Final Form 1040 1041 Trusts More Than Meets

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Final Form 1040 & 1041 Trusts: More Than Meets the Eye Raymond T. Rowe,

Final Form 1040 & 1041 Trusts: More Than Meets the Eye Raymond T. Rowe, J. D. , C. P. A. Troy, Michigan (248) 643 -8640 Rowelawfirm. com

Your Client Died - What Tax Returns are Required n Final Personal Income Tax

Your Client Died - What Tax Returns are Required n Final Personal Income Tax Return n Income Tax Returns for Estate and/or Trust n n n Allocating Income between the 1040 and 1041 How are expenses allocated Distributions n n 65 day Rule Are There Still Tax Planning Opportunities

AICPA 360 Degrees of Financial Literacy n n Available at both AICPA and MICPA

AICPA 360 Degrees of Financial Literacy n n Available at both AICPA and MICPA website What is a post-mortem election? n n n Estate planning technique that can help minimize federal transfer tax or income tax liabilities Usually made by personal representative Must be timely made in the required fashion QTIP election allows treatment of all of part of qualifying assets to pass to spouse free to tax under marital deduction Selection of tax year allows personal

Income Tax Returns in General n Executor or administrator estate or other person in

Income Tax Returns in General n Executor or administrator estate or other person in control of property must file an income tax return for the tax year that ends on date of death. Reg. Sec 1. 6012 -3(b)(1) n n The final return is due on the regular return due date Reg Sec. 1. 6072 -1(b) No requirement to make adjustments to reflect a short year. Reg Se. 1. 443. 1(a)(2) No requirement to continue to make estimated tax payments after date of death Reg. Sec. 1. 6153 -1(a)(4) Surviving spouse still has obligation to continue estimated tax payments

Income Tax Returns in General n n Executor or administrator must file tax return

Income Tax Returns in General n n Executor or administrator must file tax return for estate from date of death until estate is liquidated for each tax year in which gross income is $600. 00 or more or beneficiary is nonresident alien. Secs. 6012(a)(3), (5). Trustee of trust must file tax return for each nonexempt trust where gross income is $600. 00 or more, there is any taxable income or beneficiary is nonresident alien. Secs. 6012(a)(4), (5).

Accrued Income n Most individual taxpayers report income on a cash basis n Income

Accrued Income n Most individual taxpayers report income on a cash basis n Income received by date of death is reportable on Form 1040 n n Forms 1099 income may not make this allocation; Payer will change the Payee identity based upon receipt of information Tax return preparer should make an allocation of income based upon date of death n n Many preparers do not make this allocation Income accrued as of date of death but not received is taxable income to recipient under income in respect of a decedent rules n There is no step up in basis for accrued income

Accrued Income - Examples n n Dividends declared prior to date of death where

Accrued Income - Examples n n Dividends declared prior to date of death where taxpayer is alive on stockholders’ of record date Accrued interest on n Savings accounts and CDs Bonds Savings Bonds [but see opportunity below]

Opportunities on Final Income Tax Return n Accrued interest on U. S. Savings Bonds

Opportunities on Final Income Tax Return n Accrued interest on U. S. Savings Bonds n n Most taxpayers are on a cash basis for reporting this income Taxpayer at any time can elect to change to accrual basis for this interest n n n For year of switch all accrued and untaxed interest is taxable in year of change. There is no step up in basis for Savings Bond interest. If no change in method beneficiaries are taxable on interest when bonds are cashed in Election can be made to cover U. S. Savings Bonds held in decedent’s own name and also those held in decedent’s revocable trust Rev. Rul 79 -409, 1972 -2 C. B. 208

Opportunities on Final Income Tax Return n n Elderly clients may be in lower

Opportunities on Final Income Tax Return n n Elderly clients may be in lower tax bracket than beneficiaries Taxpayer may have high itemized deductions n n Medical expenses Carryover of excess charitable contributions Foreign tax credits carryovers (need foreign income to use) Investment interest carryover

Opportunities on Final Income Tax Return n Decedent’s net operating loss deduction n n

Opportunities on Final Income Tax Return n Decedent’s net operating loss deduction n n Rev Rul. 74 -175, 1974 -1 C. B. 52 Decedent’s capital and net operating loss sustained in final tax year are deductible only on the final tax return and are available to estate or heirs. See Secs. 165 and 172 Can carryback losses Surviving spouse may want to consider accelerating income or deferring deductions on final return to take advantage of decedent’s NOL

Opportunities on Final Income Tax Return n Capital loss carryovers n n No benefit

Opportunities on Final Income Tax Return n Capital loss carryovers n n No benefit to sell unrecognized capital gain assets in final year since these assets will receive step up in basis upon death Capital assets with unrecognized loss n Step up in basis rule also affects unrecognized loss assets. n n The basis in these assets is stepped down to current FMV If final Form 1040 year has taxable income taxpayer could sell loss assets before death to lower tax (use $3, 000 of loss)

Opportunities on Final Income Tax Return n Installment sales during year of death n

Opportunities on Final Income Tax Return n Installment sales during year of death n n n The election to treat a sale as an installment sale is an election to be made on a sale by sale basis Installment sale income is income in respect of a decedent and there is no step up in basis. 100% of gain would be reported by the recipient Compare tax rates of decedent and beneficiaries and taxable income of decedent to determine whether or not to elect installment sale income recognition

Opportunities on Final Income Tax Return n Income from partnership and S corporation returns

Opportunities on Final Income Tax Return n Income from partnership and S corporation returns n Income from pass through entities are allocated n n n For partnerships to whoever was partner at year end For S corporations to owners on either pro rata basis based on dates of ownership or by interim closing of books Election to close tax year is made at entity level Personal representative should work with entities to plan income allocation to final decedent's return Sec. 754 Election in Partnership n n Upon death partner’s outside basis is increased Partnership can make 754 Election to increase inside basis of partnership assets attributable to deceased partner is increased

Opportunities on Final Income Tax Return n Sec. 754 Election continued n Election is

Opportunities on Final Income Tax Return n Sec. 754 Election continued n Election is made on partnership return for year partner died n n Return must be filed by extended due date or within 12 months thereafter Can be revoked only with IRS approval 754 election can also be made if there is a sale of the partnership interest Suspended Passive Losses n n Deductible on final Form 1040 But only to extent that they exceed the amount by which the basis in the asset is stepped up in value. [IRC Sec. 469(g)(2)]

Opportunities on Final Income Tax Return n Election to file joint return n Personal

Opportunities on Final Income Tax Return n Election to file joint return n Personal Representative and spouse have the right but not the obligation to file a joint return for the year of death n n n Joint return is not allowed if n n n Include only income through date of death on Form 1040 If no Personal Representative is appointed spouse has sole right to decide to file a joint return Surviving spouse has remarried prior to end of survivor’s tax year Either of the spouses is a nonresident alien at any time during the tax year IRC Sec. 6013(a)(1) By filing joint return estate becomes jointly and severally liable with surviving spouse for taxes and penalties associated with the final tax return IRC Sec. 6013(d)(3)

Estate or Trust - Form 1041 n Estate and Trust are two separate entities

Estate or Trust - Form 1041 n Estate and Trust are two separate entities n Estate Decedent's Probate Estate n n n Trust n n n Exemption $600. 00 Can choose any fiscal year ending on end of month not more than 12 months after decedent’s death Exemption of $300. 00 for simple trust and $100. 00 for complex trust Must use calendar year unless it qualifies for natural business year Can elect to treat trust income on tax return for estate n Make election on Form 8855

Estate or Trust - Form 1041 n Taxation of Estate n n Administration expenses

Estate or Trust - Form 1041 n Taxation of Estate n n Administration expenses can be significant Expenses can be deducted in year paid n Unless Estate elects to report income on accrual basis n n Often expenses are paid just before closing of estate thus it may make sense to choose accrual basis No loss carry forward for excess expenses Income can carryout to beneficiaries if there are distributions Excess expenses do not carry out to beneficiaries

Estate or Trust - Form 1041 n Taxation of Trust n Expenses can reduce

Estate or Trust - Form 1041 n Taxation of Trust n Expenses can reduce taxable income n n n For simple trusts all income is taxed to beneficiaries even if not distributed For complex trusts distributions carry out taxable income n n Consider using accrual method Can elect to treat distributions made within 65 days of year end as if they were distributed during prior tax year Excess expenses n n Do not carry forward In year of trust termination excess expenses carryout to beneficiaries as itemized deduction

Estimated Tax In Final Year n n On final year for a Form 1041

Estimated Tax In Final Year n n On final year for a Form 1041 all income including capital gains is passed out to and taxed to beneficiaries By filing Form 1041 -T Allocation of Estimated Tax Payments to Beneficiaries any estimated tax can be allocated to the beneficiaries n n Must file this form within 65 days of end of tax year Does not apply to withheld taxes such as taxes withheld on retirement plan distributions

Estate or Trust - Form 1041: Distributions n Distributions generally carry out a portion

Estate or Trust - Form 1041: Distributions n Distributions generally carry out a portion of Distributable Net Income n n n Distributions in excess of DNI are corpus Distributions made to multiple beneficiaries generally cause DNI to be allocated on pro rata basis. Exception is specific sum of money and specific property n n n If paid all at once or in not more than three installments the distribution is treated as coming out of corpus and does not carryout DNI/taxable income IRC Sec. , 663(a)1) The amount of money or identity of specific property must be ascertainable under governing instrument Transfer of real estate to devisee does not carryout income if title vests immediately

Estate or Trust - Form 1041: Distributions n Separate Share Rule n n General

Estate or Trust - Form 1041: Distributions n Separate Share Rule n n General rule is that DNI is carried out pro rata Under separate share rule DNI is carried out based upon beneficiaries respective share of DNI IRC Sec. 663(c) n n n Where governing instrument creates separate economic interests in one beneficiary or a class of beneficiaries where their interests are not affected by economic interests accruing to other beneficiaries. Reg. 1. 663(c)-4 Application of separate share rule is mandatory Bequests of specific sum of money paid in more than three installments is considered to

Estate or Trust - Form 1041: Distributions n Income from assets specifically bequeathed to

Estate or Trust - Form 1041: Distributions n Income from assets specifically bequeathed to a beneficiary n n Beneficiary receiving a bequest of a specific property is entitled to net income of that property during period of administration Income from specific property is a separate share If income is not distributed during year and estate/trust pays tax on the income the beneficiary is entitled to receive the net income after tax Uniform Principal and Income Act [MCL 555. 601(a)] provides that income from

Estate or Trust - Form 1041 n Distributions in kind n Generally estate or

Estate or Trust - Form 1041 n Distributions in kind n Generally estate or trust does not recognize tax on a distribution n Exception is a distribution of capital asset in satisfaction of a pecuniary (money) bequest. Beneficiary has carryover basis from estate or trust when estate or trust does not recognize income on distribution 643€(3) election estate or trust treats distribution as a sale at fair market value n n n Beneficiary’s basis is increased by gain recognized Election is annual election and applies to all property distributed Benefits of election: Income recognized by estate or trust could offset excess deductions or capital losses

Expenses – Form 706 or Form 1041 n n Form 706 no longer as

Expenses – Form 706 or Form 1041 n n Form 706 no longer as much of an issue since exemption is $11, 400, 000. 00 Deductions that are allowable on Form 706 as administration expenses under Sec. 2053(a)(2) or losses under Sec. 2054 are not deductible on Form 1041 unless n n Election is made waiving right to deduct these items on Form 706 Copy of election is attached to Form 1041

Expenses – Form 706 or Form 1041 n n Double deductions for Deductions in

Expenses – Form 706 or Form 1041 n n Double deductions for Deductions in Respect of a Decedent Sec. 691(b) Claims against decedent’s estate accruing prior to date of death that are paid after date of death n n n Deductible as expenses on Form 1041 Deductible on Form 706 as debts Examples are interest and property taxes accrued but unpaid at date of death

Expenses on Form 706 n n If there is an estate tax liability a

Expenses on Form 706 n n If there is an estate tax liability a number of expenses are deductible on 706 and as noted above there is generally no double deductions Requirements for expenses n n Must be enforceable Related party claims & expenses must be bona fide n n n Underlying transaction must be in ordinary course of business, negotiated at arms length and free from donative intent Nature of claim or expense must be unrelated to expectation or claim of inheritance Must originate under agreement between decedent & family, related party or beneficiary & substantiated with contemporaneous evidence (for example family member who provided care prior to death is deemed to have done so for love and affection if there was no written agreement)

Expenses on Form 706 n Related party expense requirements n n Performance by claimant

Expenses on Form 706 n Related party expense requirements n n Performance by claimant is under terms of agreement and performance can be substantiated All amounts paid are reported by each party and properly taxed to claimant If claimant is a beneficiary weigh taxability of payment to tax savings to decedent Not all payments must be made by due date of Form 706 n Reasonably ascertainable claims and expenses n n n Executor commissions, attorney & CPA fees Claim or counterclaim that existed as of date of death Claims not exceeding $500, 000 existing at date of death even if contested if there is a qualified

Expenses Deductible Under IRC Sec. 67(g) n n Code Sec. 67(g) suspends the deduction

Expenses Deductible Under IRC Sec. 67(g) n n Code Sec. 67(g) suspends the deduction of miscellaneous deductions for the years 2018 to 2025 IRS issued Notice 2018 -61 to clarify how this affects trusts and estates. n Expenses paid or incurred in administration of trust or estate that would not have been incurred by individual are deductible n n n Trustee or Personal Representative fees Tax return preparation fees Appraisal fees

Expenses Deductible Under IRC Sec. 67(g) n Expenses not deductible include n n Investment

Expenses Deductible Under IRC Sec. 67(g) n Expenses not deductible include n n Investment management fees Fees and costs for the holding of property including homeowner association fees, insurance and maintenance fees If fees are grouped (for example trust administration fees) an allocation is required between the deductible and non deductible fees Excess deductions on termination of trust or estate are being studied to determine if they are deductible by beneficiaries n Limitation does not apply to capital loss or net operating loss carryovers

Election related to S Corporations n n A non-Grantor trust is not a qualified

Election related to S Corporations n n A non-Grantor trust is not a qualified S corporation shareholder An estate can hold S Corp stock for as long as necessary for reasonable administration n n If no 706 is filed estate can only qualify for 2 years. Distribution can be made to qualifying individual beneficiary, a Qualified Subchapter S Trust or and Electing Small Business Trust n Either trust make an affirmative election

IRS Audits n n Just because the client died doesn’t mean the audit is

IRS Audits n n Just because the client died doesn’t mean the audit is over Things you must do n File Form 56 – Notice Concerning Fiduciary Relationship n n Filed by the fiduciary, Personal representative, Trustee, guardian, conservator Terminating entity such as trust or estate can only file when it is still in existence Needed to be able to represent the fiduciary estate Often these are not filed

IRS Audits n Things to Do n New Form 2848 n n CPA previously

IRS Audits n Things to Do n New Form 2848 n n CPA previously represented taxpayer who is now dead CPA now needs to represent the fiduciary

References n n n Post-Mortem Tax and Estate Planning Elections; David L. Johnson, Montana

References n n n Post-Mortem Tax and Estate Planning Elections; David L. Johnson, Montana Law Review, September 1981, Article 2 The Power of Post-Mortem Estate Planning (selected issues for 2010 and 2011); Carol A. Cantrell, University of Miami, 45 th Annual Heckerling Institute on Estate Planning, January 2011 The 10 most powerful postmortem planning pointers for trusts and estates; Karen S. Cohen, CPA, Journal of Accountancy, May 2012