New Tax Rules for Trusts Mean Careful Planning is Needed

Three big changes in the way that trusts are taxed starting in 2013 are making it far more important to be careful about trust distributions.

A trust’s income and capital gains will now be taxed very differently – and much more heavily – than income and capital gains for individuals. As a result, you’ll want to think very carefully about how you arrange distributions. And you might also want to have any existing trusts reviewed to see if changes can be made that would make it easier to save taxes.

The big changes are:

  • Starting in 2013, the top income tax rate is 39.6%, and the top rate for short-term capital gains is also 39.6%. Those rates apply to income over $450,000 for married couples and $400,000 for singles. But for trusts, those rates apply to all income over $11,950! So even though the new 39.6% rates are meant to apply only to people with very high incomes, they will also apply to trusts even at very small incomes.
  • The top long-term capital gains tax rate has been raised from 15% to 20%. Again, the new rate applies to income over $450,000 for married couples and $400,000 for singles. But for trusts, the new rate applies if the trust’s taxable income is more than $11,950.
  • The new 3.8% surtax on investment income, which kicks in this year as part of the Obamacare law, applies to people with income over $250,000 for married couples and $200,000 for singles. But – you guessed it – it applies to trusts with taxable income over $11,950.

In the past, there were often advantages to accumulating income and capital gains within a trust rather than distributing the funds to beneficiaries. But now, the opposite will often be the case – there will be a tax advantage in distributing income and gains, because the beneficiaries will be taxed on them at a much lower rate than the trust would be.

In many cases, it will be wise to make “strategic” distributions, particularly when a beneficiary has losses during the year against which a capital gain can be offset.

Sometimes, trust distributions can be made in the first two months of a calendar year and have them count tax-wise for the previous year, so it may be possible to “run the numbers” at the end of each year and figure out how to make year-end distributions with the best possible tax result.

In some cases, rather than having a trust sell shares of stock and then distribute the proceeds, it might be smarter to distribute the shares directly to the beneficiaries, and have the beneficiaries sell the shares.

On the other hand, if a trust is set up to protect children, making large distributions to them purely for tax reasons might defeat the point of the trust. There might also be a problem if a trust is set up to benefit someone with special needs, because of the interplay between trust distributions and various government programs designed to help such individuals.

And there might be other reasons not to distribute income or gains in a trust. For instance, the trust might have been set up to benefit a person who isn’t able to handle large sums of money. Or leaving assets in a trust might protect those assets during a divorce or from a beneficiary’s creditors.

In situations such as these, where there’s a good reason to accumulate income in a trust, there might be some techniques that could reduce the tax bite. These include:

Different investments. Trusts that are currently set up to produce a lot of income could be reoriented with more of a buy-and-hold, growth-oriented strategy.

Tax-free options. The 3.8% surtax on investment income doesn’t apply to certain types of investments, such as Treasury bonds, municipal bonds, and life insurance.

Charitable donations. Trusts can reduce the 3.8% surtax by making direct gifts to charity, something that’s not true of individuals who receive trust distributions and then make charitable donations.

One problem is that trusts created in the past, before the new tax law came along, may have been set up in such a way that these options aren’t allowed. For instance, a trust might not permit the trustee to make charitable gifts or to invest for growth instead of income. So if you’re in such a situation, it might be wise to have your trust documents reviewed to see if the terms can be changed in a way that will minimize the tax burden.