Question

under the current law as trustee of a living trust and trust for minor children, what actions would you take to avoid higher tax rates on net investment income as a result of the provisions of the American Taxpayer Relief Act of 2012 (ATRA)

Answer 1

The net investment income of a trustee is taken into account by the person who is considered the deemed owner of the trust along with that person’s net investment income from other sources.Net investment income includes interest, dividends, royalties, and rents. Net investment income also includes any income derived in the ordinary course of a trade or business, if the trade or business is a passive activity (within the meaning of Sec. 469) for the taxpayer, and any income derived from a trade or business of trading in financial instruments or commodities (as defined in Sec. 475(e)(2)). Net investment income also includes net gain attributable to the disposition of property other than property held in a trade or business that is not a passive activity and not trading in financial instruments or commodities. Deductions allowed for income tax that are properly allocable to gross income or net gain are deductible in arriving at net investment income. For a trust, need to determine whether there is material participation in a trade or business owned directly or indirectly by the trust will put renewed emphasis on an area for which there have been no regulations for the 27 years during which Sec. 469 has applied to losses incurred by these entities.

For each distribution, the trustee must determine the current and accumulated net investment income of the trust. Accumulated net investment income is the total amount of net investment income received by a trust for all taxable years that begin after December 31, 2012, less the total amount of net investment income distributed for all prior taxable years of the trust that begin after December 31, 2012.56Essentially, this means income and gains realized before 2013 are not subject to the tax.

If there is more than one beneficiary, the net investment income will be apportioned among them based on their respective shares of the total amount paid by the CRT that taxable year. 3.8% net investment income tax can apply if the beneficiaries are over the income threshold . The IRS has released proposed regulations dealing with such investment income tax.   

The American Taxpayer Relief Act of 2012, enacted Jan. 2, 2013, also arguably made the substantial investments that many wealthy Americans had made in trusts to avoid potentially higher estate taxes a waste of money. The deal set the exemption amount at $5 million per person, with an annual inflation adjustment (the exemption is currently at $5.34 million for 2014), and made it portable for married individuals.

When assets are transferred from an owner to a trust benefiting others, the assets are no longer part of that person's estate—and thus not subject to estate taxes at his or her death. "Trusts along with buy/sell agreements and other business-planning documents can facilitate passing on businesses to the next generation.

Trusts, however, are subject to income taxes. In fact, they are taxed at the highest marginal rate—39.6 percent—on income above $11,950. They are also subject to the 3.8 percent Obamacare taxes on income over that level.

The high income-tax burden puts a premium on giving trustees, who oversee the trust, discretion to make distributions to beneficiaries in lower tax brackets. Balancing flexibility with tax efficiency is an ongoing effort for trust lawyers.

"There's a focus on building in mechanisms to provide flexibility while accomplishing the desired tax results”.

Living Trust avoids Probate

Besides allowing post-mortem portability, a Living Trust avoids the cost, delays and public disclosure that probate entails. Also, the new NIIT of 3.8 percent applies to certain income retained by trusts and estates if taxable income exceeds $12,300. Net investment income includes interest and dividend income and capital gains, but also includes passive income from rental and business activities, and from pass-through entities. As a result, many trusts and estates will be taxed in 2015 at 43.4 percent on ordinary income and 23.8 percent on qualified dividends and long-term capital gains, plus state level income taxes.