T3: Trust Taxation & Tax-Exempt Organizations

tax-exempt organizations

NFP organizations that qualify for exemption from federal income tax; most common type are Sec 501c3

qualifications to be a Sec 501c3

1. organization must be a corporation, unincorporated association, or trust

2. there must be an exempt purpose

3. no private benefit allowed

4. no political/legislative activity associated w/ the organization

exempt purposes for 501c3

• charitable

• religious

• scientific

• testing for public safety

• literary

• educational

• fostering national/international amateur sports competition

• prevention of cruelty to children or animals 

no private benefit allowed

no part of the Sec 501c3’s net earnings may benefit any person having a personal and private interest in the activities of the organization

restrictions on political activities & legislative activities

• 501c3s are prohibited from directly or indirectly participating in any political campaign for or against any candidate for elective public office

• an organization doesn’t qualify for 501c3 status if a substantial part of its activities are attempting to influence legislation (lobbying)

• allowed: voter education or registration activities as long as they’re unbiased & nonpartisan 

events that could cause the loss of tax-exempt status

• engaging in activities that aren’t related to its stated tax-exempt purpose

• organization operates for the primary purpose of conducting a trade/business that is not related to the organization’s tax-exempt purpose

• activities or earnings of the organization benefit any private interests

• participating in political campaigns

• engaging in lobbying activities attempting to influence legislation

• failing to satisfy annual filing requirements (Form 990) 

unrelated business income (UBI)

*tax-exempt organizations may be subject to regular corporate tax on income from a business enterprise that’s not related to its tax-exempt purpose

UBI income is income that is:

• derived from an activity that constitutes a trade or business

• regularly carried on

• not substantially related to the organization’s tax-exempt purpose

excluded trade or business activities from UBI (will be non-taxable)

• bingo games if legal & limited to the NFP

• activity conducted for the convenience of the organization’s members, students, patients, or employees

• convention or trade show activity

• exchange or rental of membership lists

• sale of merchandise received as gifts/contributions (thrift shop)

• sales of articles made by disabled persons as part of their rehabilitation

• activity where substantially all work is performed by unpaid volunteers

excluded types of income from UBI (non-taxable)

• dividends, interest, annuities, & other investment income

• royalties

• rents from real property

• income from research by a college, university, or hospital

• gains/losses from disposition of property not held primarily for sale to customers in the orindary course of business 

membership organizations

• usually taxed on all gross income minus deductions directly connected w/ producing that income, but not including exempt function income 

• exempt function income → gross income from dues, fees, chrages, or similar items paid by members for the goods, facilities, or services provided to members & their families and guests

trust

a separate legal entity created under state law to manage & distribute property for the benefit of 1 or more beneficiaries named in the trust agreement 

• the trust is created by a grantor, who transfers property to the trust, appoints a trustee, & identifies the terms of the trust agreement 

• trustee manages the trust property for the benefit of the beneficiaries & administers the trust according to the terms of the trust

• on an annual basis, the trust’s corpus may be used to generate taxable income, & this income passes through to either the trust’s grantor or beneficiaries

• 2 types: grantor & non-grantor

grantor trust

*trusts in which the grantor retains certain ownership powers or control over the property transferred to the trust (ex: power to take income or borrow from the trust or change trust beneficiaries)

• common type of grantor trust is a revocable living trust 

  • commonly used instead of a will to stipulate how their assets will be distributed when they pass

  • grantor of a revocable living trust maintains control over the trust assets & the provisions of the trust during their lifetime 

• grantor trusts not required to file separate tax returns

non-grantor trust

*separate taxpaying entities

• trust income is taxable either to the trust or to the beneficiaries depending on the amt. of distributions to beneficiaries, type of income, & type of trust

• classified as either simple trusts or complex trusts 

simple trust (non-grantor trust)

1. required to distribute all of its income to beneficiaries annually

2. can’t make distributions from trust principal (corpus)

3. can’t make distributions to charitable organizations 

complex trust (non-grantor trust)

*non-grantor trusts that don’t meet all 3 requirements for simple trusts are complex trusts

• trust can be simple 1 year and complex the next

a non-grantor trust is a complex trust if the trust:

1. does not distribute all its income to beneficiaries annually

2. makes distributions from trust principal (corpus)

3. makes distributions to charitable organizations 

taxation of non-grantor trust income

non-grantor trusts (simple & complex) are required to file annual fiduciary tax returns (Form 1041) & report taxable distributions to beneficiaries on K-1s

• trust taxable income is taxable to either the trust or the beneficiaries, not both

• generally a beneficiary is taxed on trust taxable income distributed to the beneficiary & the trust is taxed on trust taxable income retained by the trust 

trust accounting income (TAI) → aka book income

the book income of the trust; used to determine the amt. required to be distributed to beneficiaries each yr.

• trust income/expenses are allocated to either principal or accounting income

  • income/expense items → allocated to acct. income

  • cap G/Ls → allocated to principal

  • trust administrative expenses (ex: trustee fees) → allocated between corpus & acct. income as stipulated in the trust agreement 

trust taxable income before income distribution deduction

includes all taxable income earned by the trust, including cap G/Ls on the disposition of trust assets, reduced by deductible exp. related to the taxable income

• certain expenses allocable to corpus for TAI are included in trust taxable income

tax-exempt interest income

• doesn’t include tax-exempt interest income or expenses related to tax-exempt interest income

• if the trust has non-taxable intreest income, a portion of the costs of administering the trust (trustee fees) is also not deductible

• non-deductible portion is based on the ratio of non-taxable interest income to trust accounting income

total trust administration expenses

x (nontaxable income/trust accounting income)

=non-deductible trust administration expenses 

exemption

a trust is allowed an exemption amount in calculating trust taxable income

• $300 for simple trust

• $100 for complex trust

taxable income before income distribution deduction

trust taxable gross income including cap gain

(deductible trust expenses)

=adj. total income

(exemption amt)

=trust taxable income before income distribution deduction

distributable net income (DNI) 

a limitation on both the amount of distributions included in beneficiaries’ taxable income & the amt. of the trust’s income distribution deduction in calculating trust income

• DNI includes both taxable & non-taxable income & expenses (including 100% of trust administrative expenses), but excludes cap gains/losses

DNI calculation

trust taxable income before income distribution deduction

+exemption

(cap gains allocated to corpus)

+cap losses allocated to corpus

+tax-exempt interest

(expenses allocated to tax-exempt interest)

=distributable net income (DNI)

alternative calculation of DNI

trust taxable gross income including all cap gains

(trust deductions)

=trust total income

+adj. tax-exempt interest

(cap gains attributable to corpus)

beneficiary taxable income (simple trust beneficiary)

must include in income the amount of trust income that is required to be distributed for the current yr even if it’s not actually distributed only to the extent of the trust’s DNI

• if the trust has both taxable & nontaxable income distributions are part taxable income & part nontaxable income to the beneficiaries

• character of each type of income distributed to the beneficiary stays the same

• aif the total amt. included in the beneficiary’s income is limited by trust DNI, the amt. allocated to the different types of income is based on the relative amt. of each type of income, net of related expenses, included in trust DNI

beneficiary taxable income (complex trust beneficiary) 

must include in income the taxable amount of distributions received but only to the extent of the trust’s DNI

• if complex trust has both taxable & nontaxable income, distributions are part taxable income & part nontaxable income to the beneficiaries

• the character of each type of trust income distributed to the beneficiary stays the says

• amt. included in a beneficiary’s income from the trust is the lesser of:

  • total distributions

  • trust DNI

• total amt. is allocated to the different types & nontaxable income based on the relative amt. of each type of income, net of related expenses, included in trust DNI 

income distribution deduction & trust taxable income

a trust is allowed to take a deduction for taxable distributions to beneficiaries in calculating trust taxable income

• amt. of the income distribution deduction is the same as the taxable amt. of trust income to beneficiaries (aka the lesser of total distributions to the beneficiaries or trust DNI)

• trusts are allowed a deduction for the trust income distributed to beneficiaries so that all taxable trust income is only taxed once, either to the beneficiary or to the trust 

trust taxable income formula

trust taxable gross income including cap gains

(deductible trust expenses)

=adj. total income

(exemption amt)

=trust taxable income before income distribution deduction

(income distribution deduction)

=trust taxable income