CHAPTER 27

INCOME TAXATION OF TRUSTS AND ESTATES

SOLUTIONS TO PROBLEM MATERIALS

Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition

1 Issue ID Unchanged 1
2 Parties to a fiduciary entity Unchanged 2
3 Trusts and income shifting Unchanged 3
4 Fiduciaries and the AMT Unchanged 4
5 Simple versus complex trust; personal exemptions Unchanged 12
6 Determining taxable income: five-step approach Unchanged 5
7 Distributions of appreciated property Unchanged 6
8 Disallowance of § 212 deductions Unchanged 11
9 Cost recovery deductions of a fiduciary Unchanged 7
10 Charitable contributions of a fiduciary Unchanged 8
11 Issue ID Unchanged 9
12 Grantor trust rules Unchanged 10
13 Fiduciary AMT computations Modified 13
14 Attributes of trusts and estates Unchanged 14
15 Charitable contributions Modified 15
16 Computing DNI, taxable income Unchanged 16
17 Computing DNI, taxable income Unchanged 17
18 Separate share rule Modified 18
19 Tier distributions Modified 19
20 Constitution of DNI Unchanged 20
21 Computing DNI, taxable income Unchanged 21
22 Income in respect of a decedent Unchanged 22
23 Termination year losses Unchanged 23

27-1
27-2 2004 Comprehensive Volume/Solutions Manual

CHECK FIGURES

13. $18,850. 19.a. $50,000 first-tier, $70,000 total gross

15. $0; $7,500; $15,000. income.
16.a. $25,000. 20. $12,000 (div.), $8,000 (taxable int.),
16.b. $66,000. $4,000 (exempt int.), $6,000
16.c. $14,700. (passive); same for both.
16.d. $22,000. 21.a. $100,000.
17.a. $30,000. 21.b. $90,000.
17.b. $81,000. 21.c. $37,900.
17.c. ($300). 21.d. Lydia $16,000; Kent $12,000 taxable
17.d. $27,000. part of distribution.
18.a. $25,000.
18.b. $15,000.
 Income Taxation of Trusts and Estates 27-3

DISCUSSION QUESTIONS

1. Taxpayers create trusts for a variety of reasons. Some trusts are established primarily for
tax purposes, while others are designed to accomplish a specific financial goal or to
provide for the orderly management of assets in case of an emergency. The most
commonly encountered reasons for creating a fiduciary entity include the following.

• To hold life insurance policies on the decedent, as part of an estate plan to remove
such policies from the gross estate.

• To manage assets, reduce probate costs, and assure the privacy of the distribution of
assets near the end of the grantor’s life.

• To provide funds for an advanced education, accumulating income at a lower tax rate
than that to which the grantor is subject.

• To hold or manage the assets of the grantor while he or she is in the military,
governmental service, overseas, or in some other way divorced from the daily
management of the assets.

• To manage the assets of a tax-sheltered retirement fund, corporate liquidation, or

divorcing couple in an objective manner.

Table 27-1

2. The parties to a trust include a grantor, trustee, and one or more beneficiaries. The
parties to an estate include the decedent, the executor or administrator, and one or more
beneficiaries. In each case, at least two different parties should be involved. Figure 27-1

3. Fiduciary taxation has fallen prey to the “soak the rich” approach to tax reform.
Congress wants to prevent taxpayers from using fiduciary entities to shelter taxable
income at low tax rates. The compressed rates apply, though, regardless of the
motivation for creating the trust. On $30,000 of taxable income, a married couple and a
C corporation pay $4,500 of Federal income tax, while a single individual pays about
$5,000 and a trust pays about $11,000. p. 27-7

4. A fiduciary entity is subject to the alternative minimum tax. The entity then restates its
income and passes through AMT income, preferences, and adjustments to its
beneficiaries. Given the nature of most fiduciary operations, though, it is unlikely to
encounter this tax. No ACE adjustment need be computed by a fiduciary entity.

The entity must make estimated tax payments with respect to any AMT. The small-
corporation exception does not apply to a trust or estate.

A fiduciary claims a $22,500 AMT exemption, which phases out at a rate of one-fourth
of the amount by which AMTI exceeds $75,000. The AMTI of the entity is subject to a
26% tax rate, which reaches 28% when AMTI exceeds $175,000.

pp. 27-8 and 27-9

5. a. All income is required to be distributed currently to the granddaughter of the

grantor. No corpus distributions are made.
27-4 2004 Comprehensive Volume/Solutions Manual

b. All income is required to be distributed currently to State University, a qualifying

charity. No corpus distributions are made.

c. Income can be sprinkled at the discretion of the trustee; or, same as a. or b.,
except that a corpus distribution is made during the year.

pp. 27-7, 27-8 and Example 3

6. Step One Determine entity accounting income.

Step Two Compute entity taxable income before the distribution deduction.

Step Three Determine distributable net income (DNI) and the distribution deduction.

Step Four Compute entity taxable income [Step 2] – [Step 3].

Step Five Allocate DNI and its character to the beneficiaries, applying the tier
system if needed.

Figure 27-2

7. With respect to a distribution of appreciated property by a fiduciary, no taxable income

generally is recognized. Basis of the asset carries over to the recipient. DNI and the
distribution deduction reflect an amount for the distribution equal to the lesser of the
asset’s basis or its fair market value.

DNI and distribution deduction $65.000

Gross income to Lopez $0
Basis to Judith $65,000

Upon election, though, the distribution can become a taxable event. The gain would be
recognized by the fiduciary, and the beneficiary would take a basis in the asset equal to
its fair market value. DNI and the distribution deduction both would reflect the asset’s
fair market value.

DNI and distribution deduction $100,000

Gross income to Lopez $35,000
Basis to Judith $100,000

Examples 7 to 10

8. a. The default application of the deduction for fiduciary fees is to the estate tax
return. Section 212 expenses of this sort are deductible on an income tax return
only if a waiver of the estate tax deduction is filed.

Here, the deductions are more valuable on the estate tax return, because of the
great disparity of marginal rates. Moreover, if the payments were claimed on the
estate’s income tax return, only five-sevenths would be deductible, due to the
presence of the exempt income. Nonetheless, the executor could split the
deduction between the estate tax return and the estate’s income tax return, but
probably within the following bounds.
 Income Taxation of Trusts and Estates 27-5

Deduction Assigned to Deduction Assigned to

Case Estate Tax Return Estate’s Income Tax Return
Most favorable to estate’s $857 $2,143
income tax return
Least favorable to estate’s $3,000 $0
income tax return

b. The 2% floor applies to a few § 212 items, such as annual mutual fund membership
and processing fees, but it does not apply to items that would not have been
incurred by an individual, such as the entity’s personal exemption, trustee
commissions, and other fiduciary fees.

pp. 27-14 and 27-15

9. Cost recovery deductions related to the assets of a fiduciary are assigned proportionately
among the recipients of entity accounting income. Examples 14, 15, and §§ 167(h) and
611(b)(3) and (4)

10. If the gift is determinable in both existence and amount to the controlling will or trust
agreement, the entity is allowed a deduction for the gift that is paid from gross income.
See § 265 for disallowance possibilities.

The deduction is allowed even if the payment is made during the following tax year.
Qualifying charitable organizations for gifts by fiduciaries include all of those so
recognized for gifts by individuals, and certain non-U.S. charities.

Examples 17 and 18

11. • How much of the loss carryforwards will remain upon termination of the trust, for
pass-through to Amy?

• How many years will remain for the carryforwards?

• Will Amy’s other income sources be of the proper nature and amount so that the
carryforwards can be used immediately?

• Should the trust sell the investment assets, or should the trustee distribute the
portfolio to Amy in-kind and let her sell them off?

Examples 31 and 35

12. TAX FILE MEMORANDUM

Date: November 3, 2003

From: Deron Johnson

Subject: Grantor trust rules

27-6 2004 Comprehensive Volume/Solutions Manual

Carol’s ideas are contrary to the tax law. Life insurance premiums, since they generate
exempt income, are nondeductible. § 265

By using a trust as a fiduciary entity in this plan, Carol also brings into play the grantor
trust rules of §§ 671 – 679. Where the grantor retains the right to make investment and
distribution decisions, the trust is ignored for tax purposes. Thus, trust income and
deductions are attributed directly to Carol, the owner of the trust assets.

The donor can retain the following powers without making the entity a grantor trust.

• Invade corpus for the benefit of a beneficiary.

• Withhold income from a beneficiary, during the beneficiary’s disability or minority.

• Allocate items between entity accounting income and corpus.

• Choose charitable beneficiaries.

But if the grantor retains the income of the trust (or the right to designate who is to
receive such income), the grantor trust rules apply.

PROBLEMS

13. AMT income ($35,000 + $60,000) $95,000

AMT exemption (22,500)
AMT tax base $72,500
AMT rate for fiduciaries X 26%
Tentative minimum tax $18,850

Estimated tax payments must include AMT liability. pp. 27-8 and 27-9
 Income Taxation of Trusts and Estates 27-7

14. Attribute Estate Trust

Separate income tax Yes Yes

entity

Controlling document Will; not insurance Trust instrument

contracts, joint ownership
statutes, installment
notes, or other items
concerning nonprobate
assets

Termination date is No; termination occurs Yes, although such date

determinable from when the estate’s might be contingent upon
controlling document activities are completed. other events, such as the
This might be a grantor’s death, the benefi-
substantial period of time ciary’s graduation from
(e.g., where a § 6166 school, or the completion
election is made). of some contractual duty.

Legal owner of assets Beneficiaries Trustee during trust term,

under fiduciary’s immediately, although beneficiaries thereafter
control the executor has a
fiduciary and
management duty during
the administration period.
Indeed, the identity of
some of the heirs may not
be apparent immediately
upon the decedent’s
death, but legal title
passes immediately.

Document identifies Yes Yes

both income and
remainder beneficiaries

Separate share rules Yes Yes

apply

Generally must use No Yes

calendar tax year

pp. 27-4 to 27-6 and Figure 27-1

27-8 2004 Comprehensive Volume/Solutions Manual

15. Assumption 2003 Deduction for Contribution

Brown is a cash- $0
basis individual No deduction until 2004, when payment is made
Brown is an $7,500
accrual-basis Limited to 10% of TI, with 2 1/2 month grace period;
corporation no loss of deduction due to exempt income
$15,000
Brown is a trust Limited to 75/100 of gift, due to exempt income;
one-year grace period allowed

pp. 16-13, 16-14, and 27-16

16. a. $25,000 (1/3 of $75,000 accounting income).

b. $66,000.

c. $14,700.

d. $22,000 (1/3 of $66,000).

 Income Taxation of Trusts and Estates 27-9

Accounting Taxable Distributable Net

Item Totals Income Income Income/
Distribution
Deduction

Ordinary income $75,000 $75,000 $75,000

Net long-term capital gain 15,000 15,000

Fiduciary fees 9,000 (9,000)

Personal exemption (300)

Accounting Income/Taxable Income $75,000 $80,700 $80,700

Before the Distributions Deduction
STEP 1 STEP 2

Exemption 300

Corpus Capital Gain/Loss (15,000)

Net Exempt Income

Distributable Net Income $66,000

Distribution Deduction (66,000)

STEP 3

Entity Taxable Income $14,700

STEP 4

PROOF: The trust should be taxed on “its” $15,000 long-term capital gain less the $300
personal exemption.

Figure 27-3 and Examples 20 and 21

17. a. $30,000 (1/3 of $90,000 accounting income).

b. $81,000.

c. ($300).

d. $27,000 (1/3 of $81,000 DNI).

27-10 2004 Comprehensive Volume/Solutions Manual

Distributable Net
Accounting Taxable Income/
Item Totals Income Income Distribution
Deduction

Ordinary income $75,000 $75,000 $75,000

Net long-term capital gain 15,000 15,000 15,000

Fiduciary fees 9,000 (9,000)

Personal exemption (300)

Accounting Income/Taxable Income $90,000 $80,700 $80,700

Before the Distributions Deduction
STEP 1 STEP 2

Exemption 300

Corpus Capital Gain/Loss

Net Exempt Income

Distributable Net Income $81,000

Distribution Deduction (81,000)

STEP 3
Entity Taxable Income ($300)

STEP 4

OBSERVATION: A simple trust with no corpus capital gains recognized for the year wastes
the personal exemption of the fiduciary.

Figure 27-3 and Examples 20 and 21

 Income Taxation of Trusts and Estates 27-11

18. a. $25,000. Under the separate share rule of § 663(c), a single trust that has more
than one beneficiary and that operates using substantially separate and
independent shares for each beneficiary of the trust is treated as multiple separate
trusts. Therefore, Willie is taxed only on his share of the trust’s distributable net
income. The second-tier distribution of $10,000 from corpus to Willie is not
subject to current income tax.

b. $15,000. The separate share rule of § 663(c) applies. Sylvia’s distributable net
income is limited to $10,000—the portion of the distribution that is not
accumulated.

c. Zero. Doris’ distributable net income has been accumulated; as a result of the
separate share rule, Doris recognizes no current year gross income.

d. $35,000. The trust is taxed on the total distributable income that is accumulated
(i.e., Sylvia’s $10,000 and Doris $25,000 respective income shares). Proof:
$75,000 DNI – $25,000 taxed to Willie – $15,000 taxed to Sylvia.

Example 28

19. a. After the first tier distributions are accounted for, $2,000 DNI remains to be
assigned to the beneficiaries on the second tier ($102,000 DNI – $100,000 DNI
used for first tier distributions. Results for Clare are as follows.

Amount Received DNI Received = Gross Income, Portfolio

Income

First Tier $50,000 $50,000

Second Tier $25,000 $20,000 DNI remaining

Totals $75,000 $70,000

b. Results for David are as follows.

Amount Received DNI Received = Gross Income, Portfolio

Income

First Tier $50,000 $50,000

Second Tier $0 $0

Totals $50,000 $50,000

c. First-tier distributions are the “first” $100,000 in required payments. First-tier

distributions are those distributions which are composed of trust accounting
income that is required to be distributed currently. Claire receives all of the “tax
free” payments in excess of DNI.
27-12 2004 Comprehensive Volume/Solutions Manual

Examples 25 and 26

20. Income Type

Amount
Beneficiary Received Taxable Exempt
Dividends Passive
Interest Interest
Brenda $30,000 $12,000◆ $8,000 $4,000 $6,000
Del $30,000 $12,000 $8,000 $4,000 $6,000
Totals in DNI $30,000 $20,000 $10,000 $15,000

◆($30,000 distribution/$75,000 total DNI) X $30,000 dividends in DNI. All other

calculations by income type are similarly computed.

Example 29

21. a. $100,000.

b. $90,000.

c. $37,900.

d. Allocated as indicated below.

 Income Taxation of Trusts and Estates 27-13

Distributable Net
Accounting Taxable Income/
Item Totals Income Income Distribution
Deduction

Taxable interest income $40,000 $40,000 $40,000

Exempt interest income 60,000 60,000

Net long-term capital gain 30,000 30,000

Fiduciary fees 10,000 (4,000) *

Personal exemption (100)

Accounting Income/Taxable Income $100,000 $65,900 $65,900
Before the Distributions Deduction
STEP 1 STEP 2
Exemption 100

Corpus Capital Gain/Loss (30,000)

Net Exempt Income 54,000 **

Distributable Net Income $90,000

Distribution Deduction (28,000) ◆

STEP 3
Entity Taxable Income $37,900

STEP 4

◆$36,000 Deductible portion of DNI (taxable interest of $40,000 – $4,000 allocable fees) X 7/9
($70,000 distribution/$90,000 DNI) portion of DNI distributed.

Fiduciary fees allocation:

*Taxable income ($40,000 ÷ $100,000) X $10,000
**$60,000 – nondeductible exempt income ($60,000 ÷ $100,000) X $10,000
PROOF: The trust is taxed on:
Retained portion, deductible DNI (2/9 X $36,000) $ 8,000
Corpus capital gain 30,000
Exemption (100)
Fiduciary taxable income $37,900
27-14 2004 Comprehensive Volume/Solutions Manual

Income Type [Step 5]

Beneficiary Amount Received Taxable Interest Exempt Interest

Lydia $40,000 $16,000◆ $24,000

Kent $30,000 $12,000 $18,000

◆($40,000 distribution/$90,000 total DNI) X $36,000 taxable interest in DNI (assigning the
fiduciary fees proportionately to the two types of accounting income).

Figure 27-3 and Example 29

22.
Reported on (X)
Dora’s
Item Incurred Form 1040 José’s Estate: José’s Estate:
Income Tax First Form 1041 Form 706
Income Tax Estate Tax
a. Last paycheck X X
b. State income tax withheld on
last paycheck X X
c. Capital gain portion of
installment payment received X X
d. Ordinary income portion of
installment payment received X X
e. Dividend income, record date
was two days prior to José’s X X
death
f. Unrealized appreciation, No gross income.
Basis step-up. X
securities
g. Depreciation recapture Not reported on any return. Recapture potential
accrued as of date of death disappears at death.
h. Medical expenses of last
illness X◆
i. Apartment building, rents
accrued but not collected as X X
of death
j. Apartment building, property
tax accrued and assessed but X X
not paid as of death

◆Executor could elect to claim this on José’s last Form 1040.

 Income Taxation of Trusts and Estates 27-15

pp. 27-14 and 27-15

23. 2003 No flow-through of either the negative taxable income or the capital loss incurred.
The $300 negative taxable income, due solely to the entity’s personal exemption,
is lost forever, while the unused capital loss carries forward.

2004 Flow-through of $20,000 negative taxable income, deductible by Yellow Jr. as a

miscellaneous itemized deduction, subject to the 2% of AGI floor.

Flow-through to Yellow Jr. of $8,000 net capital loss of 2003, to be netted against
his or her own capital gain income. Loss is carried forward only, without any
expiration date.

Example 31
27-16 2004 Comprehensive Volume/Solutions Manual

NOTES