Minimizing Income Taxes for Estates, Trusts and Beneficiaries—Learn the New Rules

Will Rogers has been quoted as saying “The only difference between death and taxes is that death doesn’t get worse every time Congress meets.”  Earlier this year, Congress passed the American Taxpayer Relief Act of 2012, which may have prevented us from falling off the fiscal cliff, but further complicated the already complex world of income taxation of estates and trusts.

Whether you are a fiduciary or beneficiary of an estate or trust, or one of their advisors, you should take note of some of the more important changes under the new income tax laws, as well as strategies that can be employed to minimize the tax. For some of those strategies to be effective, action must be taken right away.  Fiduciaries, in particular, should be familiar with these strategies and deadlines.  Beneficiaries will not be very happy if they or their trusts are forced to pay additional income taxes that could have been avoided with a little planning on the fiduciary’s part.

Increase in Ordinary Income and Capital Gains Tax Rates

The top tax rate on ordinary income has increased from 35% to 39.6%.  For individuals, the top rate kicks in at taxable income of $400,000 (or $450,000 if married filing jointly); however, for estates and trusts in 2013, the top rate kicks in at taxable income of only $11,950.  The rate on long-term capital gains and qualified dividends has increased from 15% to 20%.

Medicare Surtax

There is also a new tax that applies beginning in 2013, the so-called Medicare surtax, which is a 3.8% tax on “net investment income.”  Net investment income generally includes (a) interest, dividends, annuities, royalties and rents, (b) gains attributable to the disposition of property and (c) income and gains from a trade or business, but only if such trade or business is a passive activity with respect to the taxpayer or involves trading in financial instruments or commodities.  For individuals, the surtax applies to the lesser of net investment income and the excess of modified adjusted gross income (AGI) over $200,000 (or $250,000 if married filing jointly).  For estates and trusts, the surtax applies to the lesser of undistributed net investment income and the excess of AGI over the threshold for the highest income tax bracket ($11,950 in 2013).

Strategies to Minimize Income Taxes

With these new rules in place, the following are some of the strategies that may be used to minimize income taxes.

Minimize the Medicare surtax

• Distribute net investment income to beneficiaries who are under the $200,000/$250,000 threshold at which the surtax applies.
• Convert passive activities to active.  Generally, for a trust, an activity is active if the trustee materially participates in the activity.  (The exception is grantor trusts, for which it is the participation of the grantor that matters, not that of the trustee.)  If a trustee can be appointed who materially participates in the activity, then any income from the activity will not be deemed net investment income and will not be subject to the surtax.  If the trustee does not materially participate, the surtax also can likely be avoided by distributing income from the activity to beneficiaries who actively participate in the activity.

Distribute to beneficiaries who are in low income tax brackets. This will allow the income to be taxed at the beneficiaries’ lower rates, rather than at the estate’s or trust’s rate, which is 39.6% once the $11,950 threshold is reached.

Make a 65-day election. An estate or trust may elect to treat amounts paid or credited in the first 65 days of the tax year as if they were paid or credited on the last day of the prior tax year.  For distributions to beneficiaries between January 1, 2013 and March 6, 2013, the election may allow the distributions to be taxed to the beneficiaries at the lower 2012 rates and to escape the Medicare surtax.  But, you need to make those distributions quickly.  March 6th is right around the corner.

Before making distributions to minimize income taxes, make sure to consider other factors. The fiduciary should weigh the potential income tax savings against the possible disadvantages of distributions, such as exposing the distributed assets to the beneficiaries’ creditors or to their spouses in the event of divorce.  Also, if the trust is exempt from generation-skipping transfer (GST) taxes, the transfer tax savings from accumulating income in the trust may outweigh any income tax savings from distributions.

Elect a fiscal year. Generally, estates and trusts are taxed on a calendar year basis, but estates may elect to be taxed on a fiscal year basis.  Moreover, an election may be made to treat a decedent’s qualified revocable trust as part of the estate, thereby permitting the trust to be taxed on a fiscal year basis as well.  A fiscal year is adopted when filing the estate’s first federal income tax return, Form 1041.  It is not sufficient to indicate the fiscal year when extending the due date for the Form 1041 or when applying for the estate’s Employer Identification Number (EIN).

• Unique opportunity for accumulated income in 2012/2013.  If an estate (and revocable trust) elects a fiscal year ending in 2012, then the 2012 tax regime (lower rates and no Medicare surtax) will apply to the estate’s undistributed income until the beginning of its 2013 fiscal year.  The beneficiaries of the estate and trust, who typically are taxed on a calendar year basis, report income received from the estate or trust in the year in which the estate’s tax year ends.
• For decedents who died between December 1, 2011, and November 30, 2012, elect a November 30, 2012, fiscal year.  If the election is made then, in Year 1 (ending on November 30, 2012), income will be taxed at pre-2013 rates without any potential Medicare surtax, whether the income is distributed to the beneficiaries or accumulated in the estate or trust.  If a November 30, 2012 fiscal year is elected, the Year 1 return is due on March 15, 2013 (unless extended).In Year 2 (running from December 1, 2012 to November 30, 2013), any undistributed income will be taxed at 2012 rates without any surtax.  On the other hand, any income distributed to the beneficiaries will be taxed at 2013 rates and potentially be subject to the surtax.  Thus, if the beneficiaries need money in Year 2, rather than distributing it to them, consider having the estate or trust loan it to them.  Memorialize the loan with a promissory note, and charge interest at the applicable federal rate.

If appreciated assets of the estate or trust are distributed in-kind to the beneficiaries, consider making an election to recognize the gain at the estate or trust level. Generally, when an estate or trust distributes an asset in-kind to a beneficiary (as opposed to liquidating the asset and distributing cash), there is no gain or loss to the estate or trust, and the beneficiary takes a carryover basis in the asset.  However, the estate or trust may elect to recognize the gain, in which case the beneficiary takes a basis in the asset equal to its fair market value on the date of distribution.  If made, the election applies to all in-kind distributions made during the tax year; it may not be elected on an asset-by-asset basis.There are at least two circumstances in which the election may be desirable: (1) if the trust has capital loss carryovers that can be absorbed by the gain; and (2) if the election would result in the gain being taxed to the estate or trust under the 2012 regime (15% capital gains rate and no Medicare surtax), rather than to the beneficiary under the post-2012 regime when he or she sells the asset (20% rate + 3.8% surtax). The increase from 15% to 23.8% is almost a 60% hike in the tax.  On the other hand, the election is not desirable if the beneficiary expects to hold the asset until he or she dies, because, upon death, the basis will be stepped-up to its fair market value.  The election also is not desirable if the beneficiary plans to hold the asset for a long time before selling it, because the recognition of gain may be deferred until the sale.

As you can see, there are a number of techniques that can be used to minimize income taxes under the new tax laws.  Make sure to seek the advice of an estate and trust income tax specialist to determine when and how to take advantage of these opportunities.