Higher tax rates on trust income mean more work for lawyers Trusts will need to be designed with greater flexibility

By Sylvia Hsieh
The Daily Record Newswire
BOSTON — In the aftermath of the fiscal cliff deal, trusts now face much higher taxes on income.

The top tax rate increased from 35 percent to 39.6 percent and a new Medicare surtax of 3.8 percent on investment income was imposed on top earners as of January 1.

But while the new hikes will kick in for individuals only at high incomes, trusts will get hit with both new rates at incomes above $11,950.

“You’re looking at [an] over 43 percent tax on trust income over $12,000,” said Gregory Herman-Giddens, an estate planning attorney and president of Trust Counsel in Chapel Hill, N.C.

“This is really a very, very big hit on estates and trusts,” said Jonathan Blattmachr, a trust and estates attorney at Eagle River Advisors in New York.

Nobody is suggesting that trusts are going to disappear, but trusts will now need to be designed with greater flexibility, and trust investments might have to be changed in order to shelter income from taxes. Also, trustees will have to make more strategic decisions on distributing trust income by adjusting the timing,
the beneficiaries or the amount of income to avoid big tax hits, lawyers say.

Trust distribution

The new rules will generate more work for lawyers in trust administration and in advising clients on trust creation, distribution and tax planning.

“Lawyers need to be aware when clients are either establishing a trust or clients are a trustee or beneficiary of a trust … that income taxes are higher than ever,” said Herman-Giddens.

In advising clients, lawyers must pay attention to the fact that making trust distributions “in a timely manner can be powerful in terms of beating this tax,” said Robert Keebler, a CPA in Green Bay, Wis.

For example, instead of a trust keeping $500,000 in earnings, a trustee could pay distributions to each of 10 grandchildren.

“If the trustee pays out to them, they probably are not going to pay any of those taxes. But if you trap it in the trust, you’ll get beat up at the highest possible tax rate,” said Keebler.

The law gives a trustee 65 days after the close of the calendar year (usually March 5) to decide which beneficiaries should get the income.

That opens up more tax strategies, such as shifting more trust income to a beneficiary who had large losses that year, thereby offsetting income against losses, said Blattmachr.

“If the trustee has discretion to keep the income or pay it to a class of people, the trustee can decide where the income is paid so it’s taxed at the lowest rate. ... Now that the rates are so much higher, there will be a premium on trustees really paying more attention to it,” he said.

Trustees also face greater exposure to liability from claims that they should have distributed income but did not, said Herman-Giddens, who added that another consideration is that the capital gains rate went up to 20 percent.

Transition rules

For those who died in 2012, the rules about when the new taxes take effect can also save on taxes.

The 39.6 percent income tax and the 3.8 percent Medicare tax only apply for tax years beginning after Dec. 31, 2012.

If a non-calendar year is elected for a decedent who died in 2012, and the fiscal year ends by Dec. 31, 2013, that will still fall under the 2012 tax rates.

For example, if you elect the fiscal year to end Nov. 30, 2012, “you have from Dec. 1, 2012 to Nov. 30, 2013 to collect all the income but you’re not going to pay the 39.6 percent or the 3.8 percent tax, so you avoid the taxes for 11 months,” Blattmachr said.

Other workarounds
Besides distributions, another way to lessen the sting of the tax hikes is to change trust investments to those that produce less income and more growth.

For trusts, the tax applies to the lesser of (1) undistributed net investment income or (2) the amount by which adjusted gross income exceeds the $11,950 amount (which will be adjusted each year for inflation).

Keebler says some investments such as tax-exempt bonds, Treasury bonds and life insurance are not subject to the Medicare surtax.

Another important consideration, said Blattmachr, is that while individuals cannot reduce the Medicare tax on investment income by giving to charity, trusts can.

However, the trust must specifically say that the trustee can distribute money to charity in order for the trust to be entitled to the deduction.

“It means that lawyers and planners need to consider adding that in any new trust,” Blattmachr said.