Part 2 - Businesses - Unit 3 - Content

Question 1

Farming Businesses

Answer 1

• Farming businesses may be engaged in activities such as crop production, animal production, or forestry and logging. The entity type does not matter; a business will be classified as a “farming business” as long as the business cultivates, operates, or manages a farm (or fishery) for profit. There are many types of activities that qualify as “farms.” Some examples include:
  
  • Agricultural farming: a farm that cultivates and grows any type of agricultural crops, such as: grains, beans, industrial hemp, cotton, flowers, vegetables, etc.
  • Dairy farming: a class of farming for long term production of milk and dairy products.
  • Fish farming (fisheries): involves raising fish or shellfish commercially, usually for human consumption.
  • Silk farming: the cultivation of silkworms to produce silk.
  • Fur farming: a business that breeds and raises fur-bearing animals for their pelts.
  • Apiculture (Beekeeping): a business that raises bees to collect products that the hive produces (honey, beeswax, etc.)
• A farming business operating as a sole proprietorship reports income and loss on Schedule F, Profit or Loss from Farming.

Question 2

Not Farming Businesses

Answer 2

• Certain associated businesses are not classified as farming businesses and instead must file on Schedule C (if a sole proprietorship). Examples include:
  
  • Veterinary businesses.
  • Businesses that only supply farm labor or farming equipment.
  • Businesses that only sell farm supplies, such as pesticides or herbicides.
  • Businesses that are only in the business of breeding, including those that raise or breed dogs, cats, or other household pets.
  • Businesses that provide agricultural services, such as soil preparation and fertilization, but do no actual farming of the land.
• Not Classified as Farming Income: Certain types of income associated with farming businesses are not classified as farm income. Farm income does not include any of the following:
  
  • Wages received as a farm employee.
  • Income received under a contract for grain harvesting with workers and machines furnished by the taxpayer.
  • Gains received from the sale of farmland and depreciable farm equipment.
  • Gains from the sale of securities, regardless of who owns the securities.
  • Passive rental income received from the rental of farmland where the owner of the land does not materially participate.

Question 3

Farming Rents

Answer 3

• If a farmer rents their farmland for someone else to use, the related revenue is generally classified as rental income, not farming income. This also applies to crop shares, when a tenant farmer pays a proportion of crop harvest proceeds to the landowner for the use of their farmland.
• This special type of rental activity is also commonly called “sharecropping” or “cropping.” This passive activity income is reported on Form 4835, Farm Rental Income and Expenses.
• On the other hand, if a farmer simply rents their pasture or other real property for a flat cash amount without providing services to the tenant, the landowner will report the income as rent on Schedule E.
• If a farmer materially participates in farming operations on the land he owns, the rent is considered farm income and is reported on Schedule F.
• Example: Harold is a farmer who owns 200 acres of pastureland in Wyoming. Harold rents out his pasture to someone else who owns cattle. Harold also feeds the cattle and takes care of them every day. Since he is materially participating in the activity, as well as providing services by taking daily care of the livestock, the income is reported on his Schedule F as ordinary income.
• Example: Norris also owns pastureland in Wyoming. Norris simply rents the pasture to other farmers for a flat cash amount. He does not provide any services or take care of the livestock in any way. Norris would report the income as rental income on Schedule E (Form 1040). The income would be passive activity income and not subject to self-employment tax.
• Example: Rachel owns a 90-acre farm in Montana. She generally rents out her land to a tenant farmer and does not do any of the planting herself. This year, Rachel rents her land to James, a sharecropper who grows organic beets. Rachel’s contract with James, the tenant farmer, requires him to pay twenty-five percent of the crops harvested. Rachel reports her share of the income from the crops on Form 4835, which is attached to her Form 1040. Rachel’s tenant farmer (the sharecropper) would be required to report his income on Schedule F as regular farming income, subject to self-employment tax.

Question 4

Estimated Taxes for Farmers

Answer 4

• Special rules apply to the payment of estimated tax by qualified self-employed farmers and fishermen. If at least two-thirds of the individual’s or entity’s gross income comes from farming or fishing activities, the following rules apply:
  
  • The farmer does not have to pay estimated tax if the farmer files their return and pays all the tax owed by March 1.
  • If the farmer cannot file by March 1, the farmer is required to make only one estimated tax payment, called the required annual payment, by January 15.
• Example: Dustin grows wheat and sells his wheat to a local distributor. He files Schedule F to report his income and loss. He does not pay any estimated taxes in 2023. He files his individual tax return on March 1, 2024, paying all his tax owed for the prior tax year with a single check. He will not owe an estimated tax penalty, regardless of the amount owed, because of the special rules that apply to farmers regarding estimated taxes.
• Example: Janelle is a beekeeper that raises honeybees and collects the honey for sale. She also gathers the beeswax and makes handmade creams and soaps. All of her income comes from her beekeeping activity, so she is a qualified farmer and she files a Schedule F. Janelle doesn’t plan to file her tax return until April, so she makes a single annual payment on January 15, 2024, for her 2023 tax estimate.

Question 5

Not Qualified Farmers

Answer 5

• If a farmer does not receive more than two thirds of their gross income from a qualified farming activity, the taxpayer is not eligible for this special treatment for estimated taxes. This rule also does not apply if the farming business is organized as a C corporation.
• Example: Angela grows fresh vegetables that she sells in a popular roadside shop. She is also a partner in a restaurant and receives substantial income from that activity as well. Angela files a Schedule F to report the income from her vegetable farm. She also files Schedule E to report her share of the partnership income from the restaurant activity. Her Schedule F shows $12,000 in net taxable income from the farming activity. Her Schedule K-1 from the partnership shows $45,000 in distributable net income from her restaurant partnership. Even though Angela has a legitimate farming business, less than two-thirds of her income is from farming. So, she would not qualify for the special estimated tax payment provisions. Angela is required to make estimated payments throughout the year, or she will face an estimated tax penalty.
• Example: Groveport Ranch, Inc. is a large dairy farm that is organized as a C corporation. Although all of Groveport Ranch’s income is from farming, a C corporation is not allowed to delay estimated payments. Every C corporation must make estimated tax payments if it expects its tax to be $500 or more for a tax year.

Question 6

Accounting Methods

Answer 6

• Farmers are allowed to use any accounting method that is available for other business types. In addition, there are a few special accounting methods that are applicable only to farming businesses. Farmers can use the following accounting methods:
• Cash Method
• Accrual Method
• Combination (Hybrid) Method (using two or more of the methods listed)
• Special Methods, including the Crop Method: The IRS allows a number of different special methods of accounting that apply to items such as depreciation, farm business expenses, or income. Among these is the crop method, which requires IRS approval and is allowed only for farming businesses. If crops are not harvested and disposed of in the same tax year they are planted, the farmer can capitalize the entire cost of producing the crop, including the expense of seed or young plants, and deduct them in the year income is realized.

Question 7

Cash Method for Farmers

Answer 7

• Most farmers use the cash method. For 2023, farming businesses that have average annual gross receipts of $29 million or less for the 3 preceding tax years and are not tax shelters can use the cash method instead of the accrual method.
• Inventory requirements also do not apply to most commonly grown crops. Consequently, few farming operations are required to adopt the accrual method of accounting.

Question 8

Farming Inventory

Answer 8

• Farm inventory includes all items that are held for sale, purchased for resale, and for use as feed or seed, such as the following:
  
  • Eggs in the process of hatching.
  • Harvested farm products held for sale to customers (i.e., such as grain, cotton, flowers, industrial hemp, corn, or tobacco).
  • Supplies that become a physical part of an item held for sale, such as; containers, wrappers, or other packaging.
  • Any livestock purchased for resale.
  • Purchased farm products that are being held for seed or feed, such as hay, silage, concentrates, fodder, etc.
  • Storage costs for inventory

Question 9

Depreciation of Farm Assets

Answer 9

• Farmers are allowed to use any depreciation methods available to other business types, but there are some unique rules for farmers with regard to depreciation. With regards to accelerated depreciation methods, farmers are allowed to use section 179 and bonus depreciation just like any other business. Qualified property for both section 179 and bonus depreciation may be new or used.
• The Tax Cuts and Jobs Act modified the depreciation recovery period for new farm equipment and machinery placed into service during the year. The recovery period has been shortened from 7 years to 5 years.
• Used machinery and equipment retains a seven-year class life under MACRS. Farmers may use the 200% declining-balance method of MACRS depreciation for farming assets. In prior years, most farming property was depreciated using the 150% declining-balance method.
• Note: A greenhouse that is used only to grow plants would be “single-purpose” (10-year property under MACRS). If a cash register and a sales kiosk is installed in the greenhouse so that a farmer can sell plants in addition to growing them there, the greenhouse would no longer be “single-purpose” property.

Question 10

Disposition of Farm Assets

Answer 10

• Income reported on Schedule F does not include gains or losses from sales or other dispositions of the following farm assets:
  
  • Farmland
  • Depreciable farm equipment
  • Barns, stables, and other types of farm buildings
  • Livestock held for draft, breeding, sport, or dairy purposes
  • The sale of these assets is reported on Form 4797, Sales of Business Property and may result in ordinary or capital gains or losses.

Question 11

Postponing Gain Due to Weather Conditions

Answer 11

• There are special rules for farmers regarding the postponement of gain due to weather conditions. If a farmer sells more livestock (including poultry), than they normally would in a year because of a drought, flood, or other weather-related conditions, they may postpone reporting the income from the additional animals until the following year. The taxpayer must meet all the following conditions to qualify:
  
  • The principal trade or business must be farming.
  • The farmer must use the cash method of accounting.
  • The farmer must be able to show that they would not have sold the additional animals in that year except for the weather-related condition.
  • The area must be designated as eligible for federal disaster assistance.
• The livestock does not have to be raised or sold in the affected area. However, the sale must occur solely because the weather-related condition affected the water, grazing, or other requirements of the livestock. The farmer must figure the amount to be postponed separately for each generic class of animals, such as hogs, sheep, and cattle.
• To postpone gain, the farmer must attach a statement to the tax return for the year of the sale, providing specific information about the weather conditions and circumstances that led to the postponement of gain for each class of livestock.

Question 12

Crop Insurance and Government Disaster Payments

Answer 12

• Insurance proceeds, including government disaster payments, may be received as a result of destruction or damage to crops or the inability to plant crops because of drought, flood, or another natural disaster. These payments are generally taxable in the year they are received.
• However, some farmers can elect to postpone reporting the income until the following year if the farmer meets all of these conditions:
  
  • The farming business must use the cash method of accounting.
  • Crop insurance proceeds were received in the same tax year the crops were damaged.
  • Under normal business practices, the farming business would have reported income from the damaged crops in any tax year following the year the damage occurred.
• A statement must be attached to the tax return indicating the specific crops that were damaged, and the total insurance payment received. To make this election to postpone income, the farmer must be able to prove that the crops would have been harvested or otherwise sold in the following year.
• If a farmer forgoes the planting of crops altogether and receives agricultural program payments from the government, payments are reported on Schedule F, and the full amount of the payment is subject to self-employment tax.

Question 13

Farm Income Averaging

Answer 13

• Unlike other businesses, self-employed farmers are allowed to average all or some of their farming income. Farmers may use Form 1040, Schedule J, Income Averaging for Farmers and Fishermen, to average their income by using income tax rates from the three prior years (“base years”).
• Farm income averaging allows farmers to lower their tax liability when their income varies greatly from one year to the next.
• Example: Edward is a citrus farmer in Florida. In the current year, he has a record crop with gross income nearly double that of the two prior years. In the last two years, a cold frost had damaged a large percentage of his crop, which caused his income to be much lower in those years. In the current year, Edward elects to average his farming income by filing Schedule J. His taxable income for the current year may be averaged with the corresponding amounts for the previous years, (when his income was lower) which will significantly reduce his tax liability in the current year.

Question 14

Other Unique Tax Rules

Answer 14

• There are many special rules that apply only to farming businesses. Other examples of tax rules unique to farmers include the following:
• Car and Truck Expenses: Farmers can claim 75% of the use of a car or light truck as business use without any records (such as a mileage log) if the vehicle is used most of the business day in a farming business.
• Soil Conservation: Farmers can choose to deduct as a business expense land-related expenses for soil or water conservation or for the prevention of erosion. Examples include leveling, eradication of brush, removal of trees, or planting of windbreaks. Although farmland itself is not depreciable, land conservation expenses or other costs to improve the land for farming or growing crops are deductible as business expenses. For most other businesses, these types of land improvements would be considered nondeductible capital expenses and would have to be added to the basis of the land.
• Excise Tax Credits: Farmers may be eligible to claim a credit or a refund of federal excise taxes on fuel used on a farm.

Question 15

Nonprofit Organizations

Answer 15

• The tax-exempt sector under section 501(c) of the Internal Revenue Code covers 1.5 million exempt entities of varying sizes and purposes.
• The U.S. Government Accountability Office estimates that spending in the tax-exempt sector represents about one-tenth of the U.S. economy, and the paid exempt workforce is comparable in size to some of the largest sectors of the U.S. civilian workforce, such as food and lodging.
• Charitable organizations usually rely on donor contributions to fund operations. Nonprofit organizations are generally exempt from income tax and receive other favorable treatment under the tax law; however, certain income of an exempt organization may be subject to tax, such as income from an unrelated business activity.

Question 16

Types of Exempt Entitites

Answer 16

• The majority of nonprofit organizations qualify for tax-exempt status under section 501(c)(3) of the Internal Revenue Code. In general, there are two types of exempt entities:
  
  • 501(c) charities and
  • Other 501(c) entities (this group includes non-charities, including: social clubs, labor unions, and nonprofit political organizations)
• The 501(c)(3) designation is reserved for organizations that are exclusively charitable in nature. These organizations are exempt from paying income tax in connection with their charitable activities, and they are eligible to receive charitable contributions that are tax-deductible to the donor.

Question 17

501(c)(3) Requirements

Answer 17

• To qualify as a 501(c)3 organization, an organization must meet the following requirements:
  
  • Organization: It must be organized as a corporation, a trust, or an unincorporated association, and its purpose must be limited to a qualified exempt purpose, as described in section 501(c)(3). A nonprofit entity may not be organized as a partnership or sole proprietorship.
  • Exempt Purpose: It must have one or more exempt purposes as listed under section 501(c)(3): charitable, educational, religious, scientific, literary, fostering national or international sports competition, preventing cruelty to children or animals, or testing for public safety.
  • Operation: A substantial portion of its activities must be related to its exempt purpose(s). Further, a 501(c)(3) organization must:
    
    • Refrain from participating in political campaigns of candidates. 501(c)(3) organizations must also avoid any issue that may be construed as political campaign intervention.
    • Restrict its lobbying activities to an “insubstantial” part of its total activities.
    • Grants, donations, and activities may not assist any private election campaign or endorse any political candidates for public office.
    • Ensure that its earnings do not benefit any private shareholder or individual
    • Not operate for the benefit of private interests, such as those of its founder, the founder’s family, or its shareholders
    • Not operate for the primary purpose of conducting a trade or business that is not related to its exempt purpose

Question 18

Examples: Prohibited Actions

Answer 18

• Example: Hans Friedman is a wealthy business owner. He forms the Friedman Charitable Trust. When Hans fills out the exemption application, he states that the organization will provide college scholarships and grants to low-income college students. Hans Friedman then transfers $500,000 to the trust, taking a deduction for his donation. During the year, the Friedman Charitable Trust awarded several scholarships, but all of the scholarship “winners” were direct descendants and relatives of Hans Friedman. The IRS audits the trust and retroactively revokes its tax-exempt status. The Friedman Trust will be required to pay income taxes on all its revenue, including any donations that it received, and donors will no longer be able to deduct contributions to the organization.
• Example: Andrew Smith is an ordained minister of Summit Church, a qualified section 501(c)(3) organization. During regular services of Summit Church, and shortly before the election, Minister Andrew preached on a number of issues, including the importance of voting in the upcoming election, and concluded by stating, “It is important that you all do your civic duty in the election and vote for Candidate Robert Weston, who is running for political office in our district.” Because Minister Andrew’s remarks indicating support for Candidate Weston were made during an official church service, this would constitute political campaign intervention by Summit Church, which is prohibited. The church could lose its tax-exempt status (example from Publication 1828).

Question 19

Tax Exempt Status

Answer 19

• Before applying for tax-exempt status, an organization must be created by preparing an organizing document. This is the first step, (even before requesting an EIN, or filing a formal application for exemption with the IRS).
• The organization’s “organizing document” must limit the organization’s purposes to those set forth in section 501(c)(3) and must specify that the entity’s assets will be permanently dedicated to the specified exempt purpose(s). The document should also contain a provision for distributing funds if the organization later dissolves.
• To request exempt status under section 501(c)(3), an entity must use Form 1023, Application for Recognition of Exemption. Any organization (except for private foundations), with annual gross receipts of no more than $5,000 is not required to file Form 1023 but must do so within 90 days of the tax year in which it exceeds this threshold.
• Applications for recognition of exemption on Form 1023 must be submitted electronically online at www.pay.gov. There is a user fee for filing this form.
• While an organization’s application is pending approval, the organization may operate as if it were tax exempt. Donor contributions made while an application is pending would qualify, assuming the IRS later approves its exempt status.
• Example: The Texas Cat Rescue is a qualified 501(c)(3) organization that operates on the calendar year. The rescue organization officially formed on March 5. It has an official organizing document and an EIN that the organization’s director requested from the IRS. At the end of the year, the organization had collected a total of $14,500 in donations. Since this exceeds the threshold for the first tax year, the Texas Cat Rescue must apply for formal exemption within 90 days after the end of its first tax year.

Question 20

Churches

Answer 20

• Note: Churches and similar religious organizations are not required to request a formal exemption, regardless of their size or the amount of revenue or donations that the church receives (although some churches do choose to request formal exemption, anyway).
• Churches are classified as public charities by default.

Question 21

Other Section 501(c) Organizations

Answer 21

• Other nonprofit organizations that do not qualify for exemption under section 501(c)(3) may qualify for tax exempt status by filing Form 1024, Application for Recognition of Exemption Under Section 501(a) or Form 1024-A. Both of these forms must now be submitted online on www.Pay.gov.

Question 22

Other Nonprofit Examples

Answer 22

• There are many types of organizations which fall under different exempt categories. This list is not comprehensive. Examples of “other” exempt organizations include the following:
• 501(c)(1): These are exempt corporations that are organized under an Act of Congress, including Federal Credit Unions and National Farm Loan Associations.
• 501(c)(4): Includes civic leagues and social welfare organizations. Examples include the American Civil Liberties Union (ACLU), Lions Clubs International, and the National Rifle Association.
• 501(c)(5): Includes labor unions, county fairs, agricultural cooperatives, and horticultural organizations. Examples include the United Steelworkers Union and the Texas Farm Bureau.
• 501(c)(6): Includes business leagues, professional sporting leagues, and boards of trade. Examples include the American Medical Association, American Bar Association, the National Hockey League, and the PGA Tour.
• 501(c)(7): Includes social and recreation clubs, college fraternities and sororities, athletics clubs, yacht clubs, and hobby clubs. Examples include the Boca West Country Club, the West Point Yacht Club, and the International Star Trek Fan Association.
• 501(c)(8) and 501(c)(10): Includes fraternal beneficiary societies and associations operating under the lodge system. 501(c)(8) organizations provide insurance benefits to the society’s members, while 501(c)(10) organizations provide charitable benefits. Examples include the Knights of Columbus, Freemasons, and the Shriners.
• 501(c)(13): These are nonprofit cemetery companies and crematoria. Individual contributions to 501(c)(13) entities are tax-deductible, but subject to a 30% of AGI limit for individuals.
• 501(c)(14): These are state-chartered credit unions and other mutual financial organizations. Examples include the San Diego County Credit Union, and the California Credit Union.
• 501(c)(19): These are veterans’ organizations. In order to qualify for this exempt status, the group must originate in the U.S., and at least 75% of its membership must be current or prior members of the armed forces. Contributions to 501(c)(19) organizations are tax-deductible by the donor, but subject to a 30% of AGI limit for individuals. Examples include the National Guard Association of the United States, Veterans of Foreign Wars, and the American Legion Auxiliary.

Question 23

Donor Contributions

Answer 23

• Donor contributions to civic leagues or other section 501(c)(4) organizations generally are not deductible as charitable contributions for federal income tax purposes. A significant difference between charitable organizations and 501(c)(4) organizations is that 501(c)(4) organizations are permitted to engage in political campaign activity and lobbying.
• Sometimes, a large exempt organization will split its activities into two separate exempt entities in order to preserve their ability to lobby as well as accept tax-deductible donations.
• An example of this is the American Civil Liberties Union. The ACLU Foundation is a 501(c)(3) nonprofit charity that primarily conducts advocacy and public education. The ACLU is a 501(c)(4) that primarily lobbies for political policy. The ACLU Foundation may receive donations that are tax deductible to the donor, but the ACLU cannot.
• Example 501(c)(3): ACLU Foundation. This is a 501(c)(3) foundation, a Nonprofit charity that primarily conducts advocacy and public education. Gifts are tax deductible.
• Example 501(c)(4): ACLU. The ACLU is a 501(c)(4) nonprofit, but gifts are NOT tax-deductible. It is a membership organization, and membership fees fund LEGISLATIVE LOBBYING.

Question 24

Public Charity or Private Foundation

Answer 24

• Every organization that qualifies for tax exempt status under section 501(c)(3) is further classified as either a public charity or a private foundation. All private foundations are 501(c)(3) organizations, but the same does not hold true in reverse.
• Tax-exempt entities are automatically presumed to be private foundations unless they fall into certain categories of organizations that are specifically excluded. Generally, churches, hospitals, medical research organizations, schools, colleges, and universities are automatically classified as public charities by default.
• The primary distinction between classification as a public charity or a private foundation is the organization’s source of financial support.
• A public charity tends to have a broad base of support and accepts most of its donations from its members and the general public, while a private foundation has more limited sources of support. Generally, an exempt organization will not be considered a private foundation if it receives more than one-third of its annual support from governmental units and/or the general public.
• Example: The Dallas Civil War Museum aims to preserve the heritage and history of the Civil War era. The majority of its funding comes from individual donations from the public and various fundraising events that it sponsors, so the museum is classified as a 501(c)(3) public charity. The Dallas Civil War Museum will file Form 990.
• Example: The Johannes Educational Foundation supports charter schools, and 90% of its funding comes from wealthy members of the Johannes family, so it is classified as a 501(c)(3) private foundation. The Johannes Educational Foundation is required to file Form 990-PF every year.

Question 25

Filing Requirements

Answer 25

• Every exempt organization must file an annual information return with the IRS, generally on Form 990, Return of Organization Exempt from Income Tax, unless it is specifically exempt from the filing requirement. Only the following organizations are not required to file Form 990:
  
  • Churches and their affiliated organizations
  • Government agencies
• Tax-exempt organizations with gross receipts of $50,000 or less may file Form 990-N, Electronic Notice for Tax-Exempt Organizations Not Required to File Form 990. This form is also called an “e-postcard” because it is filed electronically and is short. A small tax-exempt organization may voluntarily choose to file a long form (Form 990) instead.
• If an organization has gross receipts of less than $200,000 and total assets at the end of the year of less than $500,000, it can file Form 990-EZ.
• Amended Returns: There is no separate form to file an amended exempt return, like there is with other entity types. Instead, the entity uses Form 990, and checks the box on the form, marking “X” for an amended return.
• Example: Friends of the Brentwood Library is a 501(c)(3) organization that operates on the calendar year. At the end of each month, Friends of the Brentwood Library host a warehouse book sale, using donated books and books that have been discarded from local libraries. Funds raised support the programming and services of the library. The organization had gross receipts of $20,000 from its warehouse book sales for the year. The organization must file Form 990-N, the e postcard, by May 15.
• Example: Angelic Equine Rescue is a 501(c)(3) animal rescue organization. The organization receives $195,000 in donations from various fundraisers during the year. The entity’s total assets are $700,000 because the organization owns several horse stables as well as pastureland to house its rescue animals. Angelic Equine Rescue is required to file Form 990 (the long form) because its total assets exceed $500,000. It cannot file Form 990-N or Form 990-EZ.
• Example: As a religious organization, Calvary Methodist Church, is not required to file an application for exemption in order to be recognized as tax-exempt by the IRS. Calvary Church applies for an EIN as an exempt entity and begins regular worship. In the same year, Calvary Church hires three employees: a part-time pastor, a Sunday childcare worker, and a music leader. Although Calvary Church does not have to file Form 990, the church is still required to file employment tax returns and remit and collect employment taxes from its employees. In this way, an exempt organization is treated like every other employer.

Question 26

Penalties for Nonfiling

Answer 26

• An exempt organization that fails to file a required return may be assessed a penalty for each day the return is late. The penalty applies on each day after the due date that the return isn’t filed. The same penalty may apply if the organization provides incorrect information on the return.
• The late filing penalty for Form 990 is $20 a day, or up to 5% of the gross receipts of the organization for the year, unless the organization shows that the late filing was due to reasonable cause. The penalty applies on each day after the due date that the return is not filed.
• An organization’s exempt status may also be revoked for a failure to file. Failure to file an annual information return for three years in a row will result in the automatic revocation of exempt status. In this case, the organization would be required to reapply for exemption. However, no penalty will be imposed if reasonable cause for failure to timely file can be shown.

Question 27

UBIT

Answer 27

• Although an exempt organization must be operated primarily for tax-exempt purposes, it may engage in income producing activities that are unrelated to those purposes, so long as these activities are not a substantial part of the organization’s regular activities. Income from unrelated business activities is subject to a federal tax called the unrelated business income tax (UBIT).
• For most organizations, an activity is considered an unrelated business activity and subject to UBIT if:
  
  • It is a trade or business,
  • It is regularly carried on, and
  • It is not substantially related to furthering the exempt purpose(s) of the organization.
• An exempt organization that has $1,000 or more of gross income from an unrelated business must file Form 990–T. An exempt organization must make quarterly payments of estimated tax on unrelated business income if it expects its tax for the year to be $500 or more. The UBIT tax rate is 21%.
• Any tax due with Form 990-T must be paid in full when the return is filed, but no later than the date the return is due (determined without extensions).
• Example: Hastings University enters into a multi-year contract with a company to be its exclusive provider of sports drinks for the athletic department and concessions. As part of the contract, the university agrees to perform various services for the company, such as guaranteeing that coaches make promotional appearances on behalf of the company. The university itself is a qualified nonprofit organization, but the income received from the exclusive contract is subject to UBIT. Hastings University is required to file Form 990-T.
• Example: Windsor State College is a qualified exempt organization. The school negotiates discounted rates for the food it purchases for its dorm residents in return for an exclusive provider arrangement. Generally, discounts are considered an adjustment to the purchase price and do not constitute gross income to the purchaser. Thus, the amount of the negotiated discount is not includable in UBIT. The college is not required to file Form 990-T.
• Example: A volunteer fire association conducts monthly public dances as a fundraising activity. The fire association charges admission at the door. All of the work at the dances is performed by unpaid volunteers, so the activity is not treated as an unrelated trade or business.

Question 28

Retirement Plans in General

Answer 28

• Employers may establish retirement plans as fringe benefits for their employees. Self-employed taxpayers are also allowed to set up retirement plans for themselves. In this unit, we cover retirement plans from a business owner’s perspective.
• There are numerous forms of retirement plans that are available for small businesses; including Simplified Employee Pension (SEP) plans, Savings Incentive Match Plan for Employees (SIMPLE) plans, and qualified plans, which include 401(k) plans and traditional pensions.
• If retirement plans are structured and operated properly, businesses can deduct retirement contributions they make on behalf of their employees (or, if self-employed, themselves). Both the contributions and the earnings are generally tax-free until distribution. The rules vary depending on the type of business.
• Business retirement plans do have their drawbacks. Pension plans are not free to administer. Even simple pension plans for small businesses can cost the employer thousands of dollars annually for administration, accounting, and insurance. In contrast, a traditional IRA or Roth IRA will not require pension plan administrative fees.
• In the case of a sole proprietorship or partnership, if the owners of the business contribute to their own retirement accounts, they may take the deduction as an adjustment to income on Schedule 1 (Form 1040), but only if they have self-employment income. Any business, including a sole proprietorship or a partnership, can deduct retirement plan contributions made on behalf of employees, even if the business has a net operating loss for the year.

Question 29

SEP-IRA Plans

Answer 29

• A SEP-IRA, a Simplified Employee Pension (often shortened to “SEP”) provides the simplest and least expensive method for employers to make contributions to a retirement plan for themselves and their employees. Contributions to a SEP-IRA are treated similarly to contributions made to traditional IRAs and are subject to many of the same rules, although the contribution limits are significantly higher.
• An employer may establish a SEP as late as the due date (including extensions) of its income tax return and have it be effective for that year. The employer must also make its contribution to the plan by the due date (including extensions).
• With SEPs, there is no requirement for an official “plan document” such as those needed for qualified retirement plans. However, the employer must execute a written agreement to provide benefits to all eligible employees under the SEP-IRA. Employers can satisfy the “written agreement” requirement by adopting an IRS model SEP, using the simple Form 5305-SEP.

Question 30

SEP-IRA Employer Rules

Answer 30

• Contributions to a SEP-IRA can vary from year to year, so it is a very flexible option for small employers. A SEP-IRA can be set up for an individual person’s business even if he or she participates in another employer’s retirement plan.
• Under a SEP-IRA, employers make contributions to an individual retirement arrangement, which must be set up for each eligible employee.
• This is one of the drawbacks to a SEP-IRA arrangement. If an employer decides to set up a SEP-IRA for the business, all qualified employees must also have a SEP-IRA set up for them. An employee cannot opt-out.
• Contributions to a SEP are generally 100% tax-deductible, and investment earnings in a SEP IRA grow tax deferred. Employer contributions are pre-tax and not subject to income tax until later withdrawal.
• Contributions to a SEP-IRA are immediately 100% vested. This means that the SEP-IRA is owned and controlled by the employee, and the employer makes contributions to the financial institution where the SEP-IRA is maintained.
• Example: Herman works full-time for the post office as a mail carrier, and also runs a profitable wedding photography business with his wife on the weekends. They have $32,000 in self-employment income from their photo business. Herman may set up a SEP-IRA for himself and his wife through his photography business, even though he is already covered by a retirement plan through his job at the post office.

Question 31

SEP-IRA Employee Rules

Answer 31

• An eligible employee for SEP-IRA purposes is one who meets all the following requirements:
  
  • Is at least 21 years old
  • Has worked for the employer in at least three of the last five years
  • Has received at least $750 of compensation
• An employer can use less restrictive participation requirements than those listed but cannot use more restrictive ones. For example, an employer could choose to include all employees who are at least 18 years old, rather than at least 21 years old. The following employees can be excluded from coverage under a SEP-IRA:
  
  • Employees already covered by a union agreement (union employees are also called “collective bargaining employees” in Publication 560)
  • Nonresident alien employees who have received no U.S. source income from the employer
• Each year an employer contributes to a SEP, it must contribute to the SEPs of all participants who had qualifying compensation.

Question 32

Contributions and Distributions

Answer 32

• Contributions to a SEP can be made for participants of any age. Unlike traditional IRAs and 401(k)s, SEP IRAs do not offer any catch-up provisions.
• Employers do not have to contribute each year, but if the employer does contribute, it must contribute an identical percentage for each eligible employee.
• Participants cannot take loans from their SEP-IRAs. However, participants can make withdrawals at any time. Withdrawals can also be rolled over tax-free to another SEP IRA, to another traditional IRA, or to another qualified retirement plan.
• If an employee withdraws money from a SEP IRA before age 59½, a 10% additional tax may apply, unless the taxpayer qualifies for an exception.

Question 33

SIMPLE Plans

Answer 33

• A SIMPLE (Savings Incentive Match Plan for Employees) plan provides another simplified way for a business and its employees to contribute toward retirement. Like SEPs, SIMPLE plans have lower start-up and annual costs than most other types of retirement plans. A SIMPLE plan can be structured in one of two ways:
  
  • As a SIMPLE IRA or
  • As a SIMPLE 401(k) plan.
• If a business has 100 or fewer employees who received $5,000 (or more) of compensation during the preceding year, it can establish a SIMPLE plan. A SIMPLE Plan must be set up for each “eligible” employee. Eligible employees cannot decline.
• The business cannot maintain another retirement plan unless the other plan is specifically for a union workforce.
• The business must continue to meet the 100 employee limit each year. However, if a business maintains a SIMPLE plan and subsequently fails to meet the 100-employee limit, the business is allowed a two-year grace period to establish another retirement plan, with the business able to continue to maintain the SIMPLE plan during this 2-year grace period.

Question 34

SIMPLE IRA Rules

Answer 34

• The SIMPLE IRA plan is less burdensome for an employer than other types of retirement plans. The employer has no requirement to make annual filings to the IRS (no Form 5500).
• Unlike a SEP-IRA, employees may contribute to their own SIMPLE IRA, so they can fund their own retirement. SIMPLE IRAs also require employer contributions. Contributions to each employee’s SIMPLE IRA are made up of their own salary reduction contributions and employer contributions.
• Each year, the employer must choose to make either matching contributions or nonelective contributions to the employee’s retirement plan. In general, the employer must provide either:
  
  • Matching contributions: A dollar-for-dollar “match” on payroll contributions up to 3% of compensation. This percentage can be reduced to as low as 1% in any 2 out of 5 years.
  • Nonelective Contributions: The business may also choose to contribute a flat 2% of each eligible employee’s compensation.
• An employee may choose not to make any salary reduction contributions for a given year. This means that an employee is not required to contribute to their own SIMPLE-IRA if they do not want to.
• Example: Jones Creamery, Inc. is a dairy processing business with 30 employees. The business has a SIMPLE-IRA plan for its employees. Jones Creamery generally makes matching contributions of 3% of the employee’s compensation. However, this year, the business does poorly, and revenues are down for the year. Jones Creamery can reduce its matching contribution percentage down as low as 1% in order to conserve cash. This flexibility can help a business conserve cash flows in years when a business has a significant drop in revenues.
• Example: Berry Ranch, Inc. is a farming corporation with 50 employees. Berry Ranch decides to establish a SIMPLE IRA plan for all of its employees and will match its employees’ contributions dollar-for-dollar up to 3% of each employee’s salary. Martha works as a full-time bookkeeper for Berry Ranch. She has a yearly salary of $50,000 and decides to contribute 5% of her salary to her SIMPLE IRA. Martha’s yearly contribution is $2,500 (5% of $50,000). Berry Ranch’s matching contribution is $1,500 (3% of $50,000). Therefore, the total contribution to Martha’s SIMPLE IRA that year is $4,000 (her $2,500 contribution + the $1,500 contribution from her employer).

Question 35

SIMPLE IRA Set Up Deadline

Answer 35

• An employer can set up a SIMPLE IRA plan effective on any date from January 1 through October 1 of a year, provided the employer did not previously maintain another SIMPLE IRA plan. A new employer may set up a SIMPLE IRA plan as soon as administratively feasible after the business comes into existence, if the business is established after October 1.

Question 36

SIMPLE 401(k) Plans

Answer 36

• A subset of the 401(k) plan is the SIMPLE 401(k) plan. The SIMPLE 401(k) plan is a combination of a SIMPLE IRA and a traditional 401(k) plan. A SIMPLE 401(k) offers some features of both plans. Unlike a traditional 401(k) plan, a SIMPLE 401(k) does not require annual nondiscrimination testing.
• Since nondiscrimination testing can be very expensive for the employer, this makes the SIMPLE 401(k) appealing to a small business owner who likes the features of a traditional 401(k) but can’t afford the administration costs of nondiscrimination testing. The employer is required to make either:
  
  • A matching contribution, up to 3% of each employee’s pay, or
  • A nonelective contribution of 2% of each eligible employee’s pay.
• Note: The option to reduce matching contributions down to 1% is not available for SIMPLE 401(k)s. This is one of the major differences between a SIMPLE IRA and a SIMPLE 401(k).
• The employees are totally vested in any and all contributions. This means that the employee can withdraw from their SIMPLE 401(k) at any time.
• Unlike an IRA, participant loans are allowed from SIMPLE 401(k) plans. The loan feature can be offered to participants in both SIMPLE 401(k) plans and traditional 401(k) plans, but loans are never permitted from an IRA.
• In order to establish a SIMPLE 401(k) plan, the business:
  
  • Must have 100 or fewer employees.
  • Cannot have any other retirement plans.
  • Must file a Form 5500 annually.
• There are some notable differences between traditional 401(k)s and SIMPLE 401(k)s. Unlike a traditional 401(k), employee contributions SIMPLE 401(k) are fully vested. This is good for the employee, but not good for the employer offering the plan.
• With a traditional 401(k), employer contributions can be subject to a vesting schedule, and this may help reduce employee turnover.
• The other drawback to a SIMPLE 401(k) is that contribution limits for a SIMPLE 401(k) plan are lower than the limits for the traditional 401(k) plan.

Question 37

SIMPLE Plan Terminations

Answer 37

• SIMPLE IRA and SIMPLE 401(k) plans cannot be terminated in the middle of the year. They can only be terminated at year-end and only if the employer gives timely written notice to all its employees.
• To terminate a SIMPLE plan effective the following year, an employer must notify its employees prior to November 2nd of that year. Employers do not need to notify the IRS that they have terminated a SIMPLE plan, but they are required to notify all the employees.

Question 38

Qualified Retirement Plans

Answer 38

• A “qualified” retirement plan is an employer benefit plan that meets specific Internal Revenue Code requirements. Most large employers offer some type of qualified plan to their employees. There are two basic kinds of “qualified” retirement plans:
  
  • Defined contribution plans: like a traditional 401(k). These plans require the employee to fund their retirement account with their own money.
  • Defined benefit plans (often referred to as a pension plan or traditional pension). A defined benefit plan is a type of retirement account for which the employer invests all the money and promises a set payout when the employee retires. Defined benefit plans are generally more desirable for the employee (as they are not dependent on the investment returns of the fund like in a defined contribution plan), but they cost more money to administer and maintain. For that reason, defined benefit plans have become uncommon, except for those who work in government or public service.

Question 39

ERISA

Answer 39

• All qualified plans are subject to federal regulation under the Employee Retirement Income Security Act (ERISA). The federal government does not require an employer to establish a retirement plan, but it provides minimum federal standards for qualified plans.
• ERISA covers qualified retirement plans, as well as health and welfare benefit plans. Among other requirements, ERISA specifies that individuals who manage plans (and other fiduciaries) meet certain standards of conduct. The law also contains detailed provisions for reporting to the government and for disclosure to participants. Further, there are provisions aimed at ensuring plan funds are protected, and participants receive their benefits. ERISA mandates minimum funding requirements to ensure that benefits will be available to employees when they retire. For defined benefit plans, it requires that plan funding be certified by an actuary.
• ERISA also mandates that qualified plans meet specific requirements regarding eligibility, vesting, and communications with participants. The administrator of an employee benefit plan subject to ERISA must file an information return for the plan each year. Form 5500, Annual Return/Report of Employee Benefit Plan, must be filed by the last day of the seventh month after the plan year ends.

Question 40

Form 5500

Answer 40

• Due date: the last day of the seventh month after the plan year ends (July 31 for a calendar year plan).
• The Form 5500-EZ is available for very small plans; these are limited to owners or partners and their spouses. A plan typically will be required to file Form 5500-EZ when a plan’s assets exceed $250,000.
• https://www.irs.gov/retirement-plans/form-5500-corner
• Example: Harold is a financial planner that owns Superb Financial, Inc. an S corporation. The only other employee of the business is his wife, Karen, who works as his full-time office manager. Harold’s business has a 401(k) that covers only him and his wife. The assets in the company’s 401(k) plan are $275,000. Harold is required to file a 5500-EZ for the retirement plan. He must file the return on the last day of the seventh month after his plan year ends. Their company 401(k) is a calendar-year plan, so the Form 5500-EZ is due by July 31.

Question 41

Defined Contribution Plans

Answer 41

• A defined contribution plan provides an individual account for each participant in the plan. Examples of defined contribution plans include 401(k) plans, 403(b) plans, and 457 plans. The participant, the employer, or sometimes both, may contribute to the individual participant accounts.
• The value of the account will fluctuate due to the changes in the value of investments that have been made with the amounts contributed.
• The most common type of defined contribution plan is a traditional 401(k) plan. Many financial institutions administer 401(k) plans, which can lessen the administrative burden on individual employers of establishing and maintaining these plans.

Question 42

Defined Benefit Plans

Answer 42

• A defined benefit plan (often called a “traditional pension” plan) promises a specified benefit amount or annuity after retirement. Most federal and state governments offer defined benefit plans to their employees.
• However, fewer and fewer private companies offer defined benefit plans because they are very costly to administer, inflexible, and with the uncertainties regarding life expectancies of employees as well as investment returns. The benefits in most defined benefit plans are partially protected by federal insurance.
• The plan must file a yearly information return, so the costs will also include filing and tax preparation fees for Form 5500, Annual Return/Report of Employee Benefit Plan. The retirement plan trustee must apply for an EIN for the retirement plan’s trust.
• Contributions to a defined benefit plan for self-employed taxpayers are limited to 100% of compensation. If a self-employed taxpayer does not have any taxable business income for the year, no contribution can be made.
• The limitation on the annual benefit under a defined benefit plan in 2023 (i.e., a traditional pension) is the lower of: (1) $265,000 or (2) the average compensation of the employee in the three highest years.
• Although self-employed taxpayers are not prohibited from setting up defined benefit plans up for themselves, that would be rare, because of they are so costly to administer.
• Usually, defined benefit plans are funded by the employer and generally do not require employee contributions. Defined benefit plans are the most expensive to administer and maintain. However, sometimes defined benefit plans are used by very high net worth individuals to legally shelter large amounts of income from tax.
• An example of when a defined benefit plan might be preferable might be a professional actor or famous musician with very large amounts of taxable income, but no other employees. Defined benefit plans also have the benefit of protection from creditors, even in the event of bankruptcy, in certain circumstances.

Question 43

Estates and Trusts

Answer 43

• Estates and Trusts are covered in separate webinars and have a separate handout.
• Estates may be tested on Part 1 as well as Part 2, as they are entities, but always have living beneficiaries that receive the passthrough income from the estate.
• In Part 1, Estates are covered in Unit 18, and in Part 2, they are covered in Unit 19. (The last unit in both textbooks)

Question 44

Estate Tax

Answer 44

• Sometimes, the estate tax is called a “death tax” or an “inheritance tax.” The estate tax is not an income tax. It is a tax that is imposed on the transfer of property after a person’s death.
• Estate and gift taxes are often considered together because they share the same lifetime exemption amount. However, the estate tax applies to transfers of the decedent’s property after death, while the gift tax applies to transfers made while a person is alive.

Question 45

Creation of an Estate

Answer 45

• Estates and trusts are separate legal entities that are defined by the assets they hold. A decedent’s estate is created when a taxpayer dies.
• A bankruptcy estate is created when a taxpayer files for bankruptcy. Most of what we will be covering is the estates of deceased taxpayers.
• A trust can be created while the taxpayer is alive, or by the taxpayer’s last will and testament. A trust can hold title to property for the benefit of one or more persons or entities. Trusts are most commonly used for estate planning. We will talk more about trusts in a separate webinar on trusts.
• An estate (whether a bankruptcy estate or a decedent’s estate) is required to obtain an employer identification number (EIN), just like any other legal entity.

Question 46

Probate

Answer 46

• After a person dies, a personal representative, will typically manage the estate and settle the decedent’s final financial affairs.
• Probate is the court-supervised process of administering an estate. Not all estates have to go through probate, but this is governed by state law and varies from state to state.
• Executors are appointed when the decedent has a will, and administrators are appointed when the decedent dies without a will. If a person dies with a will, these are sometimes called testamentary probate proceedings. If a person dies without a will, the person is said to have died intestate. The executor or administrator has the legal authority to act on behalf of the estate.
• The IRS will sometimes use the term “executor” and “personal representative” interchangeably. The IRS often uses the term “personal representative” to refer to anyone filing a return on behalf of a decedent, regardless if that person has been appointed by the courts or formally named in the taxpayer’s will.
• When performing required duties for an estate before the IRS, executors must provide documentation proving their status. Documentation will vary but may include documents such as a certified copy of the will or a court order designating the executor. Merely a statement by the executor attesting to their status is insufficient.

Question 47

Responsibilities of the Executor

Answer 47

• Duties of the executor/personal representative:
  
  • Obtain an estate EIN
  • File Form 56, Notice Concerning Fiduciary Relationship.
  • Distribute Estate assets according to the decedent’s wishes
  • Sign the appropriate line of each of the following tax returns that may need to be filed:
    
    • The final income tax return (Form 1040) for the decedent (for income received before death);
    • Fiduciary income tax returns (Form 1041) for the estate for the period of its administration; and
    • The estate tax return (Form 706).
• The personal representative is responsible for determining any estate tax liability before the estate’s assets are distributed to beneficiaries.
• Example: Dominic is age 64 and unmarried. He has one 23-year-old daughter, named Jacqueline. Dominic dies on November 3. Thankfully, Dominic had a will when he died. In the will, Jacqueline is named as the sole beneficiary and the executor of her late father’s estate. Jacqueline seeks the help of a licensed tax professional as well as an attorney to help her navigate the probate process. The attorney and the accountant will help Jacqueline file all the necessary paperwork with the court as well as the IRS. Jacqueline will sign her late father’s final personal income tax return as the executor.

Question 48

Reporting Executor Fees

Answer 48

• The executor or “personal representative” must include fees paid to them from an estate in their gross income. If the executor is not in the trade or business of being an executor (for instance, the executor is a friend or family member of the deceased), these fees are reported on the executor’s individual Form 1040, as “other income.”
• If the executor is in the “trade or business” of being an executor, (such as a self-employed estate attorney), the executor would report the fees received from the estate as self-employment income on Schedule C.
• Example: Janice is an accountant who is best friends with Loretta. On June 1, Loretta dies, leaving behind two sons, ages 18 and 22. Loretta’s final will and testament names Janice as the executor of her estate. Janice agreed to be the executor as a favor to her friend. Janice is not in the “trade or business” of being an executor and has never been the executor of any other estate in the past. Janice will file Loretta’s final tax returns, as well as the tax return of the estate. She will also help distribute her deceased friend’s assets to her beneficiaries (Loretta’s two sons). Loretta’s will stipulates that the executor of her estate is entitled to 2% of the income generated by the estate. The executor fees paid to Janice would be reported on her individual Form 1040, as “other income.” The amounts would be subject to income tax, but not self-employment tax, because Janice is performing the duties of an executor only because she was a friend of the deceased.
• Example: John is a professional estate tax attorney. One of his long-time wealthy clients, Caroline, dies on January 3 after a long battle with cancer. Caroline names her attorney, John, as the executor of her estate in her will. The sole beneficiary of Caroline’s estate is her son, Benjamin, who is 17 and still a minor. By the terms outlined in the will, John will manage the affairs of the estate until Benjamin turns 21. By law, the executor has the right to charge a fee for managing an estate. Caroline’s will stipulates that the executor of her estate is entitled to 5% of the income of the estate. The remaining income will go to provide Benjamin’s ongoing support and pay for his schooling. As the attorney and executor, John would report the income that he earns as an executor on his Schedule C, subject to self-employment tax.

Question 49

Executor’s Liability

Answer 49

• The executor is responsible for determining any estate tax liability before the estate’s assets are distributed to beneficiaries. The tax liability for an estate attaches to the assets of the estate itself.
• If the assets are distributed to the beneficiaries before the taxes are paid, the beneficiaries or the executor may be held liable for the tax debt, up to the value of the assets distributed.
• A personal representative or executor of an estate cannot be held liable if an insolvent estate does not have enough assets to cover any of the income taxes due or debts.
• However, the executor must be sure that any income taxes are paid before any assets are distributed to the beneficiaries of the estate; otherwise, the executor might be held personally liable for the tax debt.
• Example: Silas, age 27, was named the executor of his late mother’s estate. Silas has two younger sisters, Rebecca and Sasha, who are both under the age of 18 and still minors. All of the siblings are equal beneficiaries of the estate, but since Silas is the only legal adult, he is named the executor of his mother’s estate by the probate court. Silas distributes a large amount of stock and cash to himself and both his sisters before he has had his mother’s assets properly appraised. After the appraisal is done, Silas realizes that his mother’s estate has a filing requirement and an estate tax liability. Since Silas distributed assets to the beneficiaries before determining the correct amount of tax due, he may be held personally liable for paying the estate tax himself.

Question 50

Filing Returns for a Decedent

Answer 50

• After a taxpayer dies, the following tax returns may need to be filed by the personal representative of the estate:
  
  • Form 1040, Final income tax return for the decedent (for income received before death).
  • Form 1041, U.S. Income Tax Return for Estates and Trusts: Fiduciary income tax returns for the estate for the period of its administration
  • Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return: If the gross estate, based on the fair market value of its assets, exceeds the applicable threshold. This return is used to report tax on the taxable estate (the gross estate minus certain deductions).
• The personal representative or executor must sign each required return. A personal representative should sign the decedent’s final income tax return as “Personal Representative” or “executor”.
• If the taxpayer’s final income tax return is a joint return, then the surviving spouse may sign as a “Surviving Spouse.”

Question 51

Estate Income Tax Return (Form 1041)

Answer 51

• An estate is a taxable legal entity that exists from the time of an individual’s death until all assets have been distributed to the decedent’s beneficiaries. Most estates are administered and distributed within 12-18 months, but sometimes, when the decedent was a very wealthy person, or if the estate is in litigation, the estate may not terminate for years, sometimes, even decades.
• The Form 1041 is an annual income tax return, similar to the return an individual or business would file. Form 706 is different: it is not an income tax return. Instead, it is a tax form used to calculate estate taxes only. Depending on the value of an estate, and income that it generates, both forms may have to be filed (or, in the case of a small estate, neither form may have to be filed).
• A decedent’s assets will often continue to earn revenue after a taxpayer has died, this income, such as rents, dividends and interest, must be reported on Form 1041. The Schedule K-1 is used to report any income that is distributed or distributable to each beneficiary and is filed with Form 1041, with a copy also given to the beneficiary.

Question 52

Termination

Answer 52

• Estates and trusts generally terminate when all of their assets and income have been distributed, and all of their liabilities have been paid.
• If an estate or trust has a loss in its final year, the loss can be passed through to the beneficiaries, allowing them deductions on their individual returns. Losses cannot be passed through to beneficiaries in a non-termination year.

Question 53

Form 1041 Due Date

Answer 53

• The due date for Form 1041 is the 15th day of the fourth month following the end of the entity’s tax year (usually April 15 for a calendar year entity), but an extension of five and-a-half months (to Sept 30) can be requested by filing Form 7004.
• The tax year of an estate may be either a calendar or a fiscal year, subject to the election made at the time the first return is filed. An election will also be made on the first return as to method (cash, accrual, or other) to report an estate’s income.
• Form 1041 must be filed for any domestic estate that has gross income for the tax year of $600 or more, or a beneficiary who is a nonresident alien (with any amount of income).

Question 54

Estate Tax Thresholds

Answer 54

• All the property the decedent owned at the time of death is included in the gross estate for estate tax purposes.
• In 2023, an estate is allowed an income tax exemption amount of $600 for income tax purposes and an exclusion amount of $12.92 million for estate tax purposes.
• If a taxpayer died in 2023, and the value of their assets at the time of death was less than $12.92 million, an estate tax return (Form 706) does not have to be filed.
• Example: Petra is 76 years old. She dies on May 1. At the time of her death, she owned a home valued at $675,000 and a vacation home valued at $900,000. She had $80,000 in a non-interest-bearing checking account. Petra also owned 5 acres of undeveloped land in Texas valued at more than $1 million. She had purchased the land as an investment several years ago but was not currently using it for anything. While her estate is valuable, it has no income-producing assets. Her only heir is her son, David, who is a US citizen. Neither a Form 706 nor a Form 1041 would need to be filed for Petra’s estate, because the value of the assets is less than the exemption amount, and no revenue is being generated by the assets.
• Example: Levi died two years ago. He was a naturalized U.S. citizen. At the time of his death, he was unmarried and did not have a will. His estate had only one valuable asset: his primary residence in Los Angeles. Levi also had a small amount of cash in his personal bank account. The sole heir of his estate is his brother, Brock, who is a German citizen living in Germany. Brock is forced to hire an attorney and an accountant to help him navigate probate on his brother’s estate. The estate is in its period of administration (Levi’s estate must go through formal probate in the courts, since he was unmarried and died without a will). The residence in Los Angeles remains empty, so no income is generated by the home. However, Levi’s bank account generates a small amount of interest; $50. Normally, a Form 1041 would not need to be filed for the estate, because the income is less than $600. However, because the beneficiary of Levi’s estate is a nonresident alien (Brock, a German citizen who lives outside of the U.S.), a Form 1041 will need to be filed every year until the assets are dispersed, and the estate is closed.

Question 55

Form 1041: Example

Answer 55

• Example: Matthew owned three rental properties before his death on June 1. The gross value of his assets on the date of Matthew’s death was $2 million, so an estate tax return (Form 706) does not have to be filed. The income from the rental properties that was received while he was alive would be reported on his final Form 1040, Schedule E. The rental income that was received by his estate after his death would be reportable on Form 1041, Annual Tax Return for Estates and Trusts.

Question 56

Final Form 1040

Answer 56

• The taxpayer’s final income tax return is filed on the same form that would have been used if the taxpayer were still alive, but “deceased” is written after the taxpayer’s name. The filing deadline is the same deadline that applies for individual income tax returns.
• The personal representative must file the final individual income tax return of the decedent for the year of death and any returns not filed for preceding years.
• On a decedent’s final tax return, the rules for deductions are the same as those that apply for any individual taxpayer. The decedent’s year of death is not treated as a short tax year.

Question 57

Form 706: Estate Tax Return

Answer 57

• An estate tax return is filed using Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. This return is due nine months after the death of the decedent. A six-month extension is allowed by filing Form 4768.
• The maximum estate tax rate is 40%.
• The applicable estate tax rate is applied to derive a tentative tax, from which any gift taxes paid or payable are subtracted to determine the gross estate tax.
  
  • Basic Exclusion Amount: This amount is adjusted for inflation each year and may be used to reduce or eliminate gift and/or estate taxes. ($12.92 million in 2023)
  • Deceased Spousal Unused Exclusion (DSUE): This is the unused portion of the decedent’s predeceased spouse’s basic exclusion (the amount that was not used to offset gift or estate tax liabilities). A portability election must be made to claim the DSUE on behalf of the surviving spouse’s estate. This election can be made automatically by timely completion and filing of Form 706 for the estate of the predeceased spouse. A Form 706 must be timely filed by the executor of any estate who intends to transfer the DSUE a decedent’s surviving spouse, regardless of the amount of the gross estate.

Question 58

The Gross Estate

Answer 58

• The gross estate is based upon the fair market value of the decedent’s property, which is not necessarily equal to its cost. The gross estate includes:
  
  • The FMV of all tangible and intangible property owned partially or outright by the decedent at the time of death,
  • Life insurance proceeds payable to the estate or, for policies owned by the decedent, payable to the heirs,
  • The value of certain annuities or survivor benefits payable to the heirs, and
  • The value of certain property that was transferred within three years before the decedent’s death.
• The gross estate does not include property owned solely by the decedent’s spouse or other individuals. Lifetime gifts that are complete (so that no control over the gifts was retained) are not included in the decedent’s gross estate. In order to qualify as a “lifetime gift,” the transfer must be complete and irrevocable.

Question 59

Deductions from the Gross Estate

Answer 59

• Once the gross estate has been calculated, certain deductions are allowed to determine the taxable estate. Deductions from the gross estate may include:
  
  • Funeral expenses paid out of the estate.
  • Administration expenses for the estate (if not deducted on Form 1041).
  • Debts owed at the time of death.
  • The marital deduction (generally, the value of the property that passes from the estate to a surviving spouse who is a U.S. citizen) (covered next).
  • The charitable deduction (generally, the value of the property that passes from the estate to qualifying charities).
  • The state death tax deduction (generally, any inheritance or estate taxes paid to any state. Some states impose a death tax, and some do not).
  • The following items are not deductible from the gross estate:
    
    • Federal estate taxes paid.
    • Alimony paid after the taxpayer’s death. These payments would be treated as distributions to a beneficiary.
    • Property taxes are deductible only if they accrue under state law prior to the decedent’s death.

Question 60

Form 706 Due Date: Example

Answer 60

• Example: Jim is a U.S. citizen who lives in Spain. He owns several properties in Spain, as well as assets in the United States. On August 20, 2023, Jim dies. At the time of his death, Jim’s assets in Spain included three vacation homes and a waterfront villa. The fair market value of these properties at the time of his death was $12 million. Jim also owned U.S. investments and a vacation home in Florida. His U.S. assets totaled approximately $10 million at the time of his death. Jim’s estate has a filing requirement because his combined worldwide assets are $22 million, so his gross estate exceeds the filing threshold ($12.92 million in 2023). All the assets must be reported on the estate tax return (including any foreign assets) and any amount over the exclusion may potentially be subject to estate tax. His estate tax return and tax payment must be made on or before May 20, 2024 (within nine months of Jim’s date of death).

Question 61

Example: Estate Administration

Answer 61

• Example: Geneva Jones is a popular writer with many bestselling novels. She is unmarried and has no children, but she has five adult siblings. Geneva dies suddenly, without a will, on January 19, at age 52. The estimated value of her estate exceeds $35 million dollars, and her novels continue to sell briskly after her death. Geneva’s siblings are her only living relatives and are therefore all of them equal heirs of her estate. The siblings immediately start to squabble over their late sister’s assets. All five siblings petition to be named the executor. The probate court is forced to appoint a professional executor, and the litigation will likely drag on for years. The estate is still generating revenue during this time, so the Form 1041 will need to be filed every year to report the ongoing income of the estate until the legal dispute between the siblings is resolved.

Question 62

Income in Respect of a Decedent (IRD)

Answer 62

• Income in respect of a decedent (IRD) is any taxable income that was earned but not received by the decedent by the time of death. IRD is not taxed on the final return of the deceased taxpayer. IRD is reported on the tax return of the person (or entity) that receives the income.
• This could be the estate, in which case it would be reported on Form 1041. Otherwise, it could be the surviving spouse or another beneficiary, such as a child. If there is no designated beneficiary for the income, then the IRD items are reported on the estate’s Form 1041.
• IRD retains the same tax nature that would have applied if the deceased taxpayer were still alive. For example, if the income would have been short-term capital gain, it is taxed the same way to the beneficiary.
• However, wages paid as income in respect of a decedent after the year of death generally are not subject to withholding for any federal taxes.
• For self-employment tax purposes only, the decedent’s self-employment income will include the decedent’s distributive share of a partnership’s income or loss through the end of the month in which death occurred.

Question 63

IRD Sources

Answer 63

• IRD can come from various sources, including:
  
  • Unpaid salary, wages, or bonuses
  • Amounts distributed from retirement plans distributed by payor before the taxpayer’s death, but not yet received by the decedent at the time of death.
  • Deferred compensation benefits
  • Accrued but unpaid interest, dividends, and rent
  • Dividends declared before the decedent’s death, but payable after death
  • Outstanding income owed to a self-employed decedent (accounts receivable) is considered IRD but is not subject to self-employment tax.
• IRD is included in the decedent’s estate and may be subject to estate tax. This may happen with a very wealthy person. If a beneficiary receives IRD and the income is subject to estate tax, the beneficiary can deduct the tax on Schedule A of their individual income tax return as a miscellaneous itemized deduction. The beneficiary must claim the IRD deduction in the same tax year in which they actually receive the income. The IRD deduction was not suspended by the Tax Cuts and Jobs Act.
• Example: Jasper is a self-employed architect with many clients. Jasper is married to Zelda, who is a homemaker and does not work in his business. Jasper reports his business income on Schedule C. Jasper dies on December 27, 2023, with several unpaid client invoices outstanding at the time of his death. Jasper’s surviving spouse, Zelda, receives all the payments from Jasper’s outstanding invoices the following year, in January 2024. Since the outstanding accounts receivable was earned by Jasper while he was alive, but not received by Zelda until after his death, then it is considered IRD to Zelda, and it would be taxed as ordinary income to her, but not subject to self-employment tax, because Zelda is not self-employed.
• Example: Wallace, age 65, sells a rental property that he had owned for many years to a private-party buyer on June 1, for $120,000. The buyer promised to deliver a cashier’s check to Wallace the following week. Two days later, on June 3, Wallace dies, before receiving the check from the buyer. Wallace’s adjusted basis in the rental property was $100,000 at the time of the sale, and he had owned the property for six years. The buyer of the property gives the $120,000 check to Wallace’s daughter, Sheri, who is her father’s only heir. The gain from the sale ($20,000) is IRD to Sheri, and she must report the gain on her own return. There is no step-up in basis, because the home was already sold by Wallace, so there is no “asset” for Sheri to step up, but Sheri is the one who received the gain from the sale. The sale generates a long-term capital gain, which Wallace would have recognized on his own return, had he lived long enough to collect the check. The income is reported and treated the same on Sheri’s return, since she is the one who received the sale proceeds.

Question 64

Net Investment Income Tax (NIIT)

Answer 64

• Estates and certain trusts are subject to the additional tax of 3.8% on net investment income. The provisions for this tax are generally similar to those for individuals, and it must be reported on Form 8960, Net Investment Tax: Individuals, Estates, and Trusts.
• For trusts and estates, the tax applies to the lesser of undistributed net investment income or the excess of adjusted gross income over the threshold amount at which the highest tax bracket begins. The NIIT does not apply to tax-exempt trusts or to grantor trusts.

Question 65

Distributable Net Income

Answer 65

• Estates and Trusts are hybrid “pass-through” entities, income can be taxed at the estate or trust level. Taxable income earned by an estate or trust is taxable to either the entity or the beneficiaries, but NOT to both. Distributable net income (DNI) is income that is currently available for distribution. The income distribution deduction (IDD) is allowed to trusts and estates for amounts that are paid, credited, or required to be distributed to beneficiaries.

Question 66

Marital Deduction

Answer 66

• The Marital Deduction: Transfers from one spouse to the other are typically tax-free. The marital deduction allows spouses to transfer an unlimited amount of property to one another during their lifetimes or at death without being subject to estate or gift taxes if the spouse is a U.S. citizen.
• To receive an unlimited marital deduction, the spouse receiving the assets must be a U.S. citizen and a legal spouse and must have outright ownership of the assets. The unlimited marital deduction is generally not allowed if the transferee spouse is not a U.S. citizen (even if the spouse is a legal resident of the United States).
• Note: The marital deduction is NOT the same thing as the Deceased Spousal Unused Exclusion, or DSUE. The DSUE is an election that is only available to U.S. citizen spouses.

Question 67

DSUE and Portability

Answer 67

• The DSUE is the unused portion of the decedent’s predeceased spouse’s basic exclusion (the amount that was not used to offset gift or estate tax liabilities). A “portability” election must be made to claim the DSUE on behalf of the surviving spouse’s estate. This election can be made automatically by timely completion and filing of Form 706 for the estate of the predeceased spouse.
• Portability is not automatic: Form 706 must be filed in order to make the election.
• This means that the executor, (usually, this is the surviving spouse, but not always), will need to transfer the unused exclusion to the surviving spouse. This is done by filing an estate tax return.
• In order to make the election, an estate tax return is required when the first spouse dies, even if no tax is owed. This return is due nine months after the death of the first spouse. A six-month extension is allowed. The DSUE is not available to nonresident alien spouses.
• Example: Anton and Victoria are married and have one adult son, named Vince. On January 3, Anton dies. His gross estate is valued at $8 million on the date of his death. All of Anton’s assets pass tax-free to his wife, Victoria, who is named the executor of her late husband’s estate. Victoria doesn’t bother to file an estate tax return for Anton’s estate, because her late husband’s estate value is below the exclusion amount. On December 29, Victoria dies suddenly in a car accident. The value of her estate is now $15 million (which equals her combined assets as well as those of her late husband). Victoria and Anton’s only son, Vince, is named as the executor of his late mother’s estate. Vince must file an estate tax return for his mother’s estate. Since Victoria did not file a timely estate tax return to claim the DSUE for her late husband’s assets, her estate is now subject to estate tax on the amount that exceeds the exclusion.
• Example: Dave and Tina are married and have one adult daughter, named Lana. Dave died on January 4, 2023, and left a gross estate valued at $22 million. All of his assets were transferred to his wife, Tina, under the terms of his will. Tina is a U.S. citizen and her solely owned assets are worth $2 million at the time of Dave’s death. None of Dave’s estate was subject to estate tax because of the unlimited marital deduction. None of the basic exclusion amount available to Dave’s estate was used (and none had been used to offset gift tax liabilities during his lifetime). Tina’s accountant advised her to file a Form 706 and elect the DSUE, electing portability which she did, filing the return on the due date, exactly nine months after Dave’s death. Tina then died later in the same year, on December 27, 2023. Tina’s total assets were worth $24 million (her $2 million + the assets of her late husband, which were worth $22 million). Since Form 706 was timely filed for Dave’s estate, electing the DSUE, and Tina had not used any of her basic exclusion amount, Dave’s unused basic exclusion is added to Tina’s basic exclusion, for a total exclusion amount of $25.84 million between their two estates ($12.92 million each). Since Tina’s estate is valued at less than $25.84 million at her death, the full amount can be excluded, and no estate tax will be owed when Tina’s assets eventually pass Lana, their sole heir and only daughter.

Question 68

Inheritances

Answer 68

• For federal income tax purposes, cash inheritances are generally not taxable to the beneficiary, although the beneficiary may be responsible if there is a related estate tax liability that has not been satisfied.
• Beneficiaries of cash inheritances generally do not have any reporting requirements, UNLESS the inheritance is coming from a foreign estate.
• Example: Caruso’s aunt, Georgina, died and left him $175,000 cash in her will. Georgina’s estate did not have a filing requirement, and no estate tax return was required. Caruso is a U.S. citizen. He does not owe any federal tax on this inheritance.
• Example: Raquel dies and leaves her entire estate to her son, Atticus. At the time of her death, she had a significant cash balance in her personal bank account as well as several valuable rental properties in New York. Raquel’s estate is worth over $13 million, so it has a filing requirement, but Atticus ignores his accountant’s advice and simply withdraws all the money from his late mother’s bank account. He also sells all the rental properties and uses the money to take several lavish trips. Although inheritances are generally not taxable to the beneficiary, the fact that Atticus took possession of his mother’s assets without filing her required estate tax return or satisfying the estate tax liability would make him directly responsible for the tax. The IRS can come after Atticus in order to satisfy the estate’s tax liability.

Question 69

Inherited Retirement Accounts

Answer 69

• Inherited retirement accounts are treated a bit differently. Distributions of retirement plan benefits or distributions from taxable IRA accounts to the decedent’s beneficiaries are generally subject to income tax when received, although inherited IRAs are not subject to an early withdrawal penalty, regardless of the beneficiary’s age.
• Qualified distributions from a Roth IRA or of previously nondeductible contributions to a traditional IRA are generally not taxable.
• The decedent’s surviving spouse may be able to defer taxation by rolling over the assets of a taxable IRA to another IRA or to a qualified plan.
• Example: Benjamin, age 55, dies on September 1. He was unmarried at the time of his death and did not have any children. His sister, Chanel, age 43, is named as the beneficiary of his estate, which consists entirely of a $170,000 traditional IRA account. There are no other assets. Since Chanel is a non-spousal beneficiary, she is not allowed to rollover the funds from her deceased brother’s IRA into her own retirement account. Instead, she is required to either distribute the funds as a lump-sum, or make a new inherited IRA account in her name and transfer the funds to this account. When Chanel starts withdrawing the money from the inherited IRA, she will not be charged a 10% early withdrawal penalty, even though she is under age 59½. She will only have to pay income tax on the withdrawals.

Question 70

The Basis of Estate Property

Answer 70

• The basis of property inherited from a decedent is generally one of the following:
  
  • The FMV of the property on the date of death (“stepped-up” or “stepped-down” basis).
  • The FMV on the alternate valuation date, if ELECTED, the alternate valuation date is six months after the date of death. The estate value and related estate tax must be less than they would have been on the date of the taxpayer’s death. However, for any assets distributed to a beneficiary after death, but prior to six months after death, the basis for these assets is the fair market value as of the date of distribution.
  • The value under a special-use valuation method for real property used in farming or another closely held business, if elected by the personal representative.
• Example: Paul, age 66, dies on February 1. Paul’s adult son, Easton, is the executor of his late father’s estate. Paul owned a large collection of collectible figurines and rare comic books. Paul’s will directs that the estate be split equally between Easton and his four siblings. The fair market value of Paul’s collectibles on the date of his death is $500,000. The collectibles are the only valuable asset that the estate owns. Since the estate’s total value is less than the exclusion amount, Easton does not file an estate tax return (Form 706) or elect the alternate valuation date. On November 15, the siblings all agree to sell their late father’s collection. The entire collection sells at auction for $552,000. Collectively, Paul’s children (his heirs) must report a capital gain of $52,000 ($552,000 sale price minus the $500,000 inherited basis).

Question 71

Example: Alternate Valuation Date

Answer 71

• Alternate Valuation Date: If elected, the alternate valuation date is six months after the date of death. The estate value and related estate tax must be less than they would have been on the date of the taxpayer’s death. However, for any assets distributed to a beneficiary after death, but prior to six months after death, the basis for these assets is the fair market value as of the date of distribution (assuming alternate valuation date is elected and a Form 706 is filed).

Question 72

Trusts in General

Answer 72

• A trust is an entity created under the laws of the state in which it is formed.
• A trust may be created during an individual’s life (an inter-vivos trust) or at the time of death under a will (a testamentary trust). A trust is generally created to hold property for the benefit of other persons.
• The establishment of a trust creates a fiduciary relationship between three parties:
  
  • The Grantor (or settlor, or trustor): The person who contributes property to the trust.
  • The Trustee (or Fiduciary): The person or entity charged with the fiduciary duties associated with the trust.
  • The Beneficiary: The person who is designated to receive the trust income or assets.
• There are many types of trusts. A trust may be created for the benefit of a disabled individual, it can be created to benefit a charity, or it can be used to legally avoid certain taxes.

Question 73

Types of Trusts

Answer 73

• While there are many different types of trusts, the two basic types are revocable and irrevocable.
• A revocable trust allows the person who created the trust to retain control of the assets in the trust, and revoke or change the terms of the trust at any time. For tax purposes revocable trusts are treated as if they are still owned by the grantor, so all items related to the trust are reported on the grantor’s 1040 returns.
• With irrevocable trusts the assets in the trust are no longer controlled by the grantor. Assets in an irrevocable trust are not included in the estate of grantor. Removing assets from a person’s estate is one of the main reasons why irrevocable trusts are formed.
• Upon the death of the grantor, a revocable trust automatically becomes irrevocable. A “testamentary” trust also becomes irrevocable upon death. A testamentary trust is a trust contained in a last will and testament of a decedent.
• Sometimes, a trust is used to transfer property in a controlled manner. For example, a parent may wish to transfer ownership of assets to his or her child but does not want the child to waste the assets or spend them unwisely.
• The assets could be transferred to a trust, with the parent as both the grantor and the trustee. The child would be the beneficiary. The parent still has control over the assets, and the child is prevented from using them all up.
• Example: Rose is having serious medical problems and decides to put her assets in a trust. She asks her attorney to create the trust, as well as manage the assets. The trust is structured so that it will pay Rose’s living expenses, with the remainder of the assets going to her grandson after she dies. While Rose is alive, the trust is revocable, and Rose still controls the assets in the trust. Upon her death, her revocable trust automatically becomes irrevocable. In this scenario, Rose is the grantor, her lawyer is the trustee, and Rose and her grandson are both the beneficiaries.

Question 74

Accounting and Filing Requirements

Answer 74

• The accounting period for a trust is generally the calendar year. The filing due date for a calendar-year trust is typically April 15. Form 1041, U.S. Income Tax Return for Estates and Trusts, is used by the fiduciary of a domestic trust to report:
  
  • Income, deductions, gains, losses, etc. of the trust;
  • Income that is either accumulated or held for future distribution or distributed currently to the beneficiaries, and
  • The income tax liability of the trust.
• A trust is required file Form 1041 if it has:
  
  • Any taxable income for the year (after subtracting the allowable exemption amount),
  • Gross income of $600 or more (regardless of whether the income is taxable or not), or
  • Any beneficiary who is a nonresident alien.

Question 75

Trust Exemption Amounts

Answer 75

• Trusts are allowed a small annual exemption, but the amount varies based on the type of trust.
• A trust that must distribute all of its income currently (also called a a simple trust) is allowed an exemption of $300 per year.
• A complex trust is allowed an exemption of $100 per year, with the exception of a qualified disability trust.
• A qualified disability trust (also called a “QDT” is allowed a $4,700 exemption in 2023). This means that a qualified disability trust can retain $4,700 tax-free each year.
• Example: The Randall Family Trust has $200 of tax-exempt interest from municipal bonds during the year. There is no other income. Normally, the trust would not be required to file a tax return because the income earned by the trust is tax-exempt. However, the Randall Family Trust has a beneficiary who is a nonresident alien. Therefore, the trust is required to file Form 1041.

Question 76

Simple and Complex Trusts

Answer 76

• With regard to income distribution, there are two types of trusts: a simple trust and a complex trust. A simple trust as a trust that:
  
  • Must distribute all of its income currently (in other words, it cannot accumulate income from year to year),
  • Makes no distributions of principal, and
  • Makes no distributions to charity.
• Any trust that is not a simple trust is automatically classified as a complex trust. Only complex trusts may accumulate income. A complex trust:
  
  • Is allowed to accumulate income,
  • Can make discretionary distributions of income,
  • Can make mandatory (or discretionary) distributions of principal, and
  • Can make distributions to charity.
• A trust may be a simple trust one year, and a complex trust in the following year. For example, if a simple trust fails to distribute all its income in the current year, it becomes a complex trust.

Question 77

Trust Taxation

Answer 77

• IN GENERAL, a revocable trust does not file a separate tax return, its income is attributed to its grantor, who reports it on their personal income tax return.
• An irrevocable trust is considered to be a separate legal entity, however, and must file a separate tax return if the income threshold is above the exemption amount.
• It is the trustee’s obligation to file the trust tax return, not the grantor’s.

Question 78

Grantor Trusts

Answer 78

• A grantor trust is a valid legal entity under state law, but it is considered a disregarded entity for federal income tax purposes. The grantor creates the trust and retains control over the trust.
• Revocable trusts are grantor trusts in which the grantor retains the right to make changes or end the trust during his lifetime. The benefit of this type of trust is that the grantor retains control over the trust.
• The drawback is that trust assets are subject to estate tax upon the grantor’s death.
• Many taxpayers use this type of trust instead of, or in addition to, a will.

Question 79

Non-Grantor Trusts

Answer 79

• A non-grantor trust is considered a separate legal entity from the individual or organization that created it, because the donor of the assets gives up all control. The trust itself is treated as a separate taxable entity. The trust’s income and deductions are reported on Form 1041. If a non-grantor trust makes distributions to a beneficiary, in general, those distributions are taxable income to the beneficiary. Examples include:
• 1. Irrevocable Trusts: An irrevocable trust is a trust that cannot be revoked after it is created. Property transferred to an irrevocable living trust does not count toward the gross value of an estate.
• 2. Qualified Disability Trusts: A qualified disability trust is a non-grantor trust created solely for the benefit of a disabled individual under age 65. A Qualified Disability Trust is a complex trust, because it is designed to hold income and assets for the benefit of a disabled beneficiary.
• 3. Charitable Trusts: A charitable trust is a type of trust devoted to qualified charitable contribution purposes. A charitable trust can allow a taxpayer to leave some or all of their estate to a qualifying charitable organization of their choice. Charitable trusts are not subject to the NIIT. Charitable trusts must be set up for a charitable purpose, and they are always irrevocable. Property transferred to a charitable trust does not count toward the gross value of an estate, and charitable trusts are often used for estate planning when a person wants to give valuable assets to charity in a controlled manner.

Question 80

Charitable Trust: Example

Answer 80

• Example: Jacqueline Smith wants the majority of her estate to go to charity. She creates a charitable trust in order to facilitate her wishes. The Smith Charitable Trust has a governing instrument that provides that her local Presbyterian Church (a qualified religious organization), and the SPCA, a 501(c)(3) charity, are each to receive 50% of the trust income for ten years. At the end of the ten-year period, the corpus will be distributed entirely to the Smithsonian Museum, also a 501(c)(3) organization. Jacqueline is allowed an income tax deduction for the value of the assets she places in the trust. The Smith Charitable Trust is irrevocable, which means that the trust cannot be modified or terminated without the permission of the beneficiary (in this case, the beneficiaries are the charitable organizations themselves).

Question 81

Qualified Disability Trusts

Answer 81

• A qualified disability trust is allowed a generous annual exemption. This means that a qualified disability trust can retain this amount tax-free each year, creating a fund for a disabled beneficiary’s future needs. A qualified disability trust may also distribute this amount tax-free to a disabled beneficiary.
• Income distributed from a qualified disability trust is exempt from the Kiddie Tax.
• Most deductions and credits allowed to individuals are also allowed to trusts. However, there is one major distinction: a trust is a potential pass-through entity that is allowed a deduction for its distributions to beneficiaries.
• The beneficiaries (and not the trust) pay income tax on their distributive share of income. Schedule K-1 (Form 1041) is used to report income that a trust distributes to beneficiaries. The income must then be reported on the beneficiaries’ income tax returns.

Question 82

Example: QDT

Answer 82

• Example: Nora Wells is 18 years old and has severe autism. Nora’s wealthy grandfather set up a disability trust on her behalf before he passed away a few years ago. The Nora Trust is a qualified disability trust, or QDT. In the current year, the trust had $19,000 of interest income and made $16,000 worth of distributions for Nora’s benefit. The money went directly to pay for Nora’s daycare and activities. The $16,000 in distributions is taxed as interest income on Nora’s individual Form 1040. Despite her age, the amounts are not subject to the kiddie tax, and Nora can take the standard deduction to shield the majority of the income from tax. This is true even if she is claimed as a dependent on her parent’s return. The remaining undistributed income ($3,000) would be reported on the trust’s income tax return (Form 1041). Since the trust is a Qualified Disability Trust with a $4,700 exemption (in 2023), there would be no income tax due on the $3,000 that was not distributed to the beneficiary (Nora).

Question 83

Abusive Trust Arrangements

Answer 83

• Sometimes, abusive or fraudulent trust arrangements may be used to hide the true ownership of assets and income or to disguise the substance of transactions.
• They frequently involve more than one trust, each holding different assets of the taxpayer (for example, the taxpayer’s business, business equipment, home, automobile, etc.).
• Some trusts may hold interests in other trusts, purport to involve charities, or be foreign trusts. Participants and promoters of abusive trust schemes may be subject to civil or criminal penalties.
• Abusive or fraudulent trust arrangements may promise such benefits as:
  
  • Deductions for personal expenses paid by the trust
  • Depreciation deductions for an owner’s personal residence
  • A stepped-up basis for property transferred to the trust
  • The reduction or elimination of self-employment taxes
  • The reduction or elimination of gift and estate taxes

Question 84

Trust Arrangements

Answer 84

• When trusts are used for legitimate business, family, or estate planning purposes, either the trust, the beneficiary, or the grantor will pay the tax on the income generated by the trust. Basically, someone has to pay the tax! If not, there is a chance that the trust is an abusive trust arrangement.
• Trusts cannot be used to transform a person’s personal expenses into deductible items. A taxpayer cannot use a trust to avoid tax liability by ignoring either the true ownership of income and assets or the true substance of transactions.
• However, do not confuse an “abusive” trust with a legitimate trust that is used to pay the living expenses of a disabled individual. A qualified disability trust is a special type of trust that allows family members to plan for the future of a child with special needs.
• Even in the case of a qualified disability trust, the income generated by the trust is taxable (usually to the beneficiary), although the trust itself is allowed a higher exemption than other trust types.

Question 85

Abusive Trust: Example

Answer 85

• Example: Curtis transfers his family residence and its furnishings to a trust, which “rents” the residence back to Curtis and his children. He deducts depreciation and the expenses of maintaining and operating the home, including landscaping, pool service, and utilities. Curtis’ second trust transfers assets to the Sham Charity Fund, which claims to be a charitable organization, but is in fact, not an IRS-qualified exempt organization. The trust pays for personal, education, and recreational expenses on behalf of Curtis and his family. The trust then claims the deductions on its tax returns. Both trusts Curtis created are fraudulent, and he would be subject to civil and criminal penalties.

Question 86

Foreign Trusts

Answer 86

• The IRS gives increased scrutiny to foreign trusts because of their growing popularity in foreign countries that provide financial secrecy and impose little or no tax on trusts. These are often in “tax haven” countries that are outside the jurisdiction of the U.S.
• A trust is considered “foreign” unless a U.S. court supervises it, and a U.S. fiduciary controls all substantial decisions.
• Many foreign trusts are treated as grantor trusts with income taxable to the grantor that should be included on Form 1040.
• U.S. taxpayers who have an interest in, or signatory or other authority over foreign trust accounts must also file FinCEN Form 114, (FBAR), if the aggregate value of the foreign trust accounts exceeds $10,000 at any time during the year.

Question 87

Abusive Foreign Trust: Example

Answer 87

• Example: Rosemary is a U.S. citizen with substantial business income. She forms an asset management company as a domestic trust, listing herself as the director and her son as the trustee. She then forms a business trust, very similar to the domestic trust, with both intended to show she is not managing her own business. Next, Rosemary forms a foreign trust in Bermuda, with the income from the business trust distributed to this foreign trust. Because the source of income is U.S.-based, and there is a U.S. trustee, this foreign trust has filing requirements, which Rosemary wants to avoid. Her next step is to form a second foreign trust. The first foreign trust funnels all its income to this second foreign trust, which has a foreigner as the trustee. Since the trustee and sources of income are now “foreign,” Rosemary claims there are no U.S. filing requirements. In actuality, she retains control of the income in this second foreign trust and has set up an elaborate scheme to evade U.S. tax laws. This is an abusive trust arrangement.