Income Taxation Of Trusts And Estates - General Issues

General Issues

Filing Requirements
Trusts and estates must file an income tax return (Form 1041) for each taxable year if the trust has earned $600 in income, or has a beneficiary that is a non-resident alien.

For a grantor trust, assuming the individual grantor has reported all items of income and expenses on their own individual income tax return (Form 1040), are not required to file a 1041. This makes the grantor liable for the total taxes under their return.

Estate income tax returns and Trust income tax returns (Form 1041) share the same filing deadline as regular taxpayers of April 15th of the year following the actual tax year (adjusted later for holidays and weekends). Extensions of time can be granted for five months if the administrator files for an automatic extension request (Form 7004).

Choice of Taxable Year
Certain trusts (complex trusts) allow flexibility to the beneficiaries to receive or defer the trust income and principal for the given tax year depending on their personal preference for the year.

Reasons for doing this might include a charitable contribution from the trust utilizing the gross accounting income, bad year in the market or possibly the beneficiary has a substantially high tax rate on their individual return due to earned income and the trust would receive a more favorable tax rate. Whatever the reason and if the trust allows, the trustee can chose to pay income or allow the income to accumulate within the trust and have the trust pay the tax due.

Tax Treatment of Distributions to Beneficiaries
Trust or estate income is taxed to the beneficiary as if they had received the income directly from the original source and not the trust itself. To clarify, an ordinary income would be fully taxable, tax-exempt interest remains tax-free and capital gains are still treated as capital gains.

How Beneficiaries Report Income:

  1. Dividends and Interest - Schedule B of Form 1040
  2. Capital Gains - Schedule D of Form 1040
  3. Real estate or business activities - shown on Schedule K-1 and reported on Schedule E (subject to passive activity restrictions)

Rate Structure
It's important to know about two separate potential tax issues when it comes to trust and estate planning and taxation. There's the federal "Income Tax Return for Trusts and Estates" (Form 1041) and also the "Estate Tax Return" (Form 706).

Trust Income Tax Rates for 2013:

If taxable income is: The tax is:  
Not over $2,450 15% of the taxable income
Over $2,450 but not over $5,700 $367.50 plus 25% of the excess over $2,450
Over $5,700 but not over $8,750 $1,180 plus 28% of the excess over $5,700
Over $8,750 but not over $11,950 $2,034 plus 33% of the excess over $8,750
Over $11,950 $3,090 plus 39.6% of the excess over $11,950


The rates in this tax table represent a substantial increase in the tax rate for trusts as a result of the American Taxpayer Relief Act, which has also raised the top capital gains rate for trusts to 20%. The 3.8% Obamacare tax also applies to all investment income that stays within a trust and is not distributed to beneficiaries. This change in the tax law will therefore have a major impact on estate planning strategies for both the wealthy and the middle class.


Estate Taxes
Estate tax computed on Form 706 is eliminated or reduced by the "unified credit," which applies to both the gift tax and the estate tax. Each taxpayer is given an exclusion amount that is exempt from federal estate tax. For 2013, that amount is $5.25 million. Estates over that amount would pay a maximum estate tax rate of 40%.  


Grantor / Non-Grantor Trusts
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