The temporarily doubled tax exemption on gifts, inheritances and generational transfers has led to the creation of many new irrevocable trusts. Some of them are grantor trusts and therefore the grantor continues to pay tax on the income of the trust. However, trusts that are not grantors face income tax challenges. Planning for these trusts is the focus of this article.
In 2022, irrevocable trusts pay tax in the top 37% tax bracket when undistributed taxable income is $13,450. Individual beneficiaries pay tax in the top tax bracket when taxable income is $539,900 for singles and $647,850 for married filers jointly. Thus, planning is necessary to determine whether to distribute income to a beneficiary in order to arbitrate tax rates between individual beneficiaries and the trust. Several taxes are at stake – tax on net investment income, tax on ordinary income, 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’s distribution language to determine the current permitted beneficiaries. Understanding how income can be distributed and to whom it can be distributed can help the trustee and advisors determine how to manage the family’s tax burden.
The next step is to assess the tax brackets of the trust and individual beneficiaries to determine if there is tax rate arbitrage. For example, if the trust has taxable income of $20,000 in 2022, the trust will pay tax in the higher bracket. If the beneficiaries are not in the upper bracket, the total tax paid could be lower 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 that there is a significant opportunity to take advantage of tax rate arbitrage based on income recipients’ tax bracket. In the example above, assuming the beneficiaries are not in the 37% bracket, the trustee could distribute the $20,000 of taxable income from the trust, and the beneficiaries could pay less tax than the trust would have paid.
The NIIT is a 3.8% surtax paid by individuals and trusts whose investment income exceeds certain thresholds. Married people pay NIIT on the lesser of investment income or the amount by which adjusted adjusted gross income exceeds $250,000, or $200,000 for single people. Trusts pay tax on the lesser of the investment income or the amount by which the modified adjusted gross income exceeds $13,450, the beginning of the top tax bracket. Individuals and trusts are subject to preferential rates on eligible dividends and long-term capital gains, although the rates may differ. Note that capital gains may not be distributable depending on the language of the trust and state law.
To be included in the 2022 tax year, distributions must be made in the calendar year or within the first 75 days of 2023. The additional 75 days allow the trustee to determine taxable income for 2022 and assess whether the trust or beneficiaries would pay less income tax.
Just because the income can be distributed to the beneficiaries does not make those distributions meaningful. There may also be beneficiaries who would be better served by limiting trust distributions. For example, if a beneficiary is in the midst of litigation or has a substance abuse problem, the needs of the beneficiary will take priority over any potential tax savings. Additionally, the beneficiaries may not need the income or may be in the higher tax bracket, in which case the trustee may simply shift the asset allocation of the portfolio to a growth orientation to minimize the income over a annual basis.
If your client creates a new irrevocable trust, you should consider making that trust a grantor trust. Grantor trusts are taxable to the creator, allowing the assets of the irrevocable trust to grow tax-free. The payment of taxes creates two benefits for the settlor: their estate is reduced by the income tax paid on behalf of the trust, and the taxes paid are not considered a gift. Even if the settlor is in a higher tax bracket than the beneficiaries, the growth of the irrevocable trust and the reduction in estate tax may be more significant than paying less income tax today. today. It is important to assess the long-term impact on the grantor’s cash flow. Potential future legislation targets grantor trusts because of their significant tax advantages.
Over the past 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 additional 3% on income over $25 million. These provisions apply to trusts whose income exceeds $200,000, or $500,000 for the additional 3% tax. Grantor trusts have also been targeted to result in the recognition of gains on the transfer of assets.
Irrevocable trusts are wonderful vehicles for estate planning and asset protection for beneficiaries. Income taxes should be assessed on an annual basis to determine whether income tax should be paid by the trust, the 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 better served by retaining the income in the trust.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Lisa Plumengill is the National Director of Wealth Planning at Comerica. She leads a team of experienced, credentialed wealth planning specialists who craft personalized personal planning and business transition planning solutions for business owners and other successful individuals.
Melissa Linn is Senior Wealth Planning Strategist at Comerica. She works with business owners, successful families and executives to develop and implement wealth management plans, business plans and family education.
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