Trust Tax Planning: Higher Tax Rates and the 3.8% Medicare Surtax

 By Michael Felz, CPA, MST  - BKL Partner

 Determining whether, and when, to make distributions from estates and trusts involves a number of factors. Among these are the increased disparity between tax rate schedules and Medicare surtax thresholds, as explained below. Trustees and fiduciaries should now, more than ever, consider the timing of estate and trust distributions to beneficiaries as part of their income tax planning. Income tax planning has long been made more difficult by the compressed tax rate schedules for estates and trusts. In 2012, estate and trusts were taxed at the maximum 35% rate at only $11,650 of taxable income, while single individual taxpayers did not reach the 35% rate until they had taxable income of $388,350. The disparity grows in 2013. Estates and trusts will be taxed at a 39.6% rate on taxable income over $11,950, while single taxpayers do not reach the 39.6% rate until $400,000 of taxable income. Though the individual tax rates schedules include a 33% bracket and then a 35% bracket before increasing to 39.6%, there is no 35% bracket for estates and trusts. Estate and trust rates go directly from 33% to 39.6%. Further, there is a new 2013 surtax of 3.8% on "net investment income" that is applicable at much lower income amounts for estates and trusts than for individuals. This new tax on "net investment income" (or the "Medicare surtax"), is equal to 3.8% of the lesser of (1) the estate or trust's undistributed net investment income or (2) the excess of the estate or trust's adjusted gross income over the dollar amount at which the highest tax bracket begins. For 2013, as discussed above, the highest tax bracket begins at $11,950. For individuals, the Medicare surtax is equal to 3.8% of the lesser of (1) net investment income or (2) the individual's modified adjusted gross income over a threshold amount. The threshold amounts are $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for other taxpayers. These threshold amounts are considerably higher than the $11,950 threshold for estates and trusts. 2013 Federal Tax Rates and Thresholds Income Taxes Medicare Surtax Filer Maximum Rate Income Threshold Rate Income Threshold Estate & Trust 39.6% $ 11,950 3.8% $ 11,950 Married filing jointly 39.6% $ 450,000 3.8% $ 250,000 Married filing separately 39.6% $ 225,000 3.8% $ 125,000 Single individual 39.6% $ 400,000 3.8% $ 200,000 This creates a situation when a trust with modest undistributed net investment income could be subject to the highest tax bracket and the Medicare surtax, when both could possibly be avoided if the net investment income was distributed to beneficiaries. For a simple example, consider a trust with $20,000 of interest income and a single beneficiary with no income. In 2013, if no distribution is made to the beneficiary, the trust’s federal income tax will be $6,238 and the Medicare surtax will be $306, totaling $6,544. If instead the trust makes a $19,900 distribution to the single beneficiary, the trust will have no tax, while the beneficiary’s federal income tax will be $2,539 with no Medicare surtax, resulting in a tax savings of $4,005. Real life situations are typically more complicated than this example, and executors and trustees must weigh a number of concerns besides taxes when making decisions regarding distributions. Further, some trusts, such as grantor trusts, are not taxpayers and will not incur the Medicare surtax. We are ready to assist you with the tax aspects of your distribution alternatives and any other questions you might have. Please note that executors and trustees can elect to treat distributions made within the first 65 days of a taxable year as being made on the last day of the preceding tax year. Thus, 2013 distributions can be paid or credited to a beneficiary as late as March 6, 2014, if the executor and trustee makes a proper election on the entity’s income tax return. If you have any questions, please feel free to call me at 847 733-7180 or email me at mfelz@bkl-cpa.com.