Trust and estate planners are zeroing in on another potential tax risk for wealthy clients: income generated by a trust.
The higher tax rates mandated by the American Taxpayer Relief Act of 2012 for individuals earning more than $200,000 a year and $250,000 for married couples filing jointly are well-known.
Less widely publicized, however, are new tax rates for estates and trusts. In addition to being in the top income tax bracket of 39.6%, estates and trusts now face a 3.8% net investment income tax - the health care surtax - if they produce more than $11,950 in income per year. That wrinkle is just now beginning to be scrutinized.
“Lawyers and [certified public accountants] are starting to get their arms around the 3.8% surtax,” said Robert S. Keebler, a partner with Keebler & Associates LLP.
The low tax threshold for income from trusts is ruffling feathers among the well-heeled, their attorneys and tax experts. What's more, these are only federal taxes. A separate set of rules that vary from state to state also apply to trusts.
As for clients and their beneficiaries, many were comfortable leaving their money in the trust when the top income tax rate was 35%, but now that it's close to 44%, there's some panic. “They're saying 'Oh, my gosh, I'm losing half of the income to taxes. What will I do?'” Mr. Keebler said.
Before clients hit the panic button, they should consider the fact that not all trusts are subject to this sharp increase in federal income taxes. Grantor trusts leave the tax burden to the grantor, the individual who started the trust. The
grantor controls the property within the trust and declares income on his or her own tax return. This way, the trust does not have to file its own return.
“Lots of estate planning is done with grantor trusts,” said Andrew Katzenstein, a partner in the personal planning department of Proskauer Rose LLP. Grantor trusts are popular because they allow the grantor to cover the taxes, thus reducing his or her estate, while allowing the trust to continue growing for the beneficiaries.
Once the grantor dies, however, the trust becomes a nongrantor trust and must file its own tax return. Its income also becomes subject to the aforementioned taxes at the $11,950 income level.
Enter the opportunity for distribution strategies. Trusts can collect an income tax deduction for distributions to beneficiaries, so if the terms of the trust permit it, this may be a good time to consider distributing the money to beneficiaries who are in a lower tax bracket, noted Charles Aulino, director of financial planning for The Glenmede Trust Co. NA.
Whether it's a good time to distribute funds depends on the individual circumstances of the client and the beneficiaries.
In a situation in which a grantor of a revocable living trust died near the end of 2012, it may be possible to elect a fiscal year for the estate and defer at least some of the tax impact.
“Say you died in November 2012, We could choose October as the end of the fiscal year for the trust,” Mr. Katzenstein said. “In that example, we get 10 months of income that isn't affected by the [3.8%] tax.” The downside is that the trust's income tax return will be due at a different time from other tax returns.
Still, the client can sock away some substantial savings. One of Mr. Katzenstein's clients saved $150,000 on taxes by setting the fiscal year-end of the trust in 2012 before the new tax regime was put in place.
It also may be a good time to think about the underlying investments in the trust. Mr. Keebler noted that life insurance is always a possibility, combining the benefit of tax-deferred growth and a tax-free death benefit. Master limited partnerships and municipal bonds also are investments that advisers might want to consider in order to shield some of a trust's assets from the harsh federal tax treatment.
“You have to be guided by a desire to have a balanced portfolio and meet your fiduciary responsibility,” Mr. Keebler said. “You won't want to buy 90% master limited partnerships, but you might want to have 3% or 4% of the trust's assets in them.”
