It is important to consider the income tax ramifications of each decision throughout the estate planning process to avoid unintended consequences. After all, an individual’s death and the gifting they do during their life affect the taxes of the decedent, a surviving spouse, the estate, the beneficiaries, and, potentially, their trusts.

Below are 10 important income tax questions to consider when creating an estate plan:

1. How will passthrough business income be taxed after transfer?

If the client owns a passthrough business, one question to focus on is how that income will be taxed after transfer. Passthrough business income is typically categorized as active, passive, or portfolio. Ideally, taxpayers want income to be classified as active because it is generally treated more favorably under the Code, compared with passive income. If a taxpayer actively participates in a business, the income may qualify for a lower tax rate or allow for a loss deduction. It may be important to preserve this treatment after lifetime transfers or at death.

Determining whether certain business income is active or passive in relation to a trust or estate is not as straightforward as it is for individuals. Participation prior to transferring the business interest is no longer relevant, and there is no authoritative IRS guidance for how activities of a trust or estate are tested for participation purposes. Instead, participation rules and guidance for an estate or trust rely heavily on two prominent court cases, Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003), and Frank Aragona Trust, 142 T.C. 165 (2014).

Based on case law, the participation of a trust or estate is determined by whether key individuals acting as a fiduciary (or agents of the fiduciary) are participating in the income-producing activity. The IRS has indicated it will propose regulations around this area. If regulations are issued, they could provide different guidance on how activities are tested for income tax purposes.

Planning point: Consider the participation rules when choosing a trustee or executor. Business income could be taxed at a higher rate, and losses may not be deductible, depending on whether the fiduciary participates in the income-producing activity. Use caution when relying on case law in planning, because the IRS has not indicated that it agrees with the outcome of the cases.