CES Financial Analysis & Planning 3 — Questions and Answers
Question 1: A trust holds a rental property generating $40,000 of net income annually. The trustee distributes $25,000 to the income beneficiary. How is the trust's distributable net income (DNI) relevant here?
- DNI caps the deduction the trust can claim for distributions (Correct answer)
- DNI determines the trust's capital gains tax rate
- DNI sets the maximum amount of income the beneficiary can exclude
- DNI calculates the trustee's fee deduction
Correct answer: DNI caps the deduction the trust can claim for distributions
DNI limits the distribution deduction a trust can claim; the trust deducts the lesser of actual distributions or DNI, and beneficiaries are taxed on the character of income up to DNI.
Question 2: A CES practitioner is comparing a taxable investment account to a tax-deferred annuity for a 65-year-old client. Which factor most favors the annuity for estate planning purposes?
- Annuities receive a stepped-up basis at death
- Annuities avoid probate through beneficiary designation (Correct answer)
- Annuity gains are taxed at long-term capital gains rates
- Annuities qualify for the estate tax marital deduction
Correct answer: Annuities avoid probate through beneficiary designation
Annuities with named beneficiaries pass outside probate, providing privacy and potentially faster transfer, though gains are subject to ordinary income tax by beneficiaries.
Question 3: Which valuation method for a closely held business applies a market-derived multiple to normalized earnings before interest, taxes, depreciation, and amortization?
- Asset accumulation method
- Capitalization of earnings method
- EBITDA multiple method (market approach) (Correct answer)
- Discounted cash flow method
Correct answer: EBITDA multiple method (market approach)
The EBITDA multiple method, a form of the market approach, values a business by multiplying normalized EBITDA by a multiple derived from comparable transactions or public companies.
Question 4: A client is concerned about the 3.8% Net Investment Income Tax (NIIT). Which income type is generally subject to this surtax for a trust?
- Distributions from a qualified pension plan
- W-2 wages passed through from an S corporation
- Passive rental income retained in the trust (Correct answer)
- Tax-exempt municipal bond interest
Correct answer: Passive rental income retained in the trust
Passive rental income retained within a trust is subject to the 3.8% NIIT once the trust's AGI exceeds the threshold (approximately $15,200 in 2024).
Question 5: When structuring an installment sale to a grantor trust for estate planning, what is the primary income tax advantage?
- Capital gains on the sale are excluded from taxation entirely
- Interest payments from the trust to the grantor are not taxable income (Correct answer)
- The trust assets receive a stepped-up basis at the grantor's death
- The sale price can be set below fair market value without gift tax
Correct answer: Interest payments from the trust to the grantor are not taxable income
Because the grantor is treated as owning the trust for income tax purposes, interest paid by the trust to the grantor on the installment note is ignored — it's a transaction with oneself.
Question 6: A fiduciary accountant is preparing a trust's Schedule K-1. Which type of income retains its character when distributed to a beneficiary?
- Ordinary income converted to principal under the unitrust rules
- Tax-exempt municipal bond interest (Correct answer)
- Depreciation recapture reinvested in the trust
- Capital gains allocated to principal and not distributed
Correct answer: Tax-exempt municipal bond interest
Tax-exempt interest retains its tax-exempt character when passed through to beneficiaries on Schedule K-1, preserving the federal income tax exclusion.
Question 7: Under the prudent investor rule, a trustee invests a trust portfolio entirely in U.S. Treasury bonds 'because they are safe.' What is the most likely fiduciary concern?
- Insufficient diversification of income sources
- Failure to consider the trust's overall investment strategy and risk/return tradeoff (Correct answer)
- Violation of the prohibition on self-dealing
- Exceeding the permitted allocation to fixed income
Correct answer: Failure to consider the trust's overall investment strategy and risk/return tradeoff
The prudent investor rule requires trustees to consider the risk/return tradeoff in the context of the entire portfolio; concentrating in Treasuries may fail to meet the return needs of beneficiaries.
CES Financial Analysis & Planning 3
A trust holds a rental property generating $40,000 of net income annually.
The trustee distributes $25,000 to the income beneficiary.
How is the trust's distributable net income (DNI) relevant here?