Income Taxation of Trusts and Estates - Examples Flashcards
Qualified Personal Residence Trust (QPRT)
Assume a widow places her $200,000 personal residence into an irrevocable trust. The trust provides that she will live in the personal residence for a 10-year term. At the end of that time, the personal residence will pass to her children. This trust is known as a Qualified Personal Residence Trust (QPRT).
The present value of her right to live in the personal residence for 10 years is $98,330 (.491651 × $200,000). Since the entire value of the personal residence placed in trust is $200,000 and the income interest retained by the grantor is $98,330, the value of the future interest gift being made at that point to the remainder person is the difference, $101,670. This entire amount ($101,670) is a taxable gift because the gift tax annual exclusion is allowed only for gifts of a present interest. Of course, up to $13,610,000 (2024) in gift taxes and estate taxes can be sheltered by her unified credit which means that the widow will pay no gift tax. Assuming the widow has gifted over $13.61 million and a minimum 40% gift tax bracket applies, the gift tax would be $40,668 ($101,670 × 40%).
If the $200,000 property appreciates at an after-tax rate of 5%, the property will be worth $325,779 by the end of the 10-year term.
Should the widow die before the term expires, the trust assets would be included in her estate at their values as of her date of death. It is treated as if the trust never existed in the first place so there would be no federal death tax savings.
But if the widow survived the 10-year period (no matter how short a period of time), none of the trust assets would be in her estate. At a 35% estate tax bracket, the savings would be approximately $78,438 [35% × ($325,779 − $101,670)]. Furthermore, because the property would not pass through probate, probate costs of $325,779 would be avoided.
Choice of Taxable Year - The executor can also select the last day of any month for the estate’s income tax year to end
For example, if December 31 is selected as the end of the estate’s income tax year, then income is reported for a calendar year. However, if the end of any month other than December 31 is chosen, then the estate is reporting income tax for a fiscal year. The use of a fiscal year allows the estate to make income distributions to heirs which will not be subject to taxation until the following calendar year.
Choice of Taxable Year - A distribution from a trust or estate is deemed to have been made on the last day of the trust’s or estate’s taxable year, regardless of which day during the tax year the distribution was actually made.
For example, Tom died on April 1, 20X2. John, his executor, chooses a fiscal year end of January 31, 20X3. In July of 20X2, John makes a distribution to the heirs of $50,000 from the income of the estate. Since the estate’s taxable year ends on January 31, 20X3, the distribution to the heirs is deemed to have been made in 20X3 even though they got the distribution in 20X2. The income is taxable to the heirs in 20X3.
Distributable Net Income (DNI) - DNI ensures that a trust or estate receives a deduction for the amounts distributed to the beneficiary, by doing this it ensures the distribution is not taxed twice.
For example, a trust earns income of $10,000 and distributes $6,000 to a beneficiary. The DNI is $10,000. The trust would receive a deduction for $6,000 and the trust is taxed on the remaining $4,000.
DNI limits the amount of trust income the beneficiary is required to report. The trust’s deduction is the lesser of the amount distributed to the beneficiary or the DNI. In the example above, if the trust had distributed $12,000 to the beneficiary the trust would deduct $10,000- the DNI. Under the “income first rule” $10,000 is considered to be income and the remaining $2,000 is a tax-free distribution of trust corpus. The beneficiary is taxed on $10,000 of the $12,000 received.
Income in Respect of a Decedent - under IRC 691, to the extent any estate tax is paid on the income portion of an IRD asset, the estate tax attributed to the income of such an asset may be used to reduce the amount of taxable income received by the beneficiary of the asset.
If in 2024, a decedent with a gross estate of $15,000,000 bequeathed his IRA valued at $600,000 to his nephew, the value of the IRA would be included in his gross estate. The decedent’s tentative tax would be $5,945,800 and the net federal estate tax would be $556,000 [($15,000,000 − estate exemption amount) × estate tax rate of 40%] after using the decedent’s unified credit amount of $5,389,800 (2024) to offset the tentative tax. However, suppose that the IRA had NOT been included in the decedent’s estate in 2024, then the uncle’s gross estate would only be worth $14,400,00, with a tentative tax of $5,705,800 and a net federal estate tax of $316,000. The difference between the estate tax which included the IRA ($556,000) and the estate tax which did not include the IRA ($316,000) [($14,400,000 − $13,610,000) × 40%] is $240,000. If the nephew received a taxable distribution of $300,000 in 2024 from the IRA, he would report income of $300,000 and receive a deduction of $120,000 ($300,000 divided by $600,000 IRA × $240,000).
IRD Assets - The Internal Revenue Code defines an item of IRD as an asset owned by a cash-basis taxpayer in which income accrued but was not taxed.
For example, if the decedent were a participant in a qualified retirement plan, the income earned in the plan is income tax deferred. Should the owner of the retirement plan die, the Internal Revenue Code will not allow the beneficiaries of the plan to receive the benefits on an income tax-free basis. In other words, since the participant of the plan received the income tax benefits during their lifetime and would have been subject to income tax liability during their lifetime (as funds were withdrawn from the plan), this same income tax liability transfers to the beneficiaries of the plan. More specifically, an asset deemed to be an item of IRD does not receive a step-up or a step-down in basis. The tax-deferred earnings will be subject to income tax.
