Problem with inherited farm

[kamckinley]

I just had a client drop a major headache in my lap and wanted to confirm the correct way to handle this situation...

Clients inherited a farm back in 2005 and have been renting it out since then for a small loss each year ($250 w/o depreciation, $1,250 w/ depreciation - annual loss). They have been reporting the income and expenses on their personal tax returns.

The problem is they recently discovered that the farm has been in an irrevocable trust for all these years. So they should have been filing trust tax returns instead of reporting the activity on their personal tax return. The trust allows the income to be passed through to the heirs, but my understanding is that tax losses from the trust can't be passed through to the heirs (however, the depreciation deduction can, is my understanding correct?). So essentially, they have been taking losses of $250 on their personal tax returns that they should not have been taking.

I believe the correct way to handle this is to file trust tax returns from 2005-2014 and to amend their personal tax returns for the same years (up to 2014, we will file that one correctly of course). However, that is a LOT of work just to send the IRS approx. $63 plus interest for all those years.

I'm just trying to determine all the potential penalties and problems so I can give the client their options and let them decide. As of now, it looks like they have a few options:

1) File trust tax returns from 2005-2013, amend personal tax returns for losses taken (that shouldn't have been) for same years. I'm not even sure how much to charge for this much work, but for nine years of tax returns, that's easily a several thousand dollar prep bill.

2) File trust tax returns starting with current year, don't file back years. Amend personal tax returns for 2011-2013 only. Alert client to potential penalties on K-1s that were not filed. Do you alert the IRS and request penalty waiver or file as just described and respond to IRS letters if/when they occur?

3) File trust tax returns starting with current year, don't file back years and don't amend personal tax returns for 2011-2013.

So when talking with client, let them know that #1 is technically the correct way to fix this mess, but let them decide which option to pursue? As long as I inform them of the potential penalties, am I covered, or do I need to recommend that they choose option #1?

Sorry about the long post, I just don't want to do or tell the client to do anything that would be negligent.

Thanks!
Kristine

[Kram BergGold]

Depreciation

If the farm was in an irrevocable trust before they inherited it, there would be no step up on the death of the grantoe. If it only entered the irrevocable trust upon the death of the grantor then there should have been a step up. Was this handled correctly?

[kamckinley]

farm in trust

If the farm was in an irrevocable trust before they inherited it, there would be no step up on the death of the grantoe. If it only entered the irrevocable trust upon the death of the grantor then there should have been a step up. Was this handled correctly?

Kram - I believe it was an intervivos trust that became effective when the client's father passed away. I do not believe it was held in trust before then, but I'm still waiting for the trust documents.

Assuming that is the case, are the options I listed above correct? Any other options to correct this mess that I haven't thought of yet?

Thank you!

[kamckinley]

farm in trust

I just got a copy of the trust and as suspected it was a revocable trust that became effective at the death of my client's father. The property should have been distributed to my client and his sister at that time (nine years ago), but that never happened. I hope this additional info helps. Any insight on the best way to correct this mess is welcome. Thanks again!

[Kram BergGold]

Reality

My next question is, I understand they were supossed to put it into an irrevocable trust. Question is, did they ever put the property into a trust, or is the deed in their names. My guess is the latter. If so then I think everything is fine as it is. I know when I went to deal with my Mom's estate the person at the probate office asked me if I was going to bother setting up a trust. From this I got the idea that you can choose to ignore setting up a trust.

[mastertaxguy]

Is this a tax pro issue or a lawyer issue?

1. The issues raised appear to involve more than tax returns.
2. The issues raised as to land title and such need to be referred to an attorney who can handle the issues raised.
3. As others have noted many times, before any questions are asked the trust document should be read and understood.

[kamckinley]

My next question is, I understand they were supossed to put it into an irrevocable trust. Question is, did they ever put the property into a trust, or is the deed in their names. My guess is the latter. If so then I think everything is fine as it is. I know when I went to deal with my Mom's estate the person at the probate office asked me if I was going to bother setting up a trust. From this I got the idea that you can choose to ignore setting up a trust.

The client recently sold the farm and at that time they were told that the property was titled in the name of the trust. Does that help?

[kamckinley]

1. The issues raised appear to involve more than tax returns.
2. The issues raised as to land title and such need to be referred to an attorney who can handle the issues raised.
3. As others have noted many times, before any questions are asked the trust document should be read and understood.

Thanks mastertaxguy. I have seen the trust document; this was a grantor trust that became irrevocable at the client's father's death. The land should have been distributed to the client and his sister, but this was never done. It was retitled into the name of the trust however. The client recently sold the land and that's when it was discovered that the land was still in the name of the trust rather than the client.

Does this need to be referred to a lawyer to have the land retitled? Or is this just a matter of correcting the tax returns? Thanks again for your help.

[mastertaxguy]

Talk with the lawyer

1. Have taxpayer get with a lawyer.
2. As you describe, I am not sure that at the end of the day there would be any difference in tax return results.
3. Posting only for myself, my malpractice insurance covers tax preparation and representation, and incidental accounting, but not giving legal advice or practicing law in general. Others may have different coverage.

[Burke]

Thanks mastertaxguy. I have seen the trust document; this was a grantor trust that became irrevocable at the client's father's death. The land should have been distributed to the client and his sister, but this was never done. It was retitled into the name of the trust however. The client recently sold the land and that's when it was discovered that the land was still in the name of the trust rather than the client.

Does this need to be referred to a lawyer to have the land retitled? Or is this just a matter of correcting the tax returns? Thanks again for your help.

Well, since the land has been sold it cannot be "retitled" now. They don't own it.

I assume the land was titled into the trust when it was set up. It had no affect on the father's tax return since it was an RLT. Even if the property was retitled into the trust at the father's death due to a pour-over clause in his will (which would have caught up all untitled assets) it would not matter. If the trust document directed it be distributed to the children, and it had been, then nothing would change in the way the tax returns were handled up to now. However, apparently it DID remain in the trust and received the legal protection such ownership provided. Trust returns should have been completed, and this would have affected the treatment of losses since it was rental property. In the end, however, all suspended losses would have been realized at sale and affected the basis used in calculating the gain/loss to the beneficiaries of the trust. You just have to deal with the tax return issue at this point.

[DonB]

Amended returns are not mandatory but may be advisable. If when one files a return and believes it to to true, correct, and complete to the best of one's knowledge and later finds a small income or deduction error; and the change results in De-minimis change, I suggest no amended return be filed.