Guide to Types of Estate and Trust Entities
Guide to Types of Entities
An estate or trust is a separate legal entity created under state law solely to transfer property from one party to another. The entity is separated by law from both the grantor and the beneficiaries. Understanding how the separate entities operate requires an understanding of the different types of entities there are.
Entities are classified into types based on their purpose. These types include:
- Decedent's Estates
- Simple Trusts
- Complex Trusts
- Qualified Disability Trusts
- Electing Small Business Trusts (ESBT)
- Grantor type Trust
- Bankruptcy Estates
- Qualified Funeral Trusts
- Split-Interest Charitable Trusts
The estate of a deceased person is a taxable entity that exists until all debts are paid, if possible, and assets have been distributed to heirs and other beneficiaries of the decedent. The income earned from the assets of the estate during the period of administration or settlement, which is usually no more than 3 years but can be much longer in some cases, is subject to tax. Generally, property received by the beneficiary of an estate, valued on the date of a decedent’s death, is not taxable income to the beneficiary (with the exception of Income In Respect of a Decedent (IRD)items). However, any income accruing after the decedent’s death will be taxed to whomever realizes the gain. Therefore, income received by the estate will be taxed either to the estate (if not distributed in the year that the income was received) or to the beneficiary. In addition, capital gains realized by the estate are ordinarily taxed to the estate. Income distributed must be reported on the beneficiary’s income tax return and is allowable as a deduction for the estate .
A simple trust is a trust that is required to distribute all of its income during the tax year in which it was received by the trust. In addition, only distributions of income are allowed to beneficiaries. Income, in this case, is defined under both local law and the governing instrument, the trust document. Historically, income has not included capital gains income; under most trust instruments and State laws, capital gains have been considered corpus. A trust will lose this classification if it distributes corpus in any tax year; thus, a trust cannot be a simple trust in its year of termination or any year of partial liquidation. Income of the trust is taxable to the recipient even if distributions are not made, although a simple trust itself can incur tax liability (i.e., realized long-term capital gains). In addition, the structure of a simple trust does not provide for charitable contributions.
Although similar in some ways to a simple trust and an estate, a complex trust is allowed to perform activities a simple trust cannot. Therefore, a complex trust satisfies at least one of the following conditions in a tax year: (a) retain some current income; (b) provide amounts to be paid, permanently set aside, or used for charitable purposes; or (c) distribute amounts allocated to the corpus of the trust. Like a simple trust, a complex trust is allowed a deduction for income distributed to beneficiaries and is allowed a standard exemption amount of $100. Like an estate, a complex trust may deduct unlimited amounts of gross income paid to recognized charities and any other amounts that were properly paid, credited, or required to be distributed in the tax year to beneficiaries. For beneficiaries of complex trusts, like those of estates and simple trusts, income distributed to them is reflected on their personal income tax returns.
Qualified Disability Trusts
A qualified disability trust is a nongrantor trust created solely for the benefit of a disabled individual under age 65. To be a qualified disability, all of the beneficiaries of the trust as of the close of the taxable year are determined by the Commissioner of Social Security to have been disabled (within the meaning of section 1614(a)(3) of the Social Security Act, 42 U.S.C. 1382c(a)(3)) for some portion of such year. A trust will still be considered a qualified disability trust if the corpus of the trust may revert to a person who is not so disabled after the trust ceases to have any beneficiary who is so disabled. Qualified disability trusts are eligible to claim a personal exemption of an individual.
Electing Small Business Trust (ESBT)
An ESBT is a statutory creature established by Congress in the Small Business Job Protection Act of 1996 (P.L. 104-188). A trust may own S Corporation shares if it meets the requirements of an ESBT. A trust may qualify as an electing small business trust and as an S Corporation stockholder even if the trustee does not distribute all of the trust's income annually to its beneficiaries. An election must be made for the trust to be treated as an ESBT.
Grantor type Trust
A grantor trust is an entity in which the creator (or grantor) retains some power or interest over the income and/or corpus of the trust. Created by a living individual, group of individuals, or other entity, this type of trust is not recognized as a separate taxable entity apart from its grantor for income tax purposes. Therefore, income earned by the assets of the trust is directly reported on the grantor or owner’s income tax return. For this type of trust, Form 1041 functions primarily as an information return. Accordingly, the grantor is deprived of any possible income tax advantages that might occur if the trust were taxed separately, such as lower marginal tax rates and a standard exemption amount.
A bankruptcy estate is created when an individual debtor files for bankruptcy under Chapter 7 (liquidation) or Chapter 11 (reorganization). This action creates an estate consisting of property that belonged to the individual debtor prior to the bankruptcy filing date. Many tax attributes of the debtor, such as net operating losses, credit carryovers, and capital loss carryovers, pass to the bankruptcy estate, although the bankruptcy estate itself is not allowed a standard exemption . In the case of these estates, Form 1041 is used only as a transmittal for Form 1040. This means that items calculated on Form 1040 are transcribed to Form 1041 for tax purposes. Therefore, the estate in bankruptcy can incur tax liability. While the fiduciary must file Form 1041 for the bankruptcy estate, the individual debtor must file his or her own individual income tax return.
Qualified Funeral Trust (QFT)
A qualified funeral trust arises as a result of a contract with a person engaged in the trade or business of providing funeral or burial services or property necessary to provide such services. The sole purpose of the trust is to hold, invest, and reinvest funds in the trust and to use such funds solely to make payments for such services or property for the benefit of the beneficiaries of the trust. The only beneficiaries of QFTs are individuals with respect to whom such services or property are to be provided at their death under the contract. The only contributions to the trust are contributions by or for the benefit of such beneficiaries. The trustee of the trust must make an election to be treated as a QFT.
Split-Interest Charitable Trusts
Split-interest means that the interest in the property is split into two parts: an income interest and a remainder interest. The income interest is separate from the remainder interest. Both interests can be assigned to a charity of charities, one or more non-charitable beneficiaries, or both depending on the type of split-interest charitable trust. In addition, charitable trusts engaging in business activities but organized to benefit charities are subject to the rules on unrelated business income. Based on the method and timing of distributions, split-interest charitable trusts are divided into the following four categories:
Charitable remainder annuity trusts - distribute income in a series of fixed payments to one or more noncharitable beneficiaries for a defined period of time, after which the remaining value of the trust is transferred to a charitable beneficiary.
Charitable remainder unitrusts - distribute a percentage of the fair market value to one or more noncharitable beneficiaries for a defined period of time, after which remaining value of the trust is transferred to a charitable beneficiary.
Charitable lead trusts - distribute a sequence of payments to a charitable beneficiary for a period of time, after which the remaining trust assets are transferred to a noncharitable beneficiary.
Pooled income funds - allow donors to donate assets to a charity. The pooled assets are invested as a group and each donor receives income based on the ratio of his or her contribution to the total value of the investment pool. After the death of the donor, his or her prorated share of the investment pool is withdrawn and given to the charitable organization.