MKA Executive Planners Blog

My prior article Investment Concerns With Taxable Trusts, addressed the new tax landscape for taxable trusts.  Subsequent to that article, on January 28, 2013 the IRS published Rev. Proc. 2013-15, the updated income tax rates for 2013.  The change resulted in a small increase in the tax brackets and an increase in the top marginal tax rate for trusts from 35% to 39.6%.  The following is an updated comparison of individual and trust tax rates.

The Ordinary Income Tax Brackets

A taxable trust has the highest income tax rate at $11,950 of distributable net income, and the matter gets worse when you factor in the additional 3.8% tax on “includible income” (which essentially is every type of investment income).  Let’s see how that trust tax rate compares to individual income tax rates when we add this component.  It is important to note that the comparison intentionally omits the special tax rates applicable to long term capital gains.

The Ordinary Income Tax Brackets

There is one last comparison to consider, and that is one in which state income taxes enter the equation.  These tax rates vary considerably, but in the case of Massachusetts, the rates are 5.25% for Massachusetts dividends and interest, rents, business income, and long term capital gains, and 12% for other types of income.  In this example, I will assume that the trust investment portfolio generates 70% of its income as 5.25% income (exclusive of capital gains with respect to which special tax rates apply for federal income tax purposes) and 30% as 12% income, with a resulting overall tax rate of 7.28%.  The comparison now looks like this:

The Ordinary Income Tax Brackets

A taxable trust will have a marginal tax rate that may be as high as 47.5% when its ordinary taxable income exceeds $11,950. 

The dilemma facing trustees is whether or not to distribute income to a beneficiary who may be in a lower tax bracket, accumulate income in the trust, or find more tax friendly investments.

Here is an example of the dilemma.  Assume the same facts as in the above comparison, and the trust has a total of $150,000 of taxable income.  If income is accumulated in the trust, the effective tax rate is 46.22%.  Simply stated, the projected rate of return is a little more than half of the projected rate.  A distribution to a beneficiary may save some taxes, but is this what the grantor really wants to do?  Is the tax tail pushing the dog?  The other alternative is to adjust the trust investment portfolio (consistent with the trust document, its purposes, and applicable fiduciary standards) to meet the tax realities by utilizing tax favored investments for at least a portion of the portfolio, since any reduction in ordinary taxable income has, in this example, a 47.52% tax benefit.

A Bit about Capital Gains Taxes

The federal tax rate for long term capital gains is 15% to 20%.  A taxable trust is subject to the higher rate when it has $11,950 of investment income.  When this rate kicks in so does the 3.8% tax.  Trusts, even relatively small ones, will be hit with the 23.8% capital gains rate (even if the beneficiary himself would be squarely in 15% capital gains territory.  The tax misery is compounded by the fact that these gains are also subject to state tax.  In Massachusetts that rate is 5.25%, for a combined adjusted tax rate of 24.2%.  Assuming a 7% projected growth rate, no management fee, and an investment turn over every 6 years, capital gain taxes will reduce the gross earnings rate by 1.49%, or 21.3% of the projected gross rate. 

If we add a management fee of 75 basis points, the projected gross rate of return after management fees and taxes is reduced by 2.10%, or almost 30% of the projected gross rate.

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.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.

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