CFP - Tax Planning (14% of the exam) - Section E.39

Income taxation of trusts and estates

Simple versus complex trusts, distributable net income, the income distribution deduction, grantor trust rules, compressed fiduciary tax brackets, the 65-day rule, and how income is taxed to the trust versus the beneficiary. Items compute or allocate trust income for a described distribution.

Subchapter JDistributable net incomeGrantor trust rules

Practice question for this objective

Free sampleTax Planninghard

The Calloway Trust is a complex trust with one beneficiary, Aaron. For the current tax year its distributable net income is 60,000 dollars, made up of 35,000 dollars of taxable interest, 15,000 dollars of qualified dividends and 10,000 dollars of tax-exempt municipal bond interest. The trust has no deductible expenses other than any distribution deduction, and no expense is allocable to the tax-exempt interest. During the year the trustee pays Aaron 90,000 dollars in cash, of which 30,000 dollars comes out of principal. What distribution deduction may the trust claim on Form 1041 for the year?

A90,000 dollars, the full amount of cash paid to Aaron during the year, since the trustee distributed both the current income and the additional principal to him.
B80,000 dollars, the full amount of cash paid to Aaron reduced by the 10,000 dollars of tax-exempt interest included in the trust's distributable net income for the year.
C60,000 dollars, the trust's whole distributable net income for the year, because the trustee paid Aaron more than that amount and so carried all of it out to him.
D50,000 dollars, being the trust's distributable net income for the year reduced by the tax-exempt interest that distributable net income contains. Correct

Compute a trust's distribution deduction as the lesser of amounts distributed and distributable net income, then reduce it by tax-exempt income. Distributable net income both caps the trust's deduction and caps what the beneficiary includes, and it preserves the character of each class of income as it passes through. The arithmetic runs in two steps. First, the lesser of the 90,000 dollars distributed and the 60,000 dollars of distributable net income is 60,000 dollars. Second, that amount is reduced by the 10,000 dollars of tax-exempt interest inside distributable net income, giving a deduction of 50,000 dollars. Aaron's Schedule K-1 reports 35,000 dollars of interest and 15,000 dollars of qualified dividends as taxable, plus 10,000 dollars of tax-exempt interest that he reports but does not pay tax on. The remaining 30,000 dollars of principal is not income to him.

Why A is wrong: Tempting because a complex trust may indeed distribute principal and the whole 90,000 dollars did leave the trust. It is wrong because distributable net income is a ceiling on the deduction, so the 30,000 dollars of principal carries out no income and generates no deduction.

Why B is wrong: Tempting because it applies the correct tax-exempt adjustment. It is wrong because the adjustment is made after the distributable net income ceiling has been applied, not to the gross amount distributed, so it still deducts 30,000 dollars of principal that carries out no income.

Why C is wrong: Tempting because it correctly applies the distributable net income ceiling. It is wrong because it leaves the tax-exempt interest in the deduction; the trust cannot deduct income that was never taxable to it, so the 10,000 dollars of municipal interest must come out.

Why D is correct: Correct. The deduction is the lesser of the amount distributed and distributable net income, which is 60,000 dollars, and that figure is then reduced by the 10,000 dollars of tax-exempt interest inside it, giving 50,000 dollars.

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Exam traps in Tax Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

The trust is taxed on the whole 70,000 dollars at its own compressed rate brackets, because it accumulated the income during the year and made no distribution to either grandchild that could carry income out.
Why it is wrong: Tempting because that is exactly the outcome for an ordinary accumulating complex trust, where retained income is taxed at the trust's steeply compressed brackets. It is wrong here because the grantor trust rules are applied first, and once they apply the trust is not a separate taxpayer at all.
It remains a simple trust, because the mandatory income distribution clause in the deed governs classification and the payment to the university is treated as a distribution of principal rather than of income.
Why it is wrong: Tempting because the deed does mandate current income distributions and forbids principal distributions to Miriam, which are two of the three tests. It is wrong because classification turns on what the trust actually did during the year, and a charitable payment made out of gross income is not recharacterised as a principal distribution.
The penalty cannot be asserted at all, because the 22,000 dollar understatement is well under 25 per cent of the 96,000 dollars of tax required to be shown on her return.
Why it is wrong: Tempting because 25 per cent is a real threshold elsewhere in the rules, but it belongs to the substantial omission of gross income test for the assessment period, not to the substantial understatement penalty.

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