An estate or trust is a separate legal entity created under state law solely to transfer property from one party to another. As legal entities, estates and trusts are separated by law from both the grantor and the beneficiaries. Estates and trusts are taxed according to how they're classified. Their classification is based on their purpose.
The estate of a deceased person is a taxable entity. It exists until all debts are paid, if possible, and assets have been distributed to heirs and other beneficiaries of the decedent. Here's how it's taxed before and after distribution:
- Income earned from the assets of the estate during the period of administration or settlement, which is usually no more than 3 years but can be much longer in some cases, is subject to tax.
- Any income accruing after the decedent's death will be taxed to whomever realizes the gain. If income received by the estate isn't distributed the same year it's received, it'll be taxed to the estate.
- Distributed income is calculated as a deduction for the estate.
- Capital gains realized by the estate are ordinarily taxed to the estate.
How beneficiaries are taxed:
- Generally, property received by the beneficiary of an estate, valued on the date of a decedent's death, isn't taxable income to the beneficiary.
- The exception is Income In Respect of a Decedent (IRD) items.
- Distributed income must be reported on the beneficiary's income tax return.
Simple trusts are required to distribute all income in the same tax year in which the income was received.
- Definition of simple trust income:
- Income is defined under both local law and the governing instrument, the trust document.
- Historically, income hasn't included capital gains income; under most trust instruments and state laws, capital gains are considered corpus.
- Distribution of corpus:
- A trust will lose its simple classification if it distributes corpus in any tax year; thus, a trust can't be a simple trust in its year of termination or any year of partial liquidation.
- Distribution of income:
- Only distributions of income are allowed to beneficiaries.
- The structure of a simple trust doesn't provide for charitable contributions.
- Taxation of income:
- Income of the trust is taxable to the recipient even if distributions aren't made.
- The trust itself can incur tax liability (for example, realized long-term capital gains).
Although similar in some ways to a simple trust or an estate, a complex trust is allowed to perform activities a simple trust cannot.
A complex trust satisfies at least one of the following conditions in a tax year:
- Retains some current income
- Provides amounts to either be paid, permanently set aside, or used for charitable purposes
- Distributes amounts allocated to the corpus of the trust
Deductions for complex trusts:
- Like a simple trust, a complex trust is allowed a deduction for income distributed to beneficiaries and is allowed a standard exemption amount of $100
- Like an estate, a complex trust can deduct unlimited amounts of gross income paid to recognized charities as well as any other amounts paid, credited, or required to be distributed in the tax year to beneficiaries
Taxation of beneficiaries:
- Income distributed to beneficiaries is reflected on their personal income tax returns
Qualified disability trust
A qualified disability trust is a non-grantor trust created solely for the benefit of a disabled individual under age 65.
- All of the beneficiaries of the trust as of the close of the taxable year are determined by the Commissioner of Social Security to have been disabled (within the meaning of section 1614(a)(3) of the Social Security Act, 42 U.S.C. 1382c(a)(3)) for some portion of such year.
- A trust will still be considered a qualified disability trust if the corpus of the trust may revert to a person who is not so disabled after the trust ceases to have any beneficiary who is so disabled.
- Qualified disability trusts are eligible to claim a personal exemption of an individual.
Electing Small Business Trust (ESBT)
As established under the Small Business Job Protection Act of 1996 (P.L. 104-188), an election must be made for a trust to be treated as an ESBT. If a trust meets the requirements of an ESBT it can:
- Own S corporation shares
- Qualify as an ESBT even if the trustee doesn't distribute all of the trust's income annually to its beneficiaries
Grantor type trust
A grantor trust is called so because the individual, group, or other entity that created it holds some power or interest over the income and/or corpus of the trust. It isn't recognized as a separate, taxable entity for income tax purposes.
How to report grantor trust income:
- Income earned by the assets of the trust is directly reported on the grantor's or owner's income tax return.
- Because the trust isn't taxed separately, the grantor is deprived of any possible tax advantages such as lower marginal tax rates and a standard exemption amount.
- For a grantor trust, Form 1041 functions primarily as an informational return.
A bankruptcy estate is created when an individual debtor files for bankruptcy under Chapter 7 (liquidation) or Chapter 11 (reorganization). This action creates an estate consisting of property that belonged to the individual debtor before the bankruptcy filing date.
The estate in bankruptcy can incur tax liability. The following rules apply:
- Many tax attributes of the debtor, such as net operating losses, credit carryovers, and capital loss carryovers, pass to the bankruptcy estate.
- A standard exemption isn't allowed.
- Form 1041 is used only as a transmittal for Form 1040. Items calculated on Form 1040 are transcribed to Form 1041.
- While the fiduciary must file Form 1041 for the bankruptcy estate, the individual debtor must file his or her own individual income tax return.
Qualified Funeral Trust (QFT)
The sole purpose of a qualified funeral trust is to pay for the beneficiaries' funeral or burial services at the time of death.
- A QFT arises as the result of a contract with a business or person engaged in providing funeral or burial services or property necessary to provide such services
- Contributions to the trust are made by or for the benefit of the beneficiaries
- The trustee must make an election for the trust to be treated as a QFT
Split-interest charitable trusts
How a split-interest charitable trust works
- Split-interest means that the interest in the property is split into two parts: an income interest and a remainder interest. The two parts are separate.
- Both interests can be assigned to a charity or charities, one or more non-charitable beneficiaries, or both, depending on the type of split-interest charitable trust.
- Charitable trusts engaging in business activities but organized to benefit charities are subject to the rules on unrelated business income.
Types of split-interest charitable trusts
Based on the method and timing of distributions, split-interest charitable trusts are divided into the following four categories:
- Charitable Remainder Annuity Trusts: trusts that distribute income in a series of fixed payments to one or more noncharitable beneficiaries for a defined period, after which the remaining value of the trust is transferred to a charitable beneficiary.
- Charitable Remainder Unitrusts: trusts that distribute a percentage of the fair market value to one or more noncharitable beneficiaries for a defined period, after which remaining value of the trust is transferred to a charitable beneficiary.
- Charitable Lead Trusts: trusts that distribute a sequence of payments to a charitable beneficiary for a period, after which the remaining trust assets are transferred to a noncharitable beneficiary.
- Pooled Income Funds: trusts that let donors give assets to a charity. The pooled assets are invested as a group and each donor receives income based on the ratio of his or her contribution to the total value of the investment pool. After the death of the donor, his or her prorated share of the investment pool is withdrawn and given to the charitable organization.