Trusts and Estates: Uses and Tax Considerations; These Entities Serve Special Purposes but Require Special Care to Manage Their Tax Implications (2017)

Time and again, CPAs and other accounting and tax professionals are faced with the unique income tax provisions related to trusts and estates. Aside from summarizing the general rules related to the income taxation of estates and trusts, this article highlights the impact of different legal authorities applicable to trusts. Further, it discusses issues related to some special trust and estate entities, namely, grantor trusts, pooled income funds, qualified subchapter S trusts (QSSTs), electing small business trusts (ESBTs), bankruptcy estates, and foreign trusts. Understanding the uses of trusts generally requires an understanding of their purpose. Some trusts are formed for tax purposes, but others are formed to achieve specific wealth management goals. The first step in appreciating the difference is to examine their general principles of fiduciary income tax liabilities. Because trusts generally have much lower deductions, compressed marginal tax rates, and a much lower threshold for the net investment income tax, they may incur higher income taxes than individuals, especially if they retain current income. TAXATION OF TRUSTS AND ESTATES In general, estates' and nongrantor trusts' income is taxed in a manner analogous to that of individual taxpayers, with the following main differences: * Trusts and estates (other than bankruptcy estates) do not get a standard deduction. * These trusts and estates get an exemption, but only $100, $300, or $600, compared with the personal and dependency exemptions available to individual taxpayers (and bankruptcy estates) of $4,050 in 2017. * Trusts and estates do get a deduction for trust income distributed to the beneficiaries, which is computed based on the actual distribution amount, distributable net income (DNI), and net accounting income (the latter two concepts are unique to trusts and estates and rely on an understanding of fiduciary accounting). * Trusts and estates do have the same progressive tax rates as individuals, with the exception of the lowest 10% rate bracket, which exists only for individual taxpayers. However, compared with those of individual taxpayers, the tax brackets are very compressed, with the highest marginal tax rate of 39.6% starting at $12,500 in taxable income for 2017. * Complex trusts and estates do not have a limitation for charitable contribution deductions from gross income. (Simple trusts cannot make charitable contributions.) * The net investment income tax applies to trusts and estates based on a threshold at the highest tax bracket and not on a fixed dollar amount. Thus, in 2017, the net investment income tax for trusts and estates is levied on the lesser of net investment income or taxable income above the $12,500 threshold. (For individuals, the threshold is $250,000 for married couples filing jointly ($125,000 if married filing separately) or $200,000 for other taxpayers.) * The top rate of 20% for net long-term capital gains and qualified dividends applies when income reaches the top marginal bracket for ordinary income of 39.6%; due to the relatively compressed brackets, this means the 20% rate goes into effect if taxable income of trusts and estates exceeds $12,500 in 2017. For individuals, the highest long-term capital gains rate does not apply for incomes below $235,350 (for married taxpayers filing separately) up to below $470,700 (joint filers). Details of these differences and accounting for trusts and estates have been discussed in prior editions of the JofA (see Income Tax Accounting for Trusts and Estates JofA, Oct. 2010, tinyurl.com/ z9mohtk, and Avoiding the Squeeze: Trusts, Estates, and the New ATRA Tax Regime, April 2014, tinyurl.com/zmpx6fl). Due to the compressed tax brackets and the net investment income tax, marginal rates can quickly reach 40% or greater. The progressivity for individual taxpayers, regardless of filing status, extends over much larger dollar amounts. …