Many new irrevocable trusts have come from the temporarily doubled gift, estate, and generation-skipping transfer tax exemption. Some of these are grantor trusts, but trusts that are non-grantor face income tax challenges. Comerica’s Lisa Featherngill and Melissa Linn share more about planning for those trusts.
The temporarily doubled gift, estate, and generation-skipping transfer tax exemption has resulted in the creation of many new irrevocable trusts. Some of these are grantor trusts, and thus the grantor continues to pay the income tax on the trust income. However, trusts that are non-grantor face income tax challenges. Planning for those trusts is the focus of this article.
In 2022, irrevocable trusts pay tax at the top tax bracket of 37% when undistributed taxable income is $13,450. Individual beneficiaries pay tax at the top tax bracket when taxable income is $539,900 for singles and $647,850 for married individuals filing jointly. Thus, there is a need for planning to determine whether to distribute income to a beneficiary to arbitrate the tax rates between the individual beneficiaries and the trust. There are several taxes at play—net investment income tax, ordinary income tax, capital gains and losses—as well as potential new tax legislation.
The first step in managing taxes for irrevocable trusts is to review the trust distribution language to determine permissible current beneficiaries. Understanding to what extent income can be distributed and to whom it can be distributed can help the trustee and advisers determine how to manage the tax burden to the family.
The next step is to evaluate the tax brackets of the trust and the individual beneficiaries to determine if there is a tax rate arbitrage. For example, if the trust has $20,000 of taxable income in 2022, the trust is going to pay tax in the top bracket. If the beneficiaries are not in the top bracket, the total tax paid could be less if the income is distributed to the beneficiaries. There are different brackets for ordinary income, net investment income tax (NIIT), and qualified dividends/capital gains. Ordinary income tax is subject to the brackets below.
You can see there is significant opportunity to take advantage of tax rate arbitrage based on the tax bracket of the income beneficiaries. In the example above, assuming the beneficiaries are not in the 37% bracket, the trustee could distribute the trust’s $20,000 of taxable income, and the beneficiaries may pay less tax than the trust would have paid.
NIIT is a 3.8% surtax paid by individuals and trusts with income from investments and income above certain thresholds. Married individuals pay NIIT on the lesser of investment income or the amount by which modified adjusted gross income exceeds $250,000, or $200,000 for singles. Trusts pay the tax on the lesser of investment income or the amount by which modified adjusted gross income exceeds $13,450, the beginning of the top tax bracket. Both individuals and trusts are subject to preferential rates on qualified dividends and long-term capital gains although the rates may differ. Note that capital gains may not be distributable depending on the trust language and state law.
To be included in the 2022 tax year, distributions must be made within the calendar year or within the first 65 days of 2023. The extra 65 days allows the trustee to determine the income taxable for 2022 and evaluate whether the trust or the beneficiaries would pay less income tax.
Just because income can be distributed to beneficiaries doesn’t mean that those distributions make sense. There also may be beneficiaries who are best served by limiting trust distributions. For example, if a beneficiary is in the middle of litigation or has a substance abuse issue, the beneficiary’s needs will take priority over any potential tax savings. In addition, the beneficiaries may not need the income or may be in the top income tax bracket, in which case the trustee may simply change the asset allocation of the portfolio to a growth orientation to minimize the income on an annual basis.
If your client is creating a new irrevocable trust, there should be some consideration on whether to make that trust a grantor trust. Grantor trusts are taxable to the creator, allowing the assets in the irrevocable trust to grow tax free. Paying the taxes creates two benefits to the grantor: their estate is decreased by the income tax paid on behalf of the trust, and the taxes paid are not considered a gift. Even if the grantor is in a higher tax bracket than the beneficiaries, the growth of the irrevocable trust and the diminished estate tax can be more meaningful than paying less income tax today. It is important to evaluate the long-term cash flow impact to the grantor. Future potential legislation is targeting grantor trusts due to their significant tax benefits.
In the last 18 months, we have seen tax proposals that would impose additional taxes on trusts. For example, the Build Back Better Act includes provisions to impose a 5% surtax on individuals with income over $10 million plus an extra 3% on income over $25 million. These provisions apply to trusts with income that exceeds $200,000, or $500,000 for the additional 3% tax. Grantor trusts have also been targeted to cause recognition of gains on the transfer of assets.
Irrevocable trusts are wonderful estate planning and asset protection vehicles for beneficiaries. Income taxes should be evaluated on an annual basis to determine if the income tax should be paid by the trust, beneficiaries or, in the case of grantor trusts, the grantor. Considerations should be more than financial in nature. Regardless of the tax consequences, beneficiaries may be best served by keeping the income in the trust.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Lisa Featherngill is the national director of wealth planning at Comerica. She leads a team of experienced and credentialed wealth planning specialists who develop customized personal planning and business transition planning solutions for business owners and other successful individuals.
Melissa Linn is a senior wealth planning strategist at Comerica. She works with business owners, successful families, and executives to develop and implement wealth plans, business plans, and family education.
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