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Taxation of Trusts and Estates in Probate

Posted on: May 18th, 2017
tax issuesIncome and estate tax implications vary for each estate depending on whether the decedent had a trust in place and, if so, the nature of the trust. If a decedent owns an interest in one or more trusts at death, the type of trust and the nature of assets held in trust will impact applicable tax. If the decedent transferred assets to an irrevocable trust during his or her lifetime, these assets might not be considered part of the decedent’s taxable estate. Where the decedent transferred assets to a revocable living trust prior to death, one or more fiduciary income tax returns might be required to report income earned by assets in the estate and/or trust after death.  

In the sections below, our tax attorneys identify a few items that trustees and executors should review with their legal counsel. Tax matters related to trusts and estates can be simple or complex, but in all cases require satisfying critical deadlines and ensuring that tax forms are prepared and filed accurately and thoroughly. 

Income Tax Considerations for Trusts 

Trust income might be taxable at both the federal and state level, depending on the trust jurisdiction. Review tax requirements for trusts in the states where our lawyers practice: North Carolina, Florida, Tennessee and New York. The prior link showcases the wide range of factors states use to determine taxation of trusts. The value of trust income and the type of assets accruing income may subject the trust to net investment income tax (NIIT). However, the NIIT may be repealed in 2017. Depending on the type of trust, federal and potentially state income tax returns may have to be filed annually, and any income tax liability due at the trust level must be satisfied by the filing deadline in order to avoid interest and penalties. Trust income will affect quarterly estimated income tax payments, which must be paid and reported on Form 1041-ES. Foreign trusts have specialized tax procedures; see details about foreign interests in probate below. 

Tax Matters During Probate

Throughout estate administration, the executor must inventory estate assets and determine date-of-death values to ensure proper tax reporting upon disposition of the assets. Typically, federal and possibly state income tax returns must be filed to report income earned by estate assets; in some circumstances, this return may also report income earned by certain trust assets for a period of time following the decedent’s death. Consult with tax counsel to determine the appropriate steps to ensure that all estate and trust income tax reporting requirements are satisfied.

In addition, the decedent may have died with existing tax debt. Prior to distribution of assets or funds to heirs, all estate debts must be satisfied. The executor will pay off existing debts such as medical expenses, credit cards, loans, and taxes. Then, depending on the value of the decedent’s taxable estate, state and/or federal estate tax, NIIT, capital gains, and other taxes may apply. 

Many states have repealed the estate tax at the state level, and the federal estate tax exemption is $5.49 million for the 2017 tax year. (All states our tax attorneys practice in, except for New York, have repealed the state estate tax.) The value of the decedent’s assets must be reported on Form 706 if their estate exceeds the amount of federal estate tax exemption available at their death. Foreign assets, interests, and trusts require unique tax compliance reporting forms, and a proposed inheritance tax on foreign assets is pending. 

Personal and Fiduciary Income Tax

The decedent’s personal income tax return (Form 1040) must be filed and taxes paid prior to completing the estate and/or trust administration. Form 1041, U.S. Income Tax Return for Estates and Trusts, reports fiduciary income tax. If distributions have been made to beneficiaries during the tax year, Schedule K-1 reports each beneficiary’s  share of taxable income, deductions, or credits to be reported on their personal income tax returns. 

Efficient administration of an estate is often achieved through thoughtful advance planning. In cases where the decedent engaged in deficient planning, there are still methods available to trustees and executors that can help to minimize the tax burden. Contact a tax and probate attorney for an estate review.
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