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TOPIC: Trust distribution and basis of assets

Trust distribution and basis of assets 3 years 3 months ago #1

  • gary
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The scenario: One asset in a revocable trust is appreciated stock. The second settlor died this year, so the trust is now irrevocable and the assets (including the stock) will be distributed to the beneficiaries. The brokerage account containing the stock has been re-registered to remove the settlor as trustee, and the tax ID (previously the second settlor's SSN) is now the trust EIN. (Re-registration of the account was required by the brokerage before the successor trustee could take over management of the account).

The beneficiaries do not desire to hold the stock. So rather than the hassle of transferring the stock in kind to the beneficiaries, they prefer to have the stock sold in the trust brokerage account and have the proceeds distributed in cash.

Question: The stock received a stepped-up basis on the death of the second trust settlor. If the stock is sold in the trust brokerage account, does this impair the use of the stepped-up basis? Or does the stock have to be distributed in kind to the beneficiaries to receive the stepped-up basis?

Seems to me that if the trust sells the stock and distributes cash, and uses a K-1 to report to the beneficiaries the proceeds of the sale, the stepped-up basis, and the resulting capital gain, that this has the same effect as distributing the stock in kind for the beneficiaries to sell and then report the proceeds/gain using the same information as would have been on the K-1.

Thanks!
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Re:Trust distribution and basis of assets 3 years 3 months ago #2

  • Michael P. Pancheri
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First, yes, the stock does receive a step-up in basis whether sold by the trust or distributed to the beneficiaries and sold by them. As a result of the step-up in basis, the sale of a capital asset within a short time after a decedent's death generally results in little or no capital gain (or loss) to the seller, whether the seller is the estate, or the trust, or individual beneficiaries.

Assuming, however, that there is a capital gain from the sale, and assuming that the sale was made by the trust (or estate), then the trust would be responsible for reporting the gain on its income tax return (Form 1041, Schedule D).

It is at this point that most people get confused. There is no question that the capital gain gets taxed for federal income tax purposes. However, the real question is who pays the tax on the capital gain. In resolving this question, the federal tax laws defer to state laws regarding how capital gains are treated for accounting purposes. For accounting purposes, most states treat capital gains as principal and not income. In that case, capital gains always stay with the trust (or estate) and are taxable to the trust (or estate). Only income for accounting purposes (i.e., dividends, interest, etc.) is taxable to the beneficiaries of a trust (or estate) if deemed to have been distributed to them during the tax year.

There is an important exception to the general rule that capital gains are treated as principal and not income; i.e., if state law or the governing instrument provides otherwise then capital gains will be treated as income. You will have to check your state laws to see if this exception applies to you.

What this all means is that any capital gain from the sale of stock by a trust (or estate) will be taxed to the trust and not the beneficiaries, even though distributions were made to the beneficiaries during the tax year (unless the exception explained above is applicable). Remember, it is only income that is deemed to have been distributed to beneficiaries from a trust (or estate) and, therefore, taxable to the beneficiaries with a corresponding deduction to the trust (see Schedule B of Form 1041).

Normally, this is not a good result because income in a trust (or estate) is taxed at much higher rates than an individual. So, if there is a large unrealized capital gain existing in a trust asset, it is generally better to distribute the asset to the beneficiaries and have them sell it. Not only are the individual tax rates much lower, you also get the benefit of spreading the gain over a number of beneficiaries, thereby lowering the rate even more.

On the other hand, if there is little or no gain to be realized (i.e., because of the step-up in basis), then it probably doesn't make much difference whether the trust sells it and distributes the proceeds or the beneficiaries sell it. This is where you have to do the math beforehand to determine the best result.

I trust this helps. If not, please let me know.
Last Edit: 3 years 3 months ago by Michael P. Pancheri.
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