Most of the tax increases in the American Tax Relief Act of 2012 (ATRA) were aimed at the wealthiest taxpayers. Unfortunately, the tax increases will hit trusts hard.
The Tax Changes
First, the Patient Protection and Affordable Care Act (often called "Obamacare") imposes a 3.8% surtax on net investment income. "Net investment income" generally is the passive investment income earned by a trust or estate.
Second, the top income tax rate went up from 35% to 39.6% and the maximum rate on dividends and capital gains will be 20%, up from 15 % in 2012. (The combined rate will be 23.8%.)
The Collateral Damage
Why are trusts hit so hard? The trust income tax brackets are compressed. For individuals, the Obamacare surtax doesn't hit until a taxpayer has more than $200,000 of income ($250,000 for married filing jointly). For trusts, the surtax hits when income is over $11,950.
For individuals, the top income tax rate of 39.6% doesn't apply until income is over $400,000 ($450,000 for joint). A trust hits the 39.6 % top bracket when trust income is over $11,950.
The 39.6% top bracket plus the 3.8 % surtax, totaling 43.4% is the trust's combined tax on income over $11,950. Ouch, that hurts. $11,950 is not very much income.
Trustees and Executors should pay particular attention to income accumulating in the trust or estate. With the new tax brackets, it will be more important than ever before for trustees and executors to distribute income to beneficiaries so that it can be taxed at beneficiaries' much lower rates rather than being taxed at the trust or estate level.
For capital gains, which do not get passed out to beneficiaries with distributions, trusts and estates will pay 23.8% when income exceeds $11,950. This means that all trusts, including relatively small trusts, will likely have to pay the combined rate of 23.8% on capital gains.
For estates and trusts that may be subject to the 3.8% surtax, the time to plan for reducing or eliminating the surtax is now. Strategies for reducing or eliminating the surtax may include: investing in tax exempt bonds, choosing a tax year beginning in 2012 instead of 2013 for estates, making estate or trust distributions to individual beneficiaries who will not be subject to the surtax, and creating above-the-line deductions.
Assets like tax-exempt municipal bonds and life insurance may become more favorable investment options when compared to other investment assets whose income is subject to the surtax. Trustees of trusts with IRA assets, both traditional and Roth IRAs, should consider that these assets will be even more tax-advantaged in 2013 when distributions from these accounts are not subject to the surtax.
Trustees should become familiar with the mechanics of charitable lead trusts and charitable remainder trusts, which may become more popular in light of the income deferral feature of charitable remainder trusts and the ability to shift investment income to charities in charitable lead trusts. Charitable remainder trusts are exempt from the surtax because they are exempt from income tax. Charitable lead trusts will be subject to the surtax, but the surtax may be partially or entirely avoided by the required annual distributions to charities.
Pressure to Distribute
Trustees must decide whether or not to release more funds to current generations of beneficiaries or to hold on to trusts assets for future generations and pay the higher tax. The basic questions for trustees are, "How much income is to be distributed, who are the beneficiaries and their tax rates and what are their needs?"
These questions are not new, but with the increased taxes inside the trust, more weight (pressure) will be given to making distributions. The question can only be answered for each trust and each trustee depending on the terms of the governing instrument and the individual situations and needs of the beneficiaries. It might even be appropriate to consider trying to terminate a trust to gain better tax treatment.
Being a trustee is a difficult and challenging job. The new tax laws make it even more so.