Decedent's Personal Income Tax Return As noted above, all income earned prior to the decedent's death will be reported on his or her final personal income tax return. This may be a Form 1040 or one of the short forms allowed for this purpose. Estate Tax Return, Form 706 As of the date of death, you will take a snapshot in time of all estate assets and this is usually the basis for the values placed on the estate tax return (unless the alternate valuation date of 6 months after death is used). This valuation determines whether estate (or death) tax is due on the decedent's estate. Fiduciary Return, Form 1041 During the period of administration from the date of death until the estate assets are distributed to the beneficiaries, all income received from estate assets is "fiduciary" income, which must be reported on Form 1041 for Federal purposes and on Form 513 for Oklahoma State purposes. This income usually is then allocated to the estate beneficiaries on Schedules K-1 and any tax due on this income is paid by the individual recipient and not by the estate. There are exceptions to every rule, but generally individuals will be taxed at a lower tax rate than the estate, so it is better to distribute the income out to the beneficiaries, rather than reporting it as trust income.
Once the estate has been settled and the estate assets distributed to the beneficiaries, a final Form 1041 will be filed and all future income will be reported directly to these new owners. Taxation of Trusts and Estates The income tax rules attributable to Trusts and Estates are found in Part One of Sub-Chapter One of the Internal Revenue Code, and specifically in Code Sections 641-683. All trusts and estates are required to file fiduciary income tax returns on Form 1041, report all taxable income, and take appropriate deductions. The rules for trusts and estates, however, are different than those applicable to individuals.
First, trusts and estates are not allowed to claim the standard deduction under Code Section 63(c) or to claim a personal exemption. Instead, they are allowed differing deductions depending upon their status. Estates are allowed one deduction, "Simple" Trusts (see definition below) are allowed a different one, and "Complex" Trusts are allowed yet a different one still. "Simple" Trusts A "Simple" Trust is one that is required to distribute all of its income currently, whether or not distributions of current income are in fact made. The Trust instrument for a Simple Trust cannot deduct charitable contributions (Code Section 651). A Trust may be a Simple Trust even though under local law or the trust instrument capital gains must be allocated to corpus. The "income" required to be distributed in order for the trust to qualify as a Simple Trust is "income" as defined under local law and governing instrument [Code Section 643(b)]. Generally, this is ordinary income since capital gains under most Trust instruments and state laws are considered corpus. A Trust can lose its classification as a Simple Trust (but not its exemption) for any year in which it distributes corpus. Thus, a Trust can never be a Simple Trust in the year of termination or in a year of partial liquidation. "Complex" Trusts The term "Complex" Trust applies to all Trusts that aren't Simple Trusts. Generally, the same rules that apply to estates apply to complex Trusts. For simple and complex trust and for estates, the deduction for distribution to beneficiaries is determined by reference to Distributable Net Income (DNI). The main difference is that Complex trusts are allowed to accumulate income or distribute principal or corpus of the trust. Also, Complex trusts are subject to certain "tier rules" as set out in Internal Revenue Code Sections 661 and 662. A complex trust or estate may deduct any amount of income for the tax year required to be distributed currently. This includes any amount required to be distributed that may be paid out of income or corpus, to the extent it is in fact paid out of income. A complex trust or estate may also deduct any other amounts properly paid, credited or required to be distributed in the tax year, including amounts distributable at the fiduciary's discretion. Fiscal Year Reporting Trusts and estates are treated differently when it comes to selecting a fiscal year. Trusts are required to use the calendar year for reporting purposes. The only exceptions are if the trust is a charitable trust or a tax exempt trust. Estates, on the other hand, may select any reasonable fiscal year. Trusts and estates also are treated differently in regard to the payment of estimated tax payments. Estates do not have to pay estimated income taxes for any tax year ending before the date two years after the decedent's death. Trusts, however, are required to pay estimated income taxes on Form 1041-ES.
Trusts and estates have an advantage over individuals when it comes to deducting costs paid or incurred in administration so long as the costs would not have been incurred if the property were not held in the trust or estate. That is, these costs are not subject to the 2% floor for miscellaneous itemized deductions, BUT this can be a trap for the unwary so know the IRS rules. Tax Deductions In general, an estate or trust is allowed deductions for ordinary and necessary expenses incurred in carrying on a trade or business, in the production of income or the management or conversion of income-producing property, and in connection with the determination, collection or funding of any tax. Reasonable amounts paid or incurred by a fiduciary on account of administration, including fiduciary fees and expenses of litigation, are deductible, even though the estate or trust might not be engaged in a trade or business, unless the expenses were for the production or collection of tax-exempt income. A trust or estate can deduct losses from a trade or business or from transactions entered into for profit under Code '165(c) and Code '212. The rules governing non-business, casualty and theft losses apply to an estate or trust, so once the per-occurrence floor has been met, losses in excess of non-business, casualty and theft are deducible to the extent they exceed 10% of entity AGI. Bad Debt Deductions An estate or trust is entitled to claim bad debt deductions under the rules governing individuals. The distinction is maintained between business debts, which may be deducted in the year in which they become partial or totally worthless, and non-business debts which may be deducted as short-term capital losses only if they become totally worthless. Estate Taxes Oklahoma has repealed its Estate tax, so it no longer has a filing requirement. Unlike Oklahoma, the Federal government still requires the filing of a Form 706, Estate and Gift Tax Return, when the decedent's taxable estate exceeds $5 million (valid for 2011 and 2012; in 2013 the exemption amount is slated to return to $1 million unless Congress acts to increase this amount prior to that time). The Federal government allows you to QTIP a surviving spouse's interest in a unified credit or "B" Trust to reduce the taxable estate, while still preventing the assets in the B Trust from being taxed at the death of the surviving spouse. Be especially cognizant of the impact of the GST tax when filing estate tax returns. The GST tax is triggered when a gift is made to a distant heir (such as a grandchild) while the heir's parent (a child) is still living. A GST tax can be triggered by a direct or an indirect skip transfer. Business Dissolution The dissolution of a business can have significant tax consequences. Depending on the nature of the entity (C-Corporation, S-Corporation, LLC, FLP, etc.), the dissolution of a business can have significantly different consequences. How is it going to be dissolved? Is the entity being sold or just its underlying assets? Does the Will or Trust provide for a buy-out by one or more of the heirs and, if so, how is it to be structured? If a corporation is being dissolved, what happens to the accumulated depletion and depreciation allowances? If it is an LLC or limited partnership, does the governing instrument require that the partnership be terminated or can the ownership interest be transferred to new partners? Is "Keyman" insurance in place? What other potential problems exist? The most important thing to remember when dealing with the dissolution of a business is to examine its structure, assets, financial situation, and the tax consequences of the dissolution before proceeding.