Trusts Pay More Tax than Individuals Beginning in 2013
One of the most common tools used in estate planning is a revocable living trust that splits into one or more irrevocable trusts upon the death of the grantor. Most often, the income earned by these irrevocable trusts is distributed to the income beneficiary during his or her lifetime and is taxed on the income beneficiary’s individual tax return. The problem is that not everything we think of as income is considered trust income. For example, capital gains are generally considered principal and not income.
Who Pays Tax on Trust Income? Income received by the trust is taxed either on the trust return (Form 1041) or on your individual income tax return (Form 1040). In order for you to pay the tax, rather than the trust, the income must be distributed to you. Please see more details about distributions later.
What Governs Taking Trust Distributions? The short answer is that most trust documents provide that income earned by the trust may be distributed to the income beneficiary at least annually. However, some receipts of a trust are considered principal rather than income. Unless the trust documents specifically permit the trustee to allocate these receipts to income, receipts such as capital gains are not permitted to be distributed to an income beneficiary and are taxed on the trust return.
Who Pays the Higher Tax? Prior to The Affordable Health Care Act and The American Taxpayer Relief Act of 2012, it made little difference to the ultimate tax bill whether the income beneficiary or the trust paid taxes. Generally, long-term capital gains and qualified dividends were taxed at 15% regardless of who paid the tax. With the passage of these two new laws, the question of who pays the tax will become quite significant.
The Affordable Health Care Act imposes a new 3.8% Medicare tax on “net investment income” of individuals, estates, and trusts. For individuals, this new tax kicks in when adjusted gross income exceeds $200k for single taxpayers and $250k for joint filers. However, for estates and trusts, this new tax kicks in when adjusted gross income exceeds just $11,950! In other words, investment income retained by a trust (rather than being distributed to an individual beneficiary) is significantly more likely to be taxed an extra 3.8%.
The American Taxpayer Relief Act of 2012, passed in early 2013, adds to the problem. This new legislation increased the top ordinary income tax rates to 39.6% (were 35%) and long term capital gain (and qualified dividend) rates to 20% (were 15%) for high income filers. The big tax hit for trusts is due to the definition of high income filers. For individuals, the increased rates apply when taxable income is over $400k or $450k depending on filing status. For trusts, the increased rates apply when taxable income is over $11,950.
Example: Ricky’s Bypass Trust realizes a long-term capital gain of $60K which is allocated to income (because this particular trust document permits such allocation) and distributes the gain to Lucy, the surviving spouse. Lucy will report the $60K long-term capital gain on her tax return and will pay tax at a rate of 15% (assuming her income is under $200K), for total tax of $9,000. However, if the bypass trust does not have this provision in place, or more likely is silent, and the gain is allocated to principal, the tax is paid by the trust. If the $60K long-term capital gain is the only trust income, the trust will pay tax at 15% on the first $11,950 of income and at a rate of 23.8% on the remaining $48,050 of income. The total tax, if the capital gain is reported on the trust return, is $13,228. This is an increase of $4,228 on just $60K of gains!!! The differences can be even more substantial if there are sales of highly appreciated assets such as real estate or an interest in a closely held business.
What can I do?
- For taxpayers with already established irrevocable trusts –
- Remember to take distributions of income (not principal unless the trust document permits). The word income is a term of art and means “fiduciary accounting income” in this context. While the exact composition of income is determined by the trust documents, most often it consists of gross income (including tax exempt interest and excluding capital gains), less ½ of the expenses.
(Please call your tax professional for a more precise discussion. Also please note that distributions made within the first 65 days of the following year may be considered made for the immediately prior year.)
- Manage assets prudently in light of the new tax laws.
- Harvest tax losses to offset tax gains.
- Consider changing the trust’s investment strategy to focus on current-income-producing assets as opposed to growth assets. However, you must be mindful of any fiduciary responsibility you have to the remainder beneficiaries.
- Discuss with your attorney whether it is desirable and/or possible to either distribute appreciated capital assets or terminate the trust. However, be certain to consider non-tax implications of such action.
- Consider the new tax laws when determining which assets to use to fund trusts.
- For taxpayers with a revocable living trust, now may be a good time to consider adding a provision in the trust agreement to permit the trustee to allocate capital gains to income. However, there may be many other implications of such a decision, and all trust changes should be thoroughly discussed with an attorney.
Each situation is unique, and there are many planning opportunities. The key, as with most tax planning, is to be aware of the rules BEFORE undertaking any action and to consult with your advisors.
Article written by Matt Wheeler, CPA and Roberta Schmalz, CPA
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