Estates and trusts will be subject to a surtax of 3.8% on “Net Investment Income” if: (1) they have” Net Investment Income” and (2) (a) “Modified Adjusted Gross Income” that exceeds (b) a “Threshold Amount” ($11,950 for 2013).[1]
“Net Investment Income” includes interest, dividends, annuity distributions, rents, royalties, net capital gain, and income derived from a passive activity less applicable deduction. “Modified Adjusted Gross Income” is, for all practical purposes, the trust’s total income from all sources less allowable deductions (including distributions to beneficiaries) and exemptions (i.e. the taxable income of the trust). For Estates and Trusts the “Threshold Amount” for 2013 is $11,950.
Assume Trust A has:
- $90,000 of interest income
- $60,000 of capital gain income
- $5,000 of “qualified dividends”
- $20,000 of distributions from an LLC in which the trust does not materially participate (“passive income”)
- Allowable deductions of $10,000 (allocated equally to capital gain income and ordinary income) and a statutory exemption of $100.
Net Investment Income = $165,000 ($90,000 + $60,000 + $5,000 + $20,000 - $10,000)
Modified Adjusted Gross Income = $164,900 ($165,000 - $100)
Threshold Amount = $11,950
Is this Trust subject to the 3.8% Surtax?
Yes, because Modified Adjusted Gross Income exceeds the Threshold Amount of $11,950 by $152,950.
What is the tax?
In this example the tax on ordinary income of $104,900 ($90,000 + $20,000 - $5,000 - $100) is $42,374.30. Ordinary income tax of $38,842.20 (tax on first $11,950 = $2,034, plus 39.6% x $92,950) plus Net Investment Income Tax of $3,532.10 (3.8% x $92,950).
Now we have to figure out the capital gain tax (15% or 20%).
The American Taxpayers Relief Act (ATRA) raised the top capital gains rate for 2013 from 15% to 20% for trusts and estates with taxable income above $11,950. In the example above the trust has taxable income of $164,900. The capital gain portion of this amount is $60,000 ($60,000 + $5,000 - $5,000).
As a result, the capital gains tax is $12,000 ($60,000 x 20%). The 3.8% net investment income surtax is also applicable to this amount, so tack on another $2,280.
Marginal Tax Rate for this Trust
In general the marginal tax rate for the ordinary income portion of trust that has more than $11,950 of Net Income is 43.4% and the marginal capital gains tax rate is 23.8%. For simplicity I have ignored state income taxes, which in states where an income tax is imposed will increase the total tax burden.[3]
Trust Strategies to Minimize High Tax Burden
- Municipal Bonds (income is tax free)
- Tax-deferred annuities (deferral of income tax)
- Life insurance (totally income tax free death benefit and cash value access if properly structured)
- Depreciation deductions for rental real estate
- Oil & Gas investments (intangible drilling cost deductions)
- Choice of accounting year for estate/trust
- Timing of estate/trust distributions
Conclusion
I am in the life insurance business, and whenever I see a high tax rate (such as 43.4%) I think of the ways in which a properly structured cash value permanent life insurance policy has a place as an alternative investment in the overall trust portfolio and provides a measure of liquidity through access to the policy cash value. You might ask why? Suppose the trust, in my example, has some portion of its portfolio invested in an asset class with a 5% pre-tax income return target. The after tax return, under the current tax regime, is 2.83%. Is it possible to achieve an equal or better after tax return with a life insurance policy design (not to mention the death benefit and perhaps long term care coverage)? Every situation is unique, but it does make sense to explore this alternative. In the right circumstances there could be a significant guaranteed, long term, tax-free, benefit that would not otherwise be available in other types of investments, plus the potential to add a long term care benefit at a very low cost.
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.
This article should not be considered as providing accounting, business, financial, investment, legal, tax, or other professional advice or services. It is not a substitute for such professional advice or services, nor should it be used as the basis for any decisions or actions that may affect your business or you personally. This should only be one part of your research. You should seek authoritative guidance from a qualified accountant or attorney before taking any action.
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[1] There are many types of trusts, each of which are taxed differently. For example, (a) a trust may be ignored for tax purposes and the grantor of the trust treated as the taxpayer, and (b) a charitable split interest trust is taxed differently than other trusts. This focus of this article is irrevocable trusts that must file a tax return, and is subject to income taxes as a separate
[2] There are a number of scenarios that require a more complicated tax computation. An example would be where the trust ordinary income is less than $11,950, and the capital gain amount when added to the ordinary income amount is in excess of $11,950. In that particular case, only a portion of the capital gain would be subject to the surtax.
[3] Massachusetts for example has a 5.25% ordinary income tax and a 12% capital gains tax.
