Folks with trusts, and that includes widows and the disabled, not just the ultra-wealthy, have been hit with a double tax whammy this year. First the 3.8% Obamacare tax that applies to net investment income kicked in Jan. 1. Then, the American Taxpayer Relief Act was signed into law on Jan. 2, imposing income and capital gains tax hikes on trusts akin to those on the wealthiest taxpayers. The top income tax rate is now 39.6%, up from 35%, and the top capital gains rate is now 20%, up from 15%.
The kicker: these taxes hit a trust on any income it does not distribute over just $11,950, far less than the $400,000/$450,000 ATRA and $200,000/$250,000 Obamacare thresholds for individuals.
“It’s hitting where it really shouldn’t,” says Laurie Hall, an estates lawyer and head of the Wealth Management Group at Edwards Wildman in Boston. “These increases weren’t intended to hit people with income below $200,000, and they will.”
Here’s why. Most trusts (non-grantor trusts) pay tax on capital gains and accumulated income that stays in the trust, while the beneficiaries pay tax on income that is distributed to them. So trusts—even relatively small ones—will be hit with the 23.8% capital gains rate (the 20% rate plus the 3.8% Obamacare tax), even if the beneficiary himself would be squarely in 15% capital gains territory. “Going forward you have to think the trust is going to be hit with the extra 8.8%,” says Hall.
True, many trust beneficiaries are ultra-wealthy and can easily bear the extra tax, but many middle-class folks have set up trusts for basic estate planning as well as non-tax reasons, and they’ll be swept into the higher tax regime too. For example, it has been common for a husband to leave money to a surviving spouse in two trusts, one sometimes called a “bypass trust” to shield assets from the federal estate tax, and another “marital” trust to keep the assets earmarked for his children in the event the surviving spouse remarries. Also, families put money into “special needs trusts” for disabled or chronically ill relatives. “You’re stuck between the human issues and the tax issues,” Hall says.
Trusts and estates lawyers are just starting to come up with ways to soften the blow of the tax hikes on trusts. On the capital gains front, instead of selling stock in the trust, you might distribute it and sell it at the beneficiary level if the trust allows this, Hall says.
The income tax hikes call for more advanced and time-sensitive planning. For many trusts it’s left to the trustee’s discretion whether or not to distribute income to any or some of the beneficiaries, and there’s always been a tension between leaving money in the trust to grow for future generations and paying out to current beneficiaries today.
The Internal Revenue Service allows a 65-day grace period (through March 6, 2013 this year) to take distributable net income out of the trust and treat it as distributed in 2012. Given the new high rates, it may make sense to accelerate income distributions to the extent there is undistributed income in the trust. For high-income beneficiaries who have an immediate need for the money, making the distribution in the window would lock in the 2012 individual tax rates, saving 4.6%, or more because the healthcare tax does not apply in 2012, says Carol Harrington, a trusts lawyer with McDermott Will & Emery in Chicago.
Going forward as trustees engage in this annual exercise, there will be more reason to hand income out to beneficiaries in lower tax brackets. The basic questions are: how much income is to be distributed, who are the beneficiaries, what are their tax rates and what are their needs, says Faith Matous, a trust officer with PNC Bank. But each trust has its own rules, and each family has its own idiosyncrasies. In one $200,000 trust she handles, she distributed the total $8,000 of income last year to a lone grandchild because the parents and grandparents had creditor problems (a great-grandparent had set up the trust).
Some families might even decide to dissolve existing trusts. A widow in her 80s who is living off a $1 million trust left by her late husband doesn’t need it for estate planning purposes any more. (ATRA made the $5 million federal estate tax exemption permanent, and indexed it for inflation). But before you rip up a trust, consider whether it’s needed to shield you from state estate and inheritance taxes, for adult children who aren’t great with money, or for protection from divorcing spouses and other creditors.
And what if you’re thinking of setting up a new trust? Make sure you have flexibility written in, says Jonathan Blattmachr, author of the 953-page treatise, Blattmachr on Income Taxation of Estates and Trusts. “The one thing that’s critical is to start with a trust,” he says. “You can always flush the income out. You can always terminate the trust.”
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