TAXATION OF ESTATES AND TRUSTS
BY STEPHEN BROOKS, CPA/PFS, CFP, MST
Notice to readers
Form 1041: Income Taxation of Estates and Trusts is intended solely for use in continuing professional education and not as a reference. It does not represent an official position of the American Institute of Certified Public Accountants, and it is distributed with the understanding that the author and publisher are not rendering legal, accounting, or other professional services in the publication. This course is intended to be an overview of the topics discussed within, and the author has made every attempt to verify the completeness and accuracy of the information herein. However, neither the author nor publisher can guarantee the applicability of the information found herein. If legal advice or other expert assistance is required, the services of a competent professional should be sought.
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ISBN 978-1-119-76379-6 (Paper)
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Course Code: 736955 ITET GS-0419-0A Revised: May 2019
Chapter 1 What is a Trust? What is an Estate?
Learning objectives
Identify the elements of a trust.
Recognize the difference between a trustee and a trustor.
Distinguish between probate and nonprobate assets.
Recall the basics of trust and estate administration.
Introduction
This course will provide a comprehensive look at the income taxation of trusts and decedents' estates and the beneficiaries of trusts and estates under the IRC. Trusts and estates are treated as separate taxable entities under the IRC, and they are unique in the way they are treated. Essentially, trusts and estates are what might be termed “semi-conduits.” That is, to the extent that they retain income, they are taxed on that income, and to the extent that they distribute income to the beneficiaries, the beneficiaries are taxed. Before we discuss in detail the taxation of trusts and estates, and the beneficiaries of each, you must first have an understanding of these entities, how they are created, and how they operate.
What is a trust?
Definition of a trust
A trust is a legal contract between the creator and the trustee for the benefit of another individual, a charitable organization, or an animal. The trustee has a fiduciary duty to abide by the terms in the trust agreement. The creator of the trust is often referred to as the settlor, grantor, or trustor. When a trust is created, the trustee takes legal title and management power over the trust property.1 The individual, organization, or animal that is benefited by trust is called the beneficiary.
Terms of the trust
The settlor's intentions in regard to how the trust property is to be held, administered, and distributed for the benefit of the trust beneficiaries are referred to as the “terms of the trust.”2 If the trust is evidenced by a written agreement, or in the settlor's last will and testament, the terms of the trust will be provided in the trust agreement or the will.
Methods of creating a trust
A trust may be created by a transfer in trust made in the settlor's will (a testamentary trust), or a transfer in trust during the settlor's lifetime (an inter vivos trust). A trust can also be created by a simple declaration by the settlor that he or she holds property as trustee, or by the exercise of a power of appointment appointing property to a person as trustee.3
Requirements to form a valid trust
In general
Under the Uniform Trust Act, a trust can only be created if all of the following are present:
The settlor is of the age of majority. The settlor has capacity.
The settlor has the intention to create a trust. There is a beneficiary.
The trustee has duties to perform.
The settlor, trustee, and beneficiary are not the same person.
These requirements will be discussed in detail in the following material.
Age of majority
The settlor must be the age of majority when the trust is created. The age of majority will be determined by state laws that govern the trust. Typically, the age of majority is either 18 or 21.
Capacity
In order to create a trust, the settlor must have the requisite mental capacity. The level of mental capacity will differ depending upon if the trust is a revocable or irrevocable trust as well as which state the trust is created in.
Intention to create a trust
There must also be an outward expression by the trust settlor of his or her intention to create a trust. No particular words are required to create the trust and the words may be written or spoken.4
Definite beneficiaries
A trust must have definite beneficiaries. A beneficiary is definite if the beneficiary can be determined, either now or in the future. If the trustee has the power to select a beneficiary from an indefinite class, that is valid. If the power is not exercised within a reasonable time however, the power fails and the property subject to the power passes to the persons who would have taken the property had the power not been conferred. Many dynasty trusts are created with the intent to benefit all future generations for as long as the trust can exist, as governed
