Federal Income Taxation of Estates, Trusts, and Decedents
Estate and trust income tax basics
Estates and trusts are separate taxable entities using Form 1041. Understand distributable net income (DNI), which caps the deduction for distributions and determines the character of income to beneficiaries. The entity is taxed on retained income; beneficiaries are taxed on distributed income. Know the tier system for distributions and the importance of the entity's fiscal year.
Decedent's final return
A decedent's final Form 1040 covers income through date of death. Income received after death belongs to the estate or to the beneficiary, depending on entitlement. Know the treatment of medical expenses paid after death (may be deductible on the estate tax return if not claimed on the final income tax return) and the deduction for estate taxes attributable to income in respect of a decedent (IRD).
Traps
- DNI is not the same as taxable income; it is computed with adjustments and limits the distribution deduction.
- IRD is taxable to whoever receives it and does not receive a stepped-up basis.
- Choosing the estate's fiscal year end affects administration and planning.
- The final return and the estate return are separate; do not double-count income.
Worked example
An estate earns $40,000 of interest and distributes $25,000 to the sole beneficiary. DNI is $40,000; the estate deducts the $25,000 distribution, and the beneficiary reports $25,000 of interest income. The estate is taxed on the retained $15,000.