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Income Tax Accounting for Trusts and Estates

Planning allocations between entities and beneficiaries is even more critical with higher tax rates on the horizon.

October 2010
by Sonja Pippin/Journal of Accountancy

Estates and non-grantor trusts must file income tax returns just as individuals do, but with some important differences. For one, their income is taxed at either the entity or beneficiary level depending on whether it is allocated to principal or allocated to distributable income, and whether it is distributed to the beneficiaries. And because their exemption amounts, tax brackets and related thresholds haven’t been indexed for inflation or modified for tax relief to the extent those for individuals have, they can be subject to higher tax rates at much lower levels of income. With the new Medicare tax on investment income on the highest tax brackets, estates and trusts pay still more taxes on incomes over $11,200, as opposed to $200,000 or $250,000 for individuals.

In this and other ways, the Patient Protection and Affordable Care and the Health Care and Education Reconciliation acts of 2010 (PL 111–148 and PL 111–152, respectively) affect trusts’ and estates’ income taxes and have introduced discrepancies that tax practitioners can review with their clients who administer trusts and estates. This article reviews some strategies for more tax-efficient allocation of income and principal by trusts and estates.

Income tax accounting for trusts and estates has received relatively little attention from tax professionals as well as lawmakers. This is not surprising because of the comparatively few taxpayers affected. In the 2008 tax year, approximately three million Forms 1041, U.S. Income Tax Return for Estates and Trusts, were filed, with an aggregate gross income of $188 billion. Aggregate taxable income and tax liability were $112 billion and $23 billion, respectively (IRS Statistics of Income, Fiduciary Returns — Sources of Income, Deductions, and Tax Liability). Compared with more than 142 million individual income tax returns (forms 1040, 1040A or 1040-EZ) reporting more than $8 trillion in gross income (IRS Statistics of Income, Individual Income Tax Returns, Preliminary Data, 2008 (PDF)), these are small numbers.

In addition, income taxation of estates and trusts does not generate much public interest — unlike the estate and gift tax, which has been subject to much debate within the professional community as well as in government and among the general public. As a consequence, practitioners and their clients may not be aware of several tax issues related to estates and trusts. However, as this article demonstrates, careful planning that takes these issues into account is no less important than for other types of returns and can reap significant tax benefits.

This article has been excerpted from Journal of Accountancy. View the full article here.