Last month’s newsletter and blog post discussed some of the proposed tax law changes to help support President Biden’s Build Back Better Act, and how it (currently) excludes provisions lowering the estate tax exemption next year and removing the step-up in basis of assets at death.
Instead, the current focus involves a new 5% surtax on individuals earning incomes above $10 million, and an additional 3% tax on incomes above $25 million. What I did not discuss in the prior post is a related detail in the proposed legislation that is beginning to cause some fuss in the estate planning community, which is that these proposed surtaxes will apply at a much lower threshold for trusts that that are taxed separately from the creator of the trust (known as non grantor trusts that have their own separate tax ID number, such as a trust that continues to exist for the benefit of children or other beneficiaries after the original creator/grantor of the trust has passed away). For these types of trusts, the 5% tax would apply to all trust income exceeding $200,000 (vs $10 million for individuals), and an 8% surtax on trust income in excess of $500,000 (vs $20 million for individuals).
What does that all mean if the proposed additional surtax on trusts becomes the law? It simply means that it will be increasingly important that people who have trusts which are likely to exceed $200k in income after they pass away be mindfully drafted when it comes to the provisions regarding the distribution of Distributable Net Income (DNI). Specifically, strong consideration should be given to allowing the trust to distribute its taxable income to the beneficiaries each year (vs retaining it in the trust and adding it to the principal). Distributing the trust’s net income to the beneficiaries will reduce or eliminate the trust’s remaining taxable annual income so that it is not taxed at these higher levels. Instead, the beneficiary will simply report the income distributed to them as part of their taxable income, which has much more favorable thresholds than trusts.
Note that the above strategy has always been an important planning tool, because even under current law the 37% maximum trust income tax rate is reached at only $13,050 of taxable income, whereas for single individuals the maximum income tax rate is not reached until $523,601 of taxable income (or, as described in Financial advisor magazine, 40 times higher than trusts). That being said, the proposed additional surtax raises the stakes even further and now therefore requires a more compelling case (such as asset protection concerns due to creditor’s claims or divorce proceedings, substance abuse problems, or disability for which public assistance is being provided) for a trust to retain it’s taxable income vs distributing it out to the beneficiaries annually.