Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA
Estates, Trusts & Gifts
A qualified revocable trust (QRT) is any trust (or part of a trust) that was treated as owned by a decedent (on that decedent’s date of death) by reason of a power to revoke that was exercisable by the decedent (without regard to whether the power was held by the decedent’s spouse). Although many practitioners are familiar with the special election to treat a QRT as an estate under Sec. 645, they may not be aware that this election can result in some complicated accounting and tax consequences as well as some interesting tax planning opportunities because of the separate-share rules. This item outlines the mechanics of the election and the treatment of items under the separate-share rules.
Most people seek the benefits of a revocable living trust (RLT) to avoid probate, though the RLT can afford additional benefits not covered in this discussion. When a grantor of an RLT dies, the RLT becomes irrevocable at death and requires a separate income tax return (Form 1041, U.S. Income Tax Return for Estates and Trusts) to report trust income earned after death. Trusts are required to use a calendar year end, no matter when the tax year begins.
In some instances, the decedent may not have been diligent about retitling assets into the RLT and may end up with a probate estate. The probate estate would have to file a separate income tax return (Form 1041) to report estate income earned after death. An estate may use a fiscal year end of its choosing, not to exceed a one-year period after death.
Example: A person dies Feb. 10, 2013—the estate can choose to end its fiscal year at the end of any month after death, including, but not after, Jan. 31, 2014.
Most RLTs are QRTs because the grantor retained the right to revoke the trust. When the decedent has both a QRT and a probate estate, the Sec. 645 election allows the trustee and the executor to effectively combine a QRT and an estate into one tax return, filed as an estate. Further, even if there is no separate probate estate, this election can be used to file the trust return (or several separate QRTs) as though the trust were an estate. Note that this election is valid for only two years following the decedent’s date of death, so the practitioner must also consider the anticipated length of trust and/or estate administration before making the election.
In making the election, certain tax planning advantages are gained by filing as an estate, rather than as a trust:
- The material participation requirement for the passive loss rules is waived (i.e., participation is treated as active) in the case of estates but not trusts for a two-year period after the owner's death (see Sec. 469(i)(4));
- The charitable set-aside deduction under Sec. 642(c) is allowed;
- The estate may use a fiscal year end and possibly defer income to a future tax year; and
- Use of the fiscal year end may allow enough time to file only one tax return and finalize matters efficiently.
The tax return for a Sec. 645 combined estate and trust appears to be one return in terms of reporting the income and expenses on the Form 1041 tax return. However, for purposes of calculating the distributable net income (DNI) deduction, the trust and estate are treated as separate shares (Regs. Sec. 1.645-1(e)(2)(iii)). Under these rules, the distributions made from the estate and the trust can result in different allocations to beneficiaries and different amounts of income tax paid by the estate/trust.
Example: The estate has $10,000 of income, and the executor made zero distributions to the trust, which is the sole beneficiary of the estate. The trust has $20,000 of income and made a $30,000 distribution to Beneficiary A . Total income reported on Form 1041 is $30,000.
DNI is calculated separately for the estate and the trust. The estate share of DNI is $10,000, but the DNI deduction is zero because there were no distributions in the tax year. The trust share of DNI is $20,000, and the DNI deduction is the lesser of the total cash distributed or the DNI. Since the DNI was less than the actual cash distributed, the DNI deduction is limited to $20,000. The Form 1041 will recognize $10,000 of taxable income and tax will be paid accordingly, and Beneficiary A will report $20,000 of income on his personal income tax return.
If the estate instead distributes $10,000 to the trust, then the trust’s share of income is $30,000 ($20,000 plus the $10,000 from the estate). In this case, the entire $30,000 of income is DNI of the trust, and the $30,000 distribution to Beneficiary A results in all $30,000 of income being reported to Beneficiary A with no tax at the trust level.
In summary, making the Sec. 645 election may be advantageous for the trust. However, the executor and the trustee should be aware that combining the two entities for tax reporting does not mean the two entities are combined for calculating the DNI deduction. Separate accounting for each entity should be maintained during the period of administration to follow the separate-share rules for the estate and trust, accordingly.
Michael Koppel is with Gray, Gray & Gray LLP, in Westwood, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.