Why might you need a trusteed IRA?

In a typical IRA, your beneficiary takes control of the IRA assets upon your death. There's nothing to stop your beneficiary from withdrawing all or part of the IRA funds at any time. This ability to withdraw assets at will may be troublesome to you for several reasons. For example, you may simply be concerned that your beneficiary will squander the IRA funds. Or it may be your wish that your IRA "stretch" after your death–that is, continue to accumulate on a tax-deferred (or in the case of Roth IRAs, potentially tax-free) basis–for as long as possible. IRA owners sometimes select much younger IRA beneficiaries because their young age means a longer life expectancy, and this in turn requires smaller required minimum distributions (RMDs) from the IRA each year after your death–allowing more of your IRA to continue to grow on a tax-favored basis for a longer period of time. Your intent to stretch out the IRA payments may be defeated if your beneficiary has total control over the IRA assets upon your death.

Even if your beneficiary doesn't deplete the IRA assets, in a typical IRA you normally have no say about where the funds go when your beneficiary dies. Your beneficiary, or the IRA agreement, usually specifies who gets the funds at that point. And in a typical IRA, particularly a custodial IRA, your beneficiary is responsible for investing the IRA assets after your death, regardless of his or her inclination, skill, or experience.

A trusteed IRA can help solve all of these problems. With a trusteed IRA, you can't stop the payment of RMDs to your beneficiary but you can restrict any additional payments from this IRA. For example, you could maximize the period your IRA will stretch by directing the trustee to pay only RMDs to your beneficiary. Or you can ensure that your beneficiary's needs are taken care of by providing the trustee with the discretion to make payments to your beneficiary in addition to RMDs as needed for your beneficiary's health, welfare, or education.

Another option is to impose restrictions on distributions only until you're comfortable your beneficiary has reached an age where he or she will be mature enough to handle the IRA assets.
In each case, the balance of the IRA (if any) passing, upon your beneficiary's death, can be paid to a contingent beneficiary of your choosing (the contingent beneficiary will continue to receive RMDs based on your primary beneficiary's remaining life expectancy). For example, if you've remarried, you may want to be sure your current spouse is provided for upon your death, but also that any IRA funds remaining on your spouse's death pass to the children of your first marriage. Or you may want to ensure that if your spouse remarries, his or her new spouse won't be the ultimate recipient of your IRA assets.

A trusteed IRA can also be structured to qualify, for example, as a marital, QTIP, or credit shelter (bypass) trust, potentially simplifying your estate planning.
Finally, a trusteed IRA can even be a valuable tool during your lifetime. For example, the IRA can provide that if you become incapacitated the trustee will step in and take over (or continue) the investment of assets, and distribute benefits on your behalf as needed or required, ensuring that your IRA won't be in limbo until a guardian is appointed.

How do you establish a trusteed IRA?

First, you'll need to find a trustee that offers IRA planning services. Not all do, and the ones that do don't all provide the same amount of flexibility. So you may need to shop around to find a trustee that can meet your particular needs. As with a typical IRA, you'll name the beneficiary of the IRA. You and your attorney will work with the trustee to draft a beneficiary designation form and trust agreement that contain any custom language that you need.

Is a trusteed IRA right for you?

While trusteed IRAs can be as flexible as a particular trustee will allow, they're not right for everyone. The minimum balance required to establish a trusteed IRA, and the fees charged, are usually significantly higher than for typical custodial IRAs, making trusteed IRAs most appropriate for large IRA accounts. You may also incur significant attorney fees and other costs. And in some cases, another approach might be more appropriate. For example, you may be able to achieve the same results as a trusteed IRA by instead naming a trust as the beneficiary of your IRA.

The "see-through" trust

Unlike a trusteed IRA, where the trust is the IRA funding vehicle and you select the beneficiary of the IRA, with a see-through trust you name the trust itself as the IRA beneficiary, and you also select the beneficiary of the trust.

Normally, when you name an IRA beneficiary that isn't an individual (i.e., a trust, charity, or your estate), that beneficiary must receive the entire balance of your IRA within five years after your death. However, special rules apply to trusts. If specific IRS rules are followed, then the trust beneficiary, and not the trust itself, will be deemed the beneficiary of the IRA, allowing RMDs to be calculated using the trust beneficiary's life expectancy and avoiding the five-year payout rule. Because the IRS looks beyond the trust to find the IRA beneficiary, this is commonly referred to as a "see-through trust.”

To qualify as a see-through trust, the following four requirements must be met in a timely manner:
•The trust beneficiaries must be individuals clearly identifiable (from the trust document) as designated beneficiaries as of September 30 following the year of your death.
•The trust must be valid under state law. A trust that would be valid under state law, except for the fact that the trust lacks a trust "corpus" or principal, will qualify.
•The trust must be irrevocable, or (by its terms) become irrevocable upon the death of the IRA owner or plan participant.
•The trust document, all amendments, and the list of trust beneficiaries (including contingent and remainder beneficiaries) must generally be provided to the IRA custodian or plan administrator by the October 31 following the year of your death.

If you have multiple trust beneficiaries, then the life expectancy of the oldest beneficiary will be used to calculate RMDs. IRS regulations provide that trust beneficiaries can't use the "separate account" rule that might otherwise allow each IRA beneficiary to use his or her own life expectancy. If you want each beneficiary to be able to use his or her own life expectancy to calculate RMDs, then you'll generally need to establish separate trusts for each beneficiary to accomplish that goal.

Generally, see-through trusts are structured as "conduit trusts," where all distributions received by the trustee from the IRA must be passed on to your beneficiary. While an accumulation trust (where the trustee can accumulate distributions, even RMDs, received from the IRA instead of paying them out) might also qualify as a see-through trust, the IRS's rules governing these trusts are not as clear.

Trusteed IRA or see-through trust?
Trusteed IRAs are generally less expensive, less complicated, and have less uncertainty than see-through trusts. However, it's important that you make your decision with an eye toward your total estate plan. You should consult an estate planning professional who can explain your options and make sure you choose the right vehicle for your particular situation.
 

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Planning before portability
Prior to the 2010 Tax Act, many married couples with estates that were greater than the applicable exclusion amount would set up an A/B (or A/B/C) trust arrangement. The first spouse to die would transfer an amount equal to the applicable exclusion amount to the "B" or credit shelter bypass trust. The B trust could benefit the surviving spouse and their children, but the B trust would be designed to bypass the surviving spouse's estate. The balance of the estate would be transferred to the surviving spouse, either outright or using an A marital trust. In some cases, a "C," "Q," or QTIP marital trust was also used if the first spouse to die wanted to control who received the marital trust property at the second spouse's death.

With a typical A/B trust arrangement, there would be no estate tax at the first spouse's death. The B trust portion was protected by the applicable exclusion amount of the first spouse to die, and the A trust portion qualified for the marital deduction. The A trust would be includable in the second spouse's estate, but would be protected (at least in part) from estate tax by that spouse's applicable exclusion amount. The A/B trust arrangement insured that neither spouse's applicable exclusion amount was wasted.

In some cases, especially if the married couple's combined estates would exceed the total amount of both spouses' applicable exclusion amounts, the spouses' planning would also attempt to equalize estates in order to use both spouses' applicable exclusion amounts, avoid higher graduated tax rates on the surviving spouse's estate, and reduce total tax on both estates. In other cases, especially where the combined estates were less than the applicable exclusion amount, the first spouse to die might simply transfer everything to the surviving spouse and defer estate tax (if any) to the second spouse's death.

Planning with portability
If you're planning today, you could transfer everything to your spouse and, if you die in 2011 or 2012, your estate can elect to transfer your unused basic exclusion amount to your surviving spouse. Your spouse will then have an applicable exclusion amount equal to the sum of his or her own basic exclusion amount and your unused basic exclusion amount, which your spouse can use for gift or estate tax purposes.  For example, if your estate transfers your $5 million unused basic exclusion to your surviving spouse, who also has a $5 million basic exclusion amount, your spouse then has a $10 million applicable exclusion amount to shelter property from gift and estate tax.

The new portability provision would seem to make planning easier, and there may be far less need to use A/B trust arrangements. But there are a few potential pitfalls to watch out for.
• Portability is set to expire in 2013. Will it be available when you and your spouse need it? A flexible plan might still include an A/B trust arrangement, just in case.
• If you are predeceased by more than one spouse, the unused basic exclusion of an earlier spouse could be lost. That is because you use the unused basic exclusion amount (if any) of your last deceased spouse. This may be another factor to consider when planning for remarriage.
• The unused basic exclusion amount that you transfer to your surviving spouse is not indexed for inflation after you die. If the property you transfer to your spouse appreciates after your death, the value of such property in your spouse's estate could exceed your unused basic exclusion amount and could result in estate tax. With an A/B trust arrangement, appreciation on property in the B trust would be sheltered by your applicable exclusion amount.
• In order to make the unused basic exclusion election, an estate tax return will need to be filed even if estate tax is not owed.
Using the applicable exclusion amount now

Even with portability, it may be useful to take advantage of the increased applicable exclusion amount by making gifts now that can reduce your taxable estate. Some reasons for using the applicable exclusion amount now might include:
• There are family members or individuals other than your spouse that you would like to provide for during your lifetime. The applicable exclusion amount could be used to shelter gifts to such persons from gift tax. (Consider also lifetime gifts that qualify for the annual gift tax exclusion, currently $13,000 per donor/donee, or as qualified transfers for medical or educational purposes. These gifts are not taxable and do not use up your applicable exclusion amount.)
• In the future, the available applicable exclusion amount may be less, portability may not be available, and tax rates may be higher.
• Appreciation on gifts you make is removed from your gross estate. For example, if you made a gift of $5 million now and the property doubles in value to $10 million in the future, the $5 million of appreciation would be removed from your gross estate. On the other hand, such property will not receive a stepped-up (or stepped-down) basis at your death for income tax purposes.
• If you would like to benefit your grandchildren and later generations, it may also be useful to use your $5 million generation-skipping transfer tax (GSTT) exemption now. The GSTT exemption is not portable between spouses and is scheduled to decrease to $1 million as indexed in 2013. Applicable exclusion amounts will often be used with generation-skipping transfers to protect the transfers from gift and estate tax.
• State death taxes can be saved. Most states do not have a gift tax. Making a gift can remove the property from your estate for state death tax purposes. Also, state exclusion amounts may be different than the federal applicable exclusion amount and may not be portable between spouses. Consult a tax or estate planning professional familiar with the laws in your state.
For many of the same reasons discussed above, it might also be useful to have your estate use all of your applicable exclusion amount at your death rather than transfer the unused exclusion to your spouse. For example, it might make sense if there are persons other than your spouse that you would like to benefit prior to the death of your spouse. In some cases, it may be useful to use A/B trust arrangements.

Estate plans and documents
Estate plans and documents written prior to the 2010 Tax Act may no longer carry out your intended wishes because of the new portability provision or the increased applicable exclusion amount. Your trusts and wills should be reviewed to see if they still meet your needs. For example, if you have an estate of $5 million and an A/B trust arrangement that would fund your credit shelter trust with the applicable exclusion amount, would you want your B trust to be funded with the full $5 million, with nothing passing to your spouse (other than whatever interests your spouse might have in the B trust)? Or might you want to transfer the $5 million to your spouse who would be able to use your basic exclusion amount to protect the $5 million from gift and estate tax? But what if the applicable exclusion amount is reduced or portability is not available?

Your documents and plans may need to be revised to reflect the tax changes for 2011 and 2012 and for the uncertainty for 2013 and beyond. Flexibility to deal with future changes is key. Everyone's situation is unique and the issues are complex. To help guide you through these opportunities and uncertain times, consult an experienced estate planning attorney.

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NQDC plans vs. qualified plans

A qualified plan, such as a profit-sharing plan or a 401(k) plan, can be a valuable employee benefit. A qualified plan provides you with an immediate income tax deduction for the amount of money you contribute to the plan for a particular year. Your employees aren't required to pay income tax on your contributions until those amounts are actually distributed from the plan. However, in order to receive this beneficial tax treatment, a qualified plan must comply with strict and complex ERISA and IRS rules, and the plan must generally cover a large percentage of your employees. In addition, qualified plans are subject to a number of limitations on contributions and benefits. These limitations have a particularly harsh effect on your highly paid executives.

In contrast, NQDC plans can be structured to provide the benefit of tax deferral while avoiding almost all of ERISA's burdensome requirements. There are no dollar limits that apply to NQDC plan benefits (although compensation must generally be reasonable in order to be deductible). And you can provide benefits to your highly compensated employees without having to provide similar benefits to your rank and file employees.

Funded vs. unfunded NQDC plans

NQDC plans fall into two broad categories–funded and unfunded. A NQDC plan is considered funded if you have irrevocably and unconditionally set aside assets with a third party (e.g., in a trust or escrow account) for the payment of NQDC plan benefits, and those assets are beyond the reach of both you and your creditors. In other words, if participants are guaranteed to receive their benefits under the NQDC plan, the plan is considered funded.

You might consider establishing a funded plan if your employees are concerned that their plan benefits might not be paid in the future due to a change in your financial condition, a change in control, or your change of heart. Because the assets in a funded plan are beyond your reach, and the reach of your creditors, these plans provide employees with maximum security that their benefits will eventually be paid. Funded plans are rare, though, because they provide only limited opportunity for tax deferral and may be subject to all of ERISA's requirements.

Unfunded plans are by far more common because they can provide the benefit of tax deferral while avoiding almost all of ERISA's requirements. With an unfunded plan, you don't formally set aside assets to pay plan benefits. Instead, you either pay plan benefits out of current cash flow ("pay-as-you-go") or you earmark property to pay plan benefits ("informal funding"), with the property remaining part of your general assets and subject to the claims of your general creditors. You can set up a trust ("rabbi trust") to hold plan assets, but those assets must remain subject to any claims of your bankruptcy and insolvency creditors. A rabbi trust can protect your employees against your change of heart or change in control, but not against a change in your financial condition leading to bankruptcy.

In order to achieve the dual goals of tax deferral and avoidance of ERISA, your NQDC plan must be both unfunded and maintained solely for a select group of management or highly compensated employees. These unfunded NQDC plans are commonly referred to as "top-hat" plans.

While there is no formal legal definition of a "select group of management or highly compensated employees," it generally means a small percentage of the employee population who are key management employees or who earn a salary substantially higher than that of other employees.

Income tax considerations

Generally you can't take a tax deduction for amounts you contribute to a NQDC plan until your participating employees are taxed on those contributions (which can be years after your contributions have been made to the plan).

Employees generally don't include your contributions to an unfunded NQDC plan, or plan earnings, in income until benefits payments are actually received from the NQDC plan. The taxation of funded NQDC plans is more complex. In general, your employees must include your contributions in taxable income as soon as they become nonforfeitable (i.e., as soon as they vest). The taxation of plan earnings depends on the structure of the plan; in some cases employees must include earnings in taxable income currently, and in some cases they aren't taxed until they're actually paid from the plan.

Who can adopt a NQDC plan?

NQDC plans are suitable only for regular (C) corporations. In S corporations or unincorporated entities (partnerships or proprietorships), business owners generally can't defer taxes on their shares of business income. However, S corporations and unincorporated businesses can adopt NQDC plans for regular employees who have no ownership in the business. NQDC plans are most suitable for employers that are financially sound and have a reasonable expectation of continuing profitable business operations in the future. In addition, since NQDC plans are more affordable to implement than qualified plans, they can be an attractive form of employee compensation for a growing business that has limited cash resources.

Types of plans

Because a NQDC plan is essentially a contract between you and your employee there are almost unlimited variations. Most common are deferral plans and supplemental executive retirement plans (also known as SERPs). In a deferral plan your employee defers the payment of current compensation (e.g., salary or bonus) to a future date. A SERP is typically designed to supplement your employee's qualified plan benefits (for example, by providing additional pension benefits).

How to implement a NQDC plan

An ERISA lawyer can guide you through the maze of legal and tax requirements, and draft the plan document. Often the board of directors or compensation committee must approve the plan. Your accountant or consulting actuary can help you decide how to finance the plan. If you choose an unfunded plan, almost all that ERISA requires is that you send a simple statement to the Department of Labor informing them of the existence of the plan, and the number of participants.

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The federal estate tax exemption defined

The federal government imposes a tax on the value of your property when you pass it along to your descendants at your death. Any amount that is passed to a surviving spouse is generally fully deductible. The estate is also allowed to exclude a certain amount that passes on to nonspouse beneficiaries. That amount is called the "basic exclusion amount," which is $5 million in 2011.

How the exemption works for married couples

Prior to the new tax law, if a spouse died without having planned for his or her exemption, the deceased spouse's estate would have passed tax free to the surviving spouse under the unlimited marital deduction (assuming all assets passed to the surviving spouse), and the deceased spouse's exemption was lost or "wasted." The surviving spouse's estate could then only transfer an amount equal to his or her own exemption free from federal estate tax. To solve this dilemma, married couples typically set up what is commonly referred to as a credit shelter trust (aka "bypass" or family trust) that sheltered or preserved the exemption of the first spouse to die.The following example illustrates how portability can achieve a similar result without the use of a credit shelter trust.

Example: Result without portability

Assume Henry and Wilma are married, have all of their assets jointly titled, and have a net worth of $10 million. Henry dies first, when the federal estate tax exemption is $5 million and there is no portability. Henry's estate passes to Wilma free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption. Assume that at the time of Wilma's death, the exemption is still $5 million, the federal estate tax rate is 35%, and Wilma's estate is still worth $10 million. With Henry's exemption completely wasted, Wilma can pass on only $5 million free from federal estate tax. Assuming no other variables, Wilma's estate will owe about $1,750,000 in federal estate tax: $10 million estate – $5 million exemption = $5 million taxable estate x 35% estate tax rate = $1,750,000.

Example: Result with portability

Assume Henry and Wilma are married, have all of their assets jointly titled, and have a net worth of $10 million. Henry dies first, when the federal estate tax exemption is $5 million and there is portability. As above, Henry's estate passes to Wilma free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption. Even though Henry's estate owes no tax, Henry's executor files a timely return on which he elects to transfer Henry's unused exemption to Wilma. Assume that at the time of Wilma's subsequent death the exemption is still $5 million, the federal estate tax rate is 35%, and Wilma's estate is still worth $10 million. Since Wilma has "inherited" Henry's unused exemption, she can pass on the entire $10 million estate free from federal estate tax. Portability of the estate tax exemption saves Henry and Wilma's heirs $1,750,000 in estate tax.

Portability does not eliminate the benefits of credit shelter trusts

Even with portability, there are still tax and nontax considerations that may lead you to use a credit shelter trust, such as:

1.    The portability feature is in effect for only two years and will expire after 2012, unless Congress enacts further legislation.

2.    The trust can help protect assets against creditors of the surviving spouse or future beneficiaries (typically children and grandchildren).

3.    The trust gives the first spouse to die control over the ultimate distribution of his or her assets. For example, in a second marriage situation, one spouse may wish to ensure that any assets remaining after his or her spouse's death pass to his or her children from a previous marriage.

4.    Appreciation of assets placed in the trust will escape estate taxation in the survivor’s estate.

5.    The portability feature applies only to estate tax; it does not apply to the generation-skipping transfer (GST) tax. Without a trust, any unused GST tax exemption of the first spouse to die will be lost.

Some technical information

To use the exemption portability, the first spouse to die must elect to use portability on his or her estate tax return. An estate tax return must be filed by the first spouse to die to use portability even if the return is not otherwise required to be filed.

Many states have state estate tax exemptions that are less than the federal estate tax exemption. So, while your surviving spouse might not be subject to federal estate tax upon your passing, your surviving spouse may have to pay state estate tax if you rely solely on the federal exemption portability.

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·         Locates and probates your will

·         Inventories, collects, and sells (if necessary) your assets

·         Pays legitimate creditor claims

·         Pays any taxes owed by your estate

·         Distributes any remaining assets to your beneficiaries

Tip: Your executor is entitled to a fee from your estate for services rendered. The fee can be waived (usually, a close family member will waive the fee).

What are the duties of an executor?

Your executor acts in a fiduciary capacity. This means that he or she must exercise a high degree of care at all times. Additionally, your executor is under court supervision, subject to its control and approval.

Some states require executors to post a bond, which is later paid back to the executor from the estate (though you may be able to waive this requirement through a will provision). In addition, your executor is personally responsible for ensuring that all the proper tax returns are filed and that any estate taxes due are paid. Finally, your executor is accountable to the court and to your beneficiaries on completion of his or her duties.

How do you select an executor?

Your choice of executor is a very important one. Ideally, you want someone you can trust, who has a close relationship to your family, who has some understanding of tax laws, and who has a keen sense of business (especially if you are a business owner).

Typically, spouses are named. Other choices include older children, siblings, or parents. Friends, attorneys, and bank or trust officers are also common. You can name multiple executors to oversee different aspects of your affairs. However, co-executors may result in an increase in paperwork and a slowdown in the probate process. Some of the attributes you should look for in a good executor are:

·         Ability to serve

·         Willingness to serve

·         Competency

·         Trustworthiness

·         Appreciation of your family's needs

·         Knowledge and experience

Individual versus professional

When choosing an executor, you can name an individual or a professional (e.g., an attorney or a bank trust department) to handle your affairs.

A family member or close friend has knowledge of your affairs and would take a personal interest in the settlement of your estate and the well-being of your beneficiaries. However, he or she may not be the best choice. Serving as an executor is a time consuming and stressful task. Some of the executor's duties are very demanding: preparing and filing tax returns, obtaining appraisals, making an accurate accounting, and these are things best left to professionals. By naming a professional to manage your affairs, you gain some permanence. A professional executor is unlikely to refuse to serve or to resign. In addition, it may be easier to hold a professional executor financially accountable for mismanagement than a nonprofessional. A professional who makes money from managing estates will have the investment expertise as well as the legal, tax, accounting, and computer abilities to do the job well and efficiently. You also gain some impartiality by having a professional manage your affairs. A professional executor should be more impartial to your beneficiaries or heirs. You also reduce the risk that your executor will make hardship loans to friends. However, by nominating a professional, you lose that personal touch from a friend or a relative who is not managing any other estates.

Technical Note: In general, state laws require that the person who manages your affairs be an adult U.S. citizen. Additionally, your executor cannot be a convicted felon. State laws may also give special powers to your executor, or spell out what your executor can or cannot do. You can also use your will to grant your executor any special powers needed to carry out the instructions in your will.

What if you don't leave a will?

If you leave no will, if you do not name an executor in your will, or if your executor refuses or fails to serve, the probate court will appoint an administrator (or curator). If this happens, you have no say about who will manage your final affairs. An administrator performs many of the same functions as an executor but has much less power and authority.

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Transfer taxes
Transfer taxes refer to excise taxes that may be imposed when you transfer property to another, either by gift during life or by bequest at death.
Generally, property transferred to a trust during life may be subject to generation-skipping transfer taxes and/or gift taxes. In this case, Federal Form 709–United States Gift (and Generation-Skipping Transfer) Tax Return–must be filed by the donor (i.e., the transferor or the person funding the trust). Additionally, under certain circumstances, trust property may be included in a decedent's estate for estate tax purposes. In this case, Federal Form 706–United States Estate (and Generation-Skipping Transfer) Tax Return–must be filed by the estate representative.

Income taxation of trusts
Property in a trust generally earns income. How that income is taxed depends on who receives it or whether the grantor or powerholder (someone who holds a general power of appointment over the trust assets; i.e., someone who has the right to say who gets them) has retained an interest in the trust.

Income retained by the trust–Generally, trusts are "pass-through entities." This means that trust income retained by the trust is taxed to the trust (but not if it is a charitable remainder trust), while distributed income is taxed to the beneficiary who receives it. In general, trusts are taxed like individuals for income tax purposes. General tax principles that apply to individuals also apply to trusts. A trust may earn tax-exempt income and may deduct expenses. Trusts are also allowed a small exemption. Income taxed to a trust is reported on Federal Form 1041 (U.S. Income Tax Return for Estates and Trusts). Federal Form 1041 is called a fiduciary income tax return because the trustee (i.e., the fiduciary) is responsible for filing it and for paying any taxes owed.  Income distributed to beneficiaries–Income distributed by a trust is taxed to the beneficiary who receives it. The income is "passed through" on Federal Form 1041, Schedule K-1 (Beneficiary's Share of Income, Deductions, Credits, etc.). The beneficiary must report his or her share of the trust's taxable income on his or her personal income tax return (Federal Form 1040).

Retained interest trusts–Trust income is taxable to the grantor or powerholder if the grantor has retained an interest in the trust (e.g., right of revocation) or if some other person is given a general power of appointment over the trust income or principal. Income taxable to the grantor or powerholder is not reported on Federal Form 1041; rather, it is reported on the grantor or powerholder's personal income tax return (Federal Form 1040). Then, either a copy of Federal Form 1040 is attached to a blank Federal Form 1041, or, in some circumstances, no Federal Form 1041 is filed at all.

Income taxation of estates
An estate may receive or earn income. How it is taxed depends on the nature of the income.  Income earned prior to death–If a decedent was a cash method taxpayer, income received (actually or constructively) by the decedent prior to death is reported on the decedent's final 1040. If the decedent was an accrual taxpayer, income accrued prior to death is reported on the final 1040.

Income earned by the taxpayer but not paid before death is reported on the income tax return of the recipient of the income. This is called income in respect of the decedent (IRD). Examples of IRD include uncollected wages, accrued interest on bank accounts, and dividends declared but not collected. If the recipient of IRD is the decedent's estate, it is reported on Federal Form 1041 (the fiduciary tax return) by the estate representative. If the recipient is an estate beneficiary, it is reported on Federal Form 1041, Schedule B, and on the beneficiary's personal income tax return, Federal Form 1040.

Income earned after death–Income earned by estate property after death is reported either on the estate's tax return (Federal Form 1041) or on the tax returns of the beneficiaries who receive the property directly from the decedent (Federal Form 1040).

Some facts about filing fiduciary income tax returns
Tax year : trust must use the calendar year ending December 31. An estate can choose a fiscal year.

Taxpayer identification number
Any trust required to file Federal Form 1041 (except for revocable or grantor-type trusts) must obtain a Taxpayer Identification Number (TIN). A TIN for a decedent's estate is needed if the estate will earn any income or if the estate representative will file a fiduciary income tax return.

Each TIN applicant must: (1) apply using the revised Form W-7, Application for IRS Individual Taxpayer Identification Number, and (2) attach a federal income tax return to the Form W-7. Applicants who meet an exception to the requirement to file a tax return (see the instructions for Form W-7) must provide documentation to support the exception.

Send your Form W-7 and proof of identity documents to Internal Revenue Service, Austin Service Center, ITIN Operation, P.O. Box 149342, Austin, TX 78714-9342. You may also apply using the services of an IRS-authorized Acceptance Agent or visit an IRS Taxpayer Assistance Center in lieu of mailing your information to the IRS in Austin.

Filing requirements
Trusts with any taxable income, trusts with a nonresident alien beneficiary, and trusts with gross income of $600 or more must file Federal Form 1041.
Federal Form 1041 must be filed if the estate's gross income is $600 more or if one of its beneficiaries is a nonresident alien.

Filing deadline
Returns for trusts must be filed by April 15 of the year following the close of the tax year.
Returns for estates must be filed by the 15th day of the 4th month of the year following the close of the tax year (remember, an estate can choose its fiscal year). So, if the close of the tax year is August 31, 2009, the return is due on December 15, 2009.

Filing extensions
Federal Form 8736 extends the filing deadline for trusts for three months. An additional three-month extension may be granted with Federal Form 8800.
A three-month extension may be granted to estates by filing Federal Form 2758. An additional three-month extension may be granted with a second Federal Form 2758.

Penalties
A late-filing penalty of 5 percent of tax per month will be imposed (up to a maximum of 25 percent). This penalty is in addition to any late-payment penalties.
 

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How does probate start?
If your estate is subject to probate, someone (usually a family member) begins the process by filing an application for the probate of your will. The application is known as a petition. The petitioner brings it to the probate court along with your will. Usually, the petitioner will file an application for the appointment of an executor at the same time. The court first rules on the validity of the will. Assuming that the will meets all of your state's legal requirements, the court will then rule on the application for an executor. If the executor meets your state's requirements and is otherwise fit to serve, the court generally approves the application.

What's an executor?
The executor is the person whom you choose to handle the settlement of your estate. Typically, the executor is a spouse or a close family member, but you may want to name a professional executor, such as a bank or attorney. You'll want to choose someone whom you trust will be able to carry out your wishes as stated in the will. The executor has a fiduciary duty–that is, a heightened responsibility to be honest, impartial, and financially responsible. Now, this doesn't mean that your executor has to be an attorney or tax wizard, but merely has the common sense to know when to ask for specialized advice.

Your executor's duties may include:

•   Finding and collecting your assets, including outstanding debts owed to you
•   Inventorying and appraising your assets
•   Giving notice to your creditors (e.g., credit card companies, banks, retail stores)
•   Filing an estate tax return and paying estate taxes, if any
•   Paying any debts or other taxes
•   Distributing your assets according to your will and the law
•   Providing a detailed report of how the estate was settled to the court and all interested parties

The probate court supervises and oversees the entire process. Some states allow a less formal process if the estate is small and there are no complicated issues to resolve. In those states allowing informal probate, the court may be involved only indirectly. This may speed up the probate process, which can take years.

What if you don't name an executor?
If you don't name an executor in your will, or if the executor can't serve for some reason, the court will appoint an administrator to settle your estate according to the terms of your will. If you die without a will, the court will also appoint an administrator to settle your estate. This administrator will follow a special set of laws, known as intestacy laws, that are made for such situations.

Is all of your property subject to probate?
Although most assets in your estate may pass through the probate process, other assets may not. It often depends on the type of asset or how an asset is titled. For example, many married couples own their residence jointly with rights of survivorship. Property owned in this manner bypasses probate entirely and passes by "operation of law." That is, at death, the property passes directly to the joint owner regardless of the terms of the will and without going through probate. Other assets that may bypass probate include:

•   Investments and bank accounts set up to pass automatically to a named person at death (payable on death)
•   Life insurance policies with a named beneficiary (someone other than the estate)
•   Retirement plans with a named beneficiary
•   Other property owned jointly with rights of survivorship
   

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• Property will pass according to a beneficiary designation even if you name a different beneficiary for the same property in your will
• Property owned jointly with rights of survivorship passes directly to the joint owner
• Property in a trust passes according to the terms of the trust
• Your surviving spouse has a right to a statutory share (e.g., 50%) of your property, regardless of what you leave him or her in your will
• Minor children have certain inheritance rights
• State law may limit your ability to leave property to charity

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• The grantor (also called a settler or trustor): The person(s) who creates and funds the trust
• The beneficiary: The person(s) who receives benefits from the trust, such as income or the right to use a home, and has what is called equitable title to trust property
• The trustee: The person(s) who holds legal title to trust property, administers the trust, and has a duty to act in the best interest of the beneficiary

• Avoids probate: Unlike property that passes to heirs by your will, property that passes by a living trust is not subject to probate, avoiding the delay of property transfers to your heirs and keeping matters private
• Maintains control: You can change the beneficiary, the trustee, any of the trust terms, move property in or out of the trust, or even end the trust and get your property back at any time
• Protects against incapacity: If because of an illness or injury you can no longer handle your financial affairs, a successor trustee can step in and manage the trust property for you while you get better.  In the absence of a living trust or other arrangement, your family may have to ask the court to appoint a guardian to manage your property

a

a