Page 59 - Successor Trustee Handbook

When each beneficiary’s individual Trust is setup (usually at the end of the initial Trust
administration), each individual Trust will require a taxpayer identification number and
tax return. When we speak about tax returns, keep in mind that there will not only be
Federal income tax returns (Form 1041), but also, depending on the legal location of the
Trust (or Trust “situs”, which your attorney and accountant will need to determine), there
may also be a state income tax return due. Some states do not have an income tax, but
may have another tax for which the Trust may be required to file a return, such an
“intangible property” tax.

Whether or not a Trust will actually pay any income taxes basically depends on whether
the Trust or the beneficiaries of the Trust end up with the trust income by the end of the
Trust year (plus a 65-day grace period after the end of the tax year). In other words, the
Trust will be required to file income tax returns, but if a Trust distributes its potentially
taxable income through this period, the beneficiaries will report the income they have
received on their own personal income tax returns, and they will be responsible for
paying the taxes. Since individuals are usually in a lower income tax bracket than a
trust, you should consult with your accountant toward the end of each tax year to
determine whether distributions to beneficiaries should be made (if the Trust terms
permit and in what amounts). However, you cannot always let the “tax tail wag the
dog” and may want to pay higher income taxes at the Trust level, rather than distribute
to a beneficiary who may squander the money or use it for less than worthwhile
purposes, or lose the protection that the Trust may be able to afford him or her against
a spouse in a divorce, creditors, lawsuits, and loss of government needs-based benefits;
therefore, the question of whether to make distributions to beneficiaries may also be
one to run by your attorney.

Upon the death of the first spouse of a married couple, assuming that “A, B and C”
Trusts are to be established, you will need to review with your attorney the effect that
allocation of certain assets to each of these new Trusts will have in the future for
income tax purposes. For example, if the surviving spouse’s residence is allocated to
the A Trust, then if that property is later sold within his or her lifetime, he or she may be
able to fully utilize the federal capital gains exclusion (currently $250,000); however,
this exclusion is not available to the B and C Trusts. Assets allocated to the A and C
Trusts will be allowed a “step-up” in their income tax basis to the fair market value of
those assets at the date of the death of the second spouse; this will effectively allow
depreciable properties like real estate to generate greater tax deductions, and will
reduce potential capital gains taxes when those A and C assets are later sold. Again,
you cannot let the income “tax tail wag the dog”, as there may be very sound estate
tax and other reasons for allocating the home to the B and C Trusts and the other
growth-oriented assets to the B Trust. These are issues you will need to review with your
attorney at the time that the allocation of assets to the A, B and C are made. (See
also, Chapter 15, “Estate Taxes”).

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