Income Tax Accounting for Trusts and Estates: Planning Allocations between Entities and Beneficiaries Is Even More Critical with Higher Tax Rates on the Horizon

By Pippin, Sonja | Journal of Accountancy, October 2010 | Go to article overview

Income Tax Accounting for Trusts and Estates: Planning Allocations between Entities and Beneficiaries Is Even More Critical with Higher Tax Rates on the Horizon


Pippin, Sonja, Journal of Accountancy


EXECUTIVE SUMMARY

* Income taxation of estates and trusts may not receive the same attention as individual income taxes or estate taxes. This article describes some of the general income tax rules of these entities, such as the different rules for allocation of income and deduction items between principal and distributable income, between tax-exempt and taxable income, and between trusts/estates and beneficiaries.

* These allocations are prescribed either by the trust instrument, state law or the Internal Revenue Code. In some cases, taxpayers have flexibility. Generally, it is advisable to "push" the taxable income and the income taxed at higher rates to the beneficiary, because the tax rate schedule for trusts and estates is depressed, with the highest bracket currently starting at $11,200.

* Pushing income to beneficiaries may become still more important if lower tax rates under the Economic Growth and Tax Relief Reconciliation Act are allowed to sunset as scheduled at the end of 2010.

* Also, since income from estates and trusts is mostly investment income, the new 3.8% unearned income Medicare contribution tax will apply to most, if not all, of the trust's income falling in the highest tax bracket. Individuals are not subject to this tax until their modified AGI reaches $250,000 (married filing jointly and surviving spouses) or $200,000. Thus, distributing trust income to beneficiaries can lower the amount subject to this extra tax.

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Estates and nongrantor trusts must file income tax returns just as individuals do, but with some important differences. For one, their income is taxed at either the entity or beneficiary level depending on whether it is allocated to principal or allocated to distributable income, and whether it is distributed to the beneficiaries. And because their exemption amounts, tax brackets and related thresholds haven't been indexed for inflation or modified for tax relief to the extent those for individuals have, they can be subject to higher tax rates at much lower levels of income. With the new Medicare tax on investment income on the highest tax brackets, estates and trusts pay still more taxes on incomes over $11,200, as opposed to $200,000 or $250,000 for individuals.

In this and other ways, the Patient Protection and Affordable Care and the Health Care and Education Reconciliation acts of 2010 (PL 111-148 and PL 111-152, respectively) affect trusts' and estates' income taxes and have introduced discrepancies that tax practitioners can review with their clients who administer trusts and estates. This article reviews some strategies for more tax-efficient allocation of income and principal by trusts and estates.

Income tax accounting for trusts and estates has received relatively little attention from tax professionals as well as lawmakers. This is not surprising because of the comparatively few taxpayers affected. In the 2008 tax year, approximately 3 million Forms 1041, U.S. Income Tax Return for Estates and Trusts, were filed, with an aggregate gross income of $188 billion. Aggregate taxable income and tax liability were $112 billion and $23 billion, respectively (IRS Statistics of Income, Fiduciary Returns-Sources of Income, Deductions, and Tax Liability, tinyurl. com/3yr5d6b). Compared with more than 142 million individual income tax returns (forms 1040, 1040A or 1040EZ) reporting more than $8 trillion in gross income (IRS Statistics of Income, Individual Income Tax Returns, Preliminary Data, 2008, tinyurl.com/yb2n2yv), these are small numbers.

In addition, income taxation of estates and trusts does not generate much public interest--unlike the estate and gift tax, which has been subject to much debate within the professional community as well as in government and among the general public. As a consequence, practitioners and their clients may not be aware of several tax issues related to estates and trusts. …

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