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It's Tax Planning Time For Trusts

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The 39.6% ordinary tax rate and 20% capital gain tax rate enacted by the American Taxpayer Relief Act of 2012 (ATRA) and the 3.8% Medicare investment surtax now apply when trust income exceeds $11,950.  These high rates apply at much lower levels of income for trusts than for individual taxpayers as shown in the Table below.  With this disparity in mind, grantors creating trusts and trustees managing trusts should consider the strategies that follow. 

Income Distributed By A Trust Is Deductible By The Trust

There are two broad types of trusts – grantor trusts and nongrantor trusts.  Grantor trusts, best exemplified by the revocable trusts used by estate planners to avoid probate, are not subject to tax.  The trust is ignored for tax purposes, and the individual grantor pays tax on the income earned by the assets in the trust on his or her personal Form 1040. 

Nongrantor trusts, usually irrevocable trusts such as qualified terminable interest property (QTIP) trusts,  bypass trusts, and spousal lifetime access trusts (SLATs), are taxable entities for which the trustee must file a tax return (Form 1041).  Trusts are taxed similar to individuals, except that they are conduit entities like partnerships and S Corporations.  Income distributed by the trustee to beneficiaries is taxable to the beneficiaries and deductible by the trust.  Income is taxed either at the trust level or the beneficiary level, but not both. 

For example, the Mary Jones Irrevocable Trust received $25,000 of interest and dividend income.  The trust paid $7,000 in trustee fees and $1,000 for the preparation of its income tax return.  The trustee has the discretion to distribute the $17,000 ($25,000 – 7,000 – 1,000) of net income to the individual beneficiaries, Sam and Deb, or retain the income in the trust.  Aware that the tax rates applicable to the income retained in the trust exceed the rates applicable to Sam and Deb, the trustee distributes the income to Sam and Deb to be taxed on their personal returns.  The trustee reports the distributions to Sam and Deb on Trust K-1s, similar to the K-1 forms used by partnerships and S Corporations.  The trust has reduced its income and tax to zero for the year. 

The reason it is planning time for trusts is the trustees of trusts have until March 6, 2015 to distribute income from the trust and take a deduction for the distribution for 2014.

Here are other Trust Distribution Planning Strategies to consider:

1.  Because trusts are taxed similar to individuals, the trustee should take advantage of deductions at the trust level before determining the amount to be distributed to the beneficiaries.  Typical deductions include the trust’s often-wasted $100 exemption deduction, transaction costs, and appraiser, accountant, attorney, and fiduciary fees. 

2.  If the beneficiaries are subject to tax, but not at the highest rates, the trustee can spread the income between the trust and the beneficiaries, adjusting the distribution to minimize the tax at both the trust and beneficiary levels.  For example, if Stan and Deb pay tax at the 25% marginal tax rate, the trustee can take advantage of the 15% marginal tax rate applicable to the trust by retaining $2,500 of net income in the trust.

3.  If the beneficiaries are dependents of their parents and the amount of investment income attributable to them exceeds $2,000, the beneficiaries may be subject to their parents’ tax rate because of the “kiddie tax.” If the parents are at the maximum tax rate, the “kiddie tax” eliminates the benefit of distributing income from the trust to the beneficiaries. 

In conclusion, under the 65-day rule, trustees have 65 days after the trust year end to think through these strategies, calculate the optimal distribution strategy, and make the distributions to the beneficiaries.