Tax Act increases income taxation of trusts
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
Summary of new Income Tax Laws for Estates and Trusts
The American Taxpayer Relief Act of 2012 (the Act) increases the highest federal income tax bracket from 35 percent to 39.6 percent for individuals with taxable income over $400,000 (single), $450,000 (joint), or $11,950 for estates and trusts. The Act also increases the tax rate for long-term capital gains and qualified dividends from 15 percent to 20 percent for individuals with taxable income over $400,000 (single), $450,000 (joint), or $11,950 for estates and trusts.
Beginning in 2013, the Patient Protection and Affordable Care Act implemented a 3.8 percent Medicare tax on the lesser of net investment income or taxable income above $200,000 (single), $250,000 (joint), or $11,950 for estates and trusts. As a result, many estates and trusts will be taxable at 43.4 percent on ordinary income and 23.8 percent on qualified dividends and capital gains, while many beneficiaries, particularly young children and grandchildren, will be taxable at lower rates.
Protection afforded by trusts
Leaving assets in trust to one’s beneficiaries at death (or during lifetime) is a popular way to protect the beneficiaries from creditors, ex-spouses and estate taxes (to the extent of the grantor’s generation-skipping tax exemption). Leaving assets in trust is also a way for the grantor to be assured his/her dispositive wishes are carried out and that the assets remain in his/her bloodline.
There is now an even larger tradeoff for the protection afforded by trusts. Trusts reach the highest tax bracket at $11,950 of taxable income (for 2013, indexed for inflation). In addition, except for marital trusts, there is no basis step-up at the beneficiary’s death for those assets held in trust. As a result of the higher tax rates, and with portability of the deceased spouse’s unused estate tax exemption becoming permanent under the Act, many married couples will dispense with credit shelter trusts. In their place, disclaimer trusts will likely be used to allow the surviving spouse to disclaim all or a portion of the decedent’s estate into a credit shelter trust, if desirable.
Minimizing trust income taxes
But what about bequests and gifts to children and more remote descendants? Many clients will be unwilling to leave assets outright to children, particularly young ones. In those situations, trusts will still be used to protect the beneficiaries from their inability, their disability, their creditors and their predators, including ex-spouses. For those clients, the tax consequences can be minimized by:
1. Investing the trust funds for qualified dividends, long-term capital gains and tax-exempt income. Paying a 23.8 percent tax is preferable to paying a 43.4 percent tax.
2. Limiting turnover to minimize gains.
3. When not threatened by creditors, distributing income and capital gains to the beneficiaries, in which case the beneficiaries will pay the taxes at their rates.
4. Investing trust funds in permanent life insurance. The build-up of cash value inside the policy, and policy loans and withdrawals (up to basis in the contract), will be income and Medicare tax free. An added benefit is that the death proceeds will also escape estate taxes.
In addition, if a permanent policy on the grantor’s life is purchased by the trust (with the grantor’s spouse as the beneficiary), the trustee can access the cash values for the benefit of the spouse. This arrangement not only has income tax benefits, but also financial/retirement options. 5. Where appropriate, investing trust funds in an annuity. Annuity contracts present special problems and raise special considerations when the owner is a trust. However, the IRS has ruled privately that ownership of an annuity by a trust can result in tax-deferral.
6. Drafting irrevocable trusts to permit an independent trustee to distribute “so much, or all of, the principal….” This type of clause may suffice to distribute the trust to current beneficiaries and thereby terminate the trust.
7. Drafting trusts to permit the trustee to distribute trust income to charitable organizations, including the grantor’s own private foundation.
Trade or business income
For purposes of the 3.8 percent Medicare tax, the term “investment income” does not include income derived from a trade or business that is not a “passive activity” under IRC Section 469 (and is not trading in financial instruments within the meaning of IRC Section 475(e)(2)). IRC Section 469(c)(1) defines “passive activity” as “the conduct of any trade or business … in which the taxpayer does not materially participate;” and IRC Section 469(h)(1) defines material participation as the involvement in the operations of the activity on a “regular, continuous, and substantial” basis.
Unfortunately, there are no regulations specifically applying the “passive activity” rules to estates and trusts. In Mattie K. Carter Trust v. United States, 256 F.Supp. 2d 536 (N.D. Tex 2003), the Federal District Court Judge held that material participation in the context of a trust is determined with reference to the individuals who conduct the business of the trust on behalf of the trust, and not just the activities of the trustee as the IRS had argued. Although, in Carter Trust, the Court found the activities of the trustee alone were sufficiently “regular, continuous, and substantial”.
In TAM 200733023, the IRS rejected the reasoning of the Carter Trust case and, citing a 1986 Committee report, reasoned that it was appropriate to look only to the activities of the trust’s fiduciaries — not its employees. The IRS also concluded that “special trustees,” who performed a number of tasks related to the trust’s business but were powerless to commit the trust to a course of action without the approval of the trustees, were not “fiduciaries” for this purpose.
Intentionally defective grantor trusts
Finally, inter-vivos trusts can be designed as intentionally defective grantor trusts (IDGTs). As such, the grantor will report and pay the IDGT’s income tax liability, which will now be more burdensome (albeit a tax-free gift to the beneficiaries of the trust) because the top combined tax rate on investment income ranges from 23.8 percent (for long-term capital gains and qualified dividends) to 43.4 percent (for other passive investment income).
If it becomes too burdensome for the grantor to continue to pay the IDGT’s income taxes, with proper drafting, grantor trust status can be “turned off.” Alternatively, depending on state law, an independent trustee can be given a discretionary power to reimburse the grantor for taxes paid on trust income. And if the trust is a spousal lifetime access trust (SLAT), distributions to the beneficiary-spouse can be used to help the grantor-spouse with the payment of taxes.
While trusts will continue to be used to preserve and protect assets, the Act has increased the cost of such protection. But with careful planning, it is possible to minimize the income tax cost of maintaining trusts.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.