Proceed with caution: pitfalls in the preparation of trust income tax returns.

• Author: Fukuto, Erin S.

Estate tax planning gains importance in everyone's life with age. As a result, tax preparers are finding that trust income lax planning and tax return compliance are growing pans of their tax practice. However, this specialization cannot be serviced properly unless the tax practitioner invests the time and effort to develop the necessary knowledge and expertise.

Trust are a very special type of hybrid entity; the related income tax accounting and compliance can haw fundamental differences from the income tax planning and compliance required for individuals and business entities. Furthermore, the tax return compliance requirements of a trust will differ from trust to trust, depending upon the type of trust. The prudent tax practitioner must be cautious and fully educated in this area of tax law to provide a high' quality of service.

There are a number of types of trusts, depending upon how they are created and the specific purpose for which they are intended. This discussion is not intended to be a comprehensive description of every type of trust The intent here is to provide a general introduction to trust income tax returns and to briefly point out certain, common problems that may arise.

Trust Types and Filing Requirements

Revocable Trusts

If a trust agreement provides that the trust can be revoked or amended at any time at the discretion of the trustor, i.e., creator of the trust, then the trust will be characterized as "revocable." Usually, there will be provisions for such a trust to become "irrevocable" (sec below) upon the death of the trust's creator, Since the trust's creator retains full control over the terms of the trust and over the assets therein, any income of the trust is treated as taxable to the creator in a manner similar to a "grantor" trust (sec discussion below).

Irrevocable Trusts

If a trust agreement provides that the creator or trustor has no power to amend or change the provisions of the trust and cannot expend trust funds or assets for the benefit of anyone other than the stated beneficiaries without specific authorization, then the trust will be characterized as "irrevocable." The trust agreement may have some limited provisions allowing the trustee certain powers to amend the trust under certain circumstances. Such powers should not invalidate the tax treatment of the trust as art irrevocable BUM; however, the tax preparer must always read and understand the trust agreement to gain assurance that the trust is being treated properly for tax purposes.

Irrevocable trusts will have a separate taxpayer identification number assigned, which n used on Form 1099s, Schedule K-1s, etc. to report the various income items received by the trust. The trust will prepare and file an annual income tax return, Form 1041, to report its income and deductions for the year (see additional...