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  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
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
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
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.
1. The Patient Protection and Affordable Care Act (P.L. 111-148), as supplemented by the Health Care and Education
Reconciliation Act of 2010 (P.L. 111-152).
See Act Section 1402 of the Reconciliation Act enacting
Code section 1411.
McGuireWoods Private Wealth Services
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cities and in London dedicated to estate planning and the analysis of related
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McGuireWoods Fiduciary Advisory Services
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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.
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.