Chapter 7.7 Income Taxation of Estates and Trusts

• Jurisdiction: Washington

§7.7 INCOME TAXATION OF ESTATES AND TRUSTS

Estates and trusts are treated as separate taxpaying entities. I.R.C. ch. 1, subch. J, §§641- 692, governs taxation of estates and trusts. The rules governing the income taxation of estates and trusts are very complex and the details of such rules are well beyond the scope of this chapter.

An estate must file an income tax return (IRS Form 1041) if its income exceeds the personal exemption deduction of $600. I.R.C. §642(b)(1). A trust, in general, must be on a calendar-year basis under I.R.C. §644, but an estate may elect a fiscal tax-year basis. A trust must file an income tax return (IRS Form 1041) if its income exceeds the personal exemption deduction of $100 or, if the trust is required to distribute all income annually, the personal exemption deduction of $300. I.R.C. §642(b)(2).

(1) Estates, simple trusts, and complex trusts

Subchapter J defines a simple trust as a trust that is required to distribute all of its income currently and does not require any of its income to be set aside for charitable purposes. I.R.C. §651(a). A complex trust is a trust that is not required to distribute all of its income currently, may distribute amounts other than income, or requires income to be set aside for charitable purposes. I.R.C. §661(a). All estates are characterized as complex trusts. I.R.C. §661(a).

(2) Taxation of ordinary income

Trusts and estates are taxed, for the most part, in the same manner as individuals except as provided by Subchapter J. I.R.C. §641(b). Subchapter J essentially provides modifications or exceptions to the rules of income taxation that govern individuals to apply such rules to the taxation of trusts and estates. The major exception is that trusts and estates are allowed a deduction for certain income distributions made to beneficiaries. I.R.C. §§651, 661. Similar to pass-through entities, the income earned by the trust or estate passes through to the individual beneficiaries for inclusion on their personal income tax return (IRS Form 1040). I.R.C. §§652, 662. Oversimplifying a bit, income (but not capital gain) that is distributed is taxed at the beneficiary level and income that is retained in the trust is taxed at the trust level.

Taxable income of an estate consists of gross income minus deductions and is computed in the same manner as for individuals. I.R.C. §641(b). If the deductions exceed the gross income for the year, the excess deduction will flow through to the beneficiaries if the estate has

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terminated during that year. Otherwise, only capital loss carryovers and net operating losses will be preserved and carried forward to the next year. I.R.C...