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Homecrystal ballEstate planners shift gears in new tax environment

Estate planners shift gears in new tax environment

Wealthy individuals aren't the only ones struggling to cope with higher income-tax rates and the new 3.8 percent investment income tax funding the president's health-care plan. The beneficiaries of trusts—wealthy or not—are also feeling the bite, and estate planners are trying to figure out ways to reduce it.

Trusts are separate legal entities created by a person or organization and managed by a trustee for the benefit of others—very often spouses or children of the trust creator. They allow a person to remove assets and property from their own estates, thereby avoiding the estate tax when they die, and enable them to control how and when assets are distributed to their beneficiaries.

Srdjan Srdjanov | E+ | Getty Images

The bigger tax hit
The variety of trusts and the rules that govern them are enormous. So-called simple trusts pay out all the income they produce to beneficiaries, who then don't face income taxes. With grantor trusts, the creator of the entity is deemed the owner and thus faces all tax liabilities stemming from its administration. However, for the rest of the universe of trusts—call them complex, nongrantor trusts—income taxes have become a much bigger deal.

The reason is that, for tax purposes, trusts are treated like wealthy individuals—only worse. While the new 39.6 percent marginal tax rate created by the American Taxpayer Relief Act applied to income over $400,000 for individuals last year, it kicked in at an income threshold of just $11,950 for trusts. The 3.8 percent Medicare surtax applied to the net investment income of individuals earning more than $200,000 also hit trusts starting at that lower threshold.

(Read more: Spoiled for investment choices? Less is much more)

The upshot is significantly higher tax bills. Assuming no capital gains income, a trust holding $1 million in assets and making a 10 percent return last year paid income taxes of $34,868 and new Medicare taxes of $3,346. That's nearly $7,400 more than it would have paid in 2012 on the same income.

While minimizing taxes is certainly not the only, nor even the primary, objective of trusts, it is a major issue for trustees with a fiduciary responsibility.

"The objective is to maximize the amount of money that family members [or other beneficiaries] receive," said Ronni Davidowitz, head of the trusts and estates practice at legal firm Katten Muchin Rosenman. "Estate planners have to revisit some of their planning patterns of the past and reevaluate what makes sense now."

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