The American Taxpayer Relief Act of 2012 imposes a 3.8% tax on the net investment
income (NII) of individuals, estates, and trusts to the extent that the
taxpayer's adjusted gross income exceeds the applicable
thresholds. While the threshold amount for married and
single filers are relatively high, the threshold for an estate or trust is only
$11,950 for the tax year 2013. Therefore, if the undistributed NII of an estate
or trust exceeds $11,950, the excess is subject to the
3.8% Medicare tax.
A trust or estate is only subject to
the NII tax if the trust or estate contains undistributed net investment
income. Therefore, the trust or estate can avoid this tax entirely by
distributing its net investment income to its beneficiaries. With some trusts, especially
those that contain mandatory distributions of all income or where the trustee
regularly distributes all the trust income to pay the beneficiaries’ expenses, this
is simple. However, for trusts that seek to minimize income distributions, such
as Supplemental Needs Trusts for beneficiaries receiving government benefits,
avoiding this tax becomes more problematic.
In situations where the distribution
of trust income has the potential to create problems the Trustee must weigh the
benefits of tax avoidance against the drawbacks of giving income to
beneficiaries who may waste it or actually do harm to themselves. In these
situations, rather than distributing income to avoid the NII tax it may be
better to restructure the trust's investments to avoid receipt of NII.
Investing in tax-exempt investments such as municipal bonds or tax-deferred
investments or accounts such as life insurance or deferred annuity contracts
can avoid the net investment income. It may also make sense to select
investments producing growth but little or no income. Trustees can sell such
assets later when cash is needed for distributions.
Another, less common concern, is that
the value of income generated by a trust will exceed the liability threshold
for a beneficiary as an individual. This issue may be addressed by including a
number of permissible, but not mandatory beneficiaries in the trust, such as
including grandchildren as permissible beneficiaries of a trust for their
parent. This allows the trustee to make distributions to a number of trust
beneficiaries who do not otherwise have sufficient income to subject themselves
to this 3.8% Medicare tax, and spreads
the income among taxpayers potentially eliminating the tax liability altogether.
It is important for trustees and personal
representatives of trusts and estates containing significant income generating
investments to review those entities as soon as possible in order to determine
the best results for each trust or estate. Clients should discuss the options
with their professionals in order to maximize tax savings.
As a reminder, the IRS treats income
distributed from a trust within the first 65 days following the year-end as
distributed in the prior year. For example if a Trustee makes distributions
from a trust of income earned in 2013 in the first 65 days of 2014, the
beneficiaries report that income on their 2013 income tax return. This gives
some flexibility in planning, but Planners should not delay acting to avoid
problems.
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