ALBUQUERQUE, N.M. — Q: I am a beneficiary of my mother’s estate with my brother and sister. My brother is a lawyer and convinced my mother to make him the executor of the estate and trustee of her trust. I have not talked to my brother in years and we agree on virtually nothing. I just received a form K-1 from my mother’s irrevocable trust for the 2018 tax year. This form shows the following: line 1 interest income $7,544, line 10 estate deductions $25,692, box 14E and box 14H are also completed with the same $7,544. I have attached a pdf version of this form. I do not understand the form because I have never received any distributions including in 2018. I would like to send an e-mail to my brother and need to formulate what to ask. From what I have found on the web I should not have any income to report unless I received distributions. Is the box 14 or 10 numbers something that would in effect allow me to disregard reporting anything?
A: Looking at the K-1 form that you forwarded I noticed the form is checked to be the final one. If accurate this explains one of the numbers reported to you, but not why you have received no distributions.
Let’s start with basics. A trust either pays tax on its income or claims a deduction for distributions made to the beneficiaries. If distributions are made the trust avoids paying tax but the beneficiaries must report the income.
There can be some twists in this basic result. First the trust’s deduction is limited to a special computation for something called “distributable net income.” Second, the trust may claim a distribution deduction if the income is required to be distributed, even if it is not actually distributed.
If your mother’s trust requires that annual income be distributed, then the trust would claim a deduction and the beneficiary would report the income. Box 14 simply explains to the beneficiary that the income, interest in this case, may allow you to claim investment interest expense deductions and may also subject you to a 3.8% surtax on net investment income (this applies only to “high income” taxpayers).
The estate deduction can make sense if this is the last year of the trust. All tax activity of a trust is reported to beneficiaries in the final year. Estates incur administrative expenses that can be deducted on an estate tax return. If an estate is not large enough to incur an estate tax liability, the administrative expenses produce no estate tax benefit. The law then allows the beneficiaries to deduct the expenses on their income tax return. Your mother’s estate was transferred to an irrevocable trust and all tax issues now relate to that trust.
This special deduction is allowed only in the year the trust is terminated. The box checked on the Form 1041 Schedule K-1 form suggests that the $25,692 may be allowed as a deduction to you as a beneficiary.
The deduction for estate administrative expenses is claimed by you on schedule A (itemized deductions). It is a miscellaneous itemized deduction but not one that must exceed 2% of adjusted gross income.
This classification issue is important because the new tax law denies any deduction for what used to be called miscellaneous deductions subject to the 2% floor.
The new law was not clear with respect to the classification of these estate deductions on a beneficiary’s return. IRS Notice 2018-61 says that the expenses are not subject to the 2% floor.
So if you follow the K-1 form reporting, you must report $7,544 of interest income that may cause you to bear a 3.8% surtax. You will also report $25,692 as an itemized deduction on schedule A.
A form K-1 is presumed to be correct and you will receive an IRS letter with a tax adjustment and interest and penalties if your reporting does not match the K-1.
The trickier issue for you appears to be communicating with your brother, in his role as trustee, to determine why no distributions have been made. If you have a copy of the trust instrument you should check whether current income distributions are mandatory.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.