Planning for the New 3.8 Percent Surtax on Trusts and Estates

April 22, 2010

Fiduciaries should consider and plan for the impact that the new income tax surcharge will have on trusts and estates. To help finance the recent healthcare reform, the legislation [1] imposes a 3.8 percent surtax on the passive investment income of certain taxpayers, including trusts and estates, for taxable years beginning on and after January 1, 2013. New section 1411 of the Internal Revenue Code ("the Code") imposes an annual 3.8 percent tax on the lesser of (i) the undistributed net investment income of a trust or estate and (ii) the amount by which adjusted gross income exceeds the top inflation-adjusted bracket for estate and trust income, which is expected to be approximately $12,000 in 2013.

Under Code section 1411, "net investment income" generally is the passive investment income earned by a trust or estate. "Adjusted gross income" is broadly defined as the sum of gross income in excess of any allowable deductions that are allocable to such gross income. "Gross income" under this section includes income from interest, dividends, annuities, royalties, rents, net gain from the disposition of property (other than property held in a trade or business), trade or business income that is from a passive activity with respect to the estate or trust, and a trade or business of trading in financial instruments or commodities.

Example 1: A trust with a $100,000 of undistributed net investment income would pay the 3.8 percent surtax on $88,000, the amount that exceeds the applicable threshold amount, yielding $3,344 in surtax.

The surtax generally excludes active trade or business income. A special exception exists for a gain or loss on the disposition of certain active interests in partnerships and S corporations. Importantly, net investment income does not include distributions from IRAs, qualified plans, and the like. Trusts in which all of the unexpired interests are devoted to one or more of the charitable purposes described in section 170(c)(2)(B) of the Code are also exempt from the surtax. Further, charitable remainder trusts are exempt from the surtax because they are exempt from income tax under Code section 664(c). In contrast, charitable lead trusts will be subject to the surtax, but the surtax may be partially or entirely avoided by the required annual distributions to charities, and in this tax environment "shark fin" lead trusts may be less popular.

The surtax will also apply to the net investment income of individual taxpayers, including distributions of net investment income from trusts and estates. The surtax will generally be paid by taxpayers with net investment income when the taxpayer's modified adjusted gross income exceeds the established thresholds, which are $125,000 for a married person (filing separately), $200,000 for an individual, or $250,000 for a married couple (filing jointly).

Example 2: A married couple filing jointly with $300,000 of modified adjusted gross income, $100,000 of which is net investment income, will pay the 3.8 percent surtax on the $50,000 of investment income that exceeds the applicable $250,000 threshold.

Fiduciaries of trusts with net investment income that is expected to exceed $12,000 in 2013 should consider the impact that the 3.8 percent surtax will have on accumulated trust income and on distributions to beneficiaries with high incomes. When distributions are discretionary, the new surtax creates additional considerations for fiduciaries in deciding whether, when, and to whom to distribute income.

Example 3: A trust has $20,000 in net investment income and needs to make $30,000 in distributions. The trust has two beneficiaries, one well below the surtax threshold for the beneficiary's filing status, the other well above the surtax threshold. If the trustee has the authority to make non-pro rata allocations of trust income and principal - an uncommon situation that may be difficult to achieve for income tax purposes - and if the beneficiaries agree, it may be advantageous to allocate more of the net investment income to the lower income trust beneficiary in order to avoid the imposition of the surtax (and higher marginal income tax rates).

For trusts and estates with less than $12,000 in net investment income annually, situations may exist where it is worth revisiting the conventional wisdom that favors the distribution of investment income to the beneficiaries in order to avoid paying tax at the trust level. There may be situations where paying fiduciary income tax inside of the trust or estate is more tax efficient than making a distribution to a trust beneficiary that will subject the distribution to the 3.8 percent surtax.

Additionally, specific assets like tax-exempt municipal bonds, tax deferred annuities, and life insurance may become more favorable investment options when compared to other investment assets whose income is subject to the surtax. Trustees of trusts with IRA assets, both traditional and Roth IRAs, should consider that these assets will be even more tax-advantaged in 2013 when distributions from these accounts are not subject to the surtax. Finally, fiduciaries should be familiar with the mechanics of charitable lead trusts and charitable remainder trusts, which may become more popular in light of the income deferral feature of charitable remainder trusts and the ability to shift investment income to charities in charitable lead trusts.

In an era of reduced investment yields and uncertain market performance, a 3.8 percent surtax on passive investment income is significant. Even though 2013 is more than two years away, considering the impact now of the coming surtax will enhance the overall health of a trust and reduce the likelihood of disappointed or surprised beneficiaries.


NOTE:

1. The Patient Protection and Affordable Care Act (P.L. 111-148), as supplemented by the Health Care and Education Reconciliation rel="noopener noreferrer" Act of 2010 (P.L. 111-152). See Act Section 1402 of the Reconciliation Act enacting Code section 1411.


McGuireWoods Private Wealth Services

Private Wealth Services is ranked by Chambers Leading Lawyers as one of two top-band private wealth services practice groups in the country, with professionals in several U.S. cities and in London dedicated to estate planning and the analysis of related tax and fiduciary issues.

McGuireWoods Fiduciary Advisory Services

Fiduciary Advisory Services advises financial institutions and other clients about planning, tax, and fiduciary matters. This includes advising executors and trustees in managing risks, avoiding litigation, and handling litigation when it does arise.

Adam M. Damerow is the principal author of this release.

For further information about the material discussed in this alert and about our team, please contact the authors, or the members of our Private Wealth Services team.

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