Other Income Tax Issues Marcia Urban Agenda Fiscal

Other Income Tax Issues Marcia Urban

Agenda • Fiscal Year Selection • IRC Sec 645(b) Qualified Election • Separate Share Rule • 65 Day Rule • Estimated Taxes • Alternative Minimum Taxes • Net Investment Income • Passive Activity Losses

Fiscal Year Selection • Estates may elect a fiscal year that cannot be longer than 12 months ending on the last day of the month • A trust must have a calendar year IRC Sec. 644 • The estate tax year begins on the day after the decedent's death • The election is made by filing the tax return for the year which is due on the 15 th day of the 4 th month after the fiscal year end • The request for an estate EIN asks for the tax year, but this is not binding on the executor

Fiscal Year Selection • Examples: • DOD is 11/30/2018 and calendar year is elected and distributions are made in December 2018 • Beneficiaries report the income in 2018 • DOD is 11/30/2018 and a November fiscal year is elected and distributions are made in December • Beneficiaries report the income in 2019 • This is used when the trustee wants the estate to pay the income tax • DOD is 2/1/2019, $10, 000 is distributed on 2/25/2019 and a February 28 fiscal year is elected • Probably minimal income is generated in the one month for the beneficiary to report

IRC Sec 645(b) Qualified Election • A "qualified revocable trust" (QRT) may elect to be treated as a part of the estate of the decedent. • QRT is a trust treated under IRC 676 as owned by the decedent (power to revoke by the grantor, but not a power held by a spouse). • Think "will substitute", "living will", or "plain vanilla revocable trust" • The election must be done by both the executor and the trustee • If no probate assets, and no executor, then the trustee may make the election • A decedent's incapacity prior to death does not lose the eligibility to be treated as a QRT

IRC Sec 645(b) Qualified Election • The trust is treated as part of the estate from the date of death until the "applicable date" • A 706 is not filed: • 2 years from the date of death • A 706 is filed: • 6 months after the date of final determination of the liability for the estate tax imposed. • Time for filing the election • No later than the time for the first estate tax return on form 8855 that shows the income and deductions of the qualified trust • Irrevocable election if made

IRC Sec 645(b) Qualified Election • Election Advantages: • • • Election of a fiscal year end Larger exemption (if it ever comes back into law) Charitable set-aside deduction Qualified S-corp shareholder during election period Deduction of Passive Activity Losses on Real estate for up to 2 years up to $25, 000 • active participation of the trust is waved for the trust if decedent was active • No estimated taxes are required for the years treated as part of the estate for 2 years • Only one form K-1 for each beneficiary • Potential Disadvantages • Income taxed at a higher rate and possibly subject to the Net Investment Income surtax

Separate Share Rule IRC 663(c) • Substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts • Easy example – IRC 645(b) election (estate and QRT) • Applies to both complex and simple trusts, as well as estates • MANDATORY at the earliest time one determines there are separate shares

Separate Share Determination • Economic interests neither affect, or are affected by the economic interests of other beneficiaries • It would be possible under IRC Secs. 661 -662 for one beneficiary receiving a distribution to be taxed on the income actually accumulated for another beneficiary • Rule prevents this taxation because a beneficiary of a separate share is only taxed on their pro rata share of DNI • Separate shares are only used for DNI allocation • No requirement for separates tax returns, EIN, accounts or exemption

Separate Share Exclusions • Specific bequests • They are excluded from the allocation of DNI • Charitable Beneficiaries • They are governed under IRC 642(c)

65 Day Rule IRC Sec. 663(b) • In the first 65 days of any taxable year of an estate or trust, and amount is properly paid or credited, such amount shall be considered paid or credited on the last day of the preceding taxable year. • Permits a trustee/PR to elect to treat this amount paid by March 6 (March 5 in a leap year) as distributed in the prior year • Check the box election on form 1041 • Can be made annually, and if made, is irrevocable

65 Day Rule Advantages • Allows the fiduciary to make early in the year distributions, prior to the filing of the tax return, and determine if the trust/estate income tax may be reduced • The fiduciary may not have had enough information prior to year-end to make tax advantaged distributions • Opportunities to consider by the fiduciary • Lower brackets of the beneficiary • Beneficiary has personal losses/deductions to offset the income • Mitigate estimated tax payment penalties the trust/estate may have • Not applicable for Simple Trusts

Estimated Taxes • Required payments for all trusts and estates • Simple trust generally is only taxed on income not included in DNI – Think capital Gains! • Often underpayments occur by a revocable trust in the year decedent dies • Estimated tax payments made by decedent prior to death are reports on the final 1040 • Estate only have to made estimated tax payments after the first 2 years • No estimated tax payments are owing where the amount due is small (< $1, 000) • No estimated tax payments are due in final year as all income and deductions are distributed to the remainder beneficiaries

Estimated Tax Payments • Required payments are to be made in 4 equal installments (like individuals) • 90% of current year's liability • 100% (or 110%) of the prior year's tax liability depending on the AGI of the trust/estate • Prior year must have been 12 months • A grantor trust that changes character qualifies as if it filed a 1041 return that showed the income required to be reported by the grantor and no tax liability of the trust • Annualized income uses actual income based on the months of the year • Trusts use one month less than an individual (Jan-Feb, Jan-Apr, Jan-July & Jan-Nov) • Distribution Deduction is only allowed if actually paid or required to be paid

Estimated Tax Payment Election • IRC 643(g) election allows a fiduciary to treat excess estimated tax payments made by the trust/estate to be made by the beneficiary • File form 1041 -T within 65 days of the tax year • File the form separately if the return is on extension or with the trust return if filed timely • The payment is treated a made on the last day fo the trust's tax year and included in the DD calculation • The payment relates to a payment made by the beneficiary on January 15 th of the following year (Beneficiary's 4 th q payment)

Alternative Minimum Tax (AMT) • Trusts and Estate are subject to AMT just like individuals, with few modifications • File 1041 Schedule I • Exemption in 2019 is $25, 000 and adjusts for inflation • Trusts calculation an AMT DD • Lesser of : • Actual distributions adjusted for tax-exempt portion, or • Distributable net AMT income (DNAMTI)

Alternative Minimum Tax (AMT) • Short year differences between regular and AMT for trusts and Estates • Regular tax cuts off at short year for calculation • AMT requires annualization of the income for a full year, but not the distributions actually made • AMT adjustments transfer out to the beneficiary on the K-1 • If more than one beneficiary, DNAMTI is allocable among them in the same manner as income is allocated for regular tax purposes

Net Investment Income (NII) IRC 1411 • A surtax of 3. 8% is applied to the lesser of: • Undistributed NII for the taxable year, or • Excess of AGI for such taxable year over the $ amount of the highest tax bracket for the trust ($12, 750 in 2019 inflation adjusted) • NII includes: Interest, dividends, capital gains, rents, royalties annuities and passive income. • NII does not include: Trade or business income or tax exempt income

Trust Strategies to Minimize NII • Investment strategies • Invest in growth assets (deferred NII until sold) • Invest in tax-exempt municipal bonds where appropriate for the asset allocation • Operate a trade or business where the trustee materially participates I the business • Distribution strategies • Exercise discretion to distribute all FAI (if document allows) in excess of the highest income tax bracket where beneficiaries are in lower tax brackets • Trustee determines whether capital gains may be included in DNI and thus available to be distributed out to the beneficiaries

Passive Activity Losses (PAL) • Same rules as apply to individuals • A few twists as to what constitutes material participation for activities • Only "Natural" persons qualify (or their estate limited to 2 years) for the special real estate PAL up to $25, 000 • When a trust terminates with PAL carryover, the beneficiary who receives the asset/activity that generated the loss will get a cost basis adjustment equal to the suspended loss • Understanding terms for "active participation" and "material participation" become important for taxpayers with passive activity income do to the impact on NII discussed above