Allowable Deductions for Trusts
Allowable Deductions for Trusts “I don’t always ask questions about trusts or estates, but when I do, I ask the Tax School…” We’re coming to you today as a follow…
May 3rd, 2021
In today’s blog, Tom discusses defining the income of a trust.
Is it taxable income?
Is it accounting income?
Is it what the trust document says it is?
OR is it a case of the trustee needing to ”Show Me The Money?”‘
by Tom O’Saben, EA
Hello everybody, this is Tom O’Saben enrolled agent, I’m the Assistant Director of Professional Education and Outreach for the University of Illinois Tax School. I’m also a fall Tax School instructor and author and reviewer of the University of Illinois Federal Tax Workbook. I’m heavily involved in the webinars we do throughout the year. And these weekly blogs that we do not only during tax season, but throughout the year, when we feel we’ve got timely information to give you to help you not just get through the tax season, but also to plan with your clients to help them be better informed. I’m also a tax practitioner and I have more than 30 years of experience. I hope you’re going to enjoy the topic we have for you today.
Just recently I was having a conversation with one of our fall Tax School instructors, Bob Rhea, I mention his name often. Bob’s a studious guy, gives a lot of thought to what he’s doing both as the instructor, he’s also a practitioner, and he’s the head person for FBFM here in Illinois. And we were having a conversation as to what exactly is “income” when we’re dealing with a trust, and I put income in quotes, so we can have just that conversation.
So when we talk about the notion of income for a trust, this is where it gets complicated and difficult for us as practitioners. Most of us, if not all of us, understand the notion of taxable income, certainly in a 1040 series, we know that that’s going to be the income that flows from all sources onto that Form 1040. Well, in the world of trust, yes there is taxable income, but there are different types of income. And that’s what we have to talk about because they have impact not just on what the trust is going to pay tax, but also on what the beneficiaries might have to pay tax on. So we have three different concepts that we’re going to talk about and we’re going to throw a scenario out to you also that Bob and I actually discussed. And we talk about the notion of taxable income, something called fiduciary accounting income, if you attended any kind of trust sessions in the past, you find that we’ve thrown out this notion. And there’s also something called income according to UPIA, the Uniform Principal and Income Act, which most states have adopted to try to define what in fact, is income when we talk about trusts.
So, why do we care? Well, we care because I need to get an initial type of concept to you in the world of trust and trust taxation. And that’s this, normally, we are not going to pay tax twice. Either the trust is going to pay tax, or the beneficiary is going to pay tax, but typically not both on the same money. That being said, we have to follow the flow of the money or to quote the Jerry Maguire movie, “show me the money.” If we can follow the flow of the money, then we can follow who’s going to pay tax. So we care about this because that income that’s available to be distributed to beneficiaries, ends up being a deduction for the trust from the income that it has to pay tax on that goes to this concept of, we’re not going to pay tax twice. But then we run into another area when we talk about income and that is when there are multiple beneficiaries there may be conflicting goals, conflicting interests. Now, that may not matter so much to us as tax practitioners. But I’ll tell you this, unless we are dealing with a trustee who is a professional, like a trust company in a bank, or a wealth management type firm, trustees are going to look to us for advice on how to handle what they’ve got to do when they have this duty as a fiduciary thrust upon them. Because when you have beneficiaries with conflicting interests, for example, you can have one that’s supposed to receive income and maybe when they die, or there’s some kind of change in their life status, that income ends, then there’s a remainder portion we describe those here in the slide is “remaindermen,” those who get what’s left over. Well, if that trustee going through the process of managing this trust for however long it’s going to be around, you want to know how long it’s going to be around? Look at the document, you’re going to hear me say that often throughout this session. If they send too much money out to the income beneficiaries, then the remaindermen are saying, “Hey, what’s left for us?” Conversely, if not enough income is being sent out to the income beneficiaries for the benefit of the remaindermen, then you’ve got the income beneficiary saying, “Hey, what about me?” So these can be issues again, that put a trustee at risk, not so much a tax advisor, but I’m telling you again, I think that trustee is going to come to us and say, “Hey, what do I do when I’m dealing with this potential conflict of interest?”
Furthermore, under the why do we care, we say who pays the tax? And I know there’s kind of a general piece of knowledge out there. I had the same thing when I first learned taxes was that when we don’t want the trust to pay tax because the tax rates are so onerous, you can hit the maximum tax bracket in a trust at about $13,000 of income. But you know what? I don’t think that should be the overriding decision. The document is going to tell us what’s supposed to happen in this trust, that grantor is probably no longer around so they had an agenda to address, and we address the agenda, and the tax will be a consequence. So once again, who pays the tax, the trust or the beneficiary? Show me the money, show me the path of the money, I will show you who pays tax. And if there’s only one beneficiary, we may not care. So if they’re getting income now, then the trust is taken to the deduction for the income that passes through, if there’s money to do so, and that’s really what we’re going to get into today. And later on, when they have distributions of principle that shouldn’t be taxed again, it should be corpus, that’s the term that’s used. Now the trust type term trust and estate term. So again, with one beneficiary, it may really not matter as long as we’re not in violation of the document or of any federal laws.
So let’s throw a scenario out there, this is the one that Bob and I talked about. So we’ve got a simple trust, which I’ll explain a little bit more in a moment, that we have a simple trust where that trust is a partner in a partnership. So at the end of the year, the trust receives a partnership K-1, line one income, you’ll see this in minute $300,000. So you’re pretty sure now that you’re going to have $300,000 of income from a taxable income perspective. But when we look further down on the K-1, we see that for whatever reason, the partnership made the decision to retain money and only made a distribution of $40,000 to the trust. How do we know that? You’ll see it here in a moment.
Here it is, here’s a carve out I did for you of the K-1. So there’s our ordinary income, $300,000, look down at box 19, distributions were $40,000. So we’re going to have a difference here between taxable income and income that’s available to be distributed to beneficiaries. Okay, why would this be done? Well, maybe the partnership made the decision that they needed to retain cash, maybe they were going to make some significant investments in property, plant and equipment, could be, maybe there’s something else going on, they foresee some expenses that they don’t have the money at the current time available to go ahead and distribute. Fact remains only $40,000 was distributed. Look for this, when you get the K-1 for that trust. What I want you to do is to not hone in on $300,000 is the driving factor of everything we’re going to talk about, it may be the two factors, the $300,000 and the $40,000.
So let’s get into some more definitions so we can get kind of our minds around what we’re trying to do here and what Bob and I had discussed. So what is a simple trust? How are you going to know that a trust is a simple trust? Go to the document and the document will say income must be distributed to beneficiaries currently. Okay, that defines a simple trust, it is supposed to distribute its income. We got to get a definition of income. So here’s where we introduce Fiduciary Accounting Income, or FAI. Looking up the definition, it says it refers to the income that’s available for payment to trust income beneficiaries. It can be dividends, interest, ordinary income. Okay, kind of makes sense. We also have to go into the Uniform Principle and Income Act and I specifically carved off for you here, what is the definition of income that’s coming from an entity? You know, in our scenario, we have an entity, a partnership, providing income to this trust. So what do we say here? That the corporation, a partnership, a limited liability company, mutual fund, a real estate investment trust (REIT). What is the definition of income? Money received from an entity is allocated to income, different words aren’t there? Not income, but money. And that kind of makes sense.
So here I went ahead and I put the information from the K-1 into my tax software, I didn’t carve off the the part that shows that it’s a simple trust, but here we go. Only source of income was the income from the partnership, you see the $300,000 that came in on line five, that is the income of the trust. Okay? So, on line 18, I’ll draw your attention, we see $40,000. Remember the distributions on the K-1? I’ll show you this in a moment, which says the only income distribution deduction we can take is $40,000. What’s going to happen? That $40,000 goes to the beneficiary and the remainder, in our case, after an exemption of $300 is that there’s $259,700 that the trust has to pay tax on and the tax comes in at just shy of $104,000 and please ignore that estimated tax penalty line, it just came out of my software. I just want to get the basic concepts to you in this point and I think we need to look a little bit more at the 1041.
So in particular, I want you to see the Schedule B, this is on page two of a 1041 and we see that we’ve got total income of $300,000. Okay? That potentially becomes our distributable net income, assuming that there’s money. But the K-1 told us we only had $40,000, that ends up being on line nine. Why? Income required to be distributed annually? Remember, what we looked at earlier, the definition of a simple trust that it’s required to distribute it’s income? Yeah, that’s why that’s on line nine, income required to be distributed currently is the money that the trust has in its hands to give to the beneficiary. So $40,000 is going out and the trust is going to pay tax on that remainder.
So here are some thoughts to ponder. Is it possible depending on the trust, and maybe we only have one beneficiary, can we just have the $300,000 be allocated to the beneficiary? The answer appears to be yes, unless there’s some remaindermen sitting out there that says, Well, you know, that beneficiary shouldn’t be getting all of this money. That could be an issue because I’ll tell you this, if we go ahead, and I could do it in my software, if I wanted to. I could say ignore the distributions from a K-1 that makes the $300,000 not just the taxable income, but the income available for distribution. Trust ends up with zero tax, but beneficiary ends up with $300,000 of taxable income. Now, if that’s going to be the case, then how do you think the beneficiaries feeling? Hmm, I’ve got to pay tax on $300,000, but I only got $40,000, so I’ve got to pay tax on $260,000 that I’ve never seen. And I could liken this beneficiary’s attitude to a character from the movie Goodfellas, named Maury. If you know the movie, you might remember Maury, he follows Jimmy around in the movie, and he’s constantly saying, “I want my money, I want my money, I want my money.” And ultimately, Jimmy gets to the point where the response to Maury is that he has an unfortunate visit or a meeting of the minds, let’s just say, with his ultimate demise, we’ll say it that way. But you can imagine that your beneficiary is going to say I want that other money because I got to pay tax and may be going back to the partnership and saying, I need a distribution in order to at least pay my tax that I owe. Or the trust needs money in order to go ahead and pay the tax, but certainly I can see us going back to the partnership, and asking for distributions.
I have a client who’s a shareholder in an S Corp and one of the things that we do at the end of the year when we do the taxes is we look at the amount of tax that was created by the S Corp allocation, then that shareholder actually goes back to the company and says, I need a distribution. And of course then they have to make a distribution all the shareholders pro rata in order to cover the tax. So I could see this beneficiary going back to the partnership and saying I need money, which means then the partnership would send money to the trust in the world of allocating funds. We’ve already claimed the $300,000, so I would believe that this money would be considered corpus and not be taxed again and that’s the point I’m saying here. Can the beneficiary receive money later tax free? Yes, tax has already been paid on the $260,000. Is there potentially no income, actually taxable to the beneficiary? You know, I found a discussion on a website, and my software didn’t do this and the discussion I ran into was a little bit old, it’s about 10 years old. So you may want to look at this a little bit further, which showed that remember back in our income distribution deduction, where we had $40,000? The calculations I was looking at in these scenarios said, Well, we also need to subtract from that cash that’s available, the tax that the trust owes. In this case, the tax that the trust owes is more than the money it actually received. Therefore, there is a no income distribution deduction which means there’s no income going to the beneficiary. I could make my software do that as well, but I wanted to make that as another thought to ponder.
So one of the things to think about when you’re looking at a trust and I have to apologize because in times past, I think I personally have used the term income too loosely. So we have to, “show me the money.” Let’s use Jerry Maguire, I’ve given you two movie references in this blog today. Show me the money, what actually came in? Have the trustee provide you with an accounting of the income and expenses before preparing the return. Let’s just not and I say let’s, I’m saying this to myself as well. Trust me on this folks, that don’t just look at the K-1’s and the 1099’s that come in, actually, let’s see from the trustee… Maybe it’s their bank account? What income did you take in? What expenses did you put out? That’ll give us an idea of the accounting because that could be important and is important as to 1) who pays the tax? 2) what is the route of the money? And before you start on any of this get the document, get the document, get the document, so you can see what the wishes or intent was of the grantor and that will help you getting deeper, deeper into these trust conversations. I know I ran a little bit long today, but the idea being is that we have different types of income definitions within a trust and I think it’s important to be aware of what we’re talking about from the standpoint of what’s the taxable income. That’s going to come off of those K-1’s and those 1099’s and all of that. What is the fiduciary accounting income, that’s the money available to distribute to beneficiaries, could be property as well and that’s going to be actual funds coming in. Does that meet the Uniform Principal and Income Act, it’s going to impact our deduction that we take for the trust, the income that we take from the trust, and allocate to the beneficiary. And then we know what the trust is going to owe, then that money kind of magically goes into a bucket of principle and when that’s later distributed, it would not be taxable again. So hopefully this gives you kind of a framework. I know the conversation with Bob was time well spent, I would say for both of us and I thought it was important to share it with you. So I’m hoping you’re getting through this last few weeks of tax season with your heads held high. So for all of us at the University of Illinois Tax School, the “I” in your team, this is Tom O’Saben saying we’ll say goodbye for just a while.
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