Ensuring Trust Terms Are Drafted To Maximize Income Tax Savings

By: Matthew F. Penater, J.D., LL.M. — matt@elvilleassociates.com

For those of us who have established a trust, are a beneficiary of a trust, or are considering implementing a trust into our estate plan, the recent changes in trust income tax rates warrants our attention. If a trust is in existence, a review of the trust terms is recommended for the reasons outlined in this article. For trust accounting purposes, a trust consist of two components: Principal and Income. Simply put, Principal consists of the assets used to fund the trust, and Income consists of earnings on those assets (dividends, interest, etc.). However, an important deviation from this concept is the treatment of capital gain on the sale of assets – this is considered Principal, even though under the Internal Revenue Code, it is taxable income. So, we have taxable income in the form of capital gain, which is Principal, and taxable income in the form of dividends/interest, which is Income. These are the conceptual inconsistencies that send a non-professional trustee into a tail-spin.

The vast majority of trusts in existence are drafted in a way that results in the following:

If Income (dividends/interest) is distributed to a beneficiary during any given year, that beneficiary must report that Income on the beneficiary’s individual income tax return in that year and then personally pay the income tax thereon; and

If Principal (which could include capital gain) is distributed to a beneficiary during any given year, that beneficiary DOES NOT report that capital gain on his or her individual income tax return – instead, the trust reports the capital gain on the trust’s income tax return and pays the income tax thereon from the assets of the trust.

The foregoing result is due to several factors, including the language of the trust and the Internal Revenue Code. This result worked fine as generally speaking, there was no more income tax being paid by the trust than would have been paid by the beneficiary. However, the changes to the tax treatment of trusts resulting from the American Taxpayer Relief Act of 2012 has caused trusts to start paying much higher rates of tax in most cases. I promised myself I would keep this article simple and generally non-technical. So, without getting into the nitty-gritty, I can summarize the tax effect as follows: a married individual will pay the highest capital gain rate of 23.8% capital gains (which includes net investment income tax) once that married couple’s combined income reaches $457,600 for 2015; a trust will pay that same 23.8% capital gains rate once the trust has taxable income of only $12,300 for 2015. This means in general, capital gain taxed within a trust will be subject to substantially more income tax than if that same capital gain were passed out to a beneficiary and taxed to that beneficiary.

The problem is that most trusts today are not drafted to allow for the trustee to pass out the capital gain to the beneficiary, in the trustee’s discretion. There are Income Tax Regulations which provide for mechanisms on how to pass the capital gain out to a beneficiary if the terms of the trust do not address it, but those Regulations are complex and can be difficult to satisfy. The best solution is to give a trustee the discretion to allocate capital gain to a beneficiary within the trust document. The tax savings can be significant. A review of existing trust documents is the first place to start.

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