With the 2016 tax season upon us, I wanted to pass along a few tips for preparing the Form 1041 income tax filings for trusts and estates, as well the Form 709 gift tax filing. This article highlights some nuances that would be useful to consider in advance of preparing these returns, including two time-sensitive income allocation topics.
Estate and Trust 1041s:
- The 65 Day Rule: The deadline on this is March 5, 2016, and it could save your client a significant amount of tax! The fiduciary overseeing an estate or complex trust has the ability to treat distributions made during the first 65 days of the following tax year as part of the income distributions for the prior year. As such, the executor or trustee can potentially shift taxable income from the estate or trust to the beneficiaries on a K-1, which is often desirable given that the maximum income tax rates and the 3.8% NIIT both kick at $12,300 of taxable income for 2015 1041s.
For example, assume we have a trust with 2015 taxable income of $30,000 from interest and dividends that could pass out to beneficiaries, but only $10,000 was paid out during 2015. Under the 65 Day Rule, the trustee can distribute up to $20,000 more to beneficiaries and elect to treat that as having been distributed on December 31, 2015 for income tax purposes. Note: To make this irrevocable election under §663(b), Question 6 on Page 2 of the 2015 1041 must be marked “Yes” on a timely filed return.
Of course, there are other concerns for a trustee when making discretionary distributions from a complex trust. But from a pure income tax perspective, this income shifting can result in serious tax savings on a trust with high investment income.
- Distribution of Capital Gains: Depending on the terms of the trust, the state law and past distribution activity, the potential exists to distribute capital gain income to beneficiaries along with ordinary investment income. The advantage here is the same tax rate arbitrage discussed above with regard to the 65 Day Rule. This could apply for complex trusts where there is capital gain income, and where distributions in excess of distributable net income were made – or where distributions were made from an estate before the final tax year of the estate. The 65 Day Rule could also be invoked to distribute capital gain income out for the prior tax year. Final Regulation Section 1.643(a)-3 discusses when capital gains can be included in DNI—and this is a complex determination. However, given the right circumstances, it could result in significant income tax savings.
- Documents: It is always best to have a copy of the trust document for reference when you are preparing a 1041. With most estates, it’s the revocable lifetime trust document that you would need—or, you would need the will if there was no trust. If you don’t have the appropriate document, request it now so you have it when you get around to reviewing the return. A quick review of the document is necessary in order to determine important income tax implications, like whether the trust is simple or complex, or whether capital gains may be passed out to beneficiaries. Also, don’t forget about Question 9 on Page 2 of the 1041, which asks whether any present or future beneficiaries are “skip persons” for the GST tax. You can’t answer that question without reviewing the document provisions, or at least discussing it with the drafting attorney.
Gift Tax Returns:
- Documents: If you have gifts made in trust to report on the 709 Form, having a copy of the trust should be a requirement before signing off on the Gift Tax return. The terms of the trust need to be reviewed in order to determine how gifts to the trust should be reported for GST tax purposes. A conversation with the drafting attorney is also useful in order to confirm the appropriate treatment in the first year of gifting to the trust. This is a very important consideration for a taxpayer with a taxable estate, and in my experience, it often does not receive the attention that it warrants. This can result in wasted GST exemption for clients with limited ability to amend returns for irrevocable elections made on the original filing.Note that the Form 709 instructions also indicate that either a copy of the trust document or a brief summary of the trust provisions should be attached to the 709 if there are any trust gifts reported. I haven’t seen the IRS question the absence of this; but technically, the gift has not been “adequately disclosed” without this attachment, meaning that the statute of limitations never begins to run on the return.
- Filing Requirements: Let’s review the filing requirements for Gift Tax returns for 2015, as there seem to be misconceptions about when a Gift Tax return is supposed to be filed, and how annual exclusion is applied.
a. Gifts to any person other than a spouse that are in excess of $14,000 (i.e., a check from one spouse’s checking account for anything over $14,000) triggers the filing. True, the gift can be split with a taxpayer’s spouse, such that up to $28,000 of annual exclusion is available per done. However, gift splitting is only available if an election is made to split the gift on a timely filed Form 709. Note that a $28,000 check from a joint account with the spouse would not require a filing, since each would be considered to have made a $14,000 gift. Gifts of “community property” are also considered to have been made equally (50%) by each spouse.
b. Gifts of “future interests”. These are not eligible for the annual exclusion, so a filing is required. For example, a gift to a trust that does not grant “Crummey” withdrawal rights to the beneficiary would be a gift of a future interest.
c. Gifts to a trust in excess of $14,000 may not technically require a filing if there are multiple beneficiaries; however, it is a good practice to file returns if there are gifts in trust to document whom the beneficiaries are, and the amount of annual exclusion claimed for each. The other reason to file in this case is that the GST tax annual exclusion is generally not available for gifts in trust. If you don’t file a return to address this issue, then the default election you are deemed to make by not filing may end up wasting some of the taxpayer’s GST exemption.
These tips touch on some complex areas of Estate, Trust, and Gift Tax law, but I wanted to offer some food for thought as you are starting to work through your 2015 returns. Please feel free to email me if you have any questions on these matters or call me at 440-449-6800.