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Income Taxation of Trusts and Estates
University of San Diego School of Law
Harris, Ann C.

Final Return Rules

§ 441 – estate can pick calendar year or its own fiscal year

441(f)(1) – can elect fiscal year starting Sunday BEFORE death

§ 644 – Generally Trusts must adopt calendar year

EXCEPTION 1 – § 645 – revocable trust that becomes irrevocable at grantor’s death can chose to be treated as part of estate for income tax purposes
EXCEPTION 2 – § 501(a) charitable trust exempt from tax
Must make election within 2 years if no Form 706, or later of 2 years after death or 6 months after final determination of estate tax liability if Form 706 required
Election made in Form 8855 by executor and trustee jointly -> if make election, only one return needed for estate and trust

Estate terminates for income tax purposes when all assets except reserve holdback have been distributed

Trust also terminates on distribution of trust corpus, but if distribution is unreasonably delayed, it is terminated for tax purposes after expiration of reasonable period of time

Personal liability for executor

§ 3713(a) – taxes have first priority on debts
§ 3713(b) – PR may have liability for unpaid tax if distribute to others and there is insufficient money held in reserve to pay taxes

Exception: court costs and reasonable compensation costs for PR and attorney; funeral costs and widow’s allowances

§ 2204 – PR can petition for early determination of tax liability

IRS Form 706 – IRS must act on petition within 9 months or else PR is automatically discharged from liability – although estate remains liable

§ 6905 – PR written request for discharge of personal liability for income/gift taxes due

IRS Form 5495 – IRS must determine tax liability within 9 months

§ 6901(c)(3) – 1 year SOL after (i) liability arises when payment is made and estate is insolvent OR (ii) expiration on period for collection of tax underlying the liability — whichever is later
§ 6903 – notification of fiduciary relationship by PR
NO DISCHARGE of liability for estate or trust’s income tax returns until final determination of estate tax liability

“final determination of estate tax liability” – issuance of closing letter from IRS, unless refund suit brought within 12 months; OR final disposition unless suit in 6 months; OR settlement agreement with IRS; OR decision by court; OR expiration of SOL

Income in Respect of Decedent (IRD)

Tax liability for year of death

Step 1: PR determine years that need to file (will include back years)
Step 2: PR files for current year of death

Make quarterly estimated payment for quarters alive however
§ 6654(e)(3) allows waiver for underpayment for “unusual circumstances”

Tax liability for estate:

§ 6654(a)(1) – decedent’s estate, or trust responsible for taxes, is NOT required to make quarterly estimated tax payments for first TWO TAXABLE years -> but recall taxable year likely less than full year
– Tax return due 4 months and 15 days after expiration of 2 year period

Income/Deductions on D’s Final Return

Reported in final year tax return
Income includes:

Wages for services rendered before death or that are constructively received before death (ie payroll deposit made night of dying are constructively received)
Proceeds from sale of capital assets received
Interest income collected
Bonds matured but not cashed
Distributions from trust to extent paid from DNI of the trust for that year
Partnership profits/losses as of date of death (death closes pship taxable year § 706(a)(2)(A))

Deductions include:

Amounts paid before death
Bad debts and casualty losses
Deductible medical expenses – even if paid after death (but have option to include on estate tax return instead – only matters if taxable estate)

Income in Respect of Decedent

Income substantially earned, but not received, before death -> right to receive income as of date of death. Four primary characteristics:

must have been taxable had D survived
income not ripened to inclusion on final return
right to receive income earned must be what is transferred
recipient received solely because of death of D

Includes:

Compensation earned BUT NOT constructively received before death (ie Accounts Receivable)
Right to receive uncertain amount attributable to services before death
Expectation to receive income in indeterminable amount -> can be depending on facts and circumstance
Pensions that have vested but not received -> except not if bene
Rents paid at end of period (in arrears), where die in middle of period
Dividends: IRD if alive for record date, even if not received
Proceeds from sales -> Estate of Peterson

Estate of Peterson has 4 factor test for determining whether D had completed a sale, exchange, or other taxable disposition at death:

Legally significant arrangement
D performed al

Income trustee may pay in discretion

§ 642 – deductions

Basically get same as individuals
EXCEPT with TCJA get to take misc admin expenses that individuals can’t take anymore if expense would not have been incurred if property was not held in trust or estate

UPIA – SEE NOTES with big sticker – guiding

Note: trust controls even if contrary to UPIA
If property goes to a specific person, income and expenses go to that person (CPC § 16340(a))
Receipts allocated to principal: (i) anything from grantor before death, IRD (ii) money from sale or principal asset (iii) recovery from trust losses (iv) eminent domain proceeds (v) stub income (vi) insurance policies if premiums paid from income
Expenses to principal: (i) ½ trustee and accounting fees (ii) principal on trust debt (iii) estate taxed (iv) expenses relating to principal (v) disbursements relating to environmental matters (vi) taxes on receipts allocated to principal
Receipts allocated to income: (i) rents unless special rules apply (ii) interest, including prepayments of principal (iii) dividends on life ins policy
Expenses to income: (i) ½ trustee fees and accountings (ii) ordinary expenses associated with administration, management, or preservation of trust property (iii) insurance premiums (iv) taxes on receipts allocated to income (v) interest on trust debt
Priority rules: UNLESS otherwise in trust, distributions taken: (i) net taxable income (ii) net STCG (iii) net LTCG (iv) tax exempt (v) trust principal
Depreciation reserve – trustee may create from cash for asset subject to depreciation BUT not allowed if bene uses property AND not allowed during administration of decedent’s estate

Taxation of depreciation:

Trust: either the trust allows depreciation reserve, and there is no deduction allocated, or it is allocated amongst beneficiaries on basis of TAI allocated to each
Estate: allocated on basis of accounting income of trust, unless will permits creation of reserve