Ethan R. Okura

Last month after writing my article on Medicaid planning techniques, we received a message from a concerned client who is worried about higher income tax rates, the new 3.8% Medicare (sometimes called Obamacare) Surtax, and in light of these developments, whether a trust is still the right solution for his family’s needs. Perhaps he read a Forbes magazine article with an alarming title “Tax Hikes Hit Trusts Hard, Beneficiaries Pull Money Out.”  In my January article I described the Estate and Gift Tax changes brought about by the American Taxpayer Relief Act of 2012 (ATRA).  Let me now touch on some of the income tax changes, how trusts are taxed, and why a trust is still a better choice for most people.

Tax Changes

1) New Income Tax Rates – Back in July of 2001, the Bush tax cuts lowered most of our income tax rates. The highest federal income tax bracket for the past decade has been taxed at a rate of 35%. After ATRA, there is a new higher tax bracket at a 39.6% rate for individuals earning $400,000+ per year or married couples earning $450,000+ per year.

2) Social Security Tax Hike – There is a 2% increase in the employee’s portion of Social Security payroll tax totaling 6.2% now. This comes out of your paycheck before you see it.

3) Capital Gains Tax Increase – Whenever you sell property at a profit (real estate, cars, stocks, mutual funds, personal property), the profit is called a capital gain, and there is a tax on that gain which is considered income. The maximum federal capital gains tax rate is being increased from 15% to 20% for individuals with taxable income over $400,000 and married couples with taxable income over $450,000.

4) Obamacare/Medicare Tax – There are two parts to this tax. The first involves an additional 0.9% payroll tax (in addition to the 2.9% that you and your employer already pay) on earned income over $200,000 for individuals and over $250,000 for married couples filing jointly. The second part is a 3.8% surtax on net investment income to the extent that it exceeds modified adjusted gross income of $250,000 for individuals or $250,000 for couples. This second part is a little tricky to understand, but the way to calculate it is to determine how much of your income is net investment income (i.e., not earned income), then subtract $200,000 (or $250,000 if married filing jointly) from your modified adjusted gross income. Compare the result with your net investment income. You will owe the 3.8% surtax on the lesser of the two numbers. If you have over $200,000 in earned income and some investment income, you will end up paying both the 0.9% extra payroll tax and the 3.8% surtax on investment income.

5) How The Changes Apply to Trusts – The highest income tax rate of 39.6% applies to a trust that earns and retains income of only $11,950 for the tax year. However, this is not a new, drastic change. In 2012, the highest income tax rate for trusts was 35% for trusts that earned and retained $11,650 for the tax year. The higher 20% Capital Gains Tax rate applies to trusts earning and retaining more than $11,950 in income. The 3.8% Medicare Surtax applies to trusts with undistributed net investment income in excess of the dollar amount that starts the highest trust tax bracket ($11,950 for 2013).

How Trusts Are Taxed

For US Federal Income Tax purposes, your trust will likely be taxed as either a Grantor Trust or a Complex Trust. Every Revocable Living Trust is a Grantor Trust. A Grantor Trust generally does not have to file its own tax returns as all of the income from the trust can be claimed on the Grantor’s (trust creator’s) tax return.  Most standard Irrevocable Trusts are complex Trusts. A complex trust can pay taxes on its own income; or, if the trustee can distribute any taxable income to the trust beneficiaries, the trust can issue a K-1 form to beneficiaries so that the beneficiaries can include the income on their own tax returns rather than having the trust pay the income taxes. However, we can also create an Irrevocable Trust as a Grantor Trust where the income of the trust is taxed to the grantor or creator of the trust. Most of our clients with irrevocable trusts have grantor trust status.

What To Do About Trusts Given New Tax Laws

If you have a Grantor Trust (Revocable or Irrevocable), then the trust income tax thresholds do not apply. The grantor’s own income tax brackets will be relevant when determining taxes owed on trust income. For a Non-Grantor Irrevocable Trust (complex trust), if the trustee distributes all trust income to the beneficiaries, the beneficiaries will claim the income on their own tax returns and their individual tax rates apply instead of the higher tax rate at low income amounts for trusts. So although these new laws mean higher taxes for high income earners, there’s no need to be concerned just because you have a trust.