On Jan. 1, 2013, the income tax playing field for estates and trusts changed drastically. First, the American Taxpayer Relief Act of 2012 (ATRA) significantly increased the top income tax rates for estates, trusts and individuals.1 Second, the Health Care and Education Reconciliation Act of 2010 imposed a new tax, the so-called “Medicare surtax,” which is assessed on certain types of passive income earned by estates, trusts and individuals.2 At the same time, ATRA decreased the top estate and gift tax rate from 45 percent to 40 percent and made permanent the $5 million exemption for estate, gift and generation-skipping transfer (GST) taxes (adjusted for inflation to $5.25 million in 2013).3 These changes may shift the focus of many taxpayers from transfer tax planning to income tax planning. Thus, it’s imperative that estate and trust practitioners know the new rules to minimize income taxes for estates, trusts and beneficiaries.
Changes in Income Tax Rules
The top tax rate on ordinary income increased from 35 percent to 39.6 percent as of Jan. 1, 2013.4 For individuals, the top rate applies to taxable income above $400,000 ($425,000 if head of household and $450,000 if married filing jointly), but for estates and trusts, the top rate applies to taxable income starting at just $11,950.5 The rate on long-term capital gains and qualified dividends for individuals, estates and trusts increased from 15 percent to 20 percent for those taxpayers in the new 39.6 percent bracket for ordinary income.6
The Medicare surtax is a 3.8 percent tax on net investment income.7 This generally includes: (1) interest, dividends, annuities, royalties and rents, (2) gains attributable to the disposition of property, and (3) income and gains from a trade or business, but only if such trade or business is a passive activity with respect to the taxpayer or involves trading in financial instruments or commodities.8 For individuals, the Medicare surtax applies to the lesser of net investment income and the excess of modified adjusted gross income (AGI) over $200,000 ($250,000 if married filing jointly).9 For estates and trusts, the Medicare surtax applies to the lesser of undistributed net investment income and the excess of AGI over the threshold for the highest income tax bracket, which is $11,950 in 2013.10
Minimizing the Medicare Surtax
One of the primary income tax planning strategies under the new rules is to minimize the application of the Medicare surtax. A fiduciary may accomplish this by distributing the estate’s or trust’s net investment income to beneficiaries who have modified AGI below the $200,000 (or $250,000) threshold at which the surtax applies. Another strategy to minimize the surtax is to convert activities from passive to active. Recall that the surtax is assessed on net investment income, which, generally, includes trade or business income from passive activities, but not from active activities. A “passive activity” is any activity that involves the conduct of a trade or business and in which the taxpayer doesn’t materially participate.11 A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis.12 There’s little authority for what this means in the context of an estate or trust, but the Internal Revenue Service has held that, in the case of a non-grantor trust, it’s the participation of the fiduciary that matters.13 (For a grantor trust, which is disregarded for income tax purposes, it’s the grantor’s participation that counts.) Thus, it may be possible to convert an activity of a non-grantor trust from passive to active by appointing a trustee who materially participates in the activity. Appointing a special trustee, whose duties are limited to participating in the activity, may also work, but only if the special trustee has discretionary powers and the power to legally bind the trust.14
Distribute Ordinary Income
Generally, distributions of income from an estate or trust to its beneficiaries will cause the income to be taxed to the beneficiaries, rather than to the estate or trust (although the allocation of income to the beneficiaries is limited to the estate’s or trust’s distributable net income (DNI)).15 Accordingly, if an estate or trust has ordinary income in excess of $11,950—the threshold at which the top 39.6 percent rate applies—and the beneficiaries are in lower tax brackets, the fiduciary may be able to minimize the overall income tax liability by distributing the income to the beneficiaries.
Of course, there are possible disadvantages to making distributions, such as exposing the distributed assets to the beneficiaries’ creditors or to their spouses in the event of divorce. The fiduciary should weigh these non-tax considerations against any potential income tax savings. In addition, if the trust is exempt from GST taxes, the transfer tax savings from accumulating income in the trust may trump any income tax savings from distributions.
Make a 65-Day Election
An estate or trust may elect under Internal Revenue Code Section 663(b) to treat amounts paid or credited in the first 65 days of the tax year as if they were paid or credited on the last day of the prior tax year.16 The amount may not exceed the greater of accounting income or DNI less amounts actually paid or credited in the prior year.17 For distributions made between Jan. 1, 2013 and March 6, 2013, the 65-day election would allow the distributions to be taxed to the beneficiaries at the lower 2012 rates and to escape the Medicare surtax. The election must be made on the estate’s or trust’s timely filed Form 1041, including extensions.18 Thus, for Forms 1041, which are currently on extension, there’s still time to make the Section 663(b) election.
Form 706 or 1041?
Generally, expenses and losses of an estate may be claimed on Form 706 or Form 1041, but not both.19 In the old days, when the top federal estate tax rate was 55 percent and the top federal income tax rate was much lower, it was a no-brainer to claim an estate deduction on Form 706, rather than Form 1041 (assuming the gross estate was in excess of the available estate tax exemption). Now the decision is more difficult. The top tax rate on ordinary income (39.6 percent) is virtually identical to the top estate tax rate (40 percent).20 Thus, at first glance, it appears not to matter whether the deduction is taken on Form 706 or Form 1041. However, to the extent income is subject to the Medicare surtax of 3.8 percent, the total income tax rate of 43.4 percent (39.6 percent + 3.8 percent) is greater than the top estate tax rate (40 percent), making a deduction on Form 1041 more beneficial. On the other hand, deducting expenses on Form 706 at a 40 percent rate may make more sense if a significant portion of the estate’s income is capital gain that would be taxed at a rate of 23.8 percent (20 percent + 3.8 percent). Moreover, deducting expenses on Form 706 may maximize the deceased spousal unused exclusion (DSUE) amount, which can be used by the surviving spouse or his estate to shelter inter vivos and testamentary transfers from gift and estate tax, respectively.21 (For details on using the DSUE, see “Portability: The New Estate Plan Modality,” by Stephanie G. Rapkin, p. 34, this issue.)
Similarly, when the estate tax rate was much higher than the top income tax rate, there typically was a clear tax motivation for an executor or trustee to accept commissions. The estate is entitled to deduct the commission on Form 706 to offset estate tax, and the commission is includible in the fiduciary’s gross income.22 Today, in states without an income tax, there’s no significant tax benefit to a fiduciary accepting a commission because the top estate tax rate (40 percent) and top ordinary income tax rate (39.6 percent) are virtually identical. Moreover, if state or local income taxes would be imposed on the commission, it makes sense, from a tax perspective, for the fiduciary to forego the commission.
Elect a Fiscal Year
Generally, estates and trusts are taxed on a calendar year basis, but estates may elect to be taxed on a fiscal year basis.23 Furthermore, an election may be made under IRC Section 645 to treat a decedent’s qualified revocable trust as part of the estate, which allows the trust to also be taxed on a fiscal year basis.24 To make a Section 645 election, file Form 8855. Both the personal representative and the trustee must sign the election, unless there’s no executor (for example, if there’s no probate estate), in which case the trustee alone can make the election.25 The election is effective for all taxable years ending after the date of the decedent’s death until the “applicable date.”26 If a Form 706 is filed, the applicable date is six months after the date of the final determination of the estate tax liability.27 If no Form 706 is filed, the applicable date is two years after the date of the decedent’s death.28
A fiscal year is adopted when filing the estate’s first Form 1041.29 It’s not sufficient to indicate the fiscal year when applying for the estate’s employer identification number (EIN) or extending the due date for the Form 1041.30
Traditional benefit of electing a fiscal year. Traditionally, the fiscal year election has been used to defer income taxes. Most beneficiaries are taxed on a calendar year basis, and beneficiaries report income received from an estate in the tax year in which the estate’s tax year ends.31 Assume the estate of an individual who died in January 2013 elects a fiscal year ending Jan. 31, 2013. Income distributed to the beneficiaries between Feb. 1, 2013 and Jan. 31, 2014 would be included in the beneficiaries’ income for 2014, not 2013, and any taxes on such income wouldn’t be payable until April 15, 2015.
Decedents dying between Dec. 1, 2011 and Nov. 30, 2012. For these decedents, electing a Nov. 30, 2012 fiscal year may provide a greater tax benefit than the typical deferral strategy. The election is still available for those estates that have Forms 1041 that are currently on extension. The latest that an extension could have been filed was March 15, 2013, which was the original due date for a Form 1041 with a fiscal year ending Nov. 30, 2012. As noted above, the year-end indicated on the estate’s EIN application or an extension of time to file isn’t binding. Thus, the estate may elect a Nov. 30, 2012 fiscal year (or any other fiscal year), even if it conflicts with the year indicated on the estate’s EIN application or extension form.
If the fiduciary elects a Nov. 30, 2012 fiscal year, then income will be taxed at pre-2013 rates with no Medicare surtax in Year 1 (ending on Nov. 30, 2012), whether such income is distributed to the beneficiaries, and in Year 2 (from Dec. 1, 2012 to Nov. 30, 2013) to the extent income is accumulated in the estate (or qualified revocable trust). On the other hand, any income distributed to the beneficiaries in Year 2 will be taxed at 2013 rates and potentially be subject to the Medicare surtax. Thus, if the beneficiaries need money in Year 2, rather than distributing it to them, the fiduciary should consider loaning it to them. The loan should be memorialized with a promissory note, and interest should be charged at no less than the applicable federal rate.
Typically, when an estate or trust distributes an asset in-kind to a beneficiary (as opposed to liquidating the asset and distributing cash), there’s no gain or loss to the estate or trust, and the beneficiary takes a carryover basis in the asset.32 In some cases, the estate or trust may want to elect, under IRC Section 643(e)(3), to recognize the gain so that the beneficiary will take a basis in the asset equal to its fair market value (FMV) on the date of distribution.33 If made, the election applies to all in-kind distributions made during the tax year; the election may not be made on an asset-by-asset basis.34
There are at least two circumstances in which the election may be desirable: (1) if the trust has capital loss carryovers that can be absorbed by the gain; and (2) if the election would result in the gain being taxed to the estate or trust under the 2012 tax rules (15 percent capital gains rate and no Medicare surtax), rather than to the beneficiary under the post-2012 tax rules when he sells the asset (20 percent rate plus 3.8 percent surtax). Using the election in the latter case is still a possibility for those estates and trusts that have placed their 2012 Forms 1041 on extension.
For example, assume a decedent’s will or revocable trust devises shares of stock to the decedent’s son and that the shares are distributed to the son in December 2012, after they’ve doubled in value since the decedent’s death from $500,000 to $1 million. The son plans to sell the shares in 2013. Assume that the son’s other income places him in the highest income tax bracket and that any net investment income received by him is subject to the Medicare surtax. If the son sells the shares in 2013 for $1 million, he will pay a tax of $119,000 ($500,000 x (20 percent + 3.8 percent surtax)). However, if a Section 643(e)(3) election is made for 2012, the estate will pay a tax of only $75,000 ($500,000 x 15 percent), a savings of $44,000.
Keep in mind, however, that if the beneficiary expects to hold the asset until he dies, a Section 643(e)(3) election isn’t desirable because, on the beneficiary’s death, the asset’s basis will be increased to its FMV.35 Nor is the election desirable if the beneficiary plans to hold the asset for a long time before selling it because the recognition of gain may be deferred until the sale.
1. American Taxpayer Relief Act of 2012 (ATRA), Pub. L. No. 112-240, Sections 101(b)(1) and 102(b).
2. Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, Section 1402.
3. ATRA, supra note 1.
4. Internal Revenue Code Section 1(i)(3)(A).
5. IRC Section 1(i)(3)(B); Revenue Procedure 2013-15, 2013-5 Internal Revenue Bulletin 444.
6. IRC Sections 1(h)(1)(D) and (11).
7. IRC Section 1411(a).
8. IRC Section 1411(c).
9. IRC Sections 1411(a)(1) and (b).
10. IRC Section 1411(a)(2).
11. IRC Section 469(c)(1).
12. IRC Section 469(h)(1).
13. Treasury regulations have been issued explaining what “material participation” means for individuals, but regulations haven’t yet been issued for trusts and estates. Treasury Regulations Section 1.469-5T, Treasury Decision 8175 (Feb. 19, 1988); Treas. Regs. Section 1.469-8 [reserved], T.D. 8417 (May 12, 1992). In the only case to address the issue, the court held that the material participation of a ranch’s manager and employees was sufficient to constitute material participation by the trust that owned the ranch. Carter v. U.S., 256 F. Supp.2d 536 (N.D. Tex. 2003). However, in subsequent rulings, the Internal Revenue Service has held that material participation of a trust is determined by the activities of the trustee only. Technical Advice Memorandum 200733023 (Aug. 17, 2007); Private Letter Ruling 201029014 (July 23, 2010).
14. See TAM 200733023 (holding that a special trustee wasn’t a fiduciary for purposes of the material participation test, when the general trustees and the special trustees had an agreement that the special trustees couldn’t legally bind the trust and didn’t have any decision-making responsibilities).
15. See IRC Sections 651, 652, 661 and 662.
16. IRC Section 663(b)(1).
17. Treas. Regs. Section 1.663(b)-1(a)(2)(i).
18. Treas. Regs. Section 1.663(b)-2(a)(1).
19. IRC Section 642(g).
20. IRC Sections 1 and 2001(c).
21. IRC Sections 2010(c)(2)(B) and (4); Treas. Regs. Section 25.2505-2T.
22. Treas. Regs. Sections 1.61-2 and 20.2053-3(b).
23. IRC Section 644(a); Treas. Regs. Sections 1.441-1(b)(1)(iv) and (c)(1).
24. IRC Section 645(a).
25. Treas. Regs. Sections 1.645-1(c)(1) and(2).
26. See supra note 24.
27. IRC Section 645(b)(2)(B).
28. IRC Section 645(b)(2)(A).
29. Treas. Regs. Section 1.441-1(c)(1).
31. IRC Section 662(c); Treas. Regs. Section 1.662(c)-1.
32. IRC Section 643(e).
33. See IRC Section 643(e)(3).
34. IRC Section 643(e)(3)(B).
35. IRC Section 1014(a).