With the significant increase to the federal estate tax exemption, many individuals feel that estate planning isn’t as important as it used to be. Regular readers of this column know that isn’t true for many non-tax reasons. Here, however, I’m going to review a very significant federal income tax surcharge that affects estates and trusts beginning this year (2013).
Most of you are aware that the Affordable Care Act (a/k/a ObamaCare) imposes a 3.8 percent Medicare surtax on most forms of unearned income when taxpayers have net investment income or modified adjusted gross income above certain amounts. ($250,000 married filing jointly; $125,000 for married filing separately; $200,000 on all others).
The surtax may also affect estates and irrevocable trusts that have Net Investment Income above a very low amount – $11,950. So, if Dad dies with a trust that benefits mom, and that trust earns interest, dividends and capital gains totaling $80,000 that are accumulated inside of the trust and are not distributed to mom, then dad’s trust could owe a Medicare surtax of $2,586.00 in addition to all of the income and capital gains taxes that it normally would pay. Moreover, the interest and dividends would be taxed at the highest ordinary income tax bracket (now 39.6%) and the capital gains tax rate in this example would also be at the highest federal marginal rate (now 20 percent).
The Medicare surtax may be minimized or even legally eliminated with proper planning both inside of your estate plan and in how your plan is administered following your death. Moreover, the income tax rates on the interest and dividends as well as the capital gains tax rates could be reduced with proper planning.
The first item to consider is that the $11,950 threshold on Net Investment Income applies to estates and irrevocable trusts. It does not apply to revocable living trusts. If you established a revocable living trust, then the income earned by the trust is taxed to you as if the trust doesn’t exist. There is no difference between having a revocable trust and not having one from an income tax perspective during your lifetime. It is tax neutral. If a revocable living trust will benefit you and your family, then the Medicare surtax should not affect your decision as to whether you should establish a new trust or retain an existing trust.
When you die, however, your estate is either created through your will, and/or may become a “testamentary trust” (which means a trust that forms after your death) for the benefit of your spouse or children. Estates under wills and testamentary trusts are by definition irrevocable. You may have also established a lifetime irrevocable trust. All are negatively affected by the low Medicare surtax threshold.
There are planning options available, however. When estates and irrevocable trusts distribute all of the Net Investment Income to the beneficiaries, then the surtax would apply to the beneficiaries’ tax schedules and not to the estate and trust schedules. By applying the individual thresholds mentioned in the second paragraph above there might not even be a Medicare surtax due, and the income and capital gains tax rates may also be drastically reduced.
But it is not always feasible to have the estate or trust distribute all of the income and capital gains to the beneficiaries. A spousal trust may have been created to protect the surviving spouse’s inheritance, minimize estate taxes when he or she dies, or to preserve the trust for the children in second marriage situations. An irrevocable trust for the children may have been created to protect the children’s inheritance from divorcing spouses, creditors or predators. Assuming that these non-tax reasons exist for the creation of the irrevocable trust to begin with, then one can’t just assume that the best course of action would be to make interest, dividend and capital gains distributions out of the trust to avoid the Medicare surtax. There one would be letting the tax tail wag the proverbial dog.
There are alternatives available. The trust could be drafted in such a way as to give the trustee (who may also be the beneficiary) discretion to recharacterize capital gains and income and make distributions to minimize the potential tax bite. The trust could also be drafted to classify the beneficiary’s interests as “grantor” interests under the Internal Revenue Code. What this means is that the collapsed $11,950 trust rate schedule would not apply to the trust shares benefitting the spouse or children. Instead, the more favorable individual tax rate schedules would apply.
Needless to say, the ObamaCare surtax along with the higher income tax rates imposed beginning this year will require clients and their advisors to review their estate planning. There isn’t a blanket answer to everyone’s plan that fixes the problem. Each individual’s plan and goals need to be considered to arrive at the right solution for his or her unique situation.
©2013 Craig R. Hersch