With the Supreme Court upholding the health care insurance reform of the Affordable Care Act earlier this summer, the additional Medicare taxes of 0.9 percent (wages) and 3.8 percent (investments) look increasingly certain to apply in 2013, especially with President Obama’s re-election. Much has been written about individual financial and tax planning for this surtax. I’ll review the basics of the surtax and then focus on various proactive opportunities for trustees to avoid it, especially with respect to common bypass and marital trusts (“trusts” refers solely to non-grantor, non-charitable trusts).
For individuals, the 3.8 percent surtax will apply in 2013 to the lesser of net investment income or the excess of a taxpayer’s modified adjusted gross income (MAGI) over:
• $125,000 (married filing separately);
• $250,000 (married filing jointly and qualifying
• $200,000 (single) (individual thresholds in Internal Revenue Code Section 1411(b)).
The “modified” applies to those who live abroad and use the foreign earned income exclusion. For 99 percent of taxpayers, this will be their adjusted gross income (AGI), which is found on the bottom line of the first page of their Form 1040.
For estates and trusts, the surtax applies to the lesser of the undistributed net investment income or the excess of an estate/trust’s AGI over $11,650 (top tax bracket, adjusted for inflation) (IRC Section 1411(a)(2)).
“Net investment income” is:
(A) (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),
(ii) other gross income derived from a trade or business described in paragraph (2), and
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2),
(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.1
Qualified retirement income is excluded from the calculation, as well as wages, self-employment income, active business income or gain from a sale of such a business (IRC Sections 1411(c)(2), (4), (5), (6)).
Given the relatively low threshold for an estate or trust to be subject to the surtax, it’s important to focus on techniques that may be used to minimize exposure to it.
There are many basic ways of restructuring finances and investments to avoid the surtax, including:
• Using tax-exempt investments, such as municipal bonds;
• Using investments or accounts with tax deferral features, for example life insurance, deferred annuity contracts or deferred compensation or qualified retirement plans;
• Using traditional techniques to defer recognition/timing of gains, like tax-free exchanges, installment sales or charitable remainder trusts;
• Investing in assets with tax depreciation features, such as traditional real estate or oil and gas investments;
• Paying more sensitive attention to tax recognition by using low turnover mutual funds, exchange-traded funds or even better, managing individual stocks and bonds;
• Accelerating the timing of income recognition into 2012, via Roth individual retirement account conversions, distributing C corporation dividends or harvesting long-term capital gains (LTCG);
• Electing, for decedent’s estates and qualifying trusts, fiscal years beginning in late 2012 (the tax applies to years beginning after Dec. 31, 2012, so a Dec. 1, 2012 to Nov. 30, 2013 fiscal year would allow 11 months of 2013 income to avoid the tax).
Most of these techniques aren’t new to the surtax and have traditionally been used for basic income tax planning. I’ll discuss more unique opportunities and pitfalls of this new surtax as applied to ongoing trusts2 through more proactive trust drafting, planning and administration. Without such planning, many trusts will get stuck paying a tax that might easily have been avoided.
Barbara, recently widowed, is the primary beneficiary of a $2 million bypass trust established by her late husband. Her income outside the trust is only $70,000 per year. For 2013, the trust has ordinary income of $40,000 (which I’ve assumed to be equal to the trust’s accounting income and distributable net income (DNI)), short-term capital gains (STCG) of $30,000 and LTCG of $60,000. The trustee allocates all capital gains to trust principal. The trustee distributes to Barbara all of the net trust accounting income ($40,000), as well as a discretionary distribution of principal of $65,000, needed for her support. The trust is entitled to a distribution deduction of $40,000 and has taxable income of $90,000 (the sum of its STCG and LTCG).3
Even if the trust mandates that all net income be paid to Barbara, the $65,000 principal distribution isn’t ordinarily included as part of what’s called the “income distribution deduction” or “DNI deduction.”4 The trust’s deduction for distributions is limited to DNI, which typically excludes taxable gains that are usually allocated to principal. That means there’s $90,000 trapped as AGI inside the trust, even though $65,000 of principal was distributed in addition to the trust accounting income. It’s this latter aspect of trust income taxation that practitioners often overlook and misunderstand—and it’s potentially the source of unnecessary surtax.
The $90,000 that’s trapped as AGI inside the trust for income tax purposes is equally subject to the surtax. The surtax applies to a trust’s “undistributed net investment income.”5 It’s tempting to make the argument that the $65,000 of principal distribution was from capital gains (net investment income) and was distributed for surtax purposes, even if not for Form K-1 and trust income tax purposes. Guided by the general unwritten principle that all income must be taxed to either a trust or the beneficiary, this is unlikely. If the $65,000 were considered distributed for surtax, yet not on the beneficiary’s K-1, it would effectively escape the 3.8 percent surtax, no matter how wealthy the beneficiary. A more logical interpretation is to read “distributed” in light of general IRC Subchapter J principles. This means, in a nutshell, looking to the K-1 as to whether capital gains income is distributed. In our example, therefore, all $90,000 of capital gains, regardless of the $65,000 principal distribution, is “undistributed,” because it’s not reflected on the beneficiary’s K-1 and is taxed to the trust for income tax purposes.
Effect of Surtax
Back to our example and the new effect of the surtax: Beginning in 2013, all of the STCG (after $11,650) are subject to top income tax rate (39.6 percent in 2013), plus the 3.8 percent surtax. All of the LTCG are subject to a top LTCG tax rate of 20 percent, plus the 3.8 percent surtax. Can we work some trust accounting alchemy to allow capital gains to escape being trapped in the trust? In our example, this may allow investment income to completely avoid the surtax (and, potentially, lower taxes on STCG as well). This would subject the STCG to a mere 28 percent or 31 percent tax in the hands of the beneficiary (the lower rate would apply if Barbara is a qualifying widower or remarried), instead of 43.4 percent (39.6 percent + 3.8 percent surtax) and subject the LTCG to a mere 20 percent in the hands of the beneficiary, instead of 23.8 percent (20 percent + 3.8 percent surtax).
Potential Tax Savings
Here’s the potential tax savings if no capital gains are trapped in the trust:
• 23.8 percent - 20 percent (3.8 percent), multiplied by LTCG ($60,000) = $2,280
(amount of overall LTCG and surtax savings from taxing to beneficiary, not trust)
• 43.4 percent - 28 percent (15.4 percent) multiplied by STCG ($30,000 -$11,650) = $2,826
(amount of STCG and surtax savings from taxing to beneficiary, not trust)
(for simplicity, we’ll assume the first $11,650 taxed to the trust would generate approximately the same tax if taxed to the beneficiary)
Total potential tax savings = $5,106
Overall savings could be higher or lower, depending on the state income taxation affecting the trust and/or the beneficiary.
If a beneficiary is in the highest tax bracket (currently $388,350 per year taxable income), then the fact that income is “trapped” in a bypass/marital trust in 2013 at the highest bracket, plus a 3.8 percent tax makes no difference—she would have paid that same level of tax anyway. Whether income is taxed to the trust or to such a beneficiary would usually be income tax rate- and Medicare surtax-neutral. Most trust beneficiaries won’t fit in this elite bracket of taxable income, however. And, even high bracket taxpayers may have capital loss carry forwards that could offset distributed capital gains.
If distribution standards would otherwise require or permit significant distributions from principal to be made to the beneficiary, then why not arrange the accounting of those same distributions in the most tax-effective manner?
There are at least three methods to avoid the problem of capital gains being trapped in trust and subjected to the surtax, while remaining investment-neutral:
1) use IRC Section 678(a) to make all capital gains taxed to the beneficiary; 2) use a unitrust to ensure more capital gains are taxed to the beneficiary; or 3) ensure that capital gains are counted in the DNI deduction. I’ll only briefly discuss the first two, which have significant drawbacks, and will focus on the various ways to count capital gains as part of the DNI deduction, which is by far the most practical and advantageous.
Method 1: Section 678(a) states that a beneficiary is considered the owner of a trust when he has the power to vest income or principal in himself.6 For instance, a trust may provide that the primary beneficiary has the right to withdraw all income, including capital gains. Some trusts have a 5 percent of corpus withdrawal power that already does this, at least in part.7 While this kind of clause would shift the income taxation (and with it, the Medicare surtaxation), such powers bring up many other negative ramifications—decreased asset protection (amounts taken or subject to such power may be subject to the beneficiary’s creditors) and increased estate inclusion (amounts taken or subject to withdrawal at death are in the beneficiary’s estate)—plus, if assets aren’t withdrawn in a given year, it results in a partially self-settled trust as to the beneficiary, which may have negative ramifications for asset protection, generation-skipping transfer tax allocation/inclusion or estate tax inclusion. Such a provision may also complicate income tax and trust accounting, because it may create a part non-grantor, part grantor (as to the beneficiary) trust, for which applicable percentages might change every year—a real quagmire. Recall that the gift tax code only protects lapses under the greater of 5 percent of the applicable corpus or $5,000.8 State trust code statutes that govern asset protection often adhere to this standard.9
Method 2: A unitrust could allow more capital gains to be allocated and taxed to the beneficiary.10 Many states now have a conversion statute, which typically allows conversions to a 3 percent to 5 percent unitrust, based on the total value of the trust (usually based on Dec. 31 values, sometimes smoothed out by formula). Although this solution would avoid the accounting complexity and some tax uncertainties of the Section 678(a) trust discussed above and is easier to both adopt and understand, a unitrust is equally rigid and inflexible and, by forcing out more distributions, has many of the asset protection and estate tax negatives noted above. In addition, it might force out more or less than needed to adequately address the optimal surtax avoidance and optimal use of brackets and deductions. A unitrust is ill-suited for optimal tax or asset protection planning—it’s a more limited solution to adapt old-fashioned trusts to modern portfolio theory and a low interest, low dividend investment environment.
Method 3: The best solution is to use one of the three exceptions noted in the Treasury regulations to allow capital gains to be treated as part of the DNI deduction. This will allow any discretionary distributions to the beneficiary to carry out capital gains as part of DNI, so that the K-1 can take care of the surtax issue by putting the capital gains on the beneficiary’s Form 1040.
Once capital gains are part of the DNI deduction, they can be carried out on the K-1 and taxed to the beneficiary. So, how do we get out of the default rule that capital gains aren’t ordinarily part of DNI?11 Generally, they’ll be included if they are: 1) allocated to fiduciary accounting income, or 2) allocated to principal and “paid, credited or required to be distributed to any beneficiary during the year.”12 The regulations regarding these exceptions are more specific:
(b) Capital gains included in distributable net income. Gains from the sale or exchange of capital assets are included in distributable net income to the extent they are, pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law)—
(1) Allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of distributable net income determined without regard to this subparagraph §1.643(a)–3(b));
(2) Allocated to corpus but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to a beneficiary; or
(3) Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.13
Let’s discuss these out of order, taking the easiest and “cleanest” first. The exception under Treasury Regulations Section 1.643(b)-2 is very straightforward. The trustee simply treats capital gains consistently as part of the beneficiary’s distribution. Ideally, language in the trust will address this.14 For new estates and trusts, this is quite easy. For an existing trust, there’s a question whether it can change this practice in January 2013, when in prior years it has been consistently not treating capital gains as part of a beneficiary’s distribution. I’ll discuss potential remedies of amendments and decanting below.
The exception under Treas. Regs. Section 1.643(b)-3 is more problematic. It can be divided into two methods—the first is to “actually distribute” capital gains. This means tracing the proceeds. So, the trustee takes the proceeds from the sale and gives the net capital gains therefrom to the beneficiary. This sounds easier than it is. For instance, what if principal distributions are needed early in the year and can’t wait until later, when the net gains can be determined? What about phantom capital gains?
In lieu of tracing, the Treas. Regs. Section 1.643(b)-3 exception also allows capital gains to be part of DNI, if the trustee uses capital gains “in determining the amount that is distributed or required to be distributed.”15 Very few trusts would use capital gains as part of a distribution provision in this manner. For instance, a trust might say that “gains from the sale of a particular business property shall go to beneficiary X.” In theory, the trust could mandate that “the trustee pay all (or X percent) of net income and net capital gains to the beneficiary” to invoke this section, but that kind of provision has the rigidity and negative asset protection problems previously discussed in regard to IRC Section 678(a) trusts and unitrusts.
Allocating gains to income pursuant to Treas. Regs. Section 1.643(b)-1 offers more flexibility than the other two exceptions, but is potentially more complex, because it involves changing the scheme of principal and income allocation.
For increasing numbers of non-marital trusts, the distinctions between principal and income are often meaningless in determining what beneficiaries receive from the trust. However, they’re still important for tax purposes.
Corollary to the above regulation, Treas. Regs. Section 1.643(b)-1 states that:
In addition, an allocation to income of all or a part of the gains from the sale or exchange of trust assets will generally be respected if the allocation is made either pursuant to the terms of the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of a discretionary power granted to the fiduciary by applicable local law or by the governing instrument, if not prohibited by applicable local law.16
Thus, in theory, not only could capital gains be allocated to income, but also, the allocation can be done at the trustee’s discretion. Sections 103-104 of the Uniform Principal and Income Act (UPIA), which provides the default principal/income rules in most states, allow a trustee to make adjustments to income and principal, in theory. However, the default prerequisites and rationale for invoking these provisions don’t fit our proactive tax planning example above, in which the goal is simply to shift taxation of the capital gains that are, arguably, already being distributed to the beneficiary.
But this doesn’t mean that a trust can’t be drafted to override the limitations of UPIA Sections 103-104. UPIA Section 103(a)(1) first requires a fiduciary to “administer a trust or estate in accordance with the trust or the will, even if there is a different provision in this Act.” UPIA Section 103(a)(2) further permits a trustee to “administer a trust or estate by the exercise of a discretionary power of administration given to the fiduciary by the terms of the trust or the will, even if the exercise of the power produces a result different from a result required or permitted by this Act.” Thus, the attorney merely has to override the UPIA default to grant wider discretion to allocate between principal and income (perhaps, to the extent of discretionary distributions), while keeping in line with both state law and Treas. Regs. Sections 1.643(b)-1 and 1.643(a)-3(b).17
Indeed, many trust documents already expressly authorize trustees to make income and principal determinations without regard to otherwise applicable statutes.
Discretion to exploit such adjustments is best left to an independent corporate trustee, rather than a beneficiary/trustee, especially if there’s “all net income” language. So, how would our power to adjust solution work under our bypass trust example above? The independent trustee would adjust all (or most) of capital gains to accounting income, then the $65,000 distribution becomes part of DNI and the distribution deduction is K-1ed out to the beneficiary.
Consistently treating capital gains as part of a beneficiary’s distribution under Treas. Regs. Section 1.643(b)-2 is the simplest exception and preferred for most new trusts. Allocating gains to income under Treas. Regs. Section 1.643(b)-1 may offer more flexibility, but there would be the additional complexity of changing internal trust principal/income accounting. After all, the greatest flexibility is gained through use of the trustee’s authority to vary discretionary distributions.
Pre-existing Irrevocable Trusts
If a trustee, historically, hasn’t been treating capital gains as part of distributions in its “books, records, and tax returns,” query whether a private settlement agreement, division, decanting or other reformation to prospectively change this would have any impact. Arguably, the trustee would, thereafter, be consistent in its treatment of capital gains pursuant to the new governing instrument. Would the IRS permit a one-time change? The IRS may not consider it to be a new trust for Treas. Regs. Section 1.643(a)-3(b) purposes simply because of a minor administrative amendment and might, therefore, regard new treatment of capital gains as inconsistent with prior practice. After all, trustees don’t typically get a completely new employer identification number for such changes. Thus, practitioners might seek a private letter ruling to adapt existing trusts that have a history of not treating capital gains as part of distributions or use one of the other methods mentioned herein, such as changing the principal and income scheme.
Impact of Changing Tax Burden
Let’s return to our example. When Barbara discovers that the $65,000 she thought was a tax-free distribution of principal is now taxed to her, she asks the trustee to gross up the amount for the 20 percent LTCG tax and/or 28 percent (or 31 percent) STCG tax she’ll have to pay on her capital gains distributions. The trustee then distributes an additional $20,000 (from capital gains), bringing the total to $85,000, which, minus taxes, is about $65,000 net of tax. So, of the $90,000 of total capital gains, $85,000 would be distributed to Barbara, bringing her personal AGI to $195,000 ($70,000 non-trust income, $40,000 trust ordinary income, $85,000 trust capital gains via K-1). The $5,000 of remaining capital gains would be trapped in the trust. Neither Barbara nor the trust pay the surtax, because both now have MAGIs under the applicable threshold. Even the remainder beneficiaries are happy, because, although Barbara got $20,000 more in gross distributions under this planning, the trust saved more than that in taxes, so they’re better off as well.
Whether this technique will save taxes depends on many factors, primarily the trust distribution provisions, state principal and income law, state taxation of the trust and beneficiary and, of course, the beneficiary’s income, deductions and capital loss carry forwards. However, in many cases of trust planning and administration for the moderately wealthy upper-middle class, it will pay to rethink the trust boilerplate, administration and tax preparation in regard to capital gains starting in 2013. The potential savings lies not only in saving trapped capital gains income from the 3.8 percent Medicare surtax, but also from the higher tax rate on STCG that will hit the top bracket of trusts at only $11,650 next year.
Rethink Trust Boilerplate
Attorneys should review the terms of their trusts to determine how capital gains are accounted for in making trust distributions and/or allocated to fiduciary accounting income and what discretion over these matters the trustee is given. For existing irrevocable trusts, attorneys should not only review the terms of the trusts as to how capital gains are accounted for, but also review how the trustee has historically handled the treatment of capital gains regarding the beneficiary’s distributions. An experienced corporate trust department would best ensure consistent documentation of the “books, records and tax returns” to comply with the regulations necessary to exploit these potential savings.
If the trustee hasn’t been treating capital gains as a part of the beneficiary’s distributions (which is likely), consideration should be given to a private settlement agreement or reformation to either correct prospective treatment of capital gains on the “books, records and tax returns” of the trust, or amend the trust provisions regarding trustee discretion to allocate capital gains to fiduciary accounting income. In the latter case, the use of a professional and independent trustee or co-trustee should be considered to properly exploit this flexibility.
—The author wishes to thank Alan Acker, a tax attorney at Carlile Patchen & Murphy LLP in Columbus, Ohio, professor and author of several BNA portfolios, for his thoughtful assistance in writing this article.
1. Internal Revenue Code Section 1411(c)(1).
2. It doesn’t apply to fully charitable trusts and charitable remainder trusts. See p. 135 of the Congressional Joint Committee on Taxation Report JCX-18-10 at www.jct.gov/publications.html?func=startdown&id=3673 and IRC Section 1411(e). This article will skip discussion of the surtax as applied to estates, because it will often be less of a problem, due to recent step-up in basis, higher than usual deductions (such as attorney, executor and probate fees) and the fact that terminating estates pass out capital gains as part of distributable net income, but estates taking over a year to settle or pouring over into a trust will involve the same issues.
3. Our example assumes that all trust/beneficiary income is otherwise subject to surtax pursuant to IRC Section 1411(c) (that is, interest, dividends, capital gains, annuities, rents, royalties, passive activity income, but not retirement income, active business income, sale of active business or other exception) and no capital gains are within a special tax rate category (such as IRC Section 1250 depreciation recapture, special rate for collectibles or “super” long-term rates of 18 percent that might be reenacted). I’ve ignored the $100/$300 deduction and other common deductible expenses for simplicity.
4. IRC Section 643(a)(3), Treasury Regulations Section 1.643(a)-3(a).
5. IRC Section 1411(a)(2)(A).
6. This is sometimes referred to as a Mallinckrodt trust, after Mallinckrodt v. Nunan, 146 F.2d 1 (8th Cir. 1945) or, more common recently, a beneficiary-defective grantor trust.
7. There are persuasive arguments that a sole beneficiary/trustee also has this IRC Section 678(a) power even when limited by an ascertainable standard, but this is generally unreliable for proactive planning purposes. See pp. 17-20 of attorney Howard Mobley’s outline at www.howardmobley.com/articles/FixingBrokenTrusts.pdf and Jonathan Blattmachr, Mitchell Gans and Alvina Lo’s article at www.eagleriveradvisors.com/pdf/A_Beneficiary_as_Trust_Owner_Decoding_Section_678.pdf.
8. IRC Sections 2514(e) and 2041(b)(2).
9. Uniform Trust Code Section 505(b)(2).
10. See examples 11-14 of Treas. Regs. Section 1.643(b)-3(e).
11. See Treas. Regs. Section 1.643(a)-3(a) for this default.
12. IRC Section 643(a)(3).
13. Treas. Regs. Section 1.643(a)-3(b).
To the extent that discretionary distributions are made from principal, the trustee shall make them and/or account for them in the books, records and tax returns of the trust in the following order:
1) from any current year net short-term capital gains, except those net gains attributable to disposition of property held in a trade or business not described in IRC Section 1411(c)(2), or attributable to disposition of an active trade or business as described in IRC Section 1411(c)(4); 2) from any current year taxable income attributable to assets described in IRC Section 1411(c)(1)(A)(i), such as an annuity payment, that was allocated to principal; 3) from any current year taxable income attributable to a qualified retirement plan distribution described in IRC Sections 401(a), 403(a), 403(b), 408, 408A or 457(b) allocated to principal; 4) from any remaining current net short term capital gains not described in paragraph 1; and 5) from any current long-term capital gains, except those net gains attributable to disposition of property held in a trade or business not described in IRC Section 1411(c)(2), or attributable to disposition of an active trade or business as described in IRC Section 1411(c)(4).
15. Treas. Regs. Section 1.643(a)-3(b)(3).
16. This is in spite of an admonition earlier in the same regulation that “trust provisions that depart fundamentally from the traditional concepts of income and principal generally will continue to be disregarded.” This ability of the fiduciary to manipulate tax consequences through its discretion pursuant to this regulation has generally been respected. See BNA 852-3rd, Acker, A67 and authorities cited therein.
Pursuant to Section 103 of the UPIA [or state UPIA citation], I hereby override the state law default treatment of allocation of capital gains to trust principal as follows: any Trustee not a beneficiary nor “related or subordinate” (as those terms are defined in IRC Section 672) to any beneficiary of a trust may reallocate capital gains taxable income from fiduciary accounting principal to fiduciary accounting income in the sole discretion of the trustee. In doing so, the trustee may consider the net tax effect of the allocation to the trust and the beneficiary together, such as whether leaving capital gains as taxable to the trust would otherwise cause a Medicare surtax or short-term capital gains rates in excess of the net additional tax effect of a reallocation on a beneficiary’s taxes.