Income tax issues for estates.

• Author: Keene, David
• Position: Part 2

EXECUTIVE SUMMARY

* Generally, the deductions and credits allowed to individuals are also allowed to estates and trusts.

* Two important planning objectives are tax deferral and using tax rate differentials.

* Tax savings depend on coordination and cooperation among the executor, attorney and CPA.

This two-part article focuses on some distinguishing features of the taxation of estates. Part I, in the last issue, examined income tax issues that arise during the probate process. This part illustrates, through comprehensive examples, how advance planning can minimize an estate's income tax and maximize distributions to beneficiaries.

The first part of this two-part article, in the last issue, explored the decision-making process that occurs at the beginning of probate. Part I emphasized the importance of an integrated approach to income and estate tax issues and engaging in teamwork among professionals.

Part II, below, examines the design of estate income taxation. After deciding which return (Form 706, U.S. Estate (and Generation-Skipping Transfer) Tax Return, or 1041, U.S. Income Tax Return for Estates and Trusts) will maximize the tax benefit from deductions, a tax adviser should examine how to optimize tax advantages by timing deductions and distributions to beneficiaries. Included in this analysis is the selection of the estate's optimal tax year-end.

Design of Estate Income Taxation

Subchapter J of the Code contains the rules governing the income taxation of estates:

* Under Sec. 641(b), taxable income is determined in the same way as for individuals.

* Under Sec. 661, an estate takes a deduction for distributions to beneficiaries (the distribution deduction).(11) (Taxable income before the distribution deduction is sometimes referred to as tentative taxable income (TTI).)

* Generally, estate taxable income equals TTI less the distribution deduction and $600 personal exemption.

* Under Sec. 662, the beneficiaries include their distributions in taxable income, but only to the extent the estate is allowed a deduction for the distributions.

Who reports the income? If there is an estate distribution deduction, a beneficiary will get the income (which will be reported via Form 1041, Schedule K-1). The character of the income (ordinary vs. capital, passive vs. active, etc.) is determined at the estate level; the income retains its character in the beneficiary's hands. However, capital gains are generally not passed through to beneficiaries, except in an estate's final tax year.

Estate income taxation does not follow the strict conduit theory applied to partnerships and S corporations. Only estate net income is passed through to beneficiaries (i.e., an estate's net loss is not passed through to beneficiaries). An exception is made for an estate's final tax year, as was discussed in Part I of this article.

Determining TTI

Sec. 641(b) provides that estate TTI (i.e., taxable income before the distribution deduction) is computed the same as for an individual, "except as otherwise provided 'in this part." Those looking through subchapter J for a description of these promised exceptions will be disappointed. Regs. Sec. 1.641(b)-1 provides that "generally, the deductions and credits allowed to individuals are also allowed to estates and trusts" but provides no examples or exceptions. These promised exceptions are found elsewhere:

* According to Sec. 67(e), the 2% disallowed itemized deductions rule does not apply to estate and trust deductions that would not have been incurred had the property not been held in a trust or estate. There have been few cases on the application of this rule.(12) However, most estate administration expenses should be deductible without regard to the 2% limit.

* Under Sec. 68(e), the disallowance of 3%/80% of itemized deductions when adjusted gross income (AGI) exceeds certain levels does not apply to estates or trusts.

* Under Sec. 469(i)(1) and (2), the $25,000 of allowed passive activity losses from rental real property does not apply to trusts. However, estates are allowed this deduction if the decedent could have claimed a loss as an active participant in the activity. This exception applies only to an estate's first two tax years, under Sec. 469(i)(4)(A). After this two-year period, no passive loss deduction is allowed.

* Under Sec. 179(d)(4), the election to expense depreciable property does not apply to estates.

* An...