Estate & Trust Administration For Dummies, 2nd Edition
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Effective January 1, 2013, there is an additional 3.8 percent tax on investment income in estates and trusts, thanks to provisions in the Health Care and Education Reconciliation Act of 2010. Now, to be honest, it’s not an additional tax on every dollar, but only on the lesser of undistributed net investment income or any amount of adjusted gross income in excess of the highest tax bracket in any year.

What sorts of investment income are included? Here’s a list:

  • Annuities

  • Capital gains (including the taxable portion of the gain on the sale of a personal residence)

  • Dividends

  • Interest

  • Passive activity income from partnerships and Subchapter S corporations

  • Rents and royalties

You may have noticed that excluded from the list are tax-exempt interest, wages, and distributions from qualified pension, profit-sharing, and stock bonus plans — although you may still be tagged with this tax (or a portion of it) if the trust or estate’s overall income is too high.

In addition, it’s important to note that the tax is on net investment income, not gross investment income. As a result, you’ll be able to allocate portions of all your deductible expenses against the total income, and only pay the tax on the portion that remains that’s over the limit.

All irrevocable trusts that are required to file Form 1041 are subject to this new tax. However, the following trusts are apparently excluded:

  • Grantor trusts (all income is reported by the grantor on his/her individual income tax return)

  • Charitable foundations

  • Charitable remainder trusts

The proposed rules surrounding how investment versus non-investment income will be treated in Electing Small Business Trusts (ESBTs) are quite complex. If you’re the trustee of an ESBT, you really should check with a competent tax advisor for assistance in this calculation.

Currently, the law is in place, but there are no draft forms, no final regulations, and the proposed regulations point to rather large gray areas, especially with regard to estates and trusts. Although it’s clear that this surtax will be added, it may take a while to figure out all the mechanics of how it will be imposed.

How to calculate the tax

The UIMC tax was only intended to apply to high-income individuals, but the basic inequity in the size of the tax brackets for trusts and estates versus individuals has created an unfriendly environment for estates and trusts, one where only quite small entities will be exempt from paying it. It’s clear that the tax will be imposed as an additional tax, after all other income taxes are levied.

How to lessen the tax’s impact

The UIMC tax is only imposed on taxable income in the trust or the estate over certain limits; if the income doesn’t reach those limits, there’s no additional tax. So, your job as executor, administrator, or trustee will be to try to reduce the taxable income in the trust, while still behaving in a responsible way. You could, for example,

  • *Keep track of your capital gains and plan to offset gains with some losses, if necessary. As executor, you should be aware of the size of the estate’s capital gains before the end of the year. If your gains are large but you own something that’s a less-than-sterling performer, sell it before the end of the tax year. The loss from that sale will reduce the total gains year-to-date.

  • *Invest in tax-exempt bonds and funds. Remember, tax-exempt income isn’t included in the threshold calculation, so it isn’t subject to the tax.

  • Increase distributions to beneficiaries, but only if the trust instrument allows, and the distribution otherwise makes sense. You still have to follow the terms of the trust instrument and pay attention to the intentions of the settlor. But if you manage to pass out income to beneficiaries, that income will be included in their threshold calculation for this additional tax, not the trust or estate’s.

  • Plan deductions to fall into years when income is higher and pay fewer deductible expenses in years the trust doesn’t perform as well or when more is distributed to the beneficiary. That’s assuming you can predict these things, which you may not be able to precisely.

    But if you normally pay a trustee fee in January, and your income for the prior year is high enough to trigger this tax, you may want to take the January fee in December of the prior year.

There is no perfect solution here because the techniques that might enable the trust or estate to pay taxes at a lower rate may not be consistent with either the intent of the donor or what’s in the best interest of the beneficiary. It’s up to you to weigh all these possibilities and arrive at the most equitable solution.

Whatever you do, be sure to jot down your reasoning and put it in the file. That way, should anyone ever question your decision, you’ll be able to remind yourself why; and next year, when faced with the same questions and the same dilemmas, you’ll be able to see what you did in the past and judge for yourself how well it worked.

About This Article

This article is from the book:

About the book authors:

Margaret Atkins Munro, EA, has more than 30 years of experience in trusts, estates, family tax, and small businesses. She lectures for the IRS annually at its volunteer tax preparer programs. Kathryn A. Murphy is an attorney with more than 20 years of experience administering estates and trusts and preparing estate and gift tax returns.

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