Many families today are attempting to reduce their tax bills by distributing trust income to beneficiaries in lower tax brackets. But it’s not always possible to distribute capital gains. If long-term gains remain “trapped” inside a trust, they’ll be taxed at rates as high as 23.8%. But there may be steps you can take to liberate capital gains from a trust and shift the income to your beneficiaries.
Income taxes in the spotlight
Historically, estate-planning strategies focused on minimizing estate taxes. But today, a generous gift and estate tax exemption (a projected $5.43 million in 2015) combined with soaring income tax rates has shifted the emphasis to income tax planning. Taxpayers with income over $400,000 ($450,000 for joint filers) are now subject to a 39.6% marginal tax rate on their ordinary income and a 20% capital gains tax rate.
In addition, taxpayers whose modified adjusted gross income (MAGI) tops $200,000 ($250,000 for joint filers) are subject to a 3.8% tax on their net investment income (NII), which includes dividends, taxable interest and capital gains. The tax applies to the lesser of 1) your net investment income, or 2) the amount by which your MAGI exceeds the threshold.
The impact of higher income taxes on nongrantor trusts is particularly harsh because the top tax rates, as well as the NII, kick in when income exceeds only $12,300. Once a trust’s income reaches that threshold, its ordinary income is taxed at 39.6% and capital gains are taxed at 20%. In addition, the trust is subject to NII tax on the lesser of 1) its undistributed net investment income, or 2) the amount by which its adjusted gross income exceeds the $12,300 threshold.
Removing capital gains
One strategy for reducing taxes on nongrantor trusts is to distribute their income to the beneficiaries. Generally, trusts are subject to tax only on their undistributed income, while income distributed to a beneficiary is taxed at the beneficiary’s marginal rate. Trust accounting rules limit these distributions to distributable net income (DNI), which typically includes dividends and interest but excludes capital gains. As a result, capital gains ordinarily are taxed at the trust level.
Depending on applicable state law and the terms of the trust document, however, it may be possible to include capital gains in distributable net income, either by amending the trust or through an exercise of trustee discretion. Consider this example:
The Jones family trust provides for Bridget to receive all of the trust’s income, plus distributions of principal per the trustee’s discretion. In 2015, the trust will earn $12,300 in qualified dividends, plus $75,000 in long-term capital gains. The trust will distribute its distributable net income (which doesn’t include capital gains) to Bridget plus $75,000 in principal. Assuming that Bridget is single, has no other income and takes the standard deduction, her tax bill will be approximately $0. The trust will owe somewhat more than $16,000 in capital gains and NII taxes.
Suppose, instead of principal, the trust distributes the $75,000 capital gain to Bridget. The trust’s tax liability would be reduced to zero and Bridget’s tax bill would be just over $6,000, for an overall tax savings of more than $10,000.
Review your trusts
If your trusts are paying capital gains taxes at the highest rates, talk to your tax advisors about whether you can include capital gains in DNI and have them taxed at the beneficiary level. The move could be a wise financial strategy.