Trusts, Capital Gains and the Net Investment Income Tax

Published on: 17:22PM Apr 29, 2014

As has been previously discussed in several posts, the highest tax rate for 2013 was raised from 35% to 39.5% and the highest capital gains tax was also raised from 15% to 20%. Obamacare also implemented a new complicated 3.8% surtax on net investment income in excess of certain thresholds. The thresholds are as follows based on a modified adjusted gross income:

  • Married filing joint: $250,000
  • Single: $200,000
  • Estates and Trusts: $12,150

As you can see, the threshold for estates and trusts is much lower. Income that is passed out to the beneficiaries of the trust reduces trust income and although it is taxed to the individual, in almost all cases this tax is lower than if taxed at the trust level. However, capital gains are typically excluded from distributable net income and typically taxed to the trust. Therefore, in a simple example, if a trust has $112,150 of capital gain income that cannot be distributed, the trust would pay around $25,000 in tax due to the 3.8% Medicare surtax and condensed tax brackets for trusts.

By contrast, if this income could have been distributed to an individual married taxpayer, this same income would have only generated around $3,000 of tax assuming no other income or dependents. Obviously that is a simple example, however, it is one I came across this last tax season. Given how many trusts hold farm land or brokerage investments, this situation can arise very often.

Capital gains do not always have to be taxed to the trust, however, and in certain situations can be distributed to beneficiaries. A great deal of attention must be focused on the governing instrument and the law of each jurisdiction; each state may differ in this regard.

As you can see, there are many unique aspects of trust and estate income taxation that in many cases can increase the income taxes paid by trusts and estates. Further, executors and trustees must adhere to fiduciary standards and owe duties of care and loyalty to all beneficiaries of the estate or trust and must be knowledgeable about the circumstances of individual beneficiaries as well as the overall structure of the entity. A decision to distribute capital gains income in one year to lower trust taxes may not be the best decision for all beneficiaries in future years. Therefore, careful consideration should be always be given when deciding if capital gain income should be kept within the trust or if it can be distributed to the beneficiaries.