Income Tax of Trusts & Estates
Professor F. Ladson Boyle
I. Decedent’s Final Return (use handout : Ch. 2 of Blattmachr)
A. The Basics
1. Decedent’s Income Tax Return:
a. For a calendar-year, cash-method taxpayer, the tax year includes income earned beginning on Jan. 1 and includes what is received before D.O.D. However, return is not due until the next taxable year on April 15th. § 1.6072-1(b).
b. Include on joint return with surviving spouse (SS) only decedent’s income from Jan. 1 until D.O.D. and surviving spouse’s income from Jan. 1 to Dec. 31. If SS also dies, they can still file a joint return: H’s income until D.O.D. and W’s income until D.O.D. § 6013(a)(2).
c. Decedent’s final return is filed based on domicile of personal representative. § 1.6091-2(a). IRC
2. Estate’s Income Tax Return:
a. Estates can have a fiscal year, and return is due 3 ½ months after close of fiscal year. For example, if you have a January 31 close of year, return due May 15.
b. Estate tax return is filed based on the decedent’s domicile. § 6091(b)(3)(B).
B. Income & Deductions:
1. Income received before D’s death and not reported on a previously filed return, is reported on a return that is filed after death. § 6012(b)(11).
2. In SC, an income tax refund belongs to the surviving spouse whether it is a joint return or not. § 12-16-550(A).
3. Specific Deductions:
a. Cash basis taxpayers usually report only actual or constructive receipts as income.
i. Deductions are allowed if paid before D’s death. § 461(h).
ii. If the check is mailed before the end of the year, the deduction is allowed even if the check isn’t cashed until the next year.
b. Medical expenses paid after decedent’s died are still deductible. § 213.
c. Savings bonds. The PR may elect to report as income on D’s final return all interest that has accrued on US Savings bond as of the decedent’s death, unless D had elected previously to annually report the income accruing on the bond. § 454(a).
i. This offers tax-deferral. While the bond is accruing interest, the investor does not pay income tax on the interest (unless he elects to do so). When the bond is cashed, you pay income tax on gain realized.
ii. Assuming the taxpayer did not pay tax on interest income as it accrued, the estate can accrue the interest on the decedent’s final return. You would want to do this when the decedent has deductions that will be wasted.
iii. If Decedent died on Jan. 14, D would have little or no income, you could accrue some interest on that return to make use of the 15% bracket (covers first $22,000).
iv. Estate could distribute the bonds in kind and let distributee pay the tax on the income. The distributee may defer reporting the bond income until the redemption of the savings bonds. Rev. Rul. 68-145; 64-104; 58-435 (p. 2-6 of handout).
v. This is an IRD:
(1) Distributee does not get a stepped up basis.
(2) The D.O.D. value is also included in the estate.
(3) There is an income tax deduction for estate tax attributable to an IRD.
4. Distributive Share of Partnership Income: If D is a partner in a partnership, the partnership’s tax year closes with respect to the decedent partner on D’s D.O.D. § 706(c)(2).
a. For example, partnership earns $100,000. D, a 50% partner dies on Jan. 15. 1/24 of $50,000 will be D’s accrued income and will be reported on D’s final return (approx. $2,000). The remaining $48,000 would be reported on the estate’s tax return.
5. Problem 1 (p.592): Under what circumstances would a PR chose to report savings bond interest on a decedent’s final return? When the interest rate is lower than 35% or the decedent had unused deductions.
6. Problem 2: D suffered a property loss during her final taxable year. A reimbursement claim against the person causing the loss exists but has not been collected at D’s death. Is the loss deductible? See § 1.165-1(d)(2) – 1(d)(3) (limiting deductibility of losses to those situations in which there is no reasonable certainty that reimbursement will be obtained).
a. If there is a loss and a possibility of reimbursement, the PR should deduct on the decedent’s final return only the loss that is expected after reimbursement. If the estate gets excess reimbursement, it will recognize income. If it gets reimbursement, it can take another deduction.
C. Income in Respect of a Decedent (IRD) (p.593)
1. IRD is taxable to the recipient as income, rather than as return of capital. As income, IRD denied stepped-up basis treatment.
a. IRD: income earned by the taxpayer but not yet received at the date of death, not reported on decedent’s final return, is included in estate’s income tax return as IRD. § 691(a).
a. D purchases savings bonds for $25. On D.O.D. the bond is worth $45 because Congress has allowed D to defer the reporting of income. To let D die and step up basis to $45 would allow the income disappear. Therefore, this is IRD, and it does not get a § 1014(a) stepped-up basis. § 1014(c).
b. A pay check earned before D.O.D. is IRD. If received before D.O.D. it is reported on final return.
c. Distributive Share: Since the portion of income earned in a partnership that accrues before D.O.D. is reported on D’s final return, it is not an I.R.D.
d. Things that would have come in regardless of whether D died or not are often IRD.
3. D receives $100 in income, pays $40 in income tax (40%). Then he dies, $60 is included in the estate, and $30 of estate tax is paid (50%), leaving $30. In contrast, if D receives $100 of income after death, pays $50 in estate tax, and then pays income tax (40%) on the $50,000 remaining, leaving $30. As long as you do not change brackets, it is the same result with the § 691(c) deduction.
4. Sale of Property (p.593)
a. Default Rule: Proceeds of sale of property under option is not IRD. Proceeds of sale of property under contract is IRD (depends on conditions in contract). Estate of Peterson.
b. Claiborne v. US (6th Cir.) (p.594)
i. Buyer entered into option contract to purchase farm land from D. Her attorney-in-fact permitted Buyer to take possession and was acting as if the sale had been closed. D died 2 weeks before the closing of the sale.
ii. Holding: The sale proceeds are IRD because D had an entitlement. D would have been entitled to specific performance under state law.
(1) D had a legal or equitable right to performance of the contract.
(2) This option was the legal equivalent of a binding contract when Buyer took possession and began work on the land.
(3) She could have sued them for the purchase price, $690,000.
c. Only ministerial acts left to be performed are IRD. Peterson.
5. Estate of Peterson v. Comm’r (8th Cir. 1981)
a. D owned calves. He agreed, before his death, to sell calves to Max. D died before he set a delivery date. Estate assumed responsibility of the calves (fed, milked, etc.)
b. Holding: Sale proceeds did not constitute IRD.
c. 4-Factor Test:
(1) Whether D entered into a legally significant arrangement re: the subject matter of the sale.
(2) Whether D performed the substantive (nonministerial) acts required as preconditions to the sale.
(3) Whether there existed at the time of D’s death any economically material contingencies which might have disrupted the sale.
(4) Whether D would have eventually received the sale proceeds if he or she lived.
d. The 8th Cir. emphasized that D had not delivered the calves, not that the estate had taken care of the calves.
e. The tax court emphasized delivery and disposal of the subject matter rather than the existence of a sales contract. D had not yet performed the substantive (nonmisterial) acts required as preconditions to the sale.
i. There does not have to be a legal contract.
ii. The feeding and caring and then delivery of the calves was not a ministerial act.
iii. It was mere time and caring for cows that prevented delivery. Arguably, there were economically material contingencies that could have disrupted the sale.
iv. D would have received the proceeds if he had lived. In time, D would have delivered the calves and received the money.
i. Keck v. Commr –ICC approval of sale of trucking business was an economically material contingency.
ii. Trust Co. v. Ross – Carl owned a series of h
everything. SS does not have right to stub income and cannot control it, so not IRD.
(3) Now, there is a stepped up basis in the $15,000 (the second ½ is post-mortem income). It is ordinary income to the remainder BEs (kids), but if it is not IRD, there is no § 691(c) deduction. This does not seem the right result: you can’t get a stepped up basis in ordinary income, so the Peterson test fails here.
(4) What if the trust instrument was silent about the distribution of income earned during the quarter in which D died? Questionable. Look at the statute: there must be glitch in the statute.
vi. D owned Series EE US Savings bonds, but had not elected to include accrued interest in income. § 454. What will be the effect if the PR elects to cash in the bonds? See Rev. Rul. 64-104. This is IRD. This is a legally significant arrangement, all D had to do was wait, when cashed in, it becomes income.
vii. At the end of each month, D is paid wages earned during the month. D is a cash-basis taxpayer using calendar year accounting. D works 2 weeks in February before he dies. On the last day of February, his employer pays his estate for the February work. How is the February payment reportable for income and estate tax purposes? IRD. For estate tax purposes, it is included in the estate. No step-up in basis.
viii.D owns Blackacre, which he purchased for $125,000, and which is worth $150,000 when he dies.
(1) What if the PR sells the land for $200,000 8 months after D’s death? $150,000 basis, so $50,000 gain if sold for $200,000.
(2) What if 4 months before death, D contracted to sell Blackacre to X for $150,000 with the closing to be one year after the contract date. The contract was binding on the PR. Estate and income tax consequences of the contract and sale? The property is included in the estate at $150,000 because it has a contract over it for that amount. An option, when exercised and becomes enforceable, is IRD. Claiborne. There is no step-up in basis and there is a $25,000 gain.
(3) Assume that in (b), the PR distributed Blackacre to the residuary legatee before the closing and the legatee closed on the contract. What will be the income tax consequence? The legatee inherits the IRD, $25,000 income to the legatee. § 691(a)(1)(c).
(4) The estate could not avoid the income tax consequences by selling the property to a third party subject to the outstanding contract. § 691(a)(2). This is a taxable disposition in anticipation of IRD income. If estate sells property subject to contract to Buyer for $145,000, Estate has a $20,000 gain ($145- $125) and Buyer, when it sells the land, has a gain of $5,000 ($150 -145).
ix. Alice is a partner in ABCD law firm. At her death on March 1, Alice was entitled to $24,000 of profits earned. Her estate received the payment on March 15.
(1) This is an asset of the estate, for estate tax purposes.
(2) Under § 706(c)(2), the partnership year closed as to Alice on the date of her death, so the $24,000 shows up on her final income tax return. Therefore, it is NOT IRD.
(3) Estate will take a deduction for income tax paid: income tax due is a debt of decedent and deductible under § 2053. The estate tax will be on $19,000, the net of $24,000 of income – $5,000 income tax.
7. Under a partnership agreement, the partnership continued the practice under the firm name, and Alice’s estate received an additional $200,000 which represented ¼ of the