Under federal income tax laws, irrevocable, non-grantor trusts (such as Bypass Trusts and Dynasty Trusts) are subject to highly compressed income tax brackets. In 2014, the top 39.6% tax rate kicks in at only $12,500 of trust income. In addition, trusts in the top tax bracket are subject to the 20% long-term capital gains rate and a 3.8% surtax on the lesser of undistributed net investment income or adjusted gross income over $12,500.
What Can Trustees Do to Lower a Trust’s Taxable Income?
Due to this unfavorable income tax treatment of irrevocable, non-grantor trusts, Trustees of this type of trust must plan carefully to minimize annual income taxes. Since trust income distributed to the beneficiaries is not taxed at the trust level, distributions may be made to beneficiaries who are in a lower income tax bracket and/or not subject to the 3.8% surtax. This, in turn, will lower the income that is taxed inside of the trust. Nonetheless, any distributions aimed at reducing a trust’s income tax liability must be made within the distribution parameters established in the trust agreement and applicable state law.
With these limitations in mind, income-reducing strategies Trustees should consider include:
- Distributing trust income to beneficiaries who are in a lower tax bracket and/or not subject to the 3.8% surtax
- Making in-kind distributions of low basis trust property to beneficiaries who are in a lower tax bracket or plan to hold on to the property and not sell it any time soon
- Invoking the 65-day rule and distributing trust income to beneficiaries who are in a lower tax bracket and/or not subject to the 3.8% surtax by March 6, 2015, which will allow the trust to deduct the income as a 2014 distribution and thereby lower the trust’s 2014 taxable income (however this 65-day rule may not apply for state income tax purposes, so Trustees should make distributions before December 31 in states that don’t allow the 65-day rule for state income tax purposes)
- Exploring options to permit capital gains to pass to beneficiaries instead of being taxed inside of the trust, such as reforming or decanting the trust to broaden the Trustee’s discretion to allocate between trust income and principal
- Shifting trust investments to minimize taxable income and gains
- Terminating small, uneconomic trusts under the terms of the trust agreement or applicable state law
Final Considerations for Trustees of Irrevocable, Non-Grantor Trusts
Planning to minimize trust income taxes is a delicate balancing act. Trustees must carefully weigh the tax benefits of making distributions or changes to the trust’s provisions against the grantor’s intent, the ongoing needs and tax status of the current beneficiaries, and what will be left for the remainder beneficiaries. In addition, income, gains, losses, and tax brackets must be reviewed annually since the needs and expenses of the trust beneficiaries will undoubtedly change from year to year.