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Separate Share Rule DNI generally passes out to the beneficiaries on a proportionate basiswhen they receive a distribution. However, if a trust has separateshares, this will not be the case. Rule: If a trust has more than one beneficiary, and those beneficiarieshave substantially separate and independent shares, those shares aretreated as separate trusts for purposes of determining:a) how much DNI is allocable to the respective beneficiary, andb) the appropriate distribution deduction of the trust or estate. (IRC §663(c);Reg. §1.663(c)-1) Separate Share In the Case of Trusts: The rule generally applies whentrust distributions are required to be made in substantially the samemanner as if separate trusts had been created. (Reg. §1.663(c)-3(a)) 26Example: Under the terms of a trust, the assets are divided into separateshares (but not separate trusts) for each of the grantor’s children, andthe trustee has discretion to distribute income and principal to thechildren from their respective share.

Separate Share Rule Separate Share in the Case of Estates: Applies when the governing instrument andapplicable local law create separate economic interests in one beneficiary or a classof beneficiaries. (Reg. §1.663(c)-4(a)) A separate share ordinarily exists if the economicinterests of one beneficiary or a class of beneficiaries neither affect nor are affectedby the economic interests accruing to another beneficiary or class of beneficiaries. Examples include:1.2.3. 27income on bequeathed property if the recipient of the bequest is entitled to suchincome,a surviving spouse’s elective share that under local law is entitled to income andshares in appreciation (and depreciation), anda qualified trust for which a §645 election was made to treat it as part of adecedent’s estate.The DNI allocable to any share is computed as if each share was a separate trust oran estate. (Reg. §1.663(c)-2(b)) Once the DNI allocable to a separate share is determined,that creates the ceiling for how much will be taxable to the beneficiary (and deductibleby the trust or estate) with respect to distributions to that beneficiary.The separate share rule is mandatory, not elective. Reg. §1.663(c)-1(d))

Separate Share Rule, cont’d. Comment: The separate share rule prevents a beneficiary from beingtaxed on a disproportionate share of trust or estate income when adistribution is made to him. Example: A decedent’s two children are each entitled to 50% of his 10 millionestate Child A receives his half of the estate in Year 1 Child B receives his half of the estate in Year 2 Without the separate share rule, assuming the estate has 50,000 ofDNI in Year 1, all of that DNI would be taxed to Child A, even thoughChild A is only entitled to 50% of the estate and its income. The effectwould be that Child A is taxed on Child B’s income. The separate share rule ensures that only 25,000 of the estate’s DNIis taxed to Child A, with the rest taxed to the estate, thereby reducingChild B’s share.28

Depreciation, Depletion and AmortizationTreatment and Allocation of Deductions

General Rules Estate: Depreciation, depletion and amortization (“DD&A”) are allocatedbetween an estate and its beneficiaries on the basis of how much of the estate'sFAI is allocable to each. (IRC §167(d), §611(b)(4), and §642(e). See also Reg. §1.167(h)-1(c) and §1.611-1(c)(5)) Trust: DD&A are allocated between a trust and its beneficiaries on thebasis of how much of the trust's FAI is allocable to each, unless the governinginstrument (or state law) requires or permits a trustee to maintain a reserve. (IRC§167(d), §611(b)(3), and §642(e). See also Reg. §1.167(h)-1(b) and §1.611-1(c)(4)) If all FAI is distributed to its beneficiaries, all of the DD&A passes out to thebeneficiaries even if it is more than the FAI. Even if a simple trust does not have any FAI, all of the DD&A passes out to thebeneficiaries. (Rev. Rul. 74-530) Typically, DD&A are not reported as separate items on a partnership K-1. Evenso, it appears that if an estate or a trust is a partner, its share of thepartnership's DD&A still must be allocated between the estate or trust and itsbeneficiaries. (Rev. Rul. 74-71)31

Charitable Income Tax Deduction Available to Estatesand Non-grantor Trusts

General Rule Estates and non-grantor trusts are allowed an unlimited charitableincome tax deduction for any gross income paid to charity pursuantto the terms of the governing instrument. (IRC §642(c)(1); Reg. §1.642(c)-1(a)(1)) Any charitable contributions made from principal or tax-exemptincome are not deductible. (Reg. §1.642(c)-3(b)) An estate, unlike a trust, is also allowed a charitable deduction forany income set aside for later distribution to charity pursuant to theterms of the governing instrument. (IRC §642(c)(2); Reg. §1.642(c)-2(a)) Example: If a trustee makes a charitable contribution of appreciatedproperty, the trust won't be entitled to a charitable deductionbecause the distribution is made from trust principal. Even if thetrustee makes the charitable contribution from trust income, it won'tbe deductible unless the trust agreement permits it.33

Application of Passive Activity Rules to Trusts & Estates

Lack of Clarity Currently, there aren't any regulations under IRC §469 that 35address when a trust or an estate is deemed to materiallyparticipate in an activity for purposes of the passive activityrules. (See Reg. §1.469-5T(g))According to the Committee Reports for the 1986 Tax ReformAct, a trust or an estate is deemed to materially participate inan activity if its executor or trustee, in its fiduciary capacity,materially participates in that activity. (S. Rept. No. 99-313 (Pub. Law 99-514) p. 735)Only current guidance are a couple of court cases and a fewrulings.

The Mattie K. Carter Trust v. U.S., 2003-1 USTC 50,418 Carter involved a trust that operated a working ranch. The trust hired a number of 36employees, including someone to manage the day-to-day operations of the ranch andmake all the important managerial and operational decisions, subject to the trustee'sapproval. Although the trust deducted the losses generated by the ranching activity, theIRS disallowed them, asserting that they were passive activity losses.The Service argued that the material participation of a trust in a trade or business forpurposes of IRC §469 should be determined by evaluating only the activities of the trustee,and in this case, those activities did not rise to the level of material participation. Thetaxpayer argued, and the District Court agreed, that because the trust (and not the trustee)is the taxpayer, material participation should be determined by assessing the activities ofthe trust. Furthermore, since a trust can only participate in an activity through itsfiduciaries, employees and agents, their activities as a whole should be considered indetermining the trust's level of participation. Applying this standard, the District Court heldthat the trust's activities rose to the level of material participation. Furthermore, the Courtconcluded that the trustee's activities alone with respect to the ranching operations weresuch that even under the IRS standard, the trust materially participated in the ranchingactivities.

TAM 200733023 A trust owned an interest in a limited liability company that engaged in an active trade or 37business. The trust had special trustees in addition to regular trustees. The issue waswhether the losses generated by the limited liability company were passive activity losses.The Service held that a trust is treated as materially participating in an activity if its trustee,in its fiduciary capacity, so participates. Furthermore, the Service concluded that theactivities of the special trustees should not be taken into account in determining whetherthe trust materially participated in the activity of the limited liability company. Even thoughthe special trustees were heavily involved in the operational and management decisions ofthe business, they could not do anything without the regular trustees' consent. Thus, theywere not fiduciaries of the trust and their activities did not count in determining whether thetrust materially participated in the business. As to the regular trustees, their activities didnot rise to the level of material participation.PLR 201029014 confirmed the IRS position taken in TAM 200733023 by concluding that atrust materially participates in a business activity only if its trustee materially participates.

TAM 201317010 The IRS once again took the position that whether a trust materially participates in an 38activity depends upon the level of activity of its trustees in their fiduciary capacity. TheService concluded that because the trusts in this TAM did not materially participate in theactivities of its S corporation, they would have to amortize their share of the S corporation’sresearch and development expenses over ten years for AMT purposes.Two identical trusts owned stock in an S corporation. The trusts had a regular trustee and aspecial trustee. The special trustee, who was one of the trust beneficiaries, was also thepresident of the company’s subsidiary and a shareholder. As special trustee, he controlledall decisions regarding the disposition of the company stock and voting of such stock, butdid not have any control over the company’s management or operations. Nevertheless, asthe subsidiary’s president, the special trustee was involved in the subsidiary’s day to dayoperations.The IRS took the position that only the special trustee’s activities in his fiduciary capacityshould be considered in determining the trust’s material participation. Thus, it refused tocount the work performed by the special trustee as the subsidiary’s president, andconcluded the activities, as special trustee, did not rise to the level of material participation.In addition, the regular trustee did not participate in the company’s day to day operationsso his activities, as well, did not rise to the level of material participation.

Frank Aragona Trust v. Commissioner, 142 T.C. No. 9(2014) The Tax Court held that a trust can qualify as a real estate professional and, assuch, materially participate in rental real estate activities. This is significantbecause any rental activity is considered per se passive unless the ownerqualifies as a real estate professional under IRC §469(c)(7). To qualify as a realestate professional, the taxpayer must perform more than one-half of hispersonal services (and more than 750 hours) in real property trades orbusinesses in which he materially participates. The IRS asserted that a trust could not qualify as a real estate professionalbecause a trust cannot render “personal services,” as required by the statute,because it is not an individual (the regulations define such services as any workperformed by an individual). The Court disagreed and held that if the trusteesare individuals, their work can be considered personal services rendered by anindividual, whereby the trust will satisfy the requirements of a real estateprofessional.39

Frank Aragona Trust v. Commissioner, 142 T.C. No. 9(2014), cont’d. Next, the Court considered whether the Aragona Trust qualified as a real estate 40professional. The Aragona Trust owned rental real properties directly and also throughentities, some of which were wholly owned and others through entities in which it ownedmajority interests. The trust had six trustees: the grantor’s five children and an independenttrustee. The trustees acted as a management board for the trust and made all majordecisions regarding the trust property. Three of the trustees worked full time for the whollyowned limited liability company that managed most of the trust’s rental real estateproperties. Two of these same trustees also owned minority interests in some of the othertrust-owned real estate entities. The other three trustees were involved in the trust’sactivities on a limited basis.Based upon the different roles of the trustees – namely, as fiduciaries, as employees of thewholly owned real estate management company, and as co-owners of some of the realestate entities – the Court held that the trustees materially participated in the trust’s realestate activities. Counting the trustees’ activities in other capacities is notable since itseems contrary to the ruling in TAM 201317010. Considering that only three of the sixtrustees were involved in the trust’s day-to-day activities, this could mean that a trust canbe deemed to materially participate in an activity even if fewer than a majority of itstrustees participate.

Special Rule for Grantor Trusts In the case of a grantor trust, material participation isdetermined by the activities of the grantor or beneficiaryto the extent either is treated as the owner of the trust forincome tax purposes. (50 S. Rept. No. 99-313 (Pub. Law 99-514) p. 735; General Explanation of the TaxReform Act of 1986 (Pub. Law 99-514) p. 242; See also Temp. Reg. §1.469-1T(b)(2) and FSA 200035006) Similarly, in the case of a Qualified Subchapter S Trustthat is treated as a grantor trust with respect to the solebeneficiary, material participation is determined by theactivities of the beneficiary. (General Explanation of Tax Reform Act of 1986 (Pub. Law 99-514) p.242)41

Income Tax Deductions for Administration Expenses

General Rules Administration expenses incurred by an estate or trust typically include: legal fees,trust accounting fees required by the trust agreement,trust tax return preparer fees,investment advisory fees,appraisal fees,selling expenses & commissions,management services, andfees paid to a trustee or executor. To be fully deductible (without the 2% limitation) in arriving at adjusted gross income,administration expenses must meet two requirements under IRC. § 67(e): the cost must be paid or incurred in connection with the administration of the estate or trust;andthe cost would not have been incurred if the property were not held in such trust or estate. If an expense does not meet these requirements it is not deductible as a miscellaneousitemized deduction as miscellaneous itemized deductions were suspended by the 2017Tax Act.44

General Rules, cont’d. Estate administration expenses are deductible only to 45the extent they are not deducted on the estate tax return(Form 706).Expenditures incurred for the benefit of the beneficiariesor heirs, rather than being essential to the settlement ofthe estate or the purpose of the trust, are not deductible.

General Rules – Grantor Trusts Items of income and expense pass through to the 46grantor, and the trust is disregarded as a separate entity.Administration expenses for a grantor trust are attributedto the grantor/owner and will be treated as expensessubject to the 2% of AGI limitation at the grantor/ownerlevel and thus not deductible under the 2017 Tax Act.

No Double Deduction for Administration Expenses Estate administration expenses and casualty and theft 47losses allowed as estate tax deductions under IRC. §2053(a)(2) and 2054 cannot be claimed as deduction onboth the Form 706 and Form 1041 [ IRC § 642(g)].Without a special election, estate administrationexpenses are deductible on Form 706.The executor or administrator may elect to claim thededuction (or a portion thereof) against gross income onForm 1041 (§642(g) election).

Attorney, Accountant, and Return Preparer Fees Expenses paid by an estate or trust for work performed by anattorney, accountant, or tax return preparer are deductiblewithout regard to the 2% of AGI limitation when suchexpenses would not be incurred if the property were heldoutside the trust. (IRC § 67(e); Reg. 1.212-1(I)) Regulations specifically include the preparation of fiduciaryincome tax and estate tax returns as an example of an expenseconsidered to be unique (and thus, fully deductible). For an estate, these fees are administration expenses.Without a special election, estate administration expenses aredeductible on Form 706.48

Allocations to Tax Exempt Income When a trust or estate has tax-exempt income, areasonable allocation of administration expenses notdirectly attributable to any certain class of income mustbe made to the tax-exempt income (and is therefore notdeductible). (Reg. 1.265-1(c))49

Deducting Investment Advisory Fees When the 2% Limitation Applies Investment advisory fees incurred in administering the estate ortrust are generally treated as miscellaneous itemized deductionsreduced by 2% of AGI and thus not deductible under the 2017 TaxAct. If such fees would not have been commonly incurred if the propertyhad been held outside the estate or trust, the 2% floor limitationdoes not apply. (IRC. §67(e)(1)) Unfortunately, this test is not easy to qualify and quantify because itrequires that an expense would not be commonly incurred if theproperty had not been held in trust or by an estate. If an expense would be incurred regardless of whether the propertyis held in trust or by an estate, if fails the “not commonly incurred”test and is subject to the 2% AGI limitation and is not deductible.50

Deducting Investment Advisory Fees, cont’d. In January 2008, the Supreme Court ruled in Knight v. Com’r, 2008-1 51USTC ¶50,132 that §67(e)(1) provides an exception from the 2%limitation only for costs that would be uncommon (or unusual, orunlikely) for a trust to incur if the property was held by an individual,rather than by a trust.In response, IRS issued proposed regulations in 2011 that wouldrequire estates and non grantor trusts to be subject to the 2% limit if thecost was a miscellaneous itemized deduction under §67(b) that wouldbe “commonly” or “customarily” incurred by a hypothetical individualholding the same property.Final regulations issued in May of 2014 largely followed therequirements in the proposed regulations (i.e., that miscellaneousitemized deductions incurred by an estate or trust are subject to the 2%floor if commonly or customarily incurred by a hypothetical i

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