Whether you are a fiduciary or beneficiary of an estate or trust, or one of their advisors, you should take note of some of the more important changes under the new income tax laws, as well as strategies that can be employed to minimize the tax.For some of those strategies to be effective, action must be taken right away.
Fiduciaries, in particular, should be familiar with these strategies and deadlines. Beneficiaries will not be very happy if they or their trusts are forced to pay additional income taxes that could have been avoided with a little planning on the fiduciary’s part.
Increase in Ordinary Income and Capital Gains Tax Rates
The top tax rate on ordinary income has increased from 35 to 39.6 percent. For individuals, the top rate kicks in at taxable income of $400,000 (or $450,000 if married filing jointly); however, for estates and trusts in 2013, the top rate kicks in at taxable income of only $11,950.
The rate on long-term capital gains and qualified dividends has increased from 15 to 20 percent.
There is also a new tax that applies beginning in 2013, the so-called Medicare surtax, which is a 3.8 percent tax on “net investment income.” Net investment income generally includes (a) interest, dividends, annuities, royalties and rents, (b) gains attributable to the disposition of property and (c) income and gains from a trade or business, but only if such trade or business is a passive activity with respect to the taxpayer or involves trading in financial instruments or commodities.
For individuals, the surtax applies to the lesser of net investment income and the excess of modified adjusted gross income (AGI) over $200,000 (or $250,000 if married filing jointly). For estates and trusts, the surtax applies to the lesser of undistributed net investment income and the excess of AGI over the threshold for the highest income tax bracket ($11,950 in 2013).
Strategies to Minimize Income Taxes
With these new rules in place, the following are some of the strategies that may be used to minimize income taxes.
Minimize the Medicare surtax
Distribute net investment income to beneficiaries who are under the $200,000/$250,000 threshold at which the surtax applies.
Convert passive activities to active. Generally, for a trust, an activity is active if the trustee materially participates in the activity. (The exception is grantor trusts, for which it is the participation of the grantor that matters, not that of the trustee.) If a trustee can be appointed who materially participates in the activity, then any income from the activity will not be deemed net investment income and will not be subject to the surtax. If the trustee does not materially participate, the surtax also can likely be avoided by distributing income from the activity to beneficiaries who actively participate in the activity.
Distribute to beneficiaries who are in low income tax brackets. This will allow the income to be taxed at the beneficiaries’ lower rates, rather than at the estate’s or trust’srate, which is 39.6 percent once the $11,950 threshold is reached.
Make a 65-day election. An estate or trust may elect to treat amounts paid or credited in the first 65 days of the tax year as if they were paid or credited on the last day of the prior tax year. For distributions to beneficiaries between Jan. 1, 2013 and March 6, 2013, the election may allow the distributions to be taxed to the beneficiaries at the lower 2012 rates and to escape the Medicare surtax. But you need to make those distributions quickly. March 6 is right around the corner.
Before making distributions to minimize income taxes, make sure to consider other factors.The fiduciary should weigh the potential income tax savings against the possible disadvantages of distributions, such as exposing the distributed assets to the beneficiaries’ creditors or to their spouses in the event of divorce. Also, if the trust is exempt from generation-skipping transfer taxes, the transfer tax savings from accumulating income in the trust may outweigh any income tax savings from distributions.
Elect a fiscal year. Generally, estates and trusts are taxed on a calendar year basis, but estates may elect to be taxed on a fiscal year basis. Moreover, an election may be made to treat a decedent’s qualified revocable trust as part of the estate, thereby permitting the trust to be taxed on a fiscal year basis as well. A fiscal year is adopted when filing the estate’s first federal income tax return, Form 1041. It is not sufficient to indicate the fiscal year when extending the due date for the Form 1041 or when applying for the estate’s Employer Identification Number.