporting FN-Reporting FN-Measurement | FNReporting FN-Reporting FN-Reporting FN-Measurement | FNReporting FN-Reporting FN-Measurement FN-Measurement FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting Communication | Analytic Analytic Analytic Analytic Analytic Communication | Analytic Analytic Analytic Analytic Analytic Analytic Analytic Communication | Analytic Analytic | Reflective Thinking Analytic | Reflective Thinking Analytic | Reflective Thinking Communication | Analytic Analytic Analytic | Reflective Thinking Analytic | Reflective Thinking Analytic Analytic Analytic Analytic | Reflective Thinking Analytic Analytic Analytic Analytic Analytic *Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB core competencies in assessment © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-4 2012 Corporations Volume/Solutions Manual Difficulty Est’d completion time 30 Medium 15 31 Medium 15 32 Medium 10 33 Medium 10 34 Medium 10 35 Hard 15 36 37 38 39 Hard Medium Medium Hard 15 20 10 15 40 Hard 25 Question/ Problem Assessment Information AICPA* AACSB* Core Comp Core Comp FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Measurement | FNReporting FN-Reporting FN-Reporting FN-Reporting FN-Measurement | FNReporting FN-Measurement | FNReporting Analytic Analytic Analytic Analytic Analytic Analytic Analytic Communication | Analytic Analytic Analytic | Reflective Thinking Communication | Analytic *Instructor: See the Introduction to this supplement for a discussion of using AICPA and AACSB core competencies in assessment © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates 20-5 CHECK FIGURES 22 23 25 Total tax, $142,429.50 $21,775 $350,000; $347,500; $372,500; $300,000 27 $76,667 current-year IRD recognized 28 $0; $12,000; $15,000 29.a $40,000; $10,000; $0 29.c $20,000; $20,000; $10,000 30.a $25,000 30.d $20,000 31.b $65,000 31.d $32,500 32.a $40,000 32.b $25,000 33.a $30,000 first-tier, $120,000 total gross income 34 Brenda: $8,000 (dividend), $4,000 (taxable interest), $5,000 (exempt interest), $3,000 (passive) 35.c $41,900 35.d Lydia $16,000; Kent $8,000 taxable part of distribution 38 2011: no loss pass-through recognized, capital loss carries forward 39 Kiddie tax applies 2011 gross income to Woody for medical costs covered by trust © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-6 2012 Corporations Volume/Solutions Manual DISCUSSION QUESTIONS Taxpayers create trusts for a variety of reasons Some trusts are established primarily for tax purposes, while others are designed to accomplish a specific financial goal or to provide for the orderly management of assets in case of an emergency The most commonly encountered reasons for creating a fiduciary entity include the following • To hold life insurance policies on the decedent, as part of an estate plan to remove such policies from the gross estate • To manage assets, reduce probate costs, and assure the privacy of the distribution of assets near the end of the grantor’s life • To provide funds for an advanced education, accumulating income at a lower tax rate than that to which the grantor is subject • To hold or manage the assets of the grantor while he or she is in the military, governmental service, overseas, or in some other way divorced from the daily management of the assets • To manage the assets of a tax-sheltered retirement fund, corporate liquidation, or divorcing couple in an objective manner Table 20.1 The parties to a trust include a grantor, trustee, and one or more beneficiaries The parties to an estate include the decedent, the executor or administrator, and one or more beneficiaries In each case, at least two different parties should be involved The grantor or decedent provides the funds that are subject to the trust instrument or will The trustee or executor manages the funds, meets financial obligations, files tax returns, and completes other administrative requirements Income and remainder beneficiaries receive distributions of income and assets as directed by the controlling document Figure 20.1 Of the beneficiaries of a fiduciary entity, the holder of the income interest receives payments of the entity’s accounting income, usually at least once a year The holder of the remainder interest receives the principal of the estate or trust when the entity terminates If the grantor of a trust is also its remainder beneficiary, that person holds a reversionary interest If the holder of an income interest is to receive payments for the rest of his/her life, that person is a life tenant This is in contrast to income payments scheduled to last for a fixed period of years, known as a term certain interest pp 20-3 and 20-4 Every trust is a complex trust, unless all of the following requirements are met • The trust is required to distribute its entire accounting income every year to the designated beneficiaries • None of the trust beneficiaries are charitable organizations • No trust corpus was distributed during the tax year © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates 20-7 A trust can be simple one year and complex the next; as the tests noted above are applied every tax year p 20-5 Each of the entities is taxed slightly differently under Federal income tax law a C corporations are separate taxable entities, distinct from their shareholders See Chapters to b Partnerships and limited liability entities are pass-through entities and never incur Federal income tax liabilities See Chapters 10 and 11 c S corporations are pass-through entities and incur Federal income tax liabilities only rarely (e.g., for the tax on excessive passive investment income) See Chapter 12 d Fiduciary entities are modified pass-through entities and incur Federal income tax when taxable income is retained by the entity, rather than distributed from taxable amounts to income beneficiaries Table 20.2 SPEECH OUTLINE Trusts, Estates, and the AMT I II III IV V VI VII A fiduciary entity can be subject to the alternative minimum tax The entity restates its income and then passes through AMT income, preferences, and adjustments to its beneficiaries No ACE adjustment is computed by a fiduciary entity The small corporation exception does not apply to a trust or estate Given the nature of most fiduciary operations, it is unusual to encounter this tax The entity must make estimated tax payments with respect to any AMT A fiduciary claims a $22,500 AMT exemption, which phases out at a rate of one-fourth of the amount by which AMTI exceeds $75,000 The AMTI of the entity is subject to a 26% tax rate, which reaches 28% when AMTI exceeds $175,000 p 20-8 a All income is required to be distributed currently to the granddaughter of the grantor No corpus distributions are made b All income is required to be distributed currently to State University, a qualifying charity No corpus distributions are made c Income can be sprinkled at the discretion of the trustee; or, same as a or b., except that a corpus distribution is made during the year Example Step One Determine entity accounting income Step Two Compute entity taxable income before the distribution deduction Step Three Determine distributable net income (DNI) and the distribution deduction Step Four Compute entity taxable income [Step 2] – [Step 3] © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-8 2012 Corporations Volume/Solutions Manual Step Five Allocate DNI and its character to the beneficiaries, applying the tier system if needed Figure 20.2 With respect to a distribution of appreciated property by a fiduciary, no taxable income generally is recognized Basis of the asset carries over to the recipient DNI and the distribution deduction reflect an amount for the distribution equal to the lesser of the asset’s basis or its fair market value DNI and distribution deduction Gross income to Liu Basis to Yang $60,000 $ –0– $60,000 Upon making a § 643(e) election, though, the distribution can become a taxable event The gain would be recognized by the fiduciary, and the beneficiary would take a basis in the asset equal to its fair market value DNI and the distribution deduction both would reflect the asset’s fair market value DNI and distribution deduction Gross income to Liu Basis to Yang $100,000 $ 40,000 $100,000 Examples to 10 10 The default application of the deduction for fiduciary fees is to the estate tax return Section 212 expenses of this sort are deductible on an income tax return only if a waiver of the estate tax deduction is filed Here, the deduction is more valuable on the estate’s income tax return, where the marginal tax rate is higher However, only 5/7ths of the deduction would be allowed there, because of the presence of exempt income The executor should consider a split of the deduction, as follows • Claim the maximum amount on the estate’s income tax return, Form 1041, [i.e., $7,000 fees × ($50,000 taxable portion of the estate’s accounting income/$70,000 total accounting income) = $5,000] • Claim the remaining $2,000 portion of the fees on the estate tax return, Form 706 pp 20-14 and 20-15 11 Cost recovery deductions related to the assets of a fiduciary are assigned proportionately among the recipients of entity accounting income Mona deducts on her Form 1040 depreciation deductions attributable to Sterling of $40,000 [$100,000 × ($1,000,000/$2,500,000)] The beneficiaries’ shares of gross, taxable, and distributable net income are irrelevant for this purpose Examples 15, 16, and §§ 167(h) and 611(b)(3) and (4) 12 If the gift is determinable in both existence and amount to the controlling will or trust agreement, the entity is allowed a deduction for the gift that is paid from gross income See § 265 for disallowance possibilities The deduction is allowed even if the payment is made during the following tax year Qualifying charitable organizations for gifts by fiduciaries include all of those so recognized for gifts by individuals, and certain non-U.S charities Examples 18 and 19 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates 13 20-9 The major functions served by distributable net income (DNI) include the following • DNI is the maximum amount of the year’s distributions by the fiduciary that can be taxed to the beneficiaries • DNI is the maximum amount of the distribution deduction that the entity uses in computing its annual Federal taxable income • 14 The tax character of the elements of DNI (e.g., taxable and exempt interest income) carry over proportionately to the beneficiaries, in determining the effects of each item on the beneficiary’s own taxable income p 20-17 Campbell is a complex trust, as it has an income beneficiary that is a charity Generally, the shifting of positive taxable income amounts to an exempt organization (like College) through distributions is a wise idea, but if the fiduciary entity generates operating losses, the benefits of the deductions for those losses are wasted on the charity Similarly, the allocation of depreciation deductions to an exempt taxpayer is not wise, as the charity cannot take advantage of the tax reduction that results from the deduction Example 22 15 • How much of the loss carryforward will remain upon termination of the trust, for pass-through to Amy? • How many years then will remain for the carryforwards? • Will Amy’s other income sources be of the proper nature and amount so that the carryforwards can be used immediately? • Should the trust sell the investment assets, or should the trustee distribute the portfolio to Amy in-kind and let her sell them off? Examples 34 and 42 16 The trust likely is a grantor trust, with income to be taxed directly to Harriet, and not subject to the rules of Subchapter J • Grantor trust rules apply when trust income is used to satisfy the legal obligations of the grantor, such as school tuition Such obligations are held by the parents, though, and not the grandparents in most cases Thus, this provision alone may not create grantor trust status • Reversionary interests create grantor trust status, with only minor exceptions that not seem to apply here • Grantors of these types of trusts often name themselves trustee The administrative and investment decisions inherent in carrying out this position also likely make this a grantor trust pp 20-25 to 20-27 17 TAX FILE MEMORANDUM Date: November 3, 2011 From: Reed Rawlings Subject: Grantor trust rules © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-10 2012 Corporations Volume/Solutions Manual Carol’s ideas are contrary to the tax law College tuition payments generally are nondeductible personal expenditures § 262(a) By using a trust as a fiduciary entity in this plan, Carol also brings into play the grantor trust rules of §§ 671 – 679 Where the grantor retains the right to make investment and distribution decisions, the trust is ignored for tax purposes Thus, trust income and deductions are attributed directly to Carol, the owner of the trust assets The donor can retain the following powers without making the entity a grantor trust • Invade corpus for the benefit of a beneficiary • Withhold income from a beneficiary during the beneficiary’s disability or minority • Allocate items between entity accounting income and corpus • Choose charitable beneficiaries But if the grantor uses the income of the trust to satisfy his/her legal obligations, the grantor trust rules apply If the tuition payments are one of Carol’s legal obligations, she is taxed on trust income used for this purpose The entity itself cannot deduct such payments Under these circumstances, there is no income tax benefit to establishing such a trust pp 20-25 to 20-27 18 Most fiduciary entities must use a calendar tax year Estimated payments are due from a fiduciary Forms 1041 and their supporting schedules can be filed electronically Paper copies are sent to the IRS Centers in: • Ogden, Utah, essentially for domestic trusts located west of the Mississippi River, • Cincinnati, for other domestic estates and trust, and • Philadelphia, for fiduciaries located outside of the United States pp 20-7 and 20-28 19 Trusts generally cannot adopt any tax year other than the calendar year, while estates have more freedom to pick their tax year It usually makes sense for the executor to choose a short first tax year, ending before the first bunching of taxable income is recognized Later, the final tax year also should be short, but not such that the beneficiaries recognize more than 12 months’ taxable income on one tax return p 20-28 20 a Because the marginal Federal income tax rates for trusts and estates are among the most progressive in the Code, the top rates are attained earlier than for any other taxpayer Thus, it usually makes more sense to shift taxable income away from the fiduciary entity p 20-28 b Generally, the high-income and wealthy beneficiaries should be assigned to receive second-tier distributions There may be a lower cash-flow demand by those parties, and the second-tier distribution rules increase the chance of those high-bracket beneficiaries receiving tax-free amounts (i.e., in excess of distributable net income) p 20-30 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates c 20-11 Generally, if the in-kind asset possesses a realized gain, the potential recognized gain should be shifted to the taxpayer (i.e., entity or beneficiary) that is in the lower tax bracket When a realized loss is involved, the loss should be shifted to the taxpayer that is in the higher tax bracket (assuming that the § 267 related party rules not apply) Example 42 PROBLEMS 21 Attribute Simple Trust Complex Trust Trust could incur its own tax liability for the year Yes (e.g., if capital gains are allocable to corpus) Yes Trust generally distributes all of DNI Yes Depends on the terms of the agreement Trust can deduct its charita- No, cannot make such ble contributions in the year payments of, or the year after, payment Yes Trust could claim a foreign tax credit No, such credit is assigned to pertinent taxpayers ratably, based on receipt of entity accounting income Yes Maximum tax rate on net long-term capital gains = 15% Yes Yes AMT preferences and adjustments flow through to beneficiaries ratably Yes Yes Trust can adopt the FIFO method for its inventory assets; the grantor had been using lower of cost or market Yes, the entity can choose its own tax accounting method Yes, the entity can choose its own tax accounting method Trust can use a tax year other than the calendar year No (unless it is tax-exempt, like a pension plan) No (unless it is tax-exempt, like a pension plan) Amount of personal exemption $300 $100 or $300 depending on whether corpus or charitable payments are made pp 20-6 to 20-8 22 Ordinary income Net passive loss Personal exemption $400,000 (–0–) (100) © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-12 2012 Corporations Volume/Solutions Manual Deductible fees Fiduciary taxable income taxed at ordinary rates 2011 income tax on $379,900 Tax on dividend income ($70,000 × 15%) Total tax (20,000) $379,900 $131,929.50 10,500.00 $142,429.50 p 20-7 23 AMT income ($75,000 + $25,000) AMT exemption (reduced) AMT tax base AMT rate for fiduciaries Tentative minimum tax $100,000 (16,250) $83,750 × 26% $ 21,775 Estimated tax payments must include AMT liability p 20-8 24 The make-up and magnitude of entity accounting income is virtually under the control of the grantor and his/her tax adviser, if appropriate language is included when the will or trust instrument is drafted Thus, it is critical that the tax adviser become aware of the wishes of the grantor to set up a trust and become active during the drafting phase of the engagement In the present example, Shirley can receive almost any amount that Betty wishes (even amounts less than that illustrated in b below), if the proper language is used in the controlling instrument a “Interest income, rental revenues, and capital gains are allocable to income; fiduciary fees and cost recovery are allocable to corpus.” Shirley receives a check for $235,000 b “Capital gains, rental revenues, and one-half of interest income are allocable to corpus; cost recovery expenses, one-half of interest income, and fiduciary administrative fees are allocable to income.” Shirley receives a check for $11,500 pp 20-9 to 20-11 and Table 20.4 25 Trust agreement provisions Trust accounting income Fees and capital gains allocable to corpus $350,000 ($300,000 + $30,000 + $20,000) Capital gains allocable to corpus, one-half of fees allocable to income $347,500 [($300,000 + $30,000 + $20,000) – ($5,000 × 1/2)] Capital gains allocable to income, silent concerning allocation of fees $372,500 Most state laws allocate fees one-half to corpus, one-half to income [($300,000 + $30,000 + $20,000 + $25,000) – ($5,000 × 1/2)] Fees and exempt income allocable to corpus, silent concerning allocation of capital gain/loss $300,000 Most state laws allocate capital gain/loss to corpus No distinction is made between AMT and non-AMT exempt interest in the document, although such an allocation would be possible Table 20.4 and Examples to © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates 26 Attribute Estate Trust Separate income tax entity Yes Yes Controlling document Will; not insurance Trust instrument contracts, joint ownership statutes, installment notes, or other items concerning nonprobate assets Can have both income and remainder beneficiaries Yes Yes Computes entity accounting income, before determining entity taxable income Yes Yes Termination date is determinable from controlling document No; termination occurs when the estate’s activities are completed This might be a substantial period of time(e.g., where a § 6166 election is made) Yes, although such date might be contingent upon other events, such as the grantor’s death, the beneficiary’s graduation from school, or the completion of some contractual duty Legal owner of assets under fiduciary’s control Beneficiaries immediately, although the executor has a fiduciary and management duty during the administration period Indeed, the identity of some of the heirs may not be apparent immediately upon death but legal title can pass immediately Trustee during trust term, beneficiaries thereafter Document identifies both income and remainder beneficiaries Yes Yes Separate share rules apply Yes Yes Generally must use calendar tax year No Yes 20-13 pp 20-2 to 20-7, 20-23, and Figure 20.1 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-14 2012 Corporations Volume/Solutions Manual 27 Roberto’s current-year IRD = $60,000 commissions + $16,667 installment gain received Examples 11 to 13 28 Assumption Sanchez is a cash-basis individual Sanchez is an accrual-basis corporation Sanchez is a trust 2011 Deduction for Contribution $0 No deduction until 2012, when payment is made $12,000 Limited to 10% of TI, with 1/2-month grace period; no loss of deduction due to exempt income $15,000 Limited to 120/160 of gift, due to exempt income; one-year grace period allowed p 20-17 29 Cost recovery deductions are assigned proportionately to the recipients of entity accounting income Allocation of depreciation to income or to corpus is irrelevant for this purpose This treatment applies to both trusts and estates a Hernandez: $40,000 [$50,000 cost recovery deduction available × ($20,000 accounting income received ữ $25,000 entity accounting income)] Jackson: $10,000 [$50,000 ì ($5,000 ÷ $25,000)] Oliver: $0 No accounting income was accumulated by the trust b No change in the solution for part a “Allocation” of depreciation pertains only to the computation of accounting income, not to the tax treatment of the related cost recovery deductions c Hernandez: $20,000 [$50,000 × ($10,000 ÷ $25,000)] Jackson: $20,000 [$50,000 × ($10,000 ÷ $25,000)] Oliver: $10,000 [$50,000 ì ($5,000 accounting income retained ữ $25,000)] d No change in the solution for part a This rule applies to both trusts and estates Examples 15 and 16 30 a $25,000 (1/2 of $50,000 accounting income) b $40,000 c $24,700 d $20,000 (1/2 of $40,000) © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates Item Totals Ordinary income $50,000 Accounting Income Taxable Income $50,000 $50,000 Net long-term capital gain 25,000 25,000 Fiduciary fees 10,000 (10,000) Personal exemption Accounting Income/Taxable Income Before the Distributions Deduction 20-15 Distributable Net Income/ Distribution Deduction (300) $50,000 STEP $64,700 STEP Exemption $64,700 300 Corpus Capital Gain/Loss (25,000) Net Exempt Income Distributable Net Income $40,000 Distribution Deduction (40,000) STEP Entity Taxable Income $24,700 STEP PROOF: The trust should be taxed on “its” $25,000 long-term capital gain less the $300 personal exemption Figure 20.3 and Examples 21 and 22 31 a $37,500 (1/2 of $75,000 accounting income) b $65,000 c ($300) d $32,500 (1/2 of $65,000 DNI) © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-16 2012 Corporations Volume/Solutions Manual Item Totals Ordinary income Accounting Income Taxable Income $50,000 $50,000 $50,000 Net long-term capital gain 25,000 25,000 25,000 Fiduciary fees 10,000 (10,000) Personal exemption Accounting Income/Taxable Income Before the Distributions Deduction Distributable Net Income/ Distribution Deduction (300) $75,000 STEP $64,700 STEP Exemption $64,700 300 Corpus Capital Gain/Loss Net Exempt Income Distributable Net Income Distribution Deduction $65,000 (65,000) STEP Entity Taxable Income ($ 300) STEP OBSERVATION: A simple trust with no corpus capital gains recognized for the year wastes the personal exemption of the fiduciary Figure 20.3 and Examples 21 and 22 32 a $40,000 Under the separate share rule of § 663(c), a single trust that has more than one beneficiary and that operates using substantially separate and independent shares for each beneficiary of the trust is treated as multiple separate trusts Therefore, Willie is taxed only on his share of the trust’s distributable net income The second-tier distribution of $10,000 from corpus to Willie is not subject to current income tax b $25,000 The separate share rule of § 663(c) applies Sylvia’s distributable net income is limited to the portion of the distribution that is not accumulated c Zero Doris’s distributable net income has been accumulated; as a result of the separate share rule, Doris recognizes no current-year gross income © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates d 20-17 $55,000 The trust is taxed on the total distributable income that is accumulated (i.e., Sylvia’s $15,000 and Doris’s $40,000 respective income shares) Proof: $120,000 DNI – $40,000 taxed to Willie – $25,000 taxed to Sylvia Example 30 33 a Results for David are as follows After the first-tier distributions are accounted for, $90,000 DNI remains to be assigned to the beneficiaries on the second tier ($150,000 DNI – $60,000 DNI used for first-tier distributions) b Amount Received DNI Received = Gross Income, Portfolio Income First Tier $30,000 $30,000 Second Tier $100,000 $90,000 Totals $130,000 $120,000 Results for Clare are as follows c Amount Received DNI Received = Gross Income, Portfolio Income First Tier $30,000 $30,000 Second Tier $0 $0 Totals $30,000 $30,000 First-tier distributions are the “first” $60,000 in required payments First-tier distributions are those distributions which are composed of trust accounting income that is required to be distributed currently David receives $10,000 “tax-free” payments in excess of DNI ($100,000 second-tier distribution – $90,000 remaining DNI) Examples 26 and 27 34 Income Type Amount Received Dividends Taxable Interest Exempt Interest Passive Activity Income Brenda $20,000 $8,000♦ $4,000 $5,000 $3,000 Del $20,000 $8,000 $4,000 $5,000 $3,000 $16,000 $8,000 $10,000 $6,000 Beneficiary Totals in DNI ♦ ($20,000 distribution/$100,000 total DNI) × $40,000 dividends in DNI © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-18 2012 Corporations Volume/Solutions Manual All other calculations by beneficiary and income type are similarly computed The estate pays Federal income tax on the accumulated amounts Example 31 35 a $100,000 b $90,000 c $41,900 d Allocated as indicated on the next page Totals Accounting Income Taxable interest income $40,000 $ 40,000 Exempt interest income 60,000 60,000 Net long-term capital gain 30,000 30,000 Fiduciary fees 10,000 (4,000)* Item Personal exemption Accounting Income/Taxable Income Before the Distribution Deduction Taxable Income Distributable Net Income/ Distribution Deduction $40,000 (100) $100,000 STEP $65,900 STEP $65,900 Exemption Corpus Capital Gain/Loss 100 (30,000) Net Exempt Income 54,000** Distributable Net Income $90,000 Distribution Deduction (24,000)♦ STEP Entity Taxable Income $41,900 STEP ♦ $36,000 Deductible portion of DNI (taxable interest of $40,000 – $4,000 allocable fees) × 6/9 ($60,000 distribution/$90,000 DNI) portion of DNI distributed Fiduciary fees allocation: *Taxable income ($40,000 ÷ $100,000) ì $10,000 **$60,000 nondeductible exempt income ($60,000 ữ $100,000) ì $10,000 â 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates PROOF: The trust is taxed on: Retained portion, deductible DNI (3/9 × $36,000) Corpus capital gain Exemption Fiduciary taxable income 20-19 $12,000 30,000 (100) $41,900 Income Type [Step 5] Beneficiary Amount Received Taxable Interest Exempt Interest Lydia $40,000 $16,000♦ $24,000 Kent $20,000 $8,000 $12,000 ♦ ($40,000 distribution/$90,000 total DNI) × $36,000 taxable interest in DNI (assigning the fiduciary fees proportionately to the two types of accounting income) Figure 20.3 and Example 31 36 Reported on (X) Dora’ s Item Incurred Form 1040 Income Tax Jose’s Estate: First Form 1041 Income Tax Jose’s Estate: Form 706 Estate Tax a Last paycheck X X b State income tax withheld on last paycheck X X c Capital gain portion of installment payment received X X d Ordinary income portion of installment payment received X X e Dividend income, record date was two days prior to José’s death X f Unrealized appreciation, securities No gross income Basis step-up due to death g Depreciation recapture accrued as of date of death Not reported on any return Recapture potential disappears at death X X © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-20 2012 Corporations Volume/Solutions Manual Reported on (X) Dora’ s Item Incurred Form 1040 Income Tax Jose’s Estate: First Form 1041 Income Tax h Medical expenses of last illness Jose’s Estate: Form 706 Estate Tax X i Apartment building, rents accrued but not collected as of death X X j Apartment building, property tax accrued and assessed but not paid as of death X X Executor could elect to claim this on José’s last Form 1040 pp 20-12 to 20-16 and 20-32 37 a TAX FILE MEMORANDUM November 3, 2011 From: Jennie Smallwood Facts: Gary transfers property in trust, income payable to wife Winnie for her life, remainder to grandson Gary’s son is the trustee Issue: Does this arrangement avoid the grantor trust rules and successfully shift recognized income away from Gary? Analysis: Gary is taxed on the trust income Under § 677(a)(1), the grantor is treated as the owner of the trust if the income of the trust is distributed to the grantor or the grantor’s spouse b TAX FILE MEMORANDUM November 3, 2011 From: Jennie Smallwood Facts: Gary transfers income-producing assets and a life insurance policy to a trust, life estate to his children, remainder to his grandchildren The policy is on wife Winnie’s life, and the trust is the beneficiary The trustee, an independent trust company, pays the premiums with income from the other assets © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates Issue: 20-21 Does this arrangement avoid the grantor trust rules and successfully shift recognized income away from Gary? Analysis: Gary is taxed on the trust income that is used to pay the life insurance premiums Under § 677(a)(3), the grantor is treated as the owner of the trust, but only to the extent that the trust’s income is applied to the payment of premiums on life insurance policies on the grantor or the grantor’s spouse c TAX FILE MEMORANDUM November 3, 2011 From: Jennie Smallwood Facts: Gary transfers property in trust, income payable to his grandchildren at wife Winnie’s discretion Winnie and an independent trust company are co-trustees Issue: Does this arrangement avoid the grantor trust rules and successfully shift recognized income away from Gary? Analysis: Gary is taxed on the income of the trust under § 674(a) The fact that Winnie is a trustee, here even only a co-trustee, leads to this result d TAX FILE MEMORANDUM November 3, 2011 From: Jennie Smallwood Facts: Gary transfers property in trust, income payable to ex-wife Winnie for her life, remainder to Gary or his estate The arrangement satisfies Gary’s alimony obligations to Winnie An independent trust company is the trustee Issue: Does this arrangement avoid the grantor trust rules and successfully shift recognized income away from Gary? Analysis: Under § 677(b), the income of a trust is taxable to the grantor, to the extent that it is applied or distributed for the support or maintenance of a beneficiary whom the grantor owes a legal or support obligation Because these distributions satisfy Gary’s legal alimony obligations to Winnie, all of the amounts paid or credited for Winnie’s benefit are taxed to Gary Examples 35 and 36 38 2011 No flow-through of either the negative taxable income or the capital loss incurred The $300 negative taxable income, due solely to the entity’s personal exemption, is lost forever, while the unused capital loss carries forward 2012 Flow-through of $30,000 negative ordinary taxable income, deductible by Yellow Jr as a miscellaneous itemized deduction, subject to the 2% of AGI floor © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-22 2012 Corporations Volume/Solutions Manual Flow-through to Yellow Jr of $15,000 net capital loss of 2009, to be netted against his or her own capital gain income Loss is carried forward only, without any expiration date for Junior Example 34 39 Assuming that Woody appoints an independent trustee, the trust is tax-effective, but only to a limited extent Generally, since Wendy is subject to a lower marginal income tax rate than is Woody, the family’s Federal income tax liability is reduced with respect to all of the investment and capital gain income generated by that portion of his investment portfolio that he transfers to the trust, but such amount of income shifting would have been limited generally to $1,900 per year until Wendy reaches age 19 (or 24) [§ 1(g)(4)] Prior to that year, Wendy will pay income tax at Woody’s rate on the recognized investment income that exceeds $1,900 A plan where the trustee would invest in growth assets, rather than incomeproducing assets, or would accumulate in the trust any recognized income in excess of $1,900, would improve the effectiveness of Woody’s income-shifting plans If Woody drafts the trust instrument so as to allocate the entity’s net capital gains to the income beneficiary, this income-shifting effect also will apply to such capital gains In this manner, Woody (via the trust) will have provided Wendy with a greater amount of financial resources for her use Such income would have been subject to the lower marginal income tax rates of the trust or the daughter This is preferable to transferring assets to her after paying his own Federal income tax thereon Moreover, the entity will avoid grantor trust status, even though the trustee is empowered to purchase insurance on Woody’s life or to satisfy some of his legal obligations (e.g., with respect to Wendy’s medical costs) To the extent, however, that the trust uses its income to purchase insurance on Woody’s life or to meet his legal obligations, such income is taxed to him The entire trust does not become subject to the grantor trust rules when this occurs; rather, only the attributable portion of the trust’s income is taxed to Woody in that year The remainder of that year’s taxable income and the income of years in which no such expenditures are made remain subject to the (income-shifting opportunities of the) usual Subchapter J rules Thus, Woody is taxable on the amount of the entity’s income that is used in 2005 through 2009 to pay the five premiums on the life insurance policy Under state law, Woody must provide health care for his dependent children, so his legal obligations are met by the trust in 2011 (or any other year), and Woody receives gross income therefrom The life insurance proceeds are not included in the trust’s 2013 gross income [§ 101] pp 20-25 to 20-27 40 Hoffman, Raabe, Smith, and Maloney, CPAs 5191 Natorp Boulevard Mason, OH 45040 November 3, 2011 Ms Annie O’Toole 22 Beneficiary Lane Bowling Green, KY 42101 © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Income Taxation of Trusts and Estates 20-23 Dear Ms O’Toole: I am pleased that you are happy with our decision several years ago to adopt a plan of lifetime gifts, so as to reduce your exposure to death taxes Now that you are forced to make additional decisions as to a potential acceleration of specific gifts, to be made, let me offer the following chart, commenting on each of your indicated choices Proposed Gift Comments Cottage, unrealized loss in • value Installment notes, deferred gain of $90,000 • Basis is stepped down if held to death • Basis is lost if subject of a gift • Gross estate is not reduced if Annie continues to live there as part of a plan • Deferred gain is recognized immediately upon the transfer Income tax deduction for attributable estate tax liability is created • Due to liquidity crisis, cash bequest is settled by the estate with appreciated property Basis is important only if son Jerry plans to sell the property • Gain is recognized by the estate immediately upon distribution I will call you soon after your return home to discuss additional matters of importance to your estate plan Good luck with your surgery! Sincerely yours, Stephanie Brewer, CPA Tax Manager TAX FILE MEMORANDUM November 3, 2011 From: Stephanie Brewer Subject: Client Annie O’Toole’s choices as to lifetime gifts a If Annie transfers the cottage as a gift, her son is subject to the basis rules of § 1015 The son’s basis for gain on the sale of the property is $30,000 (the donor’s basis); the basis for loss is $20,000 (fair market value at the time of the gift) However, if the cottage passes through Annie’s estate to her son, his basis for gain or loss on a subsequent sale of the property is determined under § 1014, at its fair market value at the date of the client’s death This could be an unfavorable result to the son if the © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-24 2012 Corporations Volume/Solutions Manual property continued to decline in value before his mother’s death and he intended to sell it within a short time of its receipt If the son intends to keep the cottage for his lifetime, it should not matter to him whether he receives the property now or at the time of his mother’s death Consequently, the income tax consequences should be irrelevant For estate tax purposes, however, Annie might wish to make a gift of the property now and remove it from her gross estate Unless she intends to retain a life estate in the cottage (which would cause the property to be included in her gross estate under § 2036), a current gift will remove the property from her gross estate, even if she should not survive the impending surgery Recall that most gifts within three years of the donor’s death are excluded automatically in the decedent’s gross estate under § 2035 (see Chapter 18) Thus, if the son intends to keep the cottage and will allow his mother to use it at any time, there is no need for Annie to retain a life estate in the property and be subject to the unfavorable estate tax consequences of § 2036 b The gift of an installment obligation is treated as a taxable disposition under § 453B Thus, if Annie makes a gift of the installment notes (in which she has a basis of $100,000 and the fair market value is $190,000), a gain of $90,000 is recognized The daughter’s basis in the installment notes is $190,000, due to the gain recognized by her mother If the daughter later collects the $200,000 maturity value, she recognizes a taxable gain of $10,000 Taxpayers who receive income in respect of a decedent must carry over the basis and report the income in the same character as the decedent would have, had he or she lived to receive it Section 691(c) provides for an income tax deduction of the death taxes that are attributable to the appreciated value of such obligations that are included in the decedent’s estate Thus, if the installment notes pass through the decedent’s estate to her daughter, the daughter may be entitled to an income tax deduction under § 691(c) c Reg § 1.661(a)-2(f)(1) provides that gain or loss must be recognized by an estate that uses other property to satisfy a specific property bequest The gain or loss is determined by the difference between the estate’s basis in the property that is distributed and the fair market value of the specific bequest property on the date of distribution See Chapters 18 and 19 pp 20-11 to 20-13 The answers to the Research Problems and the Tax Return Problems are incorporated into the Instructor’s Guide with Lecture Notes to accompany the 2012 Annual Edition of SOUTH-WESTERN FEDERAL TAXATION: CORPORATIONS, PARTNERSHIPS, ESTATES & TRUSTS © 2012 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-2 Question/ Problem *30 31 32 *33 *34 *35 *36 37 38 39 40 2012 Corporations Volume/Solutions Manual Learning... http://downloadslide.blogspot.com 20-18 2012 Corporations Volume/Solutions Manual All other calculations by beneficiary and income type are similarly computed The estate pays Federal income tax on the accumulated... or in part To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 20-22 2012 Corporations Volume/Solutions Manual Flow-through to Yellow Jr of $15,000