If you are the trustee of a trust that generated income in 2013, you may be looking at a hefty tax bill this filing season. With the new marginal income tax rates for 2013, the increased capital gains rates, and the 3.8% tax on net investment income, it is more important than ever to actively manage a trust’s tax exposure. As a Philadelphia tax lawyer licensed to practice in multiple states, I understand the importance of this issue.
Because trusts are subject to compressed income tax rates, the increased tax rates can kick in at relatively low levels, compared to individual taxpayers. The highest marginal income tax rate of 39.6 for an individual applies only to income in excess of $400,000. On the other hand, trust income is subject to the 39.6% rate after it reaches only $11,950 (for 2013). Trust income over that threshold is also subject to the 20% tax on dividends and capital gains and the 3.8% surtax on investment income.
A trust’s high tax rates can usually be avoided by distributing income out to the beneficiaries. The distributed income is then taxed as income to the recipient beneficiary, rather than to the trust. For example, assume a trust holding $500,000 of assets generated a 5% return in 2013, all in interest income. The trust would have $25,000 in taxable income. If the trust retains all the income, the tax bill would be about $8,750. If, instead, the trust distributed all of the income to a beneficiary who was subject to a 25% marginal income tax rate, the trust would pay no tax on the income, and the beneficiary would pay tax of $6,250. Simply shifting the income to the beneficiary creates a tax savings of $2,500. It may be possible to reduce the tax even further by retaining some of the income in the trust and distributing the rest.
A special rule allows a trustee to take advantage of this strategy even when distributions have not been made in the year for which the tax return is filed. By making a special election on the trust’s tax return, the trustee can treat distributions made within 65 days of the end of the calendar year as made in the prior year. This means trustees have until March 6, 2014 to make distributions that will reduce the trust’s 2013 tax liability.