How to minimize income taxes for estates, trusts and beneficiaries

On Jan. 1, 2013, the income tax playing field for estates and trusts changed drastically. First, the American Taxpayer Relief Act of 2012 (ATRA) significantly increased the top income tax rates for estates, trusts and individuals.1 Second, the Health Care and Education Reconciliation Act of 2010 imposed a new tax, the so-called “Medicare surtax,” which is assessed on certain types of passive income earned by estates, trusts and individuals.2 At the same time, ATRA decreased the top estate and gift tax rate from 45 percent to 40 percent and made permanent the $5 million exemption for estate, gift and generation-skipping transfer (GST) taxes (adjusted for inflation to $5.25 million in 2013).3 These changes may shift the focus of many taxpayers from transfer tax planning to income tax planning. Thus, it’s imperative that estate and trust practitioners know the new rules to minimize income taxes for estates, trusts and beneficiaries.

Changes in Income Tax Rules
The top tax rate on ordinary income increased from 35 percent to 39.6 percent as of Jan. 1, 2013.4 For individuals, the top rate applies to taxable income above $400,000 ($425,000 if head of household and $450,000 if married filing jointly), but for estates and trusts, the top rate applies to taxable income starting at just $11,950.5 The rate on long-term capital gains and qualified dividends for individuals, estates and trusts increased from 15 percent to 20 percent for those taxpayers in the new 39.6 percent bracket for ordinary income.6

The Medicare surtax is a 3.8 percent tax on net investment income.7 This generally includes: (1) interest, dividends, annuities, royalties and rents, (2) gains attributable to the disposition of property, and (3) 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.8 For individuals, the Medicare surtax applies to the lesser of net investment income and the excess of modified adjusted gross income (AGI) over $200,000 ($250,000 if married filing jointly).9 For estates and trusts, the Medicare surtax applies to the lesser of undistributed net investment income and the excess of AGI over the threshold for the highest income tax bracket, which is $11,950 in 2013.10