Taxation of Estates and Gifts

Trust

26 U.S.C. subchapter J categorizes trusts as simple trusts, complex trusts, and grantor trusts.

All estates are complex trusts. 26 CFR § 1.651(a)-5.

Grantor Trust

A grantor trust is a non-exclusive type of trust where the grantor retains or gives to his spouse one or more of the powers or interests in 26 U.S.C. §§ 673–678. These are basically "strings" of control over the property like having discretion over distributing income or having AART powers.

Every trust is also either a simple trust or complex trust.

Simple Trust

A simple trust is a trust that requires the distribution of all fiduciary accounting income, that does not make a charitable deduction, and that does not distribute principal.

Complex Trust

A complex trust is any trust that is not a simple trust.

Trusts required to distribute all income (all simple trusts and some complex trusts) have a deduction in lieu of a personal exemption of $300; other trusts get a $100 deduction. Estates get $600.

The tax differences between simple and complex trusts are inconsequential. So while a trust's status must be declared on the return, they can always just be analyzed as a complex trust.

Fiduciary Accounting Income

Fiduciary account income is largely determined by state law, but it includes both tax-exempt and normal income (including interest) and excludes capital gains and losses. 26 U.S.C. § 643(b).

  • Capital gains and losses are just allocated as an increase in principal, not as actual income. UPIA § 404.
    • Some other expenses may be treated like this too, and some are half included. UPIA § 502.
Distributable Net Income

The distributable net income is the taxable income of the trust (from 26 U.S.C. § 61, including capital gains and excluding tax-exempt interest at first) with some adjustments made. 26 U.S.C. § 643(a).

  1. Subtract the "distributions deduction". 26 U.S.C. § 643(a)(1).
    • I'm not entirely sure what this means. I think it's some technically-required logic thing that you don't really have to worry about.
  2. Add back the personal exemption substitute deduction from 26 U.S.C. § 642(b). 26 U.S.C. § 643(a)(2).
    • I.e., it's not allowed.
  3. Subtract net capital gains allocated to principal. 26 U.S.C. § 643(a)(3).
  4. Add tax-exempt interest. 26 U.S.C. § 643(a)(5).
Allocating Distributable Net Income

After determining DNI, it must be allocated among the distributions.

First, indirect expenses of the trust must be segregated pro rata between taxable income and tax-exempt income. The differences after subtracting direct expenses and these portions of indirect expenses from classes' gross incomes are the net amount of DNI for the classes (which should add back up to the total DNI). You really only care about the percentages here though.

Second, DNI must be allocated among the distributions according to a tier list:

  1. Required distributions. 26 U.S.C. § 662(a)(1).
  2. All other distributions. 26 U.S.C. § 662(a)(2).
  • All DNI and charitable deductions are first allocated proportionally among the tier 1 distribution beneficiaries.
  • If the DNI is greater, what's left over is then likewise allocated among the tier 2 distribution beneficiaries.
  • If there is still DNI left over, the DNI is allocated to the trust, and it will be taxed for it.

Then each person has income according to the DNI allocated to him, classified as according to the percentages that the income was classified as.

Distributions Deduction

To calculate the distributions deduction:

  1. Take the lesser of:
  2. Subtract the net tax-exempt income (TEI−Direct TEI Expenses−Allocated Indirect Expenses)
Trust Taxable Income

A trust's taxable income is its gross income from 26 U.S.C. § 61 (including capital gains and excluding tax-exempt interest) minus its expenses and charitable deductions (allocable to non-tax-exempt income (26 U.S.C. § 265.)), distributions deduction, and the personal exemption substitute deduction.