Generally speaking, if a trust earns income (dividends, interest, rent, capital gain, etc.) either the trust or some other person is required to pay income tax. The taxpayer will be either the trust or the grantor, during his or her lifetime. Although the capital gain rate is the same for individuals and trusts, the income tax brackets for trusts are quite compressed; with the top tax bracket kicking in after taxable income reaches $11,500. The focus of this article is trust income, exclusive of capital gains (Ordinary Trust Income).
The Ordinary Income Tax Brackets
|
Taxable Income |
Married Individual |
Estate or Trust |
|
|
From |
To |
||
|
$ - |
$ 2,400 |
10% |
15% |
|
$ 2,400 |
$ 5,600 |
10% |
25% |
|
$ 5,600 |
$ 8,500 |
10% |
28% |
|
$ 8,500 |
$ 11,650 |
10% |
33% |
|
$ 11,650 |
$ 17,400 |
10% |
35% |
|
$ 17,400 |
$ 70,700 |
15% |
35% |
|
$ 70,700 |
$ 142,000 |
25% |
35% |
|
$ 142,000 |
$ 217,450 |
33% |
35% |
|
$ 217,450 |
$ 388,350 |
35% |
35% |
Regardless of the taxable status of a trust during a Grantor’s lifetime, all trusts created by the Grantor are taxable trusts after his or her death.
Taxable Trusts can shift the tax on most ordinary income and/or capital gains to a beneficiary, but only by way of a distribution permitted or mandated by the trust agreement. In many cases, tax considerations will disfavor ordinary income accumulation, and encourage tax-exempt or capital gain investing.
There are additional investment alternatives that may be better suited to trust accumulation, especially where there is a 10+ year investment horizon.
Brief Summary of New Taxes:
There are two new taxes for 2013. The 0.9% tax is a tax on excess compensation above a threshold amount. The other tax (the 3.8% tax) applies to investment income in excess of the same threshold amount. In short, if your compensation exceeds the threshold amount, the excess amount is subject to an additional 0.9% tax. When compensation plus investment income exceeds the same threshold amount, the investment income (or if lower the excess amount) is taxed at the higher rate 3.8%.
The 0.9% Tax:
This tax is imposed upon individuals, estates and trusts, if compensation income exceeds a threshold amount.
It is unlikely that a taxable trust would be subject to this tax, since this tax is based on compensation, rather than investments. The threshold amount for individuals is $250,000 for a married couple filing jointly, $200,000 for a single taxpayer, and $11,650 for trusts and estates (the top tax bracket amount).
The 3.8% Tax:
This tax is imposed upon individuals, estates and trusts if aggregate compensation and investment income exceeds a threshold amount.
The 3.8% tax applies when a taxpayer’s “includible income” exceeds a prescribed threshold amount. Includible income consists of (a) wages, (b) non-wage compensation, (c) interest, (d) dividends, (e) capital gains, (f) rental and royalty income, (g) non-qualified annuities, (h) income from businesses involved in trading of financial instruments or commodities, and (g) most significantly, businesses that are passive activities.
The tax is assessed against the lesser of net investment income (includible income other than compensation) or the amount by which includable income exceeds the threshold amount. The threshold amount is the same as that for the 0.9% tax ($250,000 for a married couple filing jointly, $200,000 for a single taxpayer, and $11,650 for trusts and estates).
This 3.8% tax will be an additional tax on top of either the capital gain tax rate or the ordinary income tax rate as the case may be.
Example:
Assume a taxable trust has $1,500,000 invested in taxable investments that generate a 5.5% pre-tax rate of return or $82,500 per year (all taxable at ordinary income tax rate), $50,000 of which is distributed to beneficiaries…. leaving net undistributed taxable income of $32,500. For simplicity, no deductible expenses and no exemption amount are assumed. The federal income tax would be $10,309. The 3.8% tax is $1,235 (3.8% x the lesser of $70,850 ($82,500 - $11,650 = $70,850) or $20,850 ($82,500 - $50,000 - $11,650 = $20,850)).
Under these assumptions the total taxes are $11,101 or a little more than 34% of the undistributed taxable income ($11,101 / $32,500). The after tax rate of return on the investments that generate the undistributed taxable income is 3.63% (5.5% x (1 - 34%)).
If you would like more information on this subject, or have a client who might benefit from a discussion about it, please contact Barry Koslow at bkoslow@mkaplanners.com or (781) 939-6050.
Securities offered through Advisory Group Equity Services, Ltd., Member FINRA/SIPC. 444 Washington Street, Woburn, MA 01801 (781) 933-6100.
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