E—Estates And Trusts

With certain exceptions discussed later, a trust is a separate tax entity, and the trustee must file returns on its behalf. In addition, income of a trust may be taxable to the grantor, the beneficiaries or some third person. An estate is also a separate tax entity, and the personal representative must file returns covering its income.

Taxation Of Trusts Generally

A trust is not taxed on income distributed in the year earned. Rather, the beneficiary who receives the income is liable for the tax. If the income is accumulated, the trust is taxed on the income. In addition, the beneficiary generally must pay tax on the income when it is distributed. The beneficiary does receive a credit for any taxes paid by the trust on the distributed income.

Four categories of taxpayers may be taxed on the trust income. These are (1) the trust, (2) the grantor, (3) the beneficiaries and (4) any person with the unrestricted right to vest the corpus or income in himself or herself. The following rules, all of which are explained later in this subdivision, generally determine who is taxed:

1.      Trust income is taxable to the trust whenever it is accumulated for the benefit of a person other than the grantor or his/her spouse.

2.      Trust income is taxable to the grantor when it is paid or accumulated for the benefit of the grantor or his/her spouse. In addition, the income is taxable to the grantor if the grantor has the right to revoke the trust and revest title in the trust property, or if the corpus or the income of the trust will return to the grantor or his/her spouse and the value of this "reversionary interest" exceeds 5 percent of the trust assets.

3.      Trust income is taxable to the beneficiaries when it is distributed to them. If the trust has paid tax on the income, then the beneficiary is entitled to a tax credit.

4.      Trust income is taxable to a third person (someone other than the grantor or a beneficiary), if the grantor is not treated as the owner and the third person has the unrestricted power to vest the corpus or income in himself.

When trust income is taxed to the grantor or another person is deemed the owner of the trust, the tax law treats such income as if the taxpayer had received it directly.

Income retains its original character when distributed. For instance, if the trust receives capital gain income, then the beneficiary is entitled to treat this income as capital gain.

The taxation of trusts differs for "simple trusts" and "complex trusts." A simple trust is required to distribute all of its income currently, does not provide for charitable contributions and makes no distribution of principal during the year. All other trusts are complex trusts.

Tax Rates For Estates And Trusts

Estates and trusts have a tax rate schedule that applies only to them. The following are the tax rate schedules for 2003 and 2002 (as amended by the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001):

Estates and Trusts  (2003) *

If taxable income is:

The tax is:

Not over $1,900

15% of taxable income.

Over $1,900 but not over $4,500 

$285 plus 25% of the excess over $1,900.

Over $4,500  but not over $6,850

$935 plus 28% of  the excess over $4,500.

Over $6,850 but not over $9,350

$1,593 plus 33% of the excess over $6,850.

Over $9,350

$2,418 plus 35% of the excess over $9,350.

*Rates and brackets reflect changes made by the Jobs and Growth Tax Relief and Reconciliation Act of 2003, retroactive to 01/01/03.

Estates and Trusts  (2002)

If taxable income is:

The tax is:

Not over $1,850

15% of taxable income.

Over $1,850 but not over $4,400 

$277.50 plus 27% of the excess over $1,850.

Over $4,400  but not over $6,750

$966 plus 30% of  the excess over $4,400.

Over $6,750 but not over $9,200

$1,671 plus 35% of the excess over $6,750.

Over $9,200

$2,528.50 plus 38.6% of the excess over $9,200.

Alternative Minimum Tax

Trusts are subject to the alternative minimum tax for noncorporate taxpayers [I.R.C. §§55 through 58]. Trusts compute alternative taxable income by determining distributable net income and then making adjustments required by the alternative minimum tax rules (see discussion in Section 19, Subdivision B7). A trust is allowed a $22,500 exemption from the alternative minimum tax [I.R.C. §55(d)(C)].

Taxable Year Of Trust

Both existing and newly created trusts (other than wholly charitable trusts) are required to use the calendar year as their taxable year [I.R.C. §645]. This eliminates a practice (before the Tax Reform of 1986) of deferring tax on distributions from trusts using fiscal years to beneficiaries using calendar years.

Quarterly Estimated Tax Payments

Trusts are required to make quarterly estimated tax payments [I.R.C. §6654(l)]. If a trust`s estimated tax payments for a year exceed the income tax shown on its return for the year, the trustee may elect to treat any portion of the excess payments as having been paid by a beneficiary. Any amount for which that election is made will be credited to the beneficiary and treated as an estimated payment made by the beneficiary on January 15 following trust`s tax year [I.R.C. §643(g)].

Taxation Of Simple Trusts

As noted previously, a "simple trust" is one that (1) is required to distribute all of its income currently, (2) makes no charitable contributions and (3) makes no distributions of principal during the taxable year. Normally, the simple trust itself will pay little tax. One of the major purposes of a simple trust is to shift income tax liability from the grantor to the beneficiaries of the trust.

Taxation Of The Trust

In general, the taxable income of a simple trust is determined under the regular rules for individuals. However, it is only allowed a personal exemption of $300 and cannot take a standard deduction [I.R.C. §642(b)].

1.      A simple trust is normally allowed to deduct income which is required to be distributed currently. Its "income" is determined under the terms of the trust and the applicable local law [Reg. §1.643(b)-1]. Similarly, whether trust income is required to be distributed currently depends upon the terms of the trust instrument and local law [Reg. §1.651(a)-2(a)].  However, if the trust terms differ fundamentally from concepts of local law, they will not be recognized for federal income tax purposes. The deduction for current distributions is limited to the amount of the trust`s "distributable net income" or "DNI." This figure is derived by taking the trust`s taxable income (that is, gross income less deductions) and making the following adjustments to such amount: (1) Adding back the deduction for distributions and the personal exemption;

2.      Excluding capital gains that were allocated to corpus and not paid, credited or required to be distributed;

3.      Adding back gain excluded under Code Section 1202 on the sale of stock from a qualified small business corporation;

4.      Excluding capital losses, except to the extent taken into account in determining the amount of capital gains distributable to beneficiaries;

5.      Excluding extraordinary dividends (in cash or property) and taxable stock dividends which the trustee does not pay out or credit by reason of his good faith determination that such dividends are allocable to corpus; and

6.      Adding back tax-exempt interest, reduced by expenses which are ordinarily nondeductible under §265.

Because of the additional deduction for current distributions, a simple trust is actually taxed only on capital gains and stock dividends allocated to corpus.

Taxation Of Beneficiary

The beneficiary of a simple trust includes in gross income the lesser of (1) the trust income required to be distributed to him currently, or (2) his proportionate share of the distributable net income, whether distributed or not [I.R.C. 652(a)].

If the income required to be distributed exceeds the trust`s distributable net income a beneficiary must only include in income a proportionate part of the distributable net income.  When making this apportionment, each item retains the same character in the hands of the beneficiary as in the hands of the trust.  Thus, tax-exempt interest remains tax-exempt while dividend income retains its character as dividend income.

In addition, any deductions used to compute DNI must be allocated among income according to the following rules.  Thus, deductible items directly attributable to one class of income must be allocated to that income. For example, taxes and repairs required on rental property must be allocated against rental income [Reg. §1.652(b)-3(a)].

Where the deductions are not directly attributed to a specific class they may be allocated to any item of income, except that a portion must be allocated proportionately to nontaxable income [Reg. §1.652(b)-3(b)].

Capital gains added to the corpus and not distributed to the beneficiary are excluded in the computation of distributable net income. Thus, no part of the deductions can be allocated to them [Reg. §1.652(b)-3(a), (b); Tucker v. Comm`r, 322 F.2d 86].

If a beneficiary and the trust have different taxable years, the amount which the beneficiary is required to include in gross income is based upon the amount of income of the trust for any taxable year or years ending within or with his taxable year [I.R.C. §652(c)]. Remember, all trusts, except wholly charitable trusts, are required to use a calendar year.

Taxation Of Complex Trusts

A complex trust is any trust other than a simple trust. In other words, a trust that is not required to distribute all of its income currently, or that makes charitable contributions or principal distributions, is a complex trust for income tax purposes. Taxation of complex trusts is discussed below.

Taxation Of The Trust

Generally, the taxable income of a complex trust is determined under the same rules relating to simple trusts. Thus, to compute taxable income, the amounts distributed to beneficiaries, allowable deductions and the personal exemption are subtracted from the trust`s gross income. The complex trust has a personal exemption of $100, but no standard deduction. There are also special rules for determining the trust`s charitable deduction and the deduction for distributions. These deductions are discussed immediately following.

There are also special rules for certain credits against tax, which are discussed later in this subdivision.

Charitable Deduction

A complex trust is allowed an unlimited deduction for income actually paid or distributed to charities during the taxable year. [I.R.C. §642(c)].  A trustee may elect to claim contributions actually paid in one tax year as paid during the preceding tax year.  For example, a contribution made in 1998 could be deducted for 1998 or for 1999. Of course, the same contribution cannot be deducted twice.

Prior to January 1, 1970 trusts also were generally allowed an unlimited deduction for amounts of gross income permanently set aside for a charitable purpose. However, the Tax Reform Act of 1969 abolished this set-aside charitable deduction. Trusts created before October 10, 1969 can still qualify for this set-aside charitable contribution if either (1) an irrevocable remainder interest is transferred to charity or (2) the grantor of the trust is unable to change the trust provisions because of mental incompetency [I.R.C. §642(c)(2)(A)].

Depreciation And Amortization

Deductions for depreciation and depletion must be apportioned between the trust and the beneficiaries in accordance with the trust instrument, if it contains such provisions. Otherwise, it is apportioned on the basis of the income of the trust allocable to each [I.R.C. §§167(a), 611(b)(3), 642(e)].

The benefit of certain amortization deductions must be apportioned between the trust and its income beneficiaries in accordance with the regulations [I.R.C. §642(f)].

The rules requiring the allocation of deductions for depreciation, depletion and amortization apply to simple trusts as well.

Distributions Deduction

A complex trust is allowed a deduction for amounts paid, credited or required to be distributed to its beneficiaries. This distribution deduction is the sum of:

1.      Trust income for the taxable year that is required to be distributed currently (even if it is not actually distributed during the tax year); and

2.      Any other amounts paid, credited or required to be distributed for the taxable year.

However, the deduction under (2) for "other amounts paid, credited or required to be distributed" does not include distributions of principal to charity or charitable contributions which exceed the amount authorized by the trust instrument [Reg. §1.663(a)-2;] Crown Income Charitable Fund, Rebecca v. Com., (1993, CA7) 72 AFTR 2d 93-6524, 8 F3d 571)].  This deduction also does not include gifts of specific property or a specific sum of money paid or credited in three installments or less [I.R.C. §663(a)(1)].

In no event can the deduction for distributions to beneficiaries exceed the trust`s distributable net income.  The distributable net income of a complex trust is determined by taking the trust`` taxable income and making the following adjustments:

1.      Adding back the deduction for distributions and the personal exemption;

2.      Excluding capital gains, unless they are (a) allocated to income, (b) allocated to principal but actually distributed during the year, used to determine the amount distributed or required to be distributed, or (c) allowed as a charitable deduction;

3.      Excluding capital losses, except to the extent taken into account in determining the amount of capital gains distributable to beneficiaries;

4.      Adding back tax-exempt interest, reduced by expenses which are ordinarily nondeductible under Code Section 265(2); and

5.      For foreign trusts, adding back foreign income, reduced by nondeductible expenses, except to the extent allocable to the charitable deduction.  Foreign trusts must also include capital gains in DNI and cannot take a distributions deduction for tax-exempt foreign income.

Taxation Of Beneficiaries Of Complex Trusts

The beneficiaries of a complex trust must include in their gross income all amounts which the trust is required to distribute currently. In addition, accumulated income is taxable to the beneficiaries when it is distributed.

General Rules

Amounts distributable or distributed to the beneficiaries retain the same character in their hands as in the hands of the trust. Each beneficiary is treated as receiving a proportionate share of all types of income distributed, unless the trust instrument specifically allocates different classes of income to different beneficiaries [I.R.C. §662(b)].

If there are separate and independent shares for different beneficiaries, the distributable net income must be determined separately for each beneficiary, just as if separate trusts were involved [I.R.C. §663(c)]. This is the so-called "separate share" rule.

The discussion which follows is divided into a discussion of taxation of current income distributions and taxation of accumulated income distributions.

Distributions Of Current Income

The beneficiary to whom income for the taxable year of the trust is "required to be distributed currently" must include such amounts in his gross income. This is true whether or not the income is actually distributed to him.

However, if the amount of income required to be distributed currently to all beneficiaries exceeds the distributable net income of the trust (computed without the charitable deduction), then the beneficiary includes in gross income only the amount which bears the same ratio to distributable net income as the amount of income to the beneficiary bears to the amount required to be distributed currently to all beneficiaries [I.R.C. §662(a)(1)]. (Computation of a trust`s distributable net income was discussed earlier in this subdivision.) The amount of income "required to be distributed currently" includes any amount required to be paid out of income or corpus (such as an annuity), to the extent such amount is paid out of income [I.R.C. §662(a)(1)].

Gifts of money or specific property paid or credited at once or in not more than three installments are not taxable to beneficiaries unless they can be paid only from trust income. Also excluded is any amount qualifying for the charitable deduction [I.R.C. §663(a)].

Distributions Of Accumulated Income

Special rules called "throwback rules" were designed to tax a trust beneficiary of a trust that accumulates rather than distributes all or part of its income currently.  Under these rules, the beneficiary is taxed as if the income had been distributed to him when earned, rather than being accumulated in the trust.  Thus, if distributions form a trust to the beneficiaries exceed the distributable net income for such year, the excess amount, called the "accumulation distribution," is considered to have been made in previous years to the extent the trust accumulated income in those years [Reg. §663

Although the throwback rules, described below in more detail, have been repealed for most trusts, they still apply to the following trusts:  those created before March 1, 1984 that would be treated as multiple trusts under Code Section 643(f) and foreign trusts and domestic trusts that were once treated as foreign trusts.

Definitions

An accumulation distribution is the amount by which any amounts properly paid, credited, or required to be distributed by the trust in a given year exceed the trust`s distributable net income as reduced by any income required to be distributed currently [I.R.C. §§665(b), 661(a)]. However, an accumulation distribution will arise only where the trust has "undistributed net income" [I.R.C. §666(a)].

Undistributed net income is the amount by which the trust`s distributable net income exceeds the sum of (1) income required to be distributed currently plus other amounts properly paid and (2) the amount of taxes imposed on the trust attributable to such distributable net income [I.R.C. §§665(a), 661(a)].

Example

Assume that in year one a trust has taxable ordinary income of $50,100 (before deducting the $100 exemption), distributes $30,000 to the sole beneficiary leaving taxable income of $20,000, and pays a tax of $6,957. The trusts` undistributed net income is $13,043:

(1)   Distributable net
           income                        $50,100
(2)   Less:
           income distributed         30,000
           exemption                         100
                                             $20,000
(3)   Less:
           taxes paid by trust           6,957
(4)   Undistributed
           net income                  $13,043
                                             ======

In year two, the trust again has distributable net and taxable income of $50,100 but distributes a total of $63,000 to the beneficiary. What is the amount of the accumulation distribution?

As defined above, the accumulation distribution is the excess of an amount properly paid ($63,000) over the trust`s distributable net income for the year of distribution ($50,100). Thus, the accumulation distribution here is $12,900. There remains $143 (13,043 - 12,900) of undistributed net income which may become an accumulation distribution in a later year.

Taxes Deemed Distributed

In the above example, the trust paid taxes of $6,957 in year one. Under §666, the taxes which a trust pays with respect to undistributed net income which is distributed in a later year are treated as an "additional amount" distributed.

If the accumulation distribution is not less than the undistributed net income, the total taxes paid for a particular year will be treated as an additional distribution [I.R.C. §666(b)]. Where the accumulation distribution is less than the trust`s undistributed net income, the taxes deemed distributed are determined by multiplying the total taxes paid by the ratio of the accumulation distribution to the undistributed net income [I.R.C. §666(c)].

In the above example, the tax which the beneficiary will take into income along with the accumulation distribution of $12,900 is $6,880

(Accumulated distribution) $12,900
 --------------------------------------------------  x  $6,957  =  $6,880
(Undistributed net income) $13,043         

Computation Of Tax

When a beneficiary`s taxable income includes an accumulation distribution, the total tax for the year is the sum of (1) a partial tax computed on taxable income foe the year, but excluding the accumulation distribution and (2) a partial tax based on an averaging method applied to the taxable incomes of the five preceding taxable years [I.R.C. §667(a)]. Foreign trusts must also include a partial tax on an interest charge [I.R.C. §667(a)(3), 668].

The averaging method requires the following steps:

1.      determine the number of preceding taxable years of the trust to which the distribution is to be thrown back;

2.      throw out the highest and lowest taxable incomes for the beneficiary`s five taxable years preceding the year of the accumulation distribution;

3.      determine the average amount of the accumulation distribution by dividing the amount deemed distributed under §666 (the total distribution plus taxes paid by the trust and deemed distributed) by the number of years determined in step (1) above.

4.      add the average amount of the accumulation distribution to the taxable incomes in each of the three years determined in step (2) above; and

5.      determine the average increase in tax resulting from the application of steps (3) and (4) above by adding the tax increases for the three years and dividing the total by three [I.R.C. §667(b)].

The partial tax on the accumulation distribution is the excess of the average increase in tax multiplied by the number of throwback years (step (1) above) and subtracting the amount of taxes deemed distributed to the beneficiary by the trust under §666(b), (c).

Example

Assume that a trust makes an accumulation distribution of $20,000 in 1996. The trust has undistributed net income in its taxable years 1995, 1994 and 1993 in the following amounts:

(1) 1995................................ $ 5,000
(2) 1994................................ $ 5,000
(3) 1993................................ $10,000

Assume that the trust had to pay taxes of $952 for the years 1995 and 1994 and $1,834 in 1993. The beneficiary`s taxable income for each of the five years prior to 1996 was as follows: (1) 1995, $25,000; (2) 1994, $30,000; (3) 1993, $22,000; (4) 1992, $20,000; and (5) 1991, $15,000.

(1)   The number of years to which the distribution is thrown back is three;

(2)   The years of highest and lowest taxable income, 1994 and 1991, are eliminated;

(3)   The average amount of the accumulation distribution is:

       (a)  Total distributed                           $20,000
       (b)  Taxes deemed distributed:
             $952 + $952 + $1,834 =                   3,738
                                                               $23,738
       (c)  Divided by number of throwback            ÷ 3
       (d)  Average accumulation distribution  $  7,913
                                                                ======

(4)   Add the average accumulation distribution to the beneficiary`s three taxable years determined in step (2) above:

       (a)  1995, $25,000 + $7,913 =  $32,913
                                                    ======
       (b)  1993, $22,000 + $7,913 =  $29,913
                                                    ======
       (c)  1992, $20,000 + $7,913 =  $27,913
                                                    ======

(5)    Determine the average increase in tax resulting from the addition of the average accumulation distribution as computed in step (4):

       (a) 1995, Tax after adding
             average distribution             $ 6,570
       (b) 1995, Tax before distribution    4,354    $ 2,216
       (c) 1993, Tax after                     $ 5,730
       (d) 1993, Tax before                     3,514      2,216
       (e) 1992, Tax after                     $ 5,170
        (f) 1992, Tax before                     3,000     2,170
       (g) Total tax increase                               $ 6,602
       (h) Divide by three years                                ÷ 3
                                                                     =====
       (i) Average tax increase                            $ 2,201
                                                                     ======

Thus, the partial tax on the accumulation distribution is equal to the average tax increase ($2,201) multiplied by the number of throwback years (three), less the taxes deemed distributed by the trust ($3,738):

       (a) Average tax increase                            $2,201
       (b) Number of throwback years                        x 3
                                                                      $6,603
       (c) Less: taxes deemed distributed               3,738
                                                                      ======
       (d) Partial tax on accumulation distribution   $2,865

The partial tax of $2,865 would then be added to the beneficiary`s tax computed on taxable income without the accumulation distribution to arrive at the total tax liability for the taxable year.

Multiple Distributions

Where an individual receives accumulation distributions from 3 or more trusts which relate to identical prior taxable years of the beneficiary, the provisions of §666(b) and (c) do not apply to the third trust. Thus, the amount of tax paid by the trust will not be "deemed distributed" nor will it be allowed as a credit to offset the partial tax [I.R.C. §667(c)(1)].

This rule does not apply if distributions from the third trust are less than $1,000 [I.R.C. §667(c)(2)].

Minor Beneficiaries

A distribution of income accumulated by a trust before the birth of a beneficiary or before a beneficiary attains age 21 is not considered to be an accumulation distribution.  Consequently, the throwback rules do not apply. [I.R.C. §665(b)].

Trust Accounting Income

There is no accumulation distribution when the amount distributed does not exceed the accounting income (as distinguished from the taxable income) of the trust [I.R.C. §665(b)].  In this case, the distribution will not be subject to the throwback rules. [I.R.C. §665(b)].

Taxability Of Trust Income To Grantor

Grantor Trust Rules

Even though a grantor has conveyed legal title in property to a trust and the trustee receives the income, that income may still be taxable to the grantor. The Code taxes trust income to the grantor if he retains the right to revoke the trust or receive its income, or if he retains certain other powers over the trust property or income. For transfers after March 1, 1986, any power held by the grantor`s spouse is treated as being held by the grantor. Such trusts are often referred to as " defective " for income tax purposes.

General Principles

The grantor of a trust, under the income tax laws, is the person who furnishes the corpus (trust property), even if another person nominally transfers it to the trustee. For example, an outright gift of securities from husband to wife, followed shortly by the wife`s transfer of the securities in trust for the children, will be considered a trust created by the husband. Reciprocal trusts (where A sets up a trust for the benefit of B, and B, at the same time, sets up a trust for the benefit of A) will result in each grantor being regarded as the grantor of the trust created for his or her benefit. In effect, each grantor is left in the same economic position as he or she was in prior to the creation of the trust [Est. of Joseph P. Grace, 395 U.S. 316 (1969)].

Income taxed to the grantor is treated as received by him directly and not as a trust distribution. The trust is disregarded for this purpose [Rev. Rul. 57-390, 1957-2 C.B. 326].

Generally, the income of a trust will be taxed to the grantor under any of the following circumstances:

1.      The grantor retains a reversionary interest that is worth more than 5 percent of the initial value of the trust assets;

2.      The grantor retains the power to control the beneficial enjoyment of the trust property or income;

3.      The grantor retains administrative powers exercisable for his own personal benefit;

4.      The grantor retains the power to revoke the trust; or

5.      The trust income may be used for the personal benefit of the grantor or his spouse (including the payment of premiums on policies of insurance on the life of the grantor or his spouse) [I.R.C. §§673, 674, 675, 676, 677].

The elements governing taxability under each of these circumstances are set out briefly below, and are then discussed separately and in detail, following.

Reversionary Interests

A grantor has a reversionary interest in trust property if the property will go back to the grantor after the passage of time or upon the occurrence of some event. Income from property transferred in trust after March 1, 1986, will be taxed to the grantor if the grantor has a reversionary interest that is worth more than 5 percent of the initial value of the trust property [I.R.C. §673(a)]. This rule does not apply if the reversionary interest can take effect only upon the death before age 21 of a trust beneficiary who is a lineal descendant (e.g., child or grandchild) of the grantor.

For property transferred in trust before March 2, 1986, the grantor will not be taxed on trust income if the reversionary interest will not take effect until at least ten years and a day after the transfer. Trusts taking advantage of this rule are known as short-term reversionary trusts or Clifford trusts. These trusts were very popular income-shifting devices before the Tax Reform Act of 1986. Clifford trusts established before March 2, 1986, continue to be exempt from the grantor trust rules with respect to income from property transferred to the trust before that date. However, income from property transferred to an existing Clifford trust after March 1, 1986, will be taxed to the grantor.

Power To Control Beneficial Enjoyment

Section 674 of the Code provides that the grantor is taxable on the income of any portion of a trust with respect to which the beneficial enjoyment of the trust property or income therefrom is exercisable by him or a nonadverse party, or both, without the consent of an adverse party.

An "adverse party" means any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of a power that he possesses respecting the trust. A "nonadverse party" means any person who is not an adverse party [I.R.C. §672(a), (b)].

Certain powers may be retained by the grantor without subjecting him to tax on the trust income. These excepted powers are discussed later.

Administrative Powers Retained

Code §675 provides that the grantor is taxable on the income of any portion of a trust with respect to which he or a nonadverse party, or both, have the power, exercisable without the consent of any adverse party, to deal with the trust property or income for less than an adequate and full consideration. The same result follows with respect to a power to borrow from the trust without adequate interest or security, unless the trustee is authorized to make loans to any person without regard to interest or security.

For example, a trust grantor was treated as the owner of the entire trust under Code §675 where he borrowed trust income on an unsecured basis from a "friendly" trustee (his spouse) without repaying the loan, or paying interest [Benson v. Comm`r, 76 T.C. 1040 (1981)].

The grantor is also subject to tax on the trust income if any person has a power exercisable in a non-fiduciary capacity without the consent of a trustee (a) to substitute other property for the trust corpus, (b) to control the investment of the trust funds, or (c) to vote the stock of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control [I.R.C. §675(4)].

Power To Revoke The Trust

Under Code §676, the grantor is taxable on the income of any portion of a trust if he or a nonadverse party, or both, have the power to revest in the grantor the title to such portion.  However, if the power to revoke can only be exercised by an adverse party or only with the consent of an adverse party, the grantor will not be taxed on the trust income

However, for transfers in trust before March 2, 1986, if such power can only take effect after the death of an income beneficiary or after 10 years from the date of the transfer to the trust, whichever first occurs, the grantor will not be taxed on the trust income during that period.

Trust Income For Benefit Of Grantor Or Spouse

Under Code §677, the grantor is taxable on the income of any portion of a trust if the income, without the consent of any adverse party is, or in the discretion of the grantor or a nonadverse party, or both, may be (a) distributed to the grantor or his spouse; (b) held or accumulated for the future distribution to him or his spouse; or (c) applied to the payment of premiums to maintain insurance on his or his spouse`s life, except policies irrevocably payable to a charitable organization.

Power Held By Grantor`s Spouse

For transfers in trust after March 1, 1986, any power held by the grantor`s spouse is treated as held by the grantor. Therefore, if the grantor`s spouse holds any of the powers or interests discussed above, trust income will be taxed to the grantor.

Power To Control Beneficial Enjoyment Of Trust

Subject to important exceptions discussed below, the grantor is treated as the owner of a trust if the grantor or a nonadverse party has the power to control the beneficial enjoyment of the trust property or income.

General Rule

The grantor is taxable as trust owner on the income of any portion of a trust where he, or a nonadverse party, or both, has a power, without the consent of an adverse party, to dispose of the beneficial enjoyment of trust income or principal [I.R.C. §674(a)].

Adverse Party

An "adverse party" means any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of a power that the grantor possesses with respect to the trust. Logically, a "nonadverse party" is any person who is not an adverse party [I.R.C. §672(a)].

The fiduciary relationship of a trustee is not enough to make his interest adverse. And, as stated in the Regulations, "[o]rdinarily, a beneficiary will be an adverse party, but if his right in the income or corpus of a trust is limited to only a part, he may be an adverse party only as to that part" [Reg. §1.672(a)-1(b)].

Powers Not Subjecting Grantor To Tax

Power To Apply Income To Support Of A Dependent

A power to apply income to the support or maintenance of the grantor`s dependents, exercisable by the grantor as trustee, or by another person as trustee or otherwise, will cause the income of the trust to be taxed to the grantor only to the extent that such income is so applied and distributed [I.R.C. §§674(b)(1), 677(b)]. In other words, the presence of this power alone will not attract tax to the grantor-only the exercise of this power that is a taxable event for the grantor.

Power Affecting Beneficial Enjoyment After 10-Year Period (Pre-March 2, 1986, Transfers)

For transfers in trust before March 2, 1986, a power, the exercise of which can affect the income of the trust only for a period commencing after 10 years, will not subject the grantor to tax during the period. If such a power is still in existence after the period, however, the grantor will then be taxable on the income [I.R.C. §674(b)(2)]. For any property transferred in trust after March 1, 1986, the grantor will be treated as owner if the grantor or the grantor`s spouse has a reversionary interest worth more than 5 percent of the initial value of the trust assets.

Power Affecting Beneficial Enjoyment After Death Of Descendant

A power will not subject the grantor to tax if it may be exercised only following the death before age 21 of a beneficiary who is a lineal descendant (e.g., child or grandchild) of the grantor. However, if the power is not relinquished after the descendant attains age 21, the grantor will then be taxed on trust income [I.R.C. §674(b)(3)].

Power Exercisable Only By Will

In general, the grantor is not taxable on trust income if his power to control disposition is exercisable only by will. However, this exception is not applicable where the grantor, or a nonadverse party, or both, also has the power to accumulate trust income for disposition by will, without the approval or consent of an adverse party [I.R.C. §674(b)(3)].

For example, if the grantor provides in the trust that the income is to be accumulated during his life, and that he may appoint the accumulated income in his will, the grantor is subject to income tax on the trust income. Moreover, where income is distributed but the grantor may appoint the trust remainder by will, and under the trust and local law capital gains are added to corpus, the grantor is taxed on such gains [Reg. §1.674(b)-1(b)(3)].

Power To Allocate Corpus Or Income Among Charitable Beneficiaries

The grantor will not be taxed on trust income where he has a power to determine the beneficiaries of income or corpus, provided that payment can be made only for charitable purposes [I.R.C. §674(b)(4)].

Power To Distribute Corpus

A power to distribute corpus to a beneficiary will not subject the grantor to tax if the power is limited by a reasonably definite standard set forth in the trust instrument [I.R.C. §674(b)(5)].

For instance, a power to distribute corpus for the education, support, maintenance, or health of the beneficiary would be considered a power that is limited by a reasonable definite standard. On the other hand, a power to distribute corpus for the pleasure, desire, or happiness of a beneficiary is not limited by a reasonably definite standard [Reg. §1.674(b)-1(b)(5)].

Even though no standard is provided, a power to invade the corpus for a current income beneficiary is an excepted power, insofar as the distribution is chargeable against the proportionate share of corpus held in trust for the particular beneficiary. [I.R.C §674(b)(5)(B)].

A power to distribute corpus is never an excepted power, however, if any person has a power to add trust beneficiaries, except where the action is merely to provide for after-born or after-adopted children [I.R.C. §674(b)(7)].

Power To Withhold Income Temporarily

A power to pay or apply income to or for a current income beneficiary, or to accumulate such income for him, will not subject the grantor to tax, provided that any such accumulated income must ultimately be payable either:

1.      To such beneficiary, his estate, or his appointee under a power of appointment given such beneficiary which does not exclude from the class of possible appointees any person other than the beneficiary, his estate, his creditors or the creditors of his estate; or

2.      upon termination of the trust or in conjunction with a disposition of corpus which contains the accumulated income, to the current income beneficiaries in shares irrevocably specified in the trust instrument.

It is sufficient that the beneficiary has a broad special power of appointment; it is not necessary that he be given a general power. Accumulated income is considered to be ultimately payable in accordance with the foregoing rules, even though the trust provides for payment to contingent beneficiaries if the primary beneficiary fails to survive to the date fixed for distribution, if such date may reasonably be expected to occur within the lifetime of the primary beneficiary.

The power to withhold income is not an excepted power, however, if any person has a power to add trust beneficiaries, except where the action is merely to provide for after-born or after-adopted children [I.R.C. §674(b)(7)].

Power To Withhold Income During Minority Or Legal Disability Of Beneficiary

A power to pay or apply income to or for such beneficiary or to accumulate and add it to corpus, exercisable only while an income beneficiary is under age 21 or is under some other legal disability, will not subject the grantor to tax. Such a power is excepted even though the accumulated income will not be paid to the beneficiary from whom withheld. Accumulated income may be added to corpus and ultimately distributed to others [Reg. §1.674(b)-1(b)(7)]. Thus, the grantor will not be taxed on trust income under Code §674 where the income is payable to his daughter for life, remainder to his grandchildren, and he reserves the power to accumulate income and add it to principal while his daughter is under 21.

This power is not an excepted power, however, if any person has a power to add trust beneficiaries, except where the action is to provide for after-born or after-adopted children [I.R.C. §674(b)(7)].

Power To Allocate Between Corpus And Income

A power to allocate receipts and disbursements between principal and income will not subject the grantor to tax, even though expressed in broad language [I.R.C. §674(b)(8)].

Powers Exercisable By Independent Trustees

A broader exception is made for certain powers when exercisable solely by independent trustees. Trustees are often given the power to distribute, apportion or accumulate income to or for one or more beneficiaries or within a class of beneficiaries, or to pay out corpus to or for them. These types of powers are called "sprinkling" or "spray" powers and are discussed in more detail later in this section. Such powers will not subject the grantor to tax if solely exercisable by a trustee or trustees (without the consent of any other person), none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor. [I.R.C. §674(c)].  Thus, in the ordinary sprinkling or spray trust, the co-trustees may be a corporate fiduciary and a family member (even the decedent-grantor`s spouse).

The above power is not an excepted power, however, if any person has a power to add trust beneficiaries, except where the action is merely to provide for after-born or after-adopted children [I.R.C. §674(b)(7)]. Nor does it achieve excepted-power status if the grantor has an unrestricted power to remove the trustee, unless he is under a duty to substitute another independent trustee [Reg. §1.674(d)-2(a)].

Related or Subordinate Party

A "related or subordinate party" means any nonadverse party who is the grantor`s spouse if they are living together; a parent, issue, brother or sister; an employee of the grantor; a corporation or any employee thereof in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; or a subordinate employee of a corporation in which the grantor is an executive. There is a rebuttable presumption that a related or subordinate party is subservient to the grantor [I.R.C. §672(c)].

The fact that the grantor exercises influence with respect to an independent trustee who is amenable to the grantor`s wishes does not cause trust income to be taxable to the grantor in the absence of a legally enforceable power reserved by instrument or contract [Est. of Hilton W. Goodwyn, 35 T.C. Memo 1026, Dec. 33,954 (M), TC Memo, 1976-238].

Power To Allocate Income Limited By A Standard

A common power given to trustees is the power to distribute, apportion or accumulate income to or for one or more beneficiaries or within a class of beneficiaries, but limited to a standard such as the reasonable needs of the beneficiaries. Such a power will not subject the grantor to tax if solely exercisable by a trustee or trustees, none of whom is the grantor or a spouse living with the grantor, provided such power is exercisable without the consent of any other person and is limited by a reasonably definite external standard which is set forth in the trust instrument. The exception applies even though the power is held by a related or subordinate trustee (other than the grantor`s spouse living with him), who is subservient to the grantor.

This power is not an excepted power, however, if any person has a power to add trust beneficiaries, except where the action is to provide for after-born or after-adopted children [I.R.C. §674(b)(7)].

Control Of Administrative Powers By Grantor

The grantor is treated as the owner of any portion of a trust if, under the terms of the trust or circumstances attendant upon its operation, administrative control is exercisable primarily for the grantor`s benefit rather than for the benefit of the trust beneficiaries. Instances of such control are discussed below.

Power To Deal with Trust for Inadequate Consideration

The trust income is taxable to the grantor where a power exercisable by him or a nonadverse party, or both, without the consent of an adverse party, enables the grantor or any other person to deal with trust property or income for an inadequate consideration [I.R.C. §675(1)].

Power To Borrow Without Adequate Interest or Security

The trust income is taxable to the grantor where a power exercisable by him or a nonadverse party, or both, enables him directly or indirectly to borrow the corpus or income without adequate security or interest.

There is an exception, however, to this rule. The rule does not apply where a trustee other than the grantor is authorized under a general lending power to make loans to any person without regard to interest or security [I.R.C. §675(2)].

Borrowing Of The Trust Funds

Trust income is taxable to the grantor where he has directly or indirectly borrowed the corpus or income and has not completely repaid the loan and any interest before the beginning of the taxable year.

The foregoing rule does not apply, however, to a loan that provides for adequate interest and adequate security and is made by a trustee who is neither the grantor nor a related or subordinate trustee subservient to the grantor [I.R.C. §675(3)].

General Powers of Administration

The trust income is taxable to the grantor where a power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity [I.R.C. §675(4)]. A "power of administration" means any one or more of the following powers:

1.      a power to vote, or direct the voting, of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control;

2.      a power to control the investment of trust funds by direction or veto, to the extent that such funds consist of stock or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; and

3.      a power to reacquire the trust corpus by substituting other property of an equivalent value.

Under the above provisions, the grantor will be taxed by reason of a power over investments only where the tax investments are those in which the grantor and the trust have significant voting control, and then only if the power is exercisable in a nonfiduciary capacity-that is, in such manner as to benefit the grantor individually rather than the trust beneficiaries.

Fiduciary v. Nonfiduciary Powers

A power exercisable by a person as trustee is presumed to be exercisable in a fiduciary capacity primarily in the beneficiaries` interests. This presumption may be rebutted only by clear and convincing evidence that the best interests of the beneficiaries are not being served. If a power is not exercisable by a person as trustee, the terms of the trust, and the circumstances regarding its creation and administration, must be examined to determine whether such power is exercisable in a fiduciary or nonfiduciary capacity [Reg. §1.675-1(b)(4)(iii)].

It has been held that powers reserved by a grantor not as trustee may, nevertheless, be exercisable in a fiduciary capacity [Cushman v. Comm`r, 153 F.2d 510 (1946)].

Power To Revoke The Trust

The grantor is treated as the owner of a trust where he has the power to revoke the trust.  A grantor will be deemed to have such power if he can terminate, alter or amend the trust or if he has the power to appoint beneficiaries.

Statutory Provisions

General Rule

The grantor is taxable on the income of any portion of a trust, whether or not he is taxable under any other statutory provision, "where at any time the power to revest in the grantor title to such portion is exercisable by the grantor or a nonadverse party, or both" [I.R.C. §676(a)]. Even if the power to revoke is not exercised, and the beneficiaries receive the income, such amounts would constitute income to the grantor, and gifts to the beneficiaries [Rev. Rul. 57-51, 1957-1 C.B. 171].

Power Affecting Beneficial Enjoyment After 10-Year Period (Pre-March 2, 1986 Transfers)

For transfers in trust before March 2, 1986, a grantor retaining a reversionary interest in trust principal or income is not taxable on trust income if the reversionary interest may not reasonably be expected to take effect in possession or enjoyment until after the expiration of a 10- year period from the creation of the trust [I.R.C. §676(b)].

Power To Revoke After Death Of Descendant

A power to revoke will not subject the grantor to tax if it may be exercised only following the death before age 21 of a beneficiary who is a lineal descendant (e.g. child or grandchild) of the grantor. However, if the power is not relinquished after the descendant attains age 21, the grantor will then be taxed on trust income [I.R.C. §674(b)(3)].

Applications Of The Law

Power To Revoke On Consent Of Trustee

A trustee is not an adverse party merely by virtue of his role as trustee [Reinecke v. Smith, 289 U.S. 172]. Accordingly, a power of the grantor to revoke his trust on consent of the trustee would render the trust income taxable to the grantor.

Power To Revoke Held By Trustee Alone

Since a trustee is generally not an adverse party, the trust income is taxable to the grantor where the power to revoke is in a third-party trustee alone [Frease v. Comm`r, 150 F.2d 403].

Power To Revoke With Consent Of Beneficiary

A beneficiary is an adverse party. [Reg. §1.672(a)-1(b)]. Thus, where the grantor can revoke the trust only by and with the consent of the trust beneficiary or beneficiaries, the trust income is not taxable to him, and can be taxed only to the trust or to the beneficiaries.

Power To Be Exercised By Will

A power of appointment to be exercised by will is not a power to revest if the grantor cannot regain title during his life.

Trust Income For Benefit Of Grantor

With certain exceptions, the grantor is treated as the owner of a trust for tax purposes if the trust income may be used for the benefit of him or his spouse, without the approval or consent of any adverse party.

Statutory Provisions

General Rule

Trust income is taxable to the grantor where the income is, or in the discretion of the grantor and a nonadverse party (and without the consent of an adverse party) may be:

1.      Distributed to the grantor or his spouse;

2.      held or accumulated for future distribution to the grantor or his spouse; or

3.      applied to payment of life insurance premiums covering the grantor or his spouse, except policies irrevocably payable to charities [I.R.C. §677(a)].

For transfers in trust before March 2, 1986, income used for the benefit of the grantor`s spouse is not taxable to the grantor.

The grantor is taxable on trust income whether the provision for its distribution or accumulation for his or his spouse`s benefit is mandatory, or discretionary with him or a nonadverse party. Thus, the grantor-beneficiaries of a trust (revocable by joint action of the grantors) were held taxable on the trust`s capital gains because the trustee, who was a nonadverse party, could distribute these capital gains to the beneficiaries [de Amodio v. Comm`r, 299 F.2d 623].

Private Annuity As Grantor Trust

In some cases, private annuity transactions have been treated as transfers with a reserved life estate, and the grantor is treated as the trust owner under the grantor trust rules.  For example, in one case grantors who created an irrevocable trust for the benefit of certain family members transferred $1,000 to the trustee. The grantors later transferred their shopping center to a corporation in exchange for its stock. The stock was then transferred to the trustee in exchange for a joint and survivor annuity. Under the annuity agreement, the trust was to pay the grantors $75,000 per year for life. Upon receipt of the stock, the trustee immediately sold it to another corporation in exchange for a non-negotiable promissory note whose terms provided for payment of a minimum principal amount of $1,000,000 on January 1, 1984, with interest at $75,000 per year. The court held that the grantors were treated as the trust owners, and, therefore, were taxable on the trust income. Viewed as a whole, the court stated that the transaction was in essence a transfer of stock to the trust with a reservation of income, not a private annuity exchange. Further, the grantors were liable for gift tax in that they made a gift of the remainder interest in the stock [Simon M. Lazarus, 58 T.C. 854 (1972); Comm`r Acq. 1973-2 C.B. 2; aff`d 513 F.2d 824 (CA-9, 1975)].

However, the courts have not treated other private annuity transactions as grantor trusts where the transferor retained no control over the trustees or trust assets.  In these case, the courts examined whether the transferor took an active role in trust investment decisions or retained the power to manage the trust. [Stern, Sidney v. Com., (1984 CA9) 54 AFTR 2d 84-6412, 747 F.2d 555, 84-2 USTC 9949; LaFargue, Esther v. Com., (1982, CA9) 50 AFTR 2d 82-5944, 689 F.2d 845, 82-2 USTC 9622, rev`g (1979) 73 TC 40]

Power Affecting Beneficial Enjoyment After 10-Year Period (Pre-March 2, 1986 Transfers)

For transfers in trust before March 2, 1986, a power to give the grantor or his spouse the beneficial enjoyment of the trust corpus or future income effective after the first 10 years of the trust will not cause the trust`s current income to be taxable to him during the 10-year period. He will be taxed on the income earned after the expiration of the 10-year period, however, unless the power is relinquished [I.R.C. §677(a)].

Income To Discharge Alimony Obligation

A wife who is divorced or legally separated (or who is separated under a written agreement) must include in her gross income the amount of the income of any trust which she is entitled to receive and which otherwise would be taxable to her husband [I.R.C. §682(a)].

The above exception does not apply, however, to any portion of the trust income which the divorce decree, written separation agreement, or trust instrument fixes, in terms of an amount of money or a portion of such income, as a sum which is payable for the support of minor children of the husband [I.R.C. §682(a)].  In this case, such amounts are taxable to the husband.

Income Used To Discharge Grantor`s Obligations

Trust income is taxable to the grantor where, without the approval or consent of any adverse party, such income is used to pay the legal obligations or debts of the grantor or his spouse or may be so distributed in the discretion of the grantor or a nonadverse party, or both [I.R.C. §677(a)(1)].

The regulations apply this provision broadly. They provide, generally, that if the income of the trust may be used to discharge the grantor`s obligations he will be taxable on the trust income. Thus, if the grantor creates a trust, the income of which may, in the discretion of the grantor or a nonadverse party, be applied in the payment of the grantor`s debts, including the payment of his rent or other household expenses, such income is taxable to the grantor regardless of whether it is actually so applied [Reg. §1.677(b)-1(d)].

The income of an irrevocable trust used to pay any obligation which the grantor would be bound to pay, irrespective of the trust (except alimony and similar payments), is taxable to the grantor. Thus, where a trust was created in favor of certain beneficiaries, but the trust instrument directed the trustee to apply trust income to the payment of a debt owed by the grantor, such income was held taxable to the grantor [Helvering v. Blumenthal, 296 U.S. 552].

The Eighth Circuit has held that, since payment of a gift tax is the primary obligation of the grantor-donor, trust income used to pay this tax, either directly or by discharging a loan incurred by the trustee for this purpose, is taxable to the grantor [Est. of Sheaffer v. Comm`r, 313 F.2d 738; see also Rev. Rul. 57-564, 1957-2 C.B. 328]. However, the Sixth Circuit has held that the application of trust income earned after payment of the gift taxes to discharge a loan incurred for this purpose does not make the income taxable to the grantor [Comm`r v. Est. of Morgan, 316 F.2d 238].

Trusts For Support And Maintenance Of Dependents

Trust income which is used for the support or maintenance of the grantor`s minor children or other legal dependents is taxable to the grantor [I.R.C. §677(b); Helvering v. Schweitzer, 296 U.S. 551].

The grantor will be taxed on trust income which is required to be used for the support of the grantor`s dependents, even if all of the income distributed was not actually expended for support during the taxable year [Reg. §1.677(b)-1(f); Edgar S. Peierls, 12 T.C. 741].

The grantor will not be taxed on trust income that is used for the support and maintenance of a person whom he is not legally obligated to support, such as his wife`s relatives [Comm`r v. Donahue, 128 F.2d 739] or his adult children. The existence of a support obligation is determined by state law.

Unexercised Power To Use Income To Discharge Grantor`s Support Obligations

A power to use trust income to discharge the grantor`s support obligations, exercisable by someone other than the grantor will not cause trust income to be taxable to the grantor unless such income is actually used for support purposes [I.R.C. §677(b)].

Trust for College Education

In General

As was noted previously, irrevocable trusts are often used to accumulate funds for a child`s education. If a parent creates an education trust, a question arises as to whether the parent will be taxed on the trust income because paying for an education is within the parent`s legal obligation of support. [Note: Financial planning for education costs is discussed in detail in Section 50.1.]

State Law Question

The existence and extent of the legal obligation of a parent to support his child is determined by local law [Reg. §1.662(a)-4]. Unfortunately, however, there is little state law on this point, and what law does exist has arisen primarily in the area of divorce and separation agreements.

Although college education cases have been decided both ways, the modern trend is toward recognizing a parent`s obligation of providing a college education, assuming his or her financial ability to do so [e.g., Braun v. Comm`r, 82 T.C. No. 66 (1984) (applying New Jersey law); Mairs, Samuel v. Reynolds (1941, CA8) 27 AFTR 534, 120 F2d 857, 41-2 USTC 9554]. Since uncertainty does exist in this area, steps should be taken to avoid the problem when a trust is established for this purpose.

Contractual Obligation For Educational Expenses

The grantor may be taxed on trust income on the basis of a contractual obligation rather than an obligation of support. Thus, the grantor was held taxable on the income of short-term trusts used to discharge his implied contractual obligation to pay his minor children`s school and college expenses [Morrill, Jr. v. U.S., 228 F. Supp. 734 (1964)].

Trust Income Paid To Child Under 14

Unearned income in excess of $1,400 received by a child under age 14 will be taxed at the top marginal rate of the parent. The $1,400 figure consists of a $700 floor plus the $700 of standard deduction that a child may deduct to unearned income. This rule applies to trust income received by a child as well as to income from direct gifts.

Trust Income Used For Premiums On Policies On Life Of Grantor Or Spouse

Where any part of the income of a trust is, or in the discretion of the grantor or a nonadverse party without the approval or consent of any adverse party, may be, applied to the payment of premiums upon policies of insurance on the life of the grantor or his spouse (except policies irrevocably payable to charitable organizations), then such part of the trust income shall be included in computing the taxable income of the grantor. This rule does not apply to policies on the grantor`s spouse if the income is in trust before October 9, 1969.

In General

Trust income used to pay premiums on insurance policies on the life of the grantor or his spouse, without the approval or consent of an adverse party, is taxable to the grantor [I.R.C. §677(a)(3); Burnett v. Wells, 289 U.S. 670 (1933)].

The rule does not apply to payments for a policy covering the grantor`s spouse if the income is from property transferred in trust before October 9, 1969. The rule applies regardless of whether the trust instrument requires the income to be so used or simply fails to forbid such use.

It is immaterial who owns the policy. If the trust income is applied to premiums on such policies, without the approval or consent of an adverse party, the grantor is taxable on the income so applied [Arthur Stockstrom, 3 T.C. 664].

The "grantor" is the person who actually furnishes the trust property. Thus, where the insured gave funds to his daughters, who then established a trust whose income was used to pay premiums on policies on the father`s life, the income was taxable to the father [Iverson v. Comm., 3 T.C. 756 (1944)].

The grantor will not be taxed if the trust income is distributed to the beneficiary, who then voluntarily applies the income to purchase insurance on the grantor`s life [Booth v. Comm., 3 T.C. 605 (1944)]. If, however, this is done under an agreement with the grantor, or by his suggestion, the grantor will be taxed on that portion of the trust income [Rom v. Comm., 6 T.C. 614; Foster v. Comm., 8 T.C. 197 (1947)].

Based on an estate tax case decided under the 1939 Code, it appears that where a trust provides that all income is to be paid to the beneficiary, and that trust principal is to be used to pay premiums for insurance on the grantor`s life, the trust income is not taxable to the grantor [Bennett v. U.S., 185 F. Supp. 577].

Income Which May Be Used For Premiums

If the trustee is authorized to use the income of an irrevocable trust, pay the premiums on an insurance policy covering the grantor`s life, without the approval or consent of any adverse party, the trust income is taxable to the grantor, even if it is not actually used for this purpose. [Rieck v. Comm`r, 118 F.2d 111 (3rd Cir. 1941)]. However, where there are policies on the life of the grantor not placed in the trust, the trustee must be clearly authorized to pay premiums on them if trust income is to be taxed to the grantor.  (Iverson v. Comm., 3 TC 756 (1944)).

In Weil v. Comm., 3 T.C. 579 (1944), the grantor had transferred to himself, as trustee for the benefit of his wife, six insurance policies on his life, together with certain securities. The trust required the income from the securities to be applied first to the payment of premiums on these policies and the remainder to be paid to the beneficiary. He owned one other policy which he did not transfer to the trust, but he reserved the right as grantor to add other policies at any time. In addition, he empowered himself, as trustee, to purchase additional policies from trust income. The grantor reported, as taxable income to himself, the amounts expended from trust income for the payment of premiums on the six existing policies held by the trust. A deficiency was assessed against him on the theory that the entire income of the trust could have been used to purchase insurance on his life; hence he was taxed on all of the trust`s income during the year. The court, however, held for the grantor, saying" . . . the grantor`s liability for tax depends upon the existence in the tax year of policies upon which it would have been physically possible for the trustee to pay premiums. There was in existence during the taxable year no policy (other than the six original policies) that fell in the described category. The grantor, as an individual, owned and paid the premiums on one other policy, but the trust instrument gave the trustee no power to pay such premiums."

The same question has sometimes arisen in connection with funded life insurance trusts under which the trustee is given the power to purchase additional policies on the life of the grantor, but no insurance has been purchased. In this situation the government has argued that, because the trustee may add other policies, upon which the premiums would be paid out of the trust income, the entire income of the trust may be applied to the payment of premiums on policies on the grantor`s life. Hence, the entire trust income should be taxable to him. The courts, however, have consistently rejected that argument, holding that taxability depends upon the existence of policies upon which premiums could have been paid [Comm`r v. Mott, 85 F.2d 315 (6th Cir. 1936); Rand v. Comm., 116 F.2d 929, aff`d 40 BTA 233, cert. denied 313 U.S. 594].

Premiums Paid By The Beneficiaries

In General

Where the beneficiary of a trust is entirely free to use the trust income in any manner desired, and in the absence of any control by the grantor uses the income to pay premiums on insurance on the life of the grantor or grantor`s spouse, such income is not taxed to the grantor [Ellsworth B. Buck, 41 B.T.A. 99; Barbour v. Comm., 39 B.T.A. 910 (1939); Ralph W. Conant, 7 T.C. 453].

However, where the beneficiaries merely advance the amount needed for premiums, subject to later reimbursement out of trust income, such income will be taxed to the grantor [Rieck v. Comm`r, supra].

Pursuant To Understanding

If through an understanding with the grantor, the beneficiary uses trust income to pay premiums on insurance on the life of the grantor or his spouse, that portion of the income will be taxable to the grantor [Dunning v. Comm., 36 B.T.A. 1222 (1937); Foster v. Comm., 8 T.C. 197 (1947)].

The Tax Court has limited the application of the Dunning and Foster cases to those situations in which an actual or implied understanding exists between the grantor and the beneficiary. That is, where a trust is created, and the beneficiary in the free and unrestricted use of trust income pays premiums on insurance upon the grantor`s life, the grantor will not be taxed on the trust income.

Taxability Of Life Insurance Proceeds When Paid To A Trustee

Where a trustee is the beneficiary of a life insurance policy and distributes the proceeds to beneficiaries of the trust, the proceeds are exempt from income tax both in the hands of the trustee and when he distributes them. Where the corpus of the trust consists of proceeds paid by reason of the death of the insured, however, income from proceeds held in trust is taxable the same as any other trust income.

A policyholder may place policies in the hands of a trustee together with other income-producing property with the direction that the income from the trust properties be used to pay the premiums on the policies. Or, the grantor may simply assign the policies to the trustee with instructions to collect and disburse the proceeds while the insured pays the premiums from his individual funds outside of the trust.

In either event, however, where the beneficiary of a life insurance policy is a trustee who distributes the proceeds to beneficiaries of the trust, the proceeds are exempt from income tax both in the hands of the trustee and when distributed [I.R.C. §101(a)].

The term "proceeds" includes only the capital value of the policy upon the insured`s death. Thus, where proceeds of life insurance policies remain in a trust fund, earnings on the proceeds are taxable in the same manner as any other trust income.

Trust Income Taxable To Person Other Than Grantor

Code Section 678 describes the circumstances under which someone other than the grantor shall be treated as the substantial owner of a trust, with resultant tax liability.

People who may fall into this category include the beneficiary of an accumulating trust, the trustee, the nongrantor parent of a minor beneficiary, or the holder of a power to appoint corpus.

The Code Provisions

The General Rule

A person other than the grantor is treated as the owner of any portion of a trust if that person:

1.      Has the power exercisable solely by himself to vest corpus or income in himself; or

2.      has partially released or modified such a power, but retains sufficient control which would cause a grantor to be treated as substantial owner under the grantor trust rules discussed earlier [I.R.C. §678(a)].

Even a minor beneficiary who is prohibited by state law from exercising ownership rights in a trust without a guardian can be considered an owner of the trust under §678. The IRS has ruled that the existence of the power, rather than the capacity to exercise it, determines whether a person other than the grantor shall be treated as the owner of any part of the trust [Rev. Rul. 81-6, 1981-1 C.B. 385].

The IRS has also ruled that a widow`s power, exercisable solely by the widow, to appoint to herself certain amounts annually from the corpus of a residuary trust comes within the terms of Code §678(a)(1). Thus, the income, deductions, and credits, attributable to that portion will be included in her income tax liability, and not that of the income beneficiaries. [Rev. Rul. 67-241, 1967-2 C.B. 225]. For the federal estate tax treatment of powers of appointment, see Section 2 Subdivision B.

Exceptions

There are three exceptions to the general rule:

1.      The general rule shall not apply if the grantor of the trust is otherwise treated as the owner under the grantor trust rules [I.R.C. §678(b)].

2.      The general rule shall not apply with respect to a power which has been renounced or disclaimed within a reasonable time after the holder of the power first became aware of its existence [I.R.C.§678(d)].

3.      The general rule shall not apply to a power which enables the holder, in his capacity of trustee or co-trustee, merely to apply the income of the trust to the support or maintenance of a person whom the holder of the power is obligated to support or maintain, except to the extent that such income is so applied [I.R.C. §678(c)]. This exception is given more extended treatment under the heading "Grandfather Trusts" later in this subdivision.

The Sprinkling Trust

In General

The general rule that someone other than the grantor, under specified circumstances, shall be treated as the substantial owner of a trust may have an adverse tax effect upon the so-called "sprinkling" trust. ("Spray" trust is another term sometimes used.) Such a trust, if properly created and administered, not only is an extremely flexible estate planning device, but it can produce attractive tax savings as well.

Definition

A sprinkling trust gives the trustee the power to determine which member of a definite class of beneficiaries shall receive payments from the trust, whether income or principal, and how much. It either may be inter vivos or testamentary. A trustee possessing the sprinkling power can distribute income and principal to and among the class of beneficiaries according to their needs and at a time most advantageous from the standpoint of their respective income-tax brackets.

The power to sprinkle gives the trustee a high degree of discretion. Therefore the property owner should be careful in selecting the trustee. Any potential trustee should be consulted before being appointed. Many banks, for example, refuse to accept the responsibility of administering a sprinkling trust unless they are properly protected under the trust instrument from criticism by the named beneficiaries.

The Problem

In view of the responsibility involved in administering a sprinkling trust, a property owner may wish to appoint some member of his family as trustee. Frequently, the trustee selected is the natural object of the property owner`s bounty and therefore is included as a member of the class of beneficiaries. For example, a father may appoint his son trustee and also include him in the beneficiary class.

In this case, if the son has the sole right to vest all or a portion of the trust income or principal in himself, a question arises as to whether he would be treated as owner of the trust, and therefore taxable on its income. Code §678(a) states that he is, regardless of whether he actually selected other members of the class to receive the trust income.

Solutions

One obvious solution, and one which would not be challenged from a tax standpoint, would be to name a corporate trustee, or someone neither related to the grantor/testator, nor a member of the class of beneficiaries [I.R.C. §674(c)]. If this solution is unsatisfactory to the property owner, there are other possible solutions.

An Ascertainable Standard

Several cases indicate that if the trustee`s power to sprinkle income is limited by an ascertainable standard, he will not be treated as owner of the trust [Funk v. Comm`r, 185 F.2d 127; Falk v. Comm`r, 189 F.2d 806; Agnes K. May, 8 T.C. 860; U.S. v. Smither, 205 F.2d 518].

In the Smither case, supra, the trustee`s power to sprinkle income and principal to and among the beneficiaries including herself, was limited by an ascertainable standard relating to the beneficiaries` health, education, support or maintenance. The court held that this standard limited her sprinkling power and therefore she was not taxable on the trust income under the predecessor §678(a).

Co-Trustees

Code §678(a) applies only if the power is exercisable solely by its holder. It appears that the general rule would not apply if, in addition to naming the member of the class of beneficiaries as one trustee, a corporate or independent co-trustee also is named.

Grandfather Trusts

Definition

A typical grandfather trust is an irrevocable trust established by a grandparent for the benefit of one or more of his grandchildren. The grandchildren`s parents are in no way directly designated as beneficiaries. See also Avoiding GST Tax Using the $10,000 Per-Donee Annual Exclusion in Section 2.1, Subdivision B.

Income Tax Consequences

If the trustee is directed to pay the entire net income to the grandchildren, or if he is authorized to make discretionary payments for their benefit which would supplement but would not be in lieu of the parent`s support obligation, the grandchildren would be taxable on all the income or the amount paid or applied for their benefit, as the case may be. However, if the grandchildren are under age 14, trust income will be taxed at their parents` marginal rate [I.R.C. §101(i)].

On the other hand, the regulations provide that in any one of the following three situations, the parent, rather than the grandchildren, may be taxable on a portion or all of the income:

1.      The trust instrument requires the trustee to apply all of the income of the trust for this support of the grandchildren [Reg. §1.662(a)-4];

2.      The parent is given an unrestricted power in his or her individual capacity to require that the income of the trust be applied for the support of the grandchildren [Reg. §1.678(c)-1(b)]; or

3.      The income of the trust is applied for the support of the grandchildren in the discretion of the parent, acting as trustee [I.R.C. §678(c); Reg. §1.678(c)-1(a)].

As previously noted, the parent will be taxable only to the extent the income is actually applied to the parent`s obligations of support.

Family Estate Trusts

Under the so-called family estate trust arrangement, a taxpayer transfers all of his assets and lifetime income to a trust in exchange for a certificate of beneficial interest. Taxpayer is usually a co-trustee with broad powers over the trust income and principal. These trusts have been promoted as a way in which the taxpayer can avoid the income taxation of his earnings. However, rulings by the IRS and by the courts make it clear that the family estate trust does not have these income tax advantages. The trust is treated as a grantor-owned trust, and the trust income, deductions, etc., are treated as the taxpayer`s own [Rev. Rul. 75-257, 1975-2 C.B. 251; George T. Horvat, T.C. Memo. 1977-104. 4-11-77]. Furthermore, the family estate trust in itself may be an association taxable as a corporation, not as a trust for income tax purposes [Rev. Rul. 75-258, 1975-2 C.B. 503].

Transfers of Appreciated Property

Before its repeal by The Taxpayer Relief Act of 1997, a special tax under Code Section 644 was imposed on trusts that sold appreciated property within two years after the property had been transferred to the trust.  This tax was designed to discourage a grantor from transferring appreciated property to a trust, which could then sell it and be taxed at a lower rate.  However, because the tax rates applicable to trusts have been compressed, relatively low amounts of trust income are now taxed at higher rates.  As a result, this Code Section has been repealed, effective for sales or exchanges of appreciated trust property after August 6, 1997.

Federal Income Taxation Of Estates

An estate is a separate taxable entity [I.R.C. §641]. Its income during the period of estate administration must be reported on a fiduciary return filed by the personal representative of the estate.

Generally, estate income is taxed under the provisions which apply to complex trusts, except that the throwback rule is inapplicable to an estate. The details of these provisions are found in the preceding discussion relating to complex trusts.

Preliminary

Upon the death of a taxpayer, a final income tax return must be filed in his behalf if his gross income for the fractional part of the taxable year when he died was sufficient to require the filing of a return. Although the return is usually filed by the personal representative, this final return is that of the individual taxpayer, and not that of his estate.

The period of estate administration begins at the death of the taxpayer (even though the personal representative may not qualify until some time later). The period of administration for tax purposes is the period actually required by the personal representative to perform the duties of administration, such as the collection of assets and the payment of debts, taxes, legacies and bequests [Reg. §1.64(b)-3(a)]. A period of administration protracted beyond a time reasonably necessary to wind up the estate affairs will result in all estate income being taxed to the beneficiaries beyond that time [Est. of W.G. Farrier, 15 T.C. 277; Alma Williams, 16 T.C. 893; Reg. §1.641(b)-3(a)].

Taxation of the Estate

The taxable income of an estate is determined in general under the regular rules relating to gross income, credits and deductions of an individual. The tax rates are the same as those for trusts [I.R.C. §641(a)(3)]. Special rules will be discussed later.

The estate realizes no taxable income upon the transfer of property to it from the decedent, even though it may have appreciated in value since the decedent acquired it. Gain or loss will be based on fair market value on the date of death or alternate valuation date, if elected [I.R.C. §1013].

The collection of an obligation owed the estate is a taxable event. The estate will realize taxable gain or loss in the amount of any difference between the value of the obligation on the date of the decedent`s death, or other estate tax valuation date, and the amount collected by the estate [Est. of Herbert v. Comm`r, 139 F.2d 759, cert. denied 332 U.S. 752; Est. of Waterman v. Comm`r, 195 F.2d 241]. Similarly, the forgiveness of a decedent`s obligation on the date of his death constitutes income to the estate, but only to the extent that the fair market value of estate assets exceeded the estate`s total liabilities immediately following the forgiveness [Est. of B.M. Marcus, 34 T.C.M. 38 (1975)].

Also, if the personal representative delivers property of the estate to satisfy a cash bequest, the transaction is deemed a taxable exchange in which gain to the estate is recognized to the extent of the difference between the estate`s basis and the amount of the cash bequest [Suisman v. Eaton, 15 Supp. 113, aff`d Suisman v. Hartford-Connecticut Trust Co., 83 F.2d 1019` cert. denied, 299 U.S. 573; Comm`r v. Brinckenhoff, 168 F.2d 436; Rev. Rul. 56-270, 1956-1 C.B. 325].

Community Property States

In the community property states, the general rule is that only one-half the income from community property is taxed to the deceased spouse`s estate during the period of administration [Wells Fargo Bank & Union Trust Co. v. U.S., 245 F.2d 524 (Cal.); Sneed v. Comm`r,  220 F.2d 313 (Texas); Bishop v. Comm`r, 152 F.2d 389 (Cal.); Est. of Henderson v. Comm`r, 155 F.2d 310 (La.); Est. of Bessie A. Woodward, 24 T.C. 883 (Texas)].

The Treasury Department has ruled that under California and Washington community property laws, half of the income is taxed to the surviving spouse [Rev. Rul. 55-726, 1955-1 C.B. 24; Petersen v. Comm`r, 35 T.C. 962 (1961)].

Deductions and Credits

In General

During the course of administration, the estate incurs certain expenses. Some expenses may be deducted only on its income tax return; others may be taken as deductions on the estate tax return only. Certain charges which have accrued before the decedent`s death may be deducted on both returns, i.e., deductions in respect of a decedent. Regarding other expenses, the estate representative has a choice; he may allocate the items to either return.

Income Tax Deductions

An estate has a personal exemption of $600 [I.R.C. §642(b)]. Some deductible expenses are, in general, the same as those deductible by an individual. Nonbusiness deductions include the ordinary and necessary expenses of administration, including fiduciary fees and expenses of litigation, if any. Business expenses are deductible exactly as in the case of an individual.

Charitable Contribution Deduction

The estate is allowed an unlimited deduction for amounts of gross income paid or permanently set aside for a charitable purpose or to be used for religious, charitable, scientific, literary or educational purposes, or for the establishment, acquisition, maintenance or operation of a non profit public cemetery.  However, the unlimited charitable contribution deduction cannot be claimed for contributions made from principal.

Depreciation And Depletion Deductions

The depreciation and depletion deductions must be apportioned between the estate and its legatees, devisees or distributees on the basis of estate income allocable to each [I.R.C. §167(d); Est. of Ida W. Nissen, 41 T.C. 22].

Medical Expenses

The estate may not deduct the expenses of the decedent`s last illness on the estate`s income tax return. The deduction is ordinarily taken as a debt of the decedent under §2053 and shown on the estate tax return.

However, for medical expenses paid within one year of death, the estate may waive its right to claim the deduction under §2053 and instead take the deduction on the decedent`s final individual income tax return [I.R.C. §213(c)].

Distribution Deduction

An estate is allowed a deduction for amounts paid, credited or required to be distributed to its beneficiaries [I.R.C. §661;  U.S.Bank of America Nat. Trust & Savings Ass`n, 326 F.2d 51]. This deduction is computed in the same manner as for a complex trust.

Estate Tax Deductions

Administration expenses attributable to the earning of tax-exempt income are deductible only for estate tax purposes [I.R.C. §2053]. Other expenses which may be deducted only in the estate tax return are unpaid mortgages, claims against the estate and funeral expenses [Est.of Orville F. Yetter, 35 T.C. 737; Est. of Carolyn W. Libby, 14 T.C.M. 699].

Although interest paid by the estate during the period of administration is normally deductible on the estate`s income tax return, it has been held that post-death interest on loans taken out by the decedent to purchase "flower bonds" is deductible as an administration expense on the estate tax return [Est. of Jane Webster, 65 T.C. 968 (1976)].

Double Deduction

Certain charges which have accrued before decedent`s death are deductible in computing both income and estate taxes and are known as deductions in respect of the decedent. These items include taxes, interest, and expenses attributable to income in respect of the decedent. Similar charges accruing after decedent`s death cannot qualify as claims; they are administration expenses, deductible on either the estate tax or the income tax return, but not on both [Reg. §1.642(g)-2].

Personal Representative`s Choice

Most administration expenses and casualty losses may be taken as deductions either on the income tax return, or on the estate tax return, or divided in any manner desired between the returns, at the election of the personal representative [I.R.C. §642(g); Bingham`s Trust v. Comm`r, 325 U.S. 365; Rev. Rul. 55-225, 1955-1 C.B. 460; Rev. Rul. 56-449, 1956-2 C.B. 180].

Credits

Generally, the estate is allowed the same credits that individuals are permitted to take, including a credit for foreign taxes paid. However, this credit may be allocable to the beneficiaries of the estate and thus nondeductible by the estate itself.

Payment Of Tax

An estate is required to make quarterly estimated payments after its second taxable year [I.R.C. §6654].

Taxation Of Estate Beneficiaries

The beneficiaries of an estate must include in their gross incomes distributions made to them out of the income of the estate required to be distributed currently. They must also include other distributions made to them to the extent of their proportionate shares of the amount allowed as a distributive deduction by the estate. The income retains the same character it had in the hands of the estate, with each beneficiary considered as receiving his proportionate share of all types of income distributed-unless the decedent`s will makes specific allocations [I.R.C. §§662, 663].

The method of computing the taxable income of an estate beneficiary is the same as for a beneficiary of a complex trust. Bequests of money or specific property which are paid or credited at once or in not more than three installments are excluded, except any such amounts which can be paid only from estate income [I.R.C. §663(a)].

The rules applicable to accumulation distribution by complex trusts do not affect estates. Thus, if there is no distribution by an estate in a given taxable year, estate income may be accumulated without any adverse tax effect on the beneficiary when the estate is finally terminated.

Distributions Of Principal

There is a common misunderstanding that an estate may distribute property in kind-principal-to a beneficiary and avoid an income tax liability at the beneficiary level.

To the contrary, if an estate has distributable income in a given taxable year, a distribution of property or income will trigger income in the hands of a residuary beneficiary [Reg. §1.662(a)-3(b)]. This does not apply to specific bequests of property [I.R.C. §663(a)(1)].

Excess Deductions

When an estate terminates, its deductions may exceed its income for the final taxable year. These excess deductions will flow through to an estate beneficiary for use as itemized deductions on his or her personal income tax return [I.R.C. §642(h); Reg. §1.642(h)-2(a)].

If an individual acquires an interest in an estate by purchase, as opposed to a gift, bequest, or inheritance, such individual is not considered to be a "beneficiary." Any excess deductions which are allocable to a "purchaser`s" interest are not deductible on his or her personal return [Nemser v. Comm`r, 66 T.C. 780 (1976)].

Net operating loss or capital loss carryovers remaining at termination will also flow through to the beneficiary [I.R.C. §642(h)(1)].

The excess deduction rule applies to the termination of trusts as well as estates.

Alternative Minimum Tax

Estates are subject to the alternative minimum tax for noncorporate taxpayers. Estates compute alternative minimum taxable income by determining distributable net income under I.R.C. §§641-643 and making adjustments required under the alternative minimum tax rules (see Section 19B). An estate is permitted a $22,500 exemption from alternative minimum tax.

Taxation Of Income In Respect Of A Decedent

Income in respect of a decedent refers to income that a decedent was entitled to but which was not includible in the decedent`s final tax return under his or her accounting method.  A separate discussion of "income in respect of a decedent" is necessary because of the special tax rules that apply to such income.

Nature Of Income In Respect Of A Decedent

Income in respect of a decedent is comprised mostly of the accrued income of a decedent who reported on a cash basis such items as unpaid salary, rents, renewal commissions under an agency contract, and unpaid fees for services rendered. By statute, however, such income also includes payments to the surviving annuitant under a joint and survivor annuity, uncollected installment obligations, and payments made by a partnership to the estate of a deceased partner under §736(a) [I.R.C. §691].

Income in respect of a decedent has been held to include a bonus awarded to a decedent during his lifetime but not paid until after his death [Est. of Fred Basch, 9 T.C. 627]. The same result was reached with respect to a bonus not awarded until after the employee`s death [Est. of O`Daniel v. Comm`r, 173 F.2d 966]. According to the federal appellate courts, bonuses paid by an employer to a decedent`s estate will constitute income in respect of a decedent if the decedent had a "substantial certainty" of receiving the payments at the time of his death.  However, such right need not be a legally enforceable right [C. Halliday, CA-581-2 USTC  9652, 655 F.2d 68; C.W. Peterson Est. CA-8, 82-1 USTC 9110, 667 F.2d 675].

Other cases where income has been considered income in respect of a decedent include the following:

·         Income realized from a decedent`s claim which was in litigation when he died (Rev. Rul. 55-463, 1955-2 C.B. 277)

·         Interest owed decedent when collected by the estate or heirs (Richardson v. U.S., 294 F.2d 593)

·         Payments made under a long-term installment contract inherited from the original owner (Hedrick v. Comm`r., 63 T.C. 395 (1974))Payments made under a long-term installment contract inherited from the original owner (Hedrick v. Comm`r., 63 T.C. 395 (1974))

·         Payments made to a decedent`s widow pursuant to an agreement with his employer wherein decedent waived his rights to earned but unpaid commissions in exchange for such employer-payments to his widow (Est. of Florence E. Carr, 37 T.C. 1173)

·         The proceeds from the sale of real property completed by the executor (but which the decedent contracted for prior to death) (Rev. Rul. 78-32, 1978-1 C.B. 198). The proceeds from the sale of real property completed by the executor (but which the decedent contracted for prior to death) (Rev. Rul. 78-32, 1978-1 C.B. 198).

IRAs and Other Qualified Plan Accounts

When a participant in a qualified retirement plan, including a traditional IRA, dies, his or her undistributed account balance becomes payable to the account’s designated beneficiary. Because the account would have been ordinary income if distributed to the account owner prior to death (except to the extent of any unrecovered basis resulting from non-deductible contributions), it is income in respect of a decedent when received by the beneficiary.

If the account owner’s estate is the beneficiary (whether by designation or because there is no other beneficiary), the income in respect of the decedent must be reported as taxable income of the estate. In some instances income taxation may be avoided by executor’s assigning the qualified plan account to a charity [see, e.g., Ltr. Rul. 200234019].

Installment Obligations

Installment obligations acquired by reason of a decedent`s death, or by bequest, devise or inheritance from a decedent, are treated as income in respect of a decedent. They have the same basis in the hands of the person acquiring them as they had in the hands of the decedent [I.R.C. §691(a)(4)].

Deferred Compensation

Deferred compensation paid after a decedent`s death is income in respect of a decedent.

Surviving Joint Annuitant

Taxable amounts receive by a surviving annuitant under a joint and survivor annuity, where the decedent died after 1953 and after the annuity starting date, are treated as income in respect of a decedent for the purpose of allowing such annuitant a deduction for estate tax paid with respect to the annuity contract. The deduction for estate tax paid with respect to such annuities is spread annually over the remaining life expectancy of the surviving annuitant. For the purpose of allocating the estate tax deduction, the value of the annuity is that portion of the excess of the value of the annuity for estate tax purposes over the total amount excludable from the gross income of the surviving annuitant which is proportionate to the ratio of the value of the annuity for estate tax purposes to the value of the annuity at the date of death of the annuitant. This ratio will be one to one, unless the surviving annuitant contributed to the premiums [I.R.C. §691(d)].

U.S. Savings Bonds

If a  decedent owned a Series EE savings bond, with his wife as co-owner or beneficiary, but died before the payment of the bond, the entire amount of interest accruing on the bond would be treated as income to his wife when the bond is paid [Reg. §1.691(a)-2(b), Example (3)]. Any unreported increment in the redemption value of Series E bonds at the owner`s death is in income in respect of a decedent [Rev. Rul. 64-104, 1964-1 C.B. 223]. On the other hand, the income in respect of a decedent arising from savings bonds may be eliminated where the personal representative of the estate elects to report the increment in value at date of death in the decedent`s final income tax return [Rev. Rul. 68-145, 1968-1 C.B. 203].

Rules of Taxation

General Rule

Income in respect of a decedent received by the estate is includable in its gross income [I.R.C. §691]. Where such income is included in the gross income of the estate, but all or part of it is paid, credited, or required to be distributed to an estate beneficiary, it is taxable income to the beneficiary. The beneficiary must report the income in the year it is received [E.D. Rollert Residuary Trust, CA-6, 85-1 USTC 9139, 752 F.2d 1128].

Successive Decedents

When an estate beneficiary receives income in respect of a decedent directly by reason of the decedent`s death or by bequest, devise or inheritance from the decedent or a prior decedent, such income is includable in the beneficiary`s gross income.

For example, insurance commissions acquired by bequest from a widow`s husband would be income in respect of a decedent and items of gross income when received by the widow [Latendresse v. Comm`r, 43 F.2d 577 (1957); cert. denied, 355 U.S. 830]. Likewise if a child acquired the right to receive such commissions by reason of the widow`s death, or by bequest or inheritance from her, the commissions would still be income in respect of a decedent and items of gross income to the child when received [Reg. §1.691(a)-2(b), Example (2)].

Disposal Of Income

Where the right to income in respect of a decedent is disposed of by sale, exchange or inter vivos gift or by a person who received such right by reason of a decedent`s death or by bequest, devise or inheritance, a different rule applies. The estate or person disposing of such income must include in gross income the fair market value of the right to such income, or the consideration received, whichever amount is the greater [Reg. §1.691(a)-4)].

Character Of Income

The items of income in respect of a decedent retain the same character in the hands of the person acquiring them from the decedent as the items would have had in the hands of the decedent [Reg. §1.691(a)-3(a)].  Thus, if the income would have been tax-exempt income, capital gain, or interest to the decedent, it will be the same type of income to the beneficiary.

Deductions In Respect Of A Decedent

To correspond with the income tax treatment of income in respect of a decedent, the estate or beneficiaries are allowed to deduct certain expenses and credits of the decedent that were not allowable on the final return under the decedent`s regular method of reporting. These include deductions for taxes, depletion, business expenses and expenses incurred in the production or collection of income, and the credit for foreign taxes paid. The depletion deduction attributable to income in respect of a decedent is deductible by the taxpayer who pays the tax on that income.

Generally, expenses and taxes owed by the decedent are deductible, when paid, by the decedent`s estate. However, if the estate is not liable to discharge the obligation, the person who receives an interest in property of the decedent, subject to such obligation, is entitled to the deduction upon payment of the obligation.

Deduction For Estate Tax Paid

General Rule

A person who includes an amount in gross income as income in respect of a decedent is allowed a deduction for estate tax attributable to that income [I.R.C. §691(c)].  Such deductions must be taken as an itemized deduction on the person`s federal income tax return [I.R.C. §691(c)].

In the case of an estate or trust, the deduction is computed after excluding income in respect of a decedent which is properly paid, credited or required to be distributed to the beneficiaries during the taxable year [I.R.C. §691(c)(1)(B)].

Also, in computing the deduction, the estate tax is taken after credits against the tax. The net value for estate tax purposes of the items of income in respect of a decedent is the estate tax value of such items, less deductions from the gross estate taken for expenses, taxes and depletion, or foreign tax credit, allowable to the estate or to the person who acquired property from the decedent, subject to such obligation, by reason of the decedent`s death. The difference between the amount of the estate tax computed before and after the items of income in respect of a decedent have been removed constitutes the estate tax on all of these items.  The tax is then apportioned among all of the items of income for purposes of the deduction.

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