Death and Taxes: Form 1040 and Form 1041
Benjamin Franklin once said nothing was certain in life but death and taxes. Federal income tax is charged on a person, their estate, and/or their trust. Kansas and Missouri have individual and fiduciary income taxes, but no state estate, gift, or generation skipping transfer (GST) taxes.
When a person dies, two tax returns are usually filed for the tax year: (1) a final Form 1040 for the deceased person and (2) a Form 1041 for the deceased person’s estate and/or trust. Form 1040 is the familiar individual income tax return, while Form 1041 is the (often less familiar) fiduciary income tax return. Just like Form 1040 captures an individual’s or married couple’s income and deductions for the year, so Form 1041 captures the estate and/or trust’s taxable income, expenses, or deductions. Often both tax returns are “short year” returns, covering less than 1 year each (since the person lived less than a full year). The final Form 1040 covers the decedent’s income from January 1 through the decedent’s date of death, while the Form 1041 captures income from the decedent’s date of death through December 31. A final Form 1041 may be filed jointly with the surviving spouse.
An estate files Form 1041 if the estate had: (1) gross income of at least $600 for the tax year or (2) a nonresident alien beneficiary. A trust files Form 1041 if the trust had: (1) any taxable income for the tax year, (2) gross income of at least $600 for the tax year, or (3) a nonresident alien beneficiary. Schedule K-1 (of Form 1041) reports an estate and/or trust beneficiary’s share of income, deductions, credits, or other items. An estate can claim a $600 annual personal exemption. Most trusts only get a $100 exemption, but trusts that must distribute all accounting income get a $300 personal exemption.
Trust Income Taxes: Mind the Gap
A trust has three roles – (1) grantor, (2) trustee, and (3) beneficiary – and a trust can be taxed three ways: a trust’s income taxes could be paid by the trust’s (a) grantor, (b) trustee, or (c) beneficiary. Most trusts are designed so the trustee pays income taxes. But many trusts are designed so the grantor or the beneficiary picks up the tax bill.
Grantor Pays the Tax Bill: the Intentionally Defective Grantor Trust (IDGT)
The grantor could start an intentionally defective grantor trust, where the trust income is taxable to the grantor and the trust money is not included in the grantor’s estate, since the trust is irrevocable and outside the grantor’s control, while the grantor pays the trust’s income tax bills.
Trustee Pays the Tax Bill
Usually the trustee pays the trust’s income taxes from the trust’s assets. But trusts can be designed so the beneficiary or the grantor pays the trust’s income taxes, while the trust assets are not included in the beneficiary or grantor’s estate. Some irrevocable trusts need a third party trustee (like a bank or trust company) to avoid income tax issues when making distributions to a beneficiary, but a beneficiary can guide the trust’s investment strategy (even as “investment trustee”). Control is key – if the IRS allows a person to exclude assets from their estate, the person cannot control those assets.
Beneficiary Pays the Tax Bill: the Beneficiary Defective Inheritor’s Trust (BDIT)
A beneficiary could have a beneficiary defective trust, where the trust income is taxable to the beneficiary/recipient, but the trust money is not included in the beneficiary’s estate, since the trust is irrevocable and outside the beneficiary’s control, while the beneficiary pays the trust’s income tax bills.
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(c) 2015, Stephen M. Johnson, Esq.