Upon my wife's father's death, his trust was to remain intact to care for and provide income for his second wife until her death and then be divided equally among his children (between my wife and her two sisters). After his death and before his second wife's death, the value of the assets of the trust(stocks and mutual funds)suffered a decline in value of roughly 280K. Shouldn't each heir have received the benefit of approximately 93k worth of loss carryover?

The trustee who administered the trust after her father's death was the husband of one of my wife's sisters. I expressed my concern to my wife as to whether that was a wise decision on the part of her father to appoint her brother-in-law to serve in the Trustee capacity.


Upon the death of the second wife,each heir liquidated their 1/3 share of the trust and received the funds in May of 2009. Should there have been a K1 filed? My wife was never aware of any K1's being filed and I do not know if one was filed, however, if one was filed, would that have not been the necessary part of the Trust return to allow the capital loss carryover to be distributed equally to the three heirs.


My wife's father's death- November 2007
Father's second wife's death- March 2009

Hi CCP,

As I'm sure you know, any assets owned by your father-in-law would receive a step-up in basis to fair market value as of the date of his death. That step-up in basis applies to all assets that he may have had in his trust at the time of his death, plus all assets that he owned outside the trust. So, I believe it's safe to say that the assets of your father-in-law's trust on the date of his death and those transferred to the trust via a pour-over will would have a basis to the trust equal to the fair market value at the date of your father-in-law's death.

Let's also assume that the second wife merely had a terminable interest in the trust and that she didn't have the right to say who gets any part of the trust upon her death.

That being the case, it would be important to know if the trustee sold the stock upon the second wife's death and distributed the proceeds to the children or, conversely, if the trustee simply distributed the stock to the children.

If the trustee simply distributed the stock to the children, then there would be no sale or exchange, which would be necessary to trigger the taxation of any gain or loss. In that case, the children would take the stock with the same basis as the trust. This is referred to as a "carryover" basis. When the children later sold some or all of the stock, the gain or loss on the sale would be determined by subtracting the carryover basis from the proceeds of sale, and any taxable gain or loss would be reported on each child's Form 1040 for the year of sale. The distribution of stock from the trust to the children would not trigger a K-1 to the children, per se; however, if the trust had income during the year in which the distribution of stock was made, then the distribution of stock would carry out that income to the children, resulting in some taxable income to the children, which would be reported on Schedule K-1.

Now, let's assume, instead, that the trustee actually sold the stock and distributed the proceeds to the children. In that case, a taxable event would occur and the trustee would be responsible for reporting the sale on its income tax return (Form 1041) for the year of sale.

In that case, the trustee would determine the gain or loss on the sale of the stock by subtracting its stepped-up basis (i.e., fair market value as of your father-in-law's date of death) from the proceeds of sale. The difference would be the gain or loss to the trust.

Capital gains in a trust are normally treated as principal and not income (unless the governing instrument provides otherwise) and, therefore, are not treated as distributed to the beneficiaries. So, while the proceeds may be distributed to the beneficiaries (and may be deemed to constitute ordinary income to the extent that any exists in the trust for the year of the distribution), they don't carry out the capital gain. Instead, the capital gain is taxable to the trust and the trust can offset capital gains against any capital losses of the trust.

Likewise, capital losses in a trust are not considered distributable to the beneficiaries except for the final year of the trust. If capital losses are incurred in a taxable year other than the final taxable year, then the trust can offset the capital losses against capital gains, plus an additional $3,000 can be offset against ordinary income. Any additional capital losses can be carried forward to later years. Capital losses can be distributed to the beneficiaries in the final year of the trust because otherwise those losses would be lost and never used.

So, if it is the case that the trustee sold the stock and distributed the proceeds to the children, then a trust income tax return (Form 1041) probably should have been filed for the year in which the sale was made. And, if all the losses were not used during the years prior to the termination of the trust, then those losses should have been distributed to the children in the final year of the trust.

Please be aware that I am making some assumptions here because it's not entirely clear what the facts of your case really are. However, as stated above, it does appear that there could have been significant losses, as you state, and those losses would be available to the children if they were not used beforehand by the trustee. Since these events happened relatively recently, you have still have time to make any necessary corrections. My advise would be to speak with an experienced tax attorney or C.P.A. in your local area. It sounds like the children should have received the benefit of those tax losses. In that case, the tax savings to the children by virtue of those losses would probably far exceed the cost of having the trust tax returns done professionally.

If we can provide further assistance, please don't hesitate to post again.

Hi Michael-

Thanks so much for your time and reply. I believe the information you've provided will allow me to question the trustee as to who prepared the required returns for the trust and, if not by him, to request a contact number of the accountant or firm that did.

Some clarifying:

The trustee, upon the father's death in November of 2007, effected the sale of some, if not all, of the assets of the trust through Morgan Stanley, and of which those proceeds were reinvested and were managed by MS. Did this impact the cost basis and the Capital Loss Carryover? The sale and re-investment of the trust's assets occurred shortly after his death and before the market imploded.


The trust, as I understand it only provided for a terminable interest for the second wife until her death, with the assets then to be divided equally among his three blood born children.


The trust's income, during the period of the father's death and the second wife's death, consisted of approximately 34K of dividends and interest.


Upon the initiation of dividing up of the trust, Morgan Stanley asked each heir if they wanted to open an account in their name with their 1/3 portion of the trust's current assets or to have them liquidate their portion and mail the proceeds in a check. All three heirs chose to liquidate and receive the proceeds.

In dealing on my wife's behalf, she prefers not to deal with anything financial, I asked the MS Investment Broker at the time of division about the cost basis of my wife's portion and he indicated a rough figure, He then suggested I speak with the trustee and that the trust's accountant would be able to provide that information accurately. When preparing our taxes this year for 2009, I called the trustee and asked him about the capital loss carryover and he indicated he would contact the accountant and get back with me. That was 3 months ago, tax time has come and gone, and no call back.

Much Obliged-
Charles C. Peters

Charles,

Just want to confirm that the sale by the trustee after your father-in-law's death would trigger a taxable event, which probably would require the filing of a trust tax return (form 1041). The gain or loss would probably have been small, but would need to be reported none-the-less.

Once the proceeds were reinvested, those new assets would have a basis equal to their cost. So, a subsequent drop in the value would trigger a capital loss upon sale. That capital loss would also be reportable on the trust's Form 1041 and the unused capital loss would be carried forward and eventually distributed to the three children in the final year of the trust.

So, yes, you really should find out if tax returns were filed for the trust. Also, were the 34k of dividends ever reported by the trust? I assume that the three children never reported that income, since they never received a K-1. You need to look into that as well.

I suspect the trustee just doesn't know about such things and never hired a tax consultant to prepare the returns. You'll have to see about getting the records from your father-in-law's probate records, final income tax return, Morgan Stanley, and anywhere else - then getting the returns prepared along with the applicable K-1s.

Get a knowledgeable C.P.A. to help you. It will be money well spent.

Thanks for visiting the Living Trust Network!

Michael-

Thanks once again for your advice. It is very much appreciated.

Hope you have an enjoyable Memorial Day Holiday.

Much Obliged-
Charles

Hi Michael-

Update: The Trustee, come to find out, has/had not submitted any tax returns since the death of my Wife's Father in November of 2007. I fear that there is a Statute of Limitations(3 years)by which the heirs would be able to claim a Capital Loss Carryover. Would the 3 year Statute commence from November 2007 or the terminable interest of his wife, who died in March of 2009?

What are my options at this point to have him removed as Trustee for negligence and dereliction of duties?


Much Obliged-
Charles Peters