1041 v. 1040 taxable income for estate planning trusts

If your mother is still alive, a 1041 should be filed for only your father's trust.

It's customary because bracket creep is so steep for trusts that individuals generally pay tax on the same income at a lower rate.

Was it or could it be represented to have been transferred to your mother's trust? If so, it's ok.

The Survivor's Trust is generally a revocable trust, and as such is completely transparent for tax purposes. That is to say that no tax return is filed for it, and all income and deductions of the trust are taken on your mother's return as if they were all hers. Because in reality they are.

Income from the decedent's trust should go into the account of the survivor's trust, and spent from there. That's all you need to do.

You have not given enough information, but it appears that you are not handling the assets of the decedent's trust correctly.

Stu

Good assumption ;-). Thanks for your quick feedback.

That is what I thought, too, and my mother's (new) estate attorney made the same comment off-handedly.

But when I mentioned it to a prospective CPA (we are currently interviewing for a replacement), he suggested that since 1041s have been filed for the Survivor's Trust for so many years now, it might be better to continue, lest the IRS raise questions about the sudden stoppage.

Reading the instructions for 1041 (I know: I really need to read Pub 559 eventually), it appears that a skeletal 1041 for the Survivor's Trust should indeed be filed. By "skeletal", I mean that it should contain only the entity information, but no dollar amounts (page 6 of the 2007 1041 instructions). Even so, that is less than the recently-fired CPA has been doing for years. This confirms that what he is doing was incorrect, as you say.

Alternatively, we could use one of two optional filing methods (page 7), both of which obviate the need to file 1041. Perhaps that is what you have in mind. Option 1 seems like the easiest. That also seems to obviate the need to get an EIN for the revocable trust. They did get an EIN for the Survivor's Trust when the AB Trust assets were divided several years ago. I was not involved in the decisions at that time. But in hindsight, I had always thought it was unnecessary.

And aha! It appears that the prospective CPA's advice is correct after all, at least to some degree. Under "Changing Filing Methods" (page 7), we must now file a "final" 1041 return for 2007 with the words "pursuant to sec 1.671-4(g)" in order to obviate the need for a 1041 for the revocable Survivor's Trust in 2008, opting for Option 1 (or 2) instead.

Option 1 would also require that we file new W-9s with financial institutions, replacing the Survivor's Trust's EIN with my mothers SSN (TIN). I'm sure that does not sound like a "big deal" to most people. In my case, it is. Long story; personalities involved; not worth getting into here. But suffice it to say, it is not an insurrmountable problem.

Is my understanding correct, at least to some degree?

I can work out the details with either my mother's estate attorney (who is also a CPA, but prefers not to practice as such) or my mother's new CPA eventually.

I don't see how, since there have been no actual distributions of income, as I said ("all of the income remained in the trust assets").

Why do you say that?

The trust document does not "require" that the Decedent's Trust distribute income to my mother, the only living beneficiary. On the contrary, it states: "Income shall be accumulated and added to the principal, except as provided by paragraph 2", which states: "Trustee [my mother] shall have the discretion to distribute accumulated income and principal for Spouse's [my mother's] proper health, support and maintenance".

I have been told that that is fairly standard language for a trust of this type.

Moreover, every legal and financial advisor has told us that it is preferrable for my mother not to take income from the Decedent's Trust before diminishing the value of her own estate. They said that this decreases the chance of paying estate tax when she dies, since the Decedent's Trust is no longer subject to estate tax, whereas her own estate will be (that is, any amount over the applicable lifetime exclusion in effect at the time, less any annual gifts in excess of the annual exclusion during her lifetime).

(But see the "PS" below.)

So I believe we have done nothing wrong per se with "handling the assets" or the income therefrom.

But my question was and still remains: given the way that we have handled income from the Decedent's Trust (that is, by not distributing any of it, as the trust document permits), has the handling of the Decedent's Trust 1041 per se been correct?

Specifically, the Decedent's Trust 1041 says the income was distributed to my mother, whereas in fact it was not. Given that it has not been distributed, should the 1041 instead reflect that fact, causing the income to be taxed base on the trust tax rate schedule?

PS.... Of course, if that is the case, it raises the question: in the long run, would it be to distribute the income to my mother rather so that it can be taxed at the lower personal tax rate than if it remains in the Decedent's Trust?

That's rhetorical. I presume that is a hard question that is beyond the scope of this forum, and the answer depends on facts that I cannot share here. I just wanted to acknowledge that I "get" the fact that continuing not to distribute the Decedent's Trust income might not be a prudent course of action, even if it is permitted by the trust document.

Thanks again for your inputs.

Big snip (OP has >>, Stu has>)

Funds that the K-1 show as being distributed should be distributed. Your mother can buy CD's or make other investments with any distributed funds that are surplus to her needs. She may want/need those funds in the future. Let's put off the day that your mother has to invade the principal of the Decedent's Trust (if permitted by the trust) . I don't know who the trustee is but you might consider buying a hour of an estate lawyer's time to get up to speed.

You can read the forms and see - the tax on money held within the trust have a very high rate compared to most people's personal tax rates. If she has the choice and the trust is written to allow it, she should be given at least the yearly income, and claim it through a K-1 on her personal return. You asked earlier - "Is it truly customary to "distribute" (on paper) the estate trust income for both trusts and pay tax on it on the personal tax return?" The distribution should take place in fact, not just on paper. JOE

They can be filed, but it's not necessary to go to the expense.

What money has your mother been living on? From an income tax standpoint she should be first living off the money in the decedent's trust, and then only using money from the survivor's trust to the extent necessary. Of course, from an estate tax standpoint the opposite could be true, if her estate is large enough.

When I say "incorrect" I do not mean "illegal." What I mean is that from a financial standpoint the assets could be handled much better. If her estate is not large enough to worry about estate taxes, income should have been distributed from the decedent's trust, and used for your mother's expenses, before any money is used from the survivor's trust. If her estate is too large and the decedent's trust is throwing off too much money, change the investments to things that have more internal growth and less current income.

Not legally wrong, no, other than claiming trust deductions for distributions that didn't take place.

But if you don't distribute income from the decedent's trust, you should not take the deduction for distributions.

It's not legally incorrect to do that. But then the trust should not take deductions for distributions it did not make. If the IRS finds out, they could ask for the additional taxes the trust would have paid over what your mother did, plus interest and penalties.

That brings up the dilemma of whether distribution of those assets will increase the chances your mother's estate will be required to pay estate taxes. It depends on her precise circumstances. Given that her tax advisor thinks her estate is large enough to be concerned about estate taxes, you're probably better off shifting the decedent's trust to non-(current)-income producing assets.

Stu