Tax Alert: Saving the 3.8% Surtax on Trust Net Investment Income

January 5, 2014

As is the case for individuals, complex trusts (i.e., a trust other than a grantor trust or a simple trust) are now subject to the same 3.8% Medicare surtax (the “3.8% surtax”) on the lesser of (i) net investment income (“NII”); or (ii) adjusted gross income (“AGI”) in excess of a threshold amount. However, the threshold amount for trusts is much lower than for individuals.  The 2013 threshold amount for trusts is $11,950; whereas, for individuals, it is $200K for single filers ($250K for married couples filing jointly).

Because individuals have a higher threshold amount, complex trusts should consider making 2013 discretionary distributions to beneficiaries who might have AGI below $200K, in order to eliminate the 3.8% surtax on the trust’s net investment income.

In effect, distributions help save the 3.8% surtax where the trust’s AGI and NII (but for the distribution) is greater than $11,950 and the beneficiary’s AGI (including income attributable to the trust distributions) is less than $200K.

Distributions will also help lower the trust’s capital gain  (and qualified dividend) tax rate to 15% from 20% if, by making distributions, the trust’s taxable income may be reduced to below the $11,950 threshold (above which the 39.6% top rate kicks in).

A trust may make such distributions as late as March 6, 2014; the so-called “65-day election” will allow distributions made during the first 65 days of 2014 to be treated as 2013 distributions.  Thus, there is still time to avoid the 3.8% surtax and the 20% capital gain tax rate.

Generally, a trust may not distribute capital gain to beneficiaries. For a trust with large capital gain income, it will have to pay the 20% capital gain tax plus the 3.8% surtax.  However, depending on the terms of the trust and state law, it is possible that capital gains may also be distributed so as to reduce a trust’s AGI and NII.

Another way to reduce capital gain tax is for a trust to make in-kind distributions.  A trust does not need to recognize capital gain on in-kind distributions of property.  So, rather than dealing with the complex rules for distributing capital gains, a trust might opt for distributing appreciated stock to beneficiaries. When the beneficiaries later sell the stock, the beneficiaries, rather than the trust, would realize the capital gain income – just another way to shift capital gain (at lower tax rates) to beneficiaries.

Example 1:  A “complex” trust (i.e., not a grantor trust or a simple trust) has AGI of $111,950, consisting of NII comprised of interest income.  Assume that the trust makes no distributions.  The interest income in excess of the $11,950 threshold ($100,000) would be taxed at 43.4% (39.6% on interest income, plus the 3.8% surtax: $43,400).

Example 2:  Assume the same facts as Example 1, except that the trust distributes $100K to the trust beneficiary, and the trust beneficiary is single and has NII and taxable income of $183,250 (including the $100K of trust income). The distributed interest income would be taxed at 28%, with no surtax. The resulting tax: $28,000, representing a tax savings of $15,400.

With the higher income tax rates and the 3.8% surtax in 2013 and beyond, taxpayers should review their trust tax situation and make distributions to beneficiaries, whenever appropriate, to save overall taxes.

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