Minimizing the Net Investment Income Tax on Your Trust – February 13, 2014 by Andy Whitehair

March 6th deadline to use 65-day election strategy

The tax community has been bracing and planning for the implementation of the 3.8% Net Investment Income (NII) tax (aka Medicare Surtax) since it was introduced as part of the Affordable Care Act in 2010. Recently released final regulations clarify the implementation of the new tax (read our 12.23.13 blog post), but they also highlight the fact that the NII tax will disproportionatelyimpact trusts and estates.

While the NII tax only applies to individual taxpayers with AGI in excess of $200,000 (single) and $250,000 (married filing joint), the tax applies to trusts and estates with AGI in excess of only $11,950 for 2013 and $12,150 for 2014. In addition to the NII tax, condensed trust tax brackets result in trusts — even those at the low AGI thresholds above — paying tax at the highest marginal income tax rate. While condensed brackets are nothing new, the implementation of the NII tax combined with an increase in the top marginal income tax rate from (35% to 39.6%) and an increase in the top tax rate used for qualified dividends and long-term capital gains rates (from 15% to 20%) add new importance to considering trust distributions.

It’s not too late… yet

Because the NII tax and new income tax rates apply for 2013, what can a trustee do now that 2013 is over? Fortunately, IRC Code Sec. 663(b) allows a trustee to treat amounts paid or credited to a beneficiary of an estate or complex trust within the first 65 days following the close of the tax year — March 6, 2014, for those on a calendar year — to be considered as paid or credited on the last day of the prior tax year. This election provides considerable flexibility to the fiduciary to maximize tax savings across the entire family unit.

For example, assume parents established a trust for the benefit of their adult daughter Sally. The trust agreement provides that income may be distributed or accumulated on behalf of Sally. In 2013, the trust and Sally both expect $50,000 each of investment income eligible for the reduced qualified dividends tax rate. Case #1 assumes no tax planning, and Case #2 shows the result if the trustee makes distributions to Sally, who is in a much lower tax bracket.

Case #1
Current Situation    
  Trust Sally
Qualified Dividends 50,000 50,000
Expenses (5,000)  
Exemption/Standard Deduction (100) (10,000)
  ----------- -----------
Taxable Income 44,900 40,000
     
Regular Tax 8,015 563
Medicare NII Surtax 1,252 --
  ----------- -----------
Total Tax 9,267 563
Combined Total   $9,830
     

 

Case #2
Distributions from Trust    
  Trust Sally
Qualified Dividends 50,000 50,000
Income from Trust   44,900
Expenses (5,000)  
Exemption/Standard Deduction (100) (10,000)
Distribution Deduction (44,900)  
  ----------- -----------
Taxable Income -- 84,900
     
Regular Tax -- 7,298
Medicare NII Surtax -- --
  ----------- -----------
Total Tax -- 7,298
Combined Total -- $7,298

 

By making distributions from the trust, the combined family unit will pay approximately $2,500 less tax in this simplified illustration. Even if the trustee did not make a distribution before the end of the prior tax year, the trustee still has 65 days from the end of the tax year to make a distribution and treat it as if it were distributed in the prior tax year.There may be other reasons, such as creditor protection or estate tax planning, a trustee may not want to make distributions, even if they may result in a better tax outcome. However, beneficiary distributions along with a 65-day election can be an effective tax planning strategy in the right situation.

We want to hear from you! We encourage you to share this blog post on social media or contact Andy Whitehair at awhitehair@cohencpa.com or a member of your service team for further discussion.

This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.

Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.