- Form 56. Notice of a fiduciary relationship, Form 56, should be filed with the IRS office where the Form 1041 is filed to assure that the trustee receives tax notices: (1) For an initial return it can be file with the return; (2) When there is a change in trustees. This is important and often overlooked. The new trustee could have personal liability for unpaid taxes and if the IRS has no notice of the trustee name and address notices could be missed; and (3) on termination of the trust. The document terminating the trust should be attached. A copy of every Form 56 should also be kept in the trust permanent records.
- Estimated Tax non-grantor trusts may be required to make estimated tax payments. A decision should be made whether the trustee should elect to have any of the estimated tax paid to the beneficiary (e.g., if distributions result in the income being passed out to the beneficiary who as a result may have underpaid his/her estimated tax). File Form 1041-T. This must be filed on or before the 65th day after the close of the trust’s tax year.
- Grantor Trust Status. Determine whether the trust is properly characterized as a grantor trust for income tax purposes. If the trust provisions that create grantor trust status are capable of being turned off the trustee should corroborate whether or not grantor trust status has been changed. If the trust relies on a particular mechanism to achieve grantor trust status, such as the right to substitute assets or add charitable beneficiaries, if those rights were waived, grantor trust status might have terminated. Trustees might obtain confirmation from the various powerholders that the powers were not waived or exercised. If the trust is a grantor trust the trustee must choose which of the optional methods to use to report income.
- Passive Losses/Net Investment Income Tax. If the trust owns interests in entities that generate losses a determination has to be made as to whether the trust is a material participant in those activities such that the losses will be deductible, or so that the income will not be subject to the 3.8% surtax. How this test should be addressed in the context of trusts is uncertain. The IRS reached the opposite conclusion in various Technical Advice Memoranda that courts have reached maintaining that it is only the activities of the trustee in such capacity that should be considered in the analysis. The trustee should consider what steps if any can be taken to support material participation and what records should be maintained to corroborate that participation.
- Non-Resident Beneficiary If there are non-resident alien beneficiaries the trust may be required to withhold income tax on certain distributions. Advise the trustee of the requirements and file Forms 1042 and 1042-S. The trustee may also have an obligation to file Form 1040-NR for that foreign beneficiary unless the alien has handled the filing or has appointed an agent to do so.
- State Tax Status Determine which states the trust must report income and document the basis for the decision reached. A state will tax a resident trust on world-wide income, and a non-resident trust only on income within the state. A trust is characterized as a resident trust based on the residence of the grantor, beneficiaries and/or trustees, and/or on the basis of the situs of trust assets or the specifications in the trust agreement. Some states tax based on residency of the fiduciaries. If there has been a change in fiduciaries (trustee, investment adviser, etc.), or the location of trust real estate assets, or the operations of an active business in which the trust owns an interest could all affect state tax nexus. If it is feasible for the trustee to change favorably change state taxation of the trust, e.g., by changing trustees or assets, consideration might be given to documenting the decision reached and the basis for it.
- Investment and Other Deductions Expenses of a non-grantor trust may be subject to the 2% of adjusted gross income floor. IRC Sec. 67(e)(1). The rules as to which expenses are unique to the administration of a trust and not subject to this have been subject to considerable controversy. Trustees may be required to unbundle (break down) their fees to determine the nature of the services rendered and to what extent, if any, part of otherwise deductible fees under IRC Section 212, may be subject to reduction by the 2% floor. Records of the calculations and the basis for them should be retained.
Trust Administration: Trust Records Provide A Roadmap To Proper Trust Management Part 3
This is the third and final article in a series intended to help trustees identify many of the steps to be taken and documents they might consider retaining as part of the permanent trust records. Proper trust documentation may not only corroborate proper operation of a trust, but create a record to guide trustees and others in trust operation.
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