With all of the tax documents continuing to arrive in the mail, we are all painfully aware that it is currently tax season. If you are an Executor of an Estate or the Trustee of a Trust that is or has become irrevocable, you should know that Estates and Trusts have to file their income tax returns. When you qualified as an Executor or took over as Trustee, you probably applied for a tax identification number for the Estate or Trust. That number is how the IRS knows to be look for the reporting of income and the payment of taxes.
Just like individuals, estates and trusts may receive or earn income. Common sources of income for an estate are rental payments from real property in the estate or interest earned on an estate bank account. An executor must file a federal income tax return – Form 1041 – if gross income for the tax year was $600 or more, or a beneficiary of the estate is a nonresident alien. The estate’s tax year begins on the date on which the deceased person died. The tax year-end can be December 31st of the year of death or the end of any other month that results in an initial tax period of 12 months or less. The Form 1041 is due by the 15th day of the fourth month after the tax year-end. If you file in any month except December, the estate has a fiscal tax year instead of a calendar tax year.
Just like individuals can take deductions, estates can take deductions for things like income distributions to beneficiaries, executor’s fees (the executor must report the fees as taxable income on his or her own personal income tax return), fees paid to attorneys and accountants, and the expenses associated with administration.
Income taxation of trusts is a little more complicated. Much depends on the type of trust it is. What most folks are familiar with is the revocable living trust. With these types of trusts, the person who creates the trust is treated as if he or she owns the property in the trust and is taxed on the trust’s income as though he or she earned it directly – the trust is effectively disregarded. With irrevocable trusts, the tax implications depend on whether the trust is “simple” or “complex.”
A simple trust is one in which all of the income earned in a year must be distributed to a beneficiary. With a simple trust, the trustee is not allowed to distribute any principal or make distributions to charity. Simple trusts do not have to pay income tax. Instead, the trust beneficiaries pay tax on their share of the income, even if they do not actually receive it.
A complex trust is one in which the income is allowed to accumulate, where the trustee can make discretionary distributions of income or mandatory or discretionary distributions of principal, or can make distributions to charity. A deduction is allowed for any “income required to be distributed currently” if the terms of the trust require the trustee to distribute income within the tax year. A deduction is also allowed for “any other amounts properly paid or credited or required to be distributed,” other than income required to be distributed currently, including payments made from income or principal in the discretion of the trustee, annuity payments made from principal, amounts used to discharge a beneficiary’s legal obligation, amounts paid pursuant to court order or decree, and payments in kind (payments of trust property other than cash).
Regardless of whether a trust is simple or complex, a Form 1041 will have to be filed if the trust has gross income of $600 or more during the trust tax year, there is a nonresident alien beneficiary, or if there is any taxable income. The tax year for all trusts is based on a calendar year, unless the executor of an estate and trustee of a trust make an election that treats the estate and trust as one for tax purposes. Any income that is accumulated in an estate or trust instead of distributed to beneficiaries is taxed at much higher rates than for individuals. For example, while a married couple filing a joint return will not reach the 37% marginal tax bracket until their taxable income exceeds $628,300, an estate or trust will be taxed at 37% when taxable income exceeds just $13,051.
Finally, if you are an executor or trustee and discover that the estate or trust had more income than expected in 2020, you have 65 days from the end of the tax year to distribute that extra income to beneficiaries and still take the deduction on the 2020 tax return. Section 663(b) of the Internal Revenue Code allows a trustee or executor to make an election to treat amounts paid to beneficiaries within 65 days of the close of the trust’s or estate’s tax year as though they were made on the last day of the prior tax year. The executor or trustee must actively make an election for this treatment on a timely filed tax return in order to enjoy the benefit of this rule.
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Bob Michaels is extremely passionate about providing the best possible legal experience for his clients, and focuses his practice on elder law, estate planning, business, and real estate matters. Bob has been able to provide piece of mind and a solid foundation to many folks in the Puget Sound area over the years and wants to provide resources and relevant information whenever he can.