How the Investment Income Tax Effects Trusts and Estates

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. 

Alan Ferrara

Extra Privacy Gained from Trusts

     Increased privacy is one of the major benefits of using a living trust in estate planning. The Trust allows you to avoid public disclosure of the assets of the estate and the distribution provisions of the Will in the Probate Court. It also allows the Grantor to provide Beneficiaries with information that applies to their own distribution but not the distributions for other Beneficiaries. 

     The Michigan Trust Code (MTC), which governs the duties and powers of the trustee along with the rights and interests of trust beneficiaries, requires that a trustee of an Irrevocable Trust or a Living Trust which became Irrevocable upon the death of the Grantor inform a trust beneficiary of the following information:

• That a trust exists that names the person as a beneficiary 
• The identity of the Grantor of the trust. 
• The Trustee’s identity, including address and telephone number 
• The court, if any, in which the trust is registered The terms of the trust that describe or affect the beneficiary’s interest and relevant information about the trust property.

     The MTC also mandates that the trustee must provide an annual accounting of the Trust property to everyone who receives, or may receive, a distribution from the Trust. The Grantor of a Trust may override that statutory requirement and dictate whom, if anyone, the Trustee must provide with an accounting. It is important to note that even when the terms of the trust waive the annual accounting, a Probate Judge has the authority to order the Trustee to provide the court, or other parties, with an accounting.

     The benefits of these statutes to a Grantor include the ability to provide bequests of different values for children without revealing the differences in gifting. Alternately, it allows the Grantor to make equal gifts to multiple children, but under different terms, without creating strife because one child receives their bequest outright while other gifts continue in trust with restrictions on distribution. 

     The Michigan Trust Code strikes a balance between the Grantors’ right to privacy and the Beneficiary’s ability to confirm the Trustee meets their fiduciary duty. The information that Trustees must provide to a beneficiary gives that person sufficient information about their rights to the trust assets to determine whether the Trustee is doing their job. If the beneficiary suspects something is amiss, the information gives them a basis for the Probate Court to order a complete accounting. 

     It is important for successor trustees to understand the law and review the terms of the trust in order to determine the scope of their duty under the trust and applicable law. Often the attorney who drafted the trust document is the most useful resource for successor trustees in determining what information the trustee must provide to beneficiaries. A responsible attorney will provide clients with contact information and assurances that they will be available to help the successor trustees administer the trust when the time comes.

Matt Ferrara