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To calculate DNI, start with TI and then
• Add back the distribution deduction and the personal exemption;
• Subtract out capital gains (but add back capital losses allocable to principal [except in the year of termination]);
• Subtract out extraordinary dividends and taxable stock dividends allocated to corpus for simple trusts; and
• Add back net tax-exempt income.
Capital gains are generally taxed to the trust or estate, thus are TI but not TAI. There are exceptions, such as in the year of termination of the trust or estate, and some others (under Reg. 1.643(a)-3.
The rules of DNI and the distribution deduction apply differently to simple trusts versus complex trusts and estates.
Simple Trusts: In a simple trust, the income distributable is a deduction for the trust or estate, and is income to the beneficiary, whether or not actually received by the beneficiary. The character of income remains the same for the beneficiary as in the estate or trust. If there are multiple beneficiaries, DNI is apportioned among them in proportion to the TAI received by each.
Complex Trust: In a complex trust or an estate, the beneficiary is taxed on distributions, but only up to the amount of DNI. Gains are taxed to the trust or estate, and its distribution deduction is limited to DNI. Trust income retains its character in the beneficiary’s hands. DNI is allocated among multiple beneficiaries proportionately, based on distributions to each beneficiary.
There are several important concepts when dealing with complex trusts and estates: (i) the tier system; (ii) the separate share rule; (iii) the 65-day rule; (iv) specific bequests; and (v) distributions in kind.
Tiers. The first tier is beneficiaries to whom income is required to be distributed, and the second tier is all others. DNI is taxed first to the first tier beneficiary and any balance is taxed to the second tier.
Separate Share. This rule allocates DNI among beneficiaries based on distributions of their “share” of DNI. This applies when substantially separate and independent shares of different beneficiaries of a trust are treated as
separate trusts. An example from the materials follows:
Trust has $20,000 of DNI. Trustee distributes $30,000 to A and $10,000 to B. Under pro rata rules, A would include $15,000 of DNI ($30,000 distribution/$40,000 total distribution x $20,000 DNI), and B would include $5,000 of DNI ($10,000 distribution/$40,000 total distribution x $20,000 DNI). If the separate share rule applies, A’s separate share earns $10,000 of DNI and B’s separate share earns $10,000 of DNI. Note that this rule is solely for computing DNI, and its effect is to treat multiple beneficiaries of a single trust or estate as if each were the sole beneficiary of a single trust.
The 65-Day Rule. This rule allows a fiduciary to treat a distribution to a beneficiary made within 65 days of a new year as being made on Dec 31 of the preceding year. The election must be made by the due date of the tax return and is irrevocable. This is a year-by-year election.
Specific Bequests. Bequests of specific sums of money or specific property do not carry out DNI. For this rule to take effect, the bequest must be paid all at once or in not more than three installments, and the amount of the bequest must be ascertainable at the date of death. It is not deductible by the trust or estate or taxable to the beneficiary.
Distributions in Kind (§643(e) election). For residuary bequests, an estate or trust may elect, but is not required, to recognize gains or losses. A distribution carries out DNI, but the amount of DNI depends on whether the § 643(e) election was made. If not made, then the DNI carried out is the lesser of basis or FMV of the distributed property. If the election is made, then the DNI carried out is the FMV of the distributed property. The basis of property to the beneficiary is the basis of property to the estate or trust plus or minus any gain or loss the estate or trust elects to recognize on the distribution.
Charitable Deductions. For a charitable deduction to be valid, a charitable bequest must be paid from gross income and pursuant to the governing document. If valid, it is unlimited in amount. There is no distribution deduction if the charitable deduction is not valid. Generally, the bequest must be actually paid in current year or preceding year. Estates and pre-1969 trusts can get a charitable deduction if the amount is “permanently set aside” for charitable purposes.
Depreciation. For trusts, depreciation is apportioned between the income beneficiary and the trust by the terms of the trust document or, if none, then on the basis of trust income allocable between the beneficiary and the trust. For estates, depreciation is allocable on the basis of income allocable to the beneficiary and the estate.
The § 645 Election. When made, this election treats a “qualified revocable trust” as part of the decedent’s estate for federal fiduciary income tax purposes. The election is made on Form 8855 and must be filed by the due date of the fiduciary income tax return for the first taxable year of the estate, including extensions.
The benefits of making the election include filing one return instead of two; using a fiscal year-end; eligibility for holding sub-S stock for the duration of the election; and not being obligated to make estimated tax payments for any taxable year ending within two years of the decedent’s death.
Termination of Trust or Estate. Upon the termination of a trust or estate, any excess deductions and unused loss carryovers can be passed on to the beneficiaries.
AND NOW, WHAT YOU’VE ALL BEEN WAITING FOR...
Taking all of the above into consideration, here are the “Dirty (Baker’s) Dozen” -- Drafting and Planning Ideas:
1. Select a fiscal year-end for estates to take advantage of income tax savings.
2. Administration expenses should be elected where they will save the most taxes.
3. Draft documents with flexibility to include gains in DNI.
4. Include boilerplate language to allow non-pro-rata distributions.
5. Use specific bequests to avoid DNI carryout.
6. Avoid the separate share rule, if desired, by drafting as a spray trust or having a trust divide into separate subtrusts.
7. Take advantage of the §643(e) election to control taxation of capital gains and DNI carryout.
8. Consider §645 election to take advantage of estate’s more favorable rules.
9. Draft carefully to qualify for §642(c) fiduciary income tax charitable deduction.
10. Avoid excess deductions in year prior to termination.
11. Remember the 3.8% surtax when drafting trusts.
12. Consider “Kenan” gain when drafting formula clauses – pecuniary versus fractional (pecuniary bequests carry out income).
13. “Extra Credit”
• Separate share rule has special rule that applies to IRD.
• IRD is allocated to any share that could “potentially” be funded with IRD, whether or not actually funded with IRD.
• If intent is for IRD to go to a particular share (e.g. marital trust), draftsperson must so state in the trust instrument.
• If IRD is not specifically allocated, surprises could result.
For an example of a 2014 fiduciary income tax return for a complex trust and a resource list for this topic, see the materials on the Heckerling web site at www.law.miami.edu/heckerling and go to “Supplemental Materials.” 2:00 - 3:30 SPECIAL SESSIONS I Session I-A Projecting the Financial Consequences of Planning or Not Planning with Portability (Focus Series) Diana S.C. Zeydel, Erik S. Hendrickson Assisting clients with appropriate estate planning in light of portability is a daunting task. Using simulation based modeling, this program will examine the financial consequences of implementing different lifetime and postmortem planning strategies for modest, mid-range and ultra-wealthy married couples under a variety of scenarios taking income and transfer taxes into account. Can we really do nothing and rely on portability? This program will reveal what the numbers show.
Reporter: Tiffany L. Walker Esq.
Assisting clients with appropriate estate planning in light of portability is a daunting task. Using simulation based modeling, this program examined the financial consequences of implementing different lifetime and post-mortem planning strategies for modest, mid-range and ultra-wealthy married couples under a variety of scenarios taking income and transfer taxes into account. Can we really do nothing and rely on portability? This program revealed what the numbers show. This special session builds on the general session on the same subject.
The presentation by Ms. Zeydel and Mr. Hendrickson on Wednesday afternoon was accompanied by 56 slides (included in the printed materials), providing financial analysis on the use or non-use of portability in respect to various planning techniques. The presenters noted that the Morgan Asset Projection System (MAPS) generated the projections discussed; however, the presenters also mentioned several other options for analysis, such as the use of the Number Cruncher software.
Ms. Zeydel began by reiterating the takeaway of her presentation on Tuesday, stating that grantor trusts are the best planning option. However, throughout the discussion the presenters reminded practitioners to remain mindful of the balance between access to assets and minimization of transfer taxes in conforming the plan to the client’s wishes, as well as underlying goals such as lifetime gifting. In addition, the presenters then provided an overview of several uncertainties in the current planning environment, including Administration proposals on minimum GRAT terms and limits on valuation discounts.
The presenters continued the discussion by mentioning the importance of beginning an analysis with the determination of a client’s spending level, taking into consideration that clients have a difficult time adjusting their lifestyles to reduce spending. The presenters included the projected surplus capital in their financial analysis, stating that this information is pertinent to a client who might wish to increase either lifetime gifting or spending. As noted by the presenters, the projections take into account income taxes, inflation, and portfolio return based on a balanced portfolio, in addition to spending based on a fixed dollar amount.
As with the general session presentation on this topic, the focus turned to increasing the percentage of GST exempt assets. Ms. Zeydel commented that the federal government sort of gave away the store by setting the estate tax exemption at $5 million indexed for inflation. As a result, estate tax savings do not vary as significantly from scenario to scenario as the percentage of GST exempt assets.
The first fact pattern involved a couple with $10 million in assets in a jurisdiction without state income tax. The presenters noted that although the couple is not likely to owe an estate tax, the creation of a QTIP trust increases the proportion of GST exempt wealth after the second death in comparison to no planning. In addition, the presenters also noted that the scenario does not take into account the other benefits of planning, including asset protection and control of ultimate disposition.
The presenters then introduced a second fact pattern, outlining a couple with $30 million in assets and the goal of a $5 million dollar spending cushion. Noted by the presenters was the projection’s use of an indexed DSUE amount until the first spouse’s death in year five of the fact pattern. The second fact pattern projected a loss of $13 million due to transfer taxes, using a QTIP trust established upon the first spouse’s death. The presenters stated that based on the projections, even in the most difficult markets, planning was necessary. Also noted, was the importance of informing the client of the worst-case scenario, in comparison to the best case and median case scenarios, each projected in the printed materials. It is important for the client to see in the projections that their comfort will not be disturbed, even under the worst-case scenario. In addition, the presenters commented that basis is not as much of a concern for a couple with a balanced portfolio. In the event of a closely-held family business, the presenters mentioned the use of a concentrated, single stock as a proxy for the financial analysis.
Within the calculations, the presenters provided an example based on the same 5-year time horizon as the previous fact pattern, concluding that a 19.81% return would be required for a lifetime gift to be more beneficial than a testamentary transfer. However, the presenters pointed out that the longer the time horizon, the less return needed to break even. In addition, the presenters stated that even a 100% basis asset would not have a 100% probability of breaking even due to the potential for the asset to decline in value. Another notable difference involves the introduction of income taxation into the analysis, the presenters highlighted that a Florida resident (not subject to state income tax) would need less of a return to break even than a California resident (subject to state income tax).
Continuing with the analysis of the second fact pattern, the presenters added in the use of a Credit Shelter Trust. In comparison, the presenters noted that the use of a Credit Shelter Trust increased the GST exempt assets to over 50% on average. However, Ms. Zeydel noted that the result is even better with a Super Charged Credit Shelter Trust, increasing this amount to over 75%. Based on the same analysis, the presenters also pointed out that the probability of more wealth being transferred increased to 99%.