Fiscal Year Election for Qualified Revocable Trusts

Question:   My father died holding all of his assets in a revocable trust.  Must the trust’s tax returns be filed using a calendar year-end?

Answer:   Generally speaking, revocable trusts are not separate taxpayers during the lifetime of the trust creator or grantor. This means that income, loss and other tax items of the trust must be  reported on the personal income tax returns of the trust’s grantor.  After the grantor’s death, the trust becomes a separate taxpayer and is generally required to file its tax returns on a calendar year basis. When a legal entity such as a trust uses a calendar year for tax reporting purposes, there is usually less of an opportunity to defer income taxes. 

A qualified revocable trust which becomes a separate taxpayer on the grantor’s death is allowed to make a tax election, known as a “645 election”, to treat the trust as an estate for income tax reporting purposes. The primary advantage of this election is that an eligible trust can report its income with a year-end other than December 31.  A 645 election, once made, will remain in effect for a period of two years following the decedent’s death or, if an estate tax return is required to be filed for the decedent’s estate, for a period of six months following the final determination of the decedent’s estate tax liability. The 645 election can offer a deferral opportunity for the trust and its beneficiaries.

Consider a decedent who died on April 30, 2018 whose assets were held in a qualified revocable trust. The income from the trust’s assets from January 1, 2018 to April 30, 2018 would be reported on the decedent’s final individual income tax return.  The income from the trust’s assets for the balance of the 2018 calendar year would be reported on a separate income tax return filed for the trust. Under normal trust income tax reporting  rules, the trust income from May 1, 2018 through December 31, 2018 will either be taxed to the trust if the income is retained by the trust or taxed to the beneficiaries if the income is distributed to the beneficiaries. In either case, all of this income will be taxable in 2018. If instead the trust makes a 645 election, the trust can select a year-end other than December 31. If the trust selected a fiscal year-end of January 31, the income for the period from May 1, 2018 through January 31, 2019 will be reported on the trust’s income tax return for the fiscal year ending January 31, 2019.  If the trust timely distributes its income to the trust beneficiaries for the year ending January 31, 2019,  that income will be taxed to the beneficiaries in the 2019 year which could result in a meaningful deferral of taxable income.

A qualified revocable trust is a trust treated as owned by the trust’s grantor during the grantor’s lifetime by virtue of certain powers the grantor held under the trust agreement.  Assuming your father had the right to revoke the trust, the trust will likely constitute a qualified revocable trust and be eligible to make the 645 election. In fact, most standard living trusts are qualified revocable trusts eligible to make the 645 election upon the grantor’s death.

While the flexibility to use a fiscal year-end is usually the primary benefit of the 645 election, there are other, more technical, tax benefits which can be realized.  If the decedent had passive losses the deduction of which were limited to the amount of income the decedent generated from passive activities, it may be easier to avoid passive loss treatment if the 645 election is made treating the trust as an estate.  It may also be easier to deduct charitable contributions if a qualified revocable trust elects to be treated as an estate. While some additional accounting work is  required if a 645 election is made, the benefits which can be realized from a 645 election usually outweigh the increased administrative burden.

You should first confirm that your father’s trust constitutes a qualified revocable trust. If so, you should strongly consider the 645 election which will allow you to defer the reporting and taxation of some of the trust’s income.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.