Wednesday, May 12, 2021
My article last month on the use of the revocable trust in an estate plan generated many nice comments. You can read that article here: https://lawprofessors.typepad.com/agriculturallaw/2021/04/the-revocable-living-trust-is-it-for-you.html. I also received several questions concerning what happens from an income tax standpoint when the grantor of the trust dies. After answering those questions, I thought it might be a good idea to write an article on it for the blog.
What are the income tax impacts of a revocable trust when the grantor dies – it’s the topic of today’s post.
Income Tax Issues for the Year of Death
When the grantor of a revocable trust dies, the trust assets are not impacted. The trust continues according to its terms and, as mentioned in last month’s article, the assets contained in the trust are not included in the decedent’s probate estate. For income tax purposes, the trust is required to obtain a taxpayer identification number (TIN). That’s the case even if the trust had obtained a TIN during the grantor’s lifetime. Treas. Reg. §301.6109-1(3)(i)(A). That means that the trustee will likely have to establish new accounts for the trust with banks and other financial institutions with which the trust does business.
For the year of the grantor’s death, all tax items must be allocated between the grantor and the trust for the pre-death and post-death periods. This requires the trustee to establish some type of system to make sure that the proper amounts of income, loss, deduction, credit, etc., are allocated appropriately in accordance with the trust’s method of accounting.
Returns and Reporting Issues
When the grantor of a revocable trust dies, the trust is no longer a grantor trust. Thus, all tax-related activity of the trust that occurred before the grantor’s death during the year of death must be reported on the grantor’s final income tax return. Upon the grantor’s death, the trust becomes a separate taxpayer (from the grantor’s estate) with a calendar year as its tax year. I.R.C. §644(a). Because of this separate taxpayer status, the grantor’s estate will also have to obtain a TIN and report tax items separately from those of the trust.
Note: If the terms of the trust require all of the trust income to be distributed annually but not trust corpus, the trust is a “simple” trust. If not, the trust is a “complex” trust.
Note: The grantor’s estate can elect either a fiscal year or a calendar year for tax reporting purposes. When a grantor dies late in the year, it may be beneficial for the executor of the grantor’s estate to elect a fiscal year. That may provide some ability to use tax-deferral techniques for the estate or the beneficiaries and can allow the executor more time to deal with administrative duties concerning the estate.
One technique that can help simplify tax filings after the grantor dies is for the trustee to work with the administrator of the grantor’s estate in considering whether to make an I.R.C. §645 election. The election can be used for certain revocable trusts, and has the effect of treating the trust as part of the decedent’s estate. I have written about the I.R.C. §645 election here: https://lawprofessors.typepad.com/agriculturallaw/2020/11/merging-a-revocable-trust-at-death-with-an-estate-tax-consequences.html. To recap that article, the election can reduce the number of separate income tax returns that will have to be filed after the grantor’s death. The irrevocable election is made via Form 8855.
A Sec. 645 election makes available several income tax advantages that would not otherwise be available in a separate trust tax filing. I detailed those in my article linked above that I wrote last fall, but for our purposes here, while the election is in force (two years if no federal estate tax return is required to be filed; other deadlines apply if a Form 706 is required (See Treas. Reg. §1.645-1(f)) income and deductions are reported on a combined basis – all trust income and expense is reported on the estate’s income tax return. The one exception is for distributable net income (DNI). DNI is computed separately. The combined reporting on the estate’s income tax return might be on a fiscal year instead of the calendar year-end that is required for trusts.
When the election period terminates, the “electing trust” is deemed to be distributed to a new trust. That’s a key point to understand. The new trust must use the calendar year for reporting purposes. As a result, the trust beneficiaries might receive two Schedule K-1s if the co-electing estate files on a fiscal year.
If the decedent’s estate was large enough to require the filing of Form 706, the assets in the revocable trust are aggregated and reported on Schedule G. They are not listed separately. Part 4 should be answered, “yes.” In addition, a verified copy of the trust should be attached to Form 706.
Complexity of Farm Estates
A decedent’s estate is a separate entity for income tax purposes. In general, an estate’s net income, less deductions for the value of property distributed to heirs, is taxed to the estate. The distributions are taxed to the heirs in the calendar year which includes the last day of the estate fiscal year during which the distributions were made. When these principles are applied to the unique aspects of a farmer’s estate, problems (and opportunities) arise. A farmer’s estate has numerous attributes that require specialized application of the general principles of estate income taxation. Those include the seasonal nature of the business with bunching of income and expense in different times of the year; a complex mix of land and depreciable property that is subject to recapture; inventory; common use of income tax deferral due techniques; the problem of establishing income tax basis in property; determining accurate property inventories; and unique capital gain holding periods for certain assets.
A revocable trust is a common and often beneficial part of the estate plan of a farmer or rancher. But, understanding the tax issues when the trust grantor dies is important. Likewise, fitting the tax aspects a revocable trust that are triggered by the grantor’s death with the overall complexity of an agricultural estate is crucial.