Fundamentals of Fiduciary Taxation
As a general rule, trusts and estates are taxed in the same manner as individuals. Code §§ 641–692, however, set forth several exceptions. These exceptions include:
1. Estates and trusts are taxed only on income that is retained, but the beneficiaries are taxed to the extent income is distributed or distributable to them. Double taxation is avoided by a distribution deduction allowed on the fiduciary income tax return.
2. An estate may use a calendar year or a fiscal year for its taxable period. Although a trust must use a calendar year, a trust may elect to be treated as an estate for income tax purposes, allowing the trust income to be taxed on a fiscal year with the estate.
3. The tax rates for fiduciary income tax returns are the same as for individual returns, but the brackets are compressed significantly for fiduciary income tax purposes. For the year 2003, fiduciary income in excess of $9,350 will be taxed at the highest income tax rate of 38.6%. In contrast, for individuals filing jointly the tax rate is 38.6% for adjusted gross income in excess of $311,950. Consequently, in addition to general income tax planning techniques, tax planning for fiduciary income tax involves minimizing the taxable income at the trust and estate level unless the beneficiaries are also in the highest income tax bracket.
These exceptions provide the impetus for some of the planning in the fiduciary income tax area.
Election to Treat Revocable Trust as Part of Grantor’s Estate
Revocable trusts have received considerable attention in both the popular and legal press in recent years and are widely used in estate planning for clients. One aspect of revocable trusts that may be overlooked, however, is that the income tax treatment of these trusts upon the death of the grantor is not as favorable as that afforded a decedent’s estate. For instance, a decedent’s estate
• may use a fiscal year for income tax purposes,
• is entitled to a charitable set-aside deduction under Code § 642(c),
• recognizes loss upon the satisfaction of a pecuniary bequest with assets having a fair marketvalue less than basis under Code§ 267(b), and
• is not subject to the active participation requirements of the passive loss rules for tax years ending less than two years after decedent’s date of death.
A revocable trust (which, of course, is irrevocable as of the grantor’s death) is not entitled to these tax advantages upon the grantor’s death unless a Code § 645 election is properly made. If both the executor (if any) of a decedent’s estate and the trustee of a “qualified revocable trust” established by the decedent make a Code § 645 election, the trust will be treated for income tax purposes as a part of the decedent’s estate for all tax years of the estate ending after the decedent’s date of death and beforethe “applicable date.” A Code § 645election once made is irrevocable.
Congress enacted Code § 645 as part of the Taxpayer Relief Act of 1997, Pub. L. No. 105–34, § 1305(a). Initially, IRS set forth rules for making the election in Rev. Proc. 98–13. In December 2000, the IRS published Prop. Reg. § 1.645(1), which contains alternative electionand reporting requirements. These regulations were finalized on December 24, 2002 (T.D. 9032). IRS Notice 2001–26 provides that estates and revocable trusts of decedents who die after December 31, 1999, and before the effective date of final Code § 645 regulations, may follow either the election and reporting requirements under Rev. Proc. 98–13 or those in Prop. Reg. § 1.645(1). This article concentrates on the requirements of the regulations because they are less onerous, provide more flexibility, and are now finalized.
Qualified Revocable Trust and Applicable Date
A Code § 645 election must be made with respect to a “qualified revocable trust” (QRT). A QRT is any trust (or portion thereof) that Code § 676 treats as owned by the decedent because of a power held by the decedent, determined without regard to Code § 672(e) (which treats a grantor as holding any power or interest held by his or her spouse). A trust in which the power to revoke is held only by the decedent’s spouse, and not by the decedent, is not a QRT, but a trust in which the power to revoke is exercisable by the decedent with the consent of the spouse is a QRT.
For estates that do not need to file an estate tax return, the “applicable date” is the date that is two years after decedent’s date of death. If an estate tax return is filed, the applicable date is the date that is six months after the date of the final determination of estate tax liability. The date of final determination can be based on a number of possible events, such as the issuance of an estate tax closing letter, the execution of a settlement agreement fixing the estate tax liability, or a court decree resolving the estate tax liability. For example:
D dies on June 30, 2002, and a Code § 645 election is made to treat D’s revocable trust as a part of D’s estate. A Form 706 is filed and the IRS conducts an audit. On January 5, 2005, D’s estate executes a settlement agreement with the IRS that determines the estate tax liability. The date of final determination of estate tax liability would be January 5, 2005, and the applicable date would be July 5, 2005. As of July 5, 2005, the QRT would be taxed as a separate entity.
Reg. § 1.645 sets forth the election procedures, which are straightforward. Of note is the ability of a trustee of a QRT to file the election if there is no executor of the related estate. In this case, the election must include a representation by the trustee that there is no executor and, to the trustee’s knowledge and belief, one will not be appointed. If no executor is appointed, the election is made on Form 8855; if an executor is appointed, a form provided by the IRS will be attached to the initial Form 1041 of the estate.
If there is an executor, one Form 1041 is filed for the combined QRT and related estate under the name and TIN of the estate (the QRT does not need to file a Form 1041 for the balance of the tax year after decedent’s death). One $600 personal exemption is permitted, and all items of income, deduction, and credit are combined, except as required under the separate share rule (explained below). If there is no executor, the QRT trustee files Form 1041, treating the trust as an estate.
Separate Share Rule
The QRT and related estate are treated as separate shares for purposes of calculating distributable net income (DNI). Accordingly, if the QRT or the related estate makes distributions, the DNI of the entity making the distribution must be determined. In addition, distributions between the QRT and related estate shares will affect the computation of DNI. The regulations provide the following helpful example (all events are in the same tax year):
The residue of A’s estate is to be distributed to the electing QRT. The sole beneficiary of the QRT is C. The estate share has $15,000 of gross income, $5,000 of deductions, and $10,000 of taxable income and DNI. A’s estate distributes $15,000 to QRT. The distribution reduces the DNI of A’s estate by $10,000. The QRT has $25,000 of gross income and $5,000 of deductions. The QRT’s DNI is increased by $10,000 (the amount of the related estate’s DNI reduction) and the QRT’s DNI is therefore $30,000. The QRT distributes $35,000 to C, and as a result, C must include $30,000 in gross income. The Form 1041 filed for A’s estate and the QRT would report $40,000 of gross income.
See Treas. Reg. § 1.645(e)(2) (iii)(B).
Termination of Election Period
At the close of the election period, in other words on the applicable date, a distribution is deemed to be made by the combined QRT and related estate, if there is an executor, or, if there is no executor, from the QRT. The deemed distribution is to a new trust and consists of the QRT share, as determined under the separate share rule discussed above. The combined related estate and QRT, or the QRT, as the case may be, is entitled to a distribution deduction for the deemed distribution. The new trust will include the distribution in gross income to the extent required under the inclusion rules of Code § 662.
As noted above, a Code § 645 election can prove beneficial under several circumstances. Some benefits can flow directly and immediately to the QRT beneficiaries. For example:
B is a calendar year beneficiary of a QRT for which a Code § 645 election has been made. The QRT and related estate have a taxable year of February 1, 2002, through January 31, 2003. B receives a taxable distribution on February 10, 2002. Pursuant to Code § 662(c),B will not have to report any income as a result of the distribution until 2003 and will have until April 15, 2004, to file an income tax return including the income from the distribution.
S Corporation Stock Ownership
An important area in the closely held business arena is the ownership ofS corporation stock by a trust. Closely held business owners often desire to pass the value of the stock in the business down to the next generation, either during life or upon death. These owners, however, do not always want the recipient to own the stock outright. The child or grandchild may not be old enough to undertake the responsibility of owning the stock, or the business owner may not want the beneficiary to possess the voting rights over the stock. Trusts are often used to address these concerns.
Code § 1361(c)(2)(A) provides the requirements for trusts that qualify as shareholders of S corporations. These trusts include
• the “grantor trust” under Subchapter J of the Code,
• the “electing small business trust” (ESBT),
• a trust that is a “grantor trust” before the death of the grantor for a two-year period after the grantor’s death,
• a trust to which stock is transferred pursuant to a will, but only for a two-year period,
• a voting trust, and
• a “qualified Subchapter S trust” (QSST).
In addition, an election under Code§ 645 will treat a trust as part of an estate, which is a qualified S corpo-ration shareholder.
Code §§ 671 through 679 set forth the grantor trust rules. An analysis of these rules is beyond the scope of this article. Certain trusts can intentionally be made grantor trusts,however, and revocable living trusts typically qualify as grantor trusts.
Grantor trusts offer more flexibility than QSSTs or ESBTs because they allow the grantor to control distributions. The trust terms can be very flexible, and, as long as the trust qualifies as a grantor trust, it may own S corporation stock. Regardless of the dispositive provisions, all of the income from a grantor trust will be taxed to the grantor. QSSTs and ESBTs, on the other hand, have a myriad of other requirements.
The requirements for a QSST, which limit the dispositive provisions of the trust, are set forth in Code § 1361(d). First, the beneficiary must make an election to qualify as a QSST within the first two months and 15 days of the eligibility period. Second, the terms of the trust must require that
• there be only one beneficiary;
• the corpus may be distributed only to such beneficiary;
• the income interest must terminate on the earlier of the beneficiary’s death or the termination of the trust;
• upon the termination of the trust during the beneficiary’s lifetime, the trust will distribute all of the assets to the beneficiary; and
• all of the income must be distributed currently to the incomebeneficiary.
If the trust qualifies as a QSST, the beneficiary is treated as owning, for purposes of Code § 678(a), the portion of the trust that consists of stock in the S corporation. The trust’s portion of the S corporation income will flow directly to the QSST beneficiary. If the trust sells the S corporation stock, however, the consideration received by the QSST is treated as received by the trust, not the beneficiary. This is discussed in more detail below.
One of the more onerous requirements of the QSST is the mandatory distribution of income to a single beneficiary. If the beneficiary is a minor, the trustee may distribute income to a minor custodial account without violating the current income distribution requirement. See PLRs 8435153 and 9410035.
Because QSSTs do not permit the accumulation of income or the ability to have multiple beneficiaries, a potential problem before the permissibility of ESBTs was the transfer of stock upon death to a nonqualifying trust. Estate planning documents are sometimes drafted without recognizing that upon the death of the decedent trusts established for children or other beneficiaries may own S corporation stock. Before ESBTs, if these trusts had multiple beneficiariesor did not require that all of the income be distributed, the company’s S corporation election could be disqualified.
To address this potential problem, the Small Business Job Protection Act of 1996, Pub. L. No. 104–188, 110 Stat. 1755 (1996), added ESBTs as permissible S corporation shareholders. Code § 1362 provides that a trust may qualify as an ESBT if it satisfies the following conditions:
• All beneficiaries must be individuals, estates, or charitable organizations;
• The interest must be acquired by gift, bequest, or inheritance; and
• An election must be made within the first two months and 15 days of the eligibility period.
Further, each beneficiary of the ESBT will be counted as a separate shareholder for purposes of the number-of-shareholder limitation for S corporations.
The portion of the ESBT that consists of stock in an S corporation is treated as a separate trust for purposes of computing the income tax attributable to the S corporation stock. This portion of the trust is taxed at the highest income tax rate applicable to estates and trusts on the S corporation income and the gain or loss from the sale of theS corporation stock. The non-S corporation portion of the trust is taxed under the usual rules of Subchapter J. Because of the taxation at the highest rate, the ESBT may not be the optimal solution in many cases and may be used more often as a safety valve. If, however, the beneficiaries of the ESBT are already in the highest individual income tax bracket, the ESBT can provide flexibility in drafting the estate plan for the S corporation shareholder.
Taxable Income vs.Accounting Income
One of the reasons for the complexities in this area is the difference between taxable income and accounting income. The Code determines taxable income for a fiduciary income tax return, in general, in the same manner as for an individual. Accounting income, determined under fiduciary accounting rules, is relevant in that it may determine the amount of distributions, which in turn may determine how much taxable income will be carried out to the beneficiaries. “Income required to be distributed currently,” as defined in the Code, means the fiduciary accounting income that must be distributed currently according to the governing instrument or state law. Because fiduciary accounting income is determined by state law and the governing instrument, complications often arise because of the differences between taxable income and accounting income. For example, most, if not all, of the income of a decedent from an IRA is principal for fiduciary accounting purposes but taxable income for income tax purposes. Also, profits or capital gains are usually principal for fiduciary accounting purposes but taxable income for income tax purposes.
A will or trust may provide the fiduciary with the discretion to change the otherwise applicable fiduciary accounting rules. This discretion can cause problems in at least two scenarios. In the first instance, assume an S corporation has taxable income to the shareholder (the trust) of $100,000. But the corporation distributes only 40% of the taxable income, enough to cover the income tax liability for most individuals. In this case the trust receives $40,000 of distributable income from the company but has $100,000 of taxable income. If the trust does not have any other assets to distribute, $60,000 of the taxable income will be trapped at the trust level, which may be at a higher income tax rate than the individual beneficiary of the trust. If the trust is an ESBT, the trust is already in the highest income tax bracket. If the trust is a QSST, however, the trust may be paying income tax at a higher rate than the individual because of the inability to carry out the taxable income from the trust to the beneficiary.
In the second case, assume that the taxable income is minimal but the S corporation makes a large distribution of cash resulting from a nontaxable sale of assets. The issue is whether this distribution should be treated as trust accounting income even though it is not taxable. Although ordinary S corporation distributions from the sale of assets in an S corporation may be allocated to principal, if the terms of the trust provide the fiduciary with the discretion to allocate these receipts between income and principal, the trustee can use his or her judgment to make an equitable allocation. If the trust or will does not provide this discretion to the trustee, however, and state law does not directly address this issue, the fiduciary must make an interpretation of state law to determine whether the proceeds from the sale of the assets should be allocated to income or principal. This determination could ultimately determine who receives the assets from the sale and could put the trustee in a precarious situation.
Sale of Assets by QSSTs
A specific issue relating to QSSTs involves the sale of the stock by the QSST. Although the QSST istreated as a grantor trust for income tax purposes, in 1995 Treas. Reg.§ 1.1361–1(j)(8) reversed the Treasury’s prior position and held that if a QSST sells the S corporation stock, the gain or loss is recognized by the trust, not the beneficiary. A potential problem occurs when the S corporation sells its assets and is subsequently liquidated. The gain or loss from the sale of theS corporation assets is carried out and taxable to the income beneficiary under Code § 678. If the sale results in capital gain, the amount of the capital gain would increase the basis in the stock in the hands of the shareholder (the trust). In the event of the death of the shareholder, the stock may have already received a step-up in basis, and the sale of the assets would provide an additional increase in the basis of the stock, resulting in a double step-up. Upon the liquidation of the company or some other disposition of the stock, however, the loss resulting from the double step-up would be recognized at the trust level, while the gain from the sale of assets would be picked up by the beneficiary of the trust. Consequently, there is a mismatching of the gain and the loss.
Although the loss at the trust level will be carried out to the beneficiary upon liquidation of the trust, the sale of the S corporation stock does not necessarily mean the trust willterminate.
There are at least two ways to avoid this problem. One way, if permitted by the terms of the trust, is to distribute the S corporation stock to the beneficiary before the liquidation. The individual would then recognize the loss upon the liquidation or sale of the stock and could use the loss to offset the gain from the sale of the stock. The second possibility is to terminate the trust after the sale of the stock in the same calendar year. Termination would cause the capital loss to be carried out from the trust to the beneficiary. Obviously, termination is not always practical or possible.
Closing an Entity Tax Year
Upon the death of a shareholder owning S corporation stock, the decedent’s pro rata share of the S corporation income and loss through his or her date of death is included on his or her final income tax return. This amount is computed on a per-share per-day basis, without consideration of the date of the event recognizing the income and loss. At the shareholders’ consent, however, the S corporation may close its taxable year on the death of the shareholder and create a separate taxable year from the date of death until the end of the corporation’s tax period. The determination of which method is used to allocate theS corporation income or loss may have dramatic effects in certain cases.
For instance, assume an S corporation incurs a loss of $1 million after the death of a shareholder who died on December 1 and who owned 50% of the stock. If the losses are allocated on a per-share per-day basis, most of the decedent’s share of the loss would be allocated to the decedent’s final income tax return. To the extent the decedent cannot use the loss on his or her final individual income tax return, the loss would be wasted. But if the shareholders elect to terminate the tax year and create a separate taxable year from the date of death, because the loss was incurred after the decedent’s death, the entire loss would be allocated to the trust. To the extent the loss cannot be used in the first year of the trust, the loss may be carried forward and used in future years. If the loss is not used before the termination of the estate or trust, it will be distributed out to the beneficiaries upon the termination of the trust.
For a partnership, the assumption is that the partnership year closes upon the death of the partner. Under the § 706(c) regulations, the partnership may elect to pro rate items based on the portion of taxable year that lapsed before the closing or may use any other method that may be reasonable. Therefore, contrary to the S corporation rules, the presumption in the partnership is that the taxable year closes, and to pro rate the items based on a per-day basis an election must be made. The persons administering an estate or trust must keep these distinctions in mind to avoid the waste of a potential loss or the mismatching of gains or losses.
In planning for the owner of a closely held business, the document drafter must consider the effects of the estate plan on fiduciary income tax issues to avoid unintended consequences. Failure to do so can result in higher income taxes, mismatching of gains and losses, wasted losses,or even the disqualification of an S corporation.