Special Estimated Tax Exceptions for Trusts and Beneficiaries

For trusts, two little-known rules exist for calculating quarterly estimated tax payments based on the annualized income method, with one applying at the trust level and the other being available to a trust beneficiary.

Trusts

In general, a trust (or estate) is subject to the same estimated tax payment requirements as an individual (Sec. 6654(l)(1)). Thus, like an individual, a trust can avoid penalties for underpaying estimated tax either by making quarterly payments of at least one fourth of the prior year’s taxes or basing those quarterly estimates on annualized income for the current year. For an individual using the annualization method, the quarterly payments must be at least 90% of the tax due determined by annualizing taxable income for "the months in the taxable year ending before the due date of the installment" (Sec. 6654(d)(2)). For example, a payment due on June 15 is based on an individual’s income through May 31, and the estimate due on September 15 uses earnings through August 30.

Congress apparently realized, however, that although an individual can probably calculate taxable income within 15 days after the end of the month, a typical trust officer can have over 100 different trusts or estates for which to compute annualized earnings. Thus, trusts and estates are given an extra month to perform these computations. Rather than move the payment date back, however, Congress moved the cut-off date forward. The payment due on June 15, for example, covers income not through May 31 but, rather, through April 30. More importantly, the estimated tax payment due on January 15 only covers income through November 30, rather than the income for the full calendar year.

Thus, a "loophole" exists when a trust in existence for a full 12 months receives the vast majority of its earnings in December. This could occur, for example, due to either a large capital gain on a sale in December of a highly appreciated asset, or because the trust invested in a deferred annuity and only withdraws funds in December. Because the annualized estimated tax payment due on January 15 does not include the December earnings, no estimated tax payments are required for the entire year. Although it is probably not effective to try to intentionally administer a trust or estate with the goal of avoiding estimated tax payments by pushing all the income into December, a wise tax adviser can look like a "hero" by using the special rules when this situation presents itself.

Beneficiary

As mentioned, individuals have the option of basing their estimated tax payments on the annualized income for the "months in the taxable year ending before the due date for the installment." Thus, for individuals (unlike trusts), the January 15 estimate must include all income up through and including December. A beneficiary of a trust or an estate, however, may have taxable income reported for December that (as of January 15) was not otherwise taxable to him or her as of the end of December, and in fact is showing up on his or her return based solely on elections made by the trustee as late as March 5 following the end of the year.

In general, a beneficiary of a complex trust or an estate is taxed only on the amount of income actually distributed during the tax year (Sec. 662(a)). If no distributions occur, the earnings for the year are taxed to the trust or estate. A trust (or an estate after 1997) can, however, choose to make a distribution during the first 65 days of the tax year and have it be treated as a distribution "on the last day of the preceding taxable year" (Sec. 663(b)(1)). This rule gives the trustee (or executor) a limited period to calculate the taxable income for the preceding year and then make distributions, shifting this income to the beneficiary’s (presumably lower) tax rates, rather than paying tax at the trust’s compressed tax brackets.

Because the beneficiary does not know as of January 15, whether or not the trustee or executor will make this distribution sometime prior to March 5, Rev. Rul. 78-158 specifically stated that the beneficiary is not required to include this income in annualized earnings when computing the January 15 estimated tax payment. This is true even though the income related to the "65 day" distribution will show up on the beneficiary’s personal income tax return as if it had been distributed in December.

For example, assume that a trust not required to distribute its earnings (i.e., a "complex trust") has $100,000 of taxable income for 2002, but has distributed only $2,000 during the year. On Feb. 1, 2003, however, the trustee chooses to distribute $95,000 to the beneficiary and makes a Sec. 663(b) election to tax those earnings to the beneficiary. As of January 15, the beneficiary does not know that the trustee will make this distribution the following month and thus makes personal estimated tax payments based solely on his or her annualized income, including only $2,000 of trust earnings. Even though the beneficiary will not have deposited (in estimated tax payments) at least 90% of the tax on the total income ultimately shown on his or her 2002 return, there will be no underpayment penalty, because the $95,000 trust distribution can be excluded from the beneficiary’s annualized earnings calculation.

Conclusion

Admittedly, both of these exceptions are unusual and infrequently used. Nevertheless, when the particular situation arises, a tax adviser can seize the opportunity to help a client avoid potentially significant underpayment penalties simply by "knowing the loopholes."

From Marvin D. Hills, CPA/PFS, South Bend, IN