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The Basics of Fiduciary Income Taxation | The American College of Trust and Estate Counsel - YouTube
Channel: The American College of Trust and Estate Counsel
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hello i'm laura davis an act tech fellow
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from dallas texas and i'm here with
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farhad agtme an act tech fellow from
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richmond virginia
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today we're going to talk about the
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basics of fiduciary income taxation
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farhad
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what does fiduciary income taxation mean
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yeah well good morning laura it's good
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to see you again it's good to be here um
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fiduciary income taxation is really the
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income taxation of estates and trusts
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and
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that should be contrasted with the
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estate tax i know we use those terms
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somewhat interchangeably but when we're
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talking about fiduciary income taxation
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we're really talking about
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the income taxation of the assets that
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are in a person's estate
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or the income taxation of assets that
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are held in a trust
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and this should be contrasted with the
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estate tax which is really sort of a
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one-time tax that occurs at a person's
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death and i'll use a simple example or
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simple analogy to explain the
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distinction
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um think about a a a
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a farmer who owns an apple orchard
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and um the the farmer passes away
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there may be an estate tax due
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on the value of that apple orchard and
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you'd have an appraiser determine what
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the value is and you would subtract any
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applicable deductions and a credit
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there's an 11.7 million estate tax
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credit
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um that's available and that's sort of a
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one-time tax that's paid the fiduciary
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income taxation though is really the tax
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on what is generated by that property
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and if you've got an apple orchard
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you're you're growing apples every year
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and the income is really the the apples
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that are being grown every year that's
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what's been being generated from that
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property and so
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you file an annual income tax return
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reporting the income that's generated by
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property so let's parse it out a little
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bit what can you explain exactly what an
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estate is
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sure sure so when a person passes away
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the assets that they own
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are all now held that they owned at the
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time of their death are held in their
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estate
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and
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the estate really captures
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all of the income fiduciary income tax
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return captures all the income that's
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earned during the period of a state
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administration really from the moment of
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death until the assets are distributed
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to the beneficiaries so if a person dies
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let's say on may 17th
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all the income that they earn from
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january 1st to may 17th while they're
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alive would be reported on form 1040
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their personal income tax return and
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then all the income starting from may 17
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through the end of the year
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would be captured on a form 1041 which
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is the fiduciary income tax
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oh okay that makes sense and so what's a
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trust
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yeah a trust is really an arrangement
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where property is transferred to a
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person
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who's known as the trustee
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and they hold and manage that property
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subject to the terms of a trust
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agreement typically in writing for the
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benefit of a beneficiary and the trustee
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owes certain fiduciary duties to the
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beneficiary
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trusts can be revocable that is they can
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be amended changed revoked or they can
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be irrevocable
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often revocable trusts are used really
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as well substitutes
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and they're often referred to as living
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trusts
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whereas irrevocable trusts are created
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during lifetime
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often for gift planning purposes where
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you want to make a transfer to an
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irrevocable trust and make sure that
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a gift is complete for gift tax purposes
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also revocable trusts become irrevocable
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at a person's death because they can no
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longer
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amend amended or change
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gotcha so there's lots of different
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kinds of trusts from an income tax
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perspective how are trusts generally
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taxed
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yeah generally they really work with a
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what i call sort of a modified conduit
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form of taxation and
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the way i sort of think about it is if a
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dollar of income flows into the trust
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and the trustee holds on to that income
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then the trust pays tax on the income
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if the trustee turns on the faucet and
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says hey we're going to allow this
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dollar of income to flow down to the
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beneficiary then the beneficiary has
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received the income and they pay the tax
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on that and the trust gets an offsetting
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income distribution deduction
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so from a tax perspective trusts fall
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into three broad categories simple trust
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complex trust and grantor trusts will
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you explain what those are
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so a simple trust is a trust where
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all of the income must be
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distributed out to the beneficiary
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annually and so basically if there's any
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income interest dividends rents proceeds
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from the sale of apples
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if that comes into the trust the trustee
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is obligated to distribute the the
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income out to the beneficiary
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a complex trust is trust where the
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trustee has discretion to either
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distribute some all or none of the
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income out to the beneficiary
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and then there's a third type of trust
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which is called a grantor trust and
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that's a trust where actually the person
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who set up the trust and not the
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beneficiary is taxed on the income
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and there's certain reasons why certain
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powers that cause a trust to be
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considered a grantor trust and actually
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there's a subset of grantor trusts where
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not the grantor but the beneficiary is
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considered the owner of the trust income
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so a lot of people ask if trusts are
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taxed at a higher rate and we know the
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answer to that is no but that is
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somewhat misleading will you explain how
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trusts are taxed differently than
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individuals sure so you're absolutely
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right that trusts don't pay tax at a
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higher rate but they get to the higher
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rate much more quickly so in the case of
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a married couple that's filing jointly
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they don't get to the top income tax
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rate of 37 percent the top bracket until
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they have about 628 000 of income in in
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2021 so
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there's a lot of income that doesn't get
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taxed at that top rate you have to get
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to 628 whereas in the case of a trust
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they get to the top tax rate of 37
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percent at with only about 13 000 of
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taxable income and so
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the trust tax rates are very compressed
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and so keeping
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income inside a trust can be
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disadvantageous because you know many of
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the dollars are ultimately taxed at the
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highest rate
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there is the ability to distribute
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income out to a beneficiary and it's
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important for trustees to sort of
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monitor trust income because you could
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potentially distribute income out to the
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beneficiary at a lower tax rate
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that's great information to have for hud
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the tax return used for trust in the
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states is a form 1041. who files that
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income tax return and when is it due
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yeah so typically the um fiduciary
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whether it's the executor or personal
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representative of the estate or the
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trustee of the trust uh they're
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responsible for preparing and filing the
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um the fiduciary income tax return the
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form 1041
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that's typically due um on the 15th day
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of the fourth month following the close
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of the um
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the trust or states
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taxable year and in most calendar year
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trusts that will be april 15th
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of the year following the year um in
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which the uh the trust
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you know at its prior year
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um and then estates can be on a calendar
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on a i'm sorry on a fiscal year
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and as long as
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as long as the first fiscal year is no
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longer than 12 months and so it would be
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due
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on the fourth on the 15th day of the
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fourth month following that the end of
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that year
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great so how do beneficiaries report the
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income that they received from the
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estate or the trust the beneficiary
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reports the income on
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they will receive from
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the trustee or from the estate a form
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k-1
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which reports their share of the
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income
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gain loss credit deduction
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from the trust that is passed out to
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them and so they'll take that schedule
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k-1
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and they'll
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enter the information from that k-1 on
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their personal return and that's how
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they effectively report that income
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so does a trustee of a grantor trust
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always need to file a form 1041
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not in all cases they're really two
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methods first you can prepare
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uh and and file a grantor trust tax
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return which is really an abbreviated
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return it just has the name of the trust
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the trustee and their address and then
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it is attached to it sort of a list of
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items of income gain loss credit
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deduction and those are almost act like
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a k-1 for the grand tour and they would
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report those on their personal return
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and then in some cases um a grantor
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trust return is not filed at all and all
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of the items
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are reported just directly on the
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grantor's personal return
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great that seems a little bit easier
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than filing a return
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so can you explain again how fiduciary
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income taxation is different from a
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state taxation
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sure the state taxation really um looks
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at the value of a person's estate
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um at the at the moment of death you
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sort of take a snapshot of the value of
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all the assets in their estate at the
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time of death and you value those and
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you subtract any deductions or any
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credits or exemptions and as i mentioned
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there's an 11.7 million state tax
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exemption that is available
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and that's a one-time tax that's paid
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it's typically due nine months from the
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date of death
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in the case of fiduciary income taxation
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that is really on the income that's
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being generated by those assets in the
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estate
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and so um as use the analogy with
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the the apple apple orchard owner
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if the farmer dies
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the estate taxes on the value of all of
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his trees and his farming operations and
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you'd value all those and you'd pay this
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one-time estate tax
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but also those trees are growing fruit
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each year
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and when that fruit is sold that is
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generating income and that's where the
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fiduciary income tax would come into
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play and you report the income from
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the apple proceeds that are sold
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great that's helpful because i know it's
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always confusing that there's two estate
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tax returns
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farhad thank you so much for your clear
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explanations of fiduciary income
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taxation and the form 1041.
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thank you laura it's great to see you
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again i appreciate it
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you
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