Drafting Income Tax-Sensitive Trusts
From: Blase & Associates, LLC
The disparate federal income tax treatment between trusts and individuals, that has existed since 1986, has grown even more pronounced than it was prior to the passage of the 2017 and 2019 year-end tax laws. This article will examine the problems which currently face us and will propose solutions to these problems.
Part I: Impact of the 2017 Year-End Tax Changes
As a result of the 2017 year-end tax changes, structuring trusts for spouses, descendants and other beneficiaries, in a fashion which minimizes the aggregate federal income tax liability for the trust and its beneficiaries, became more important than ever. Discussed below are some of the reasons why:
In 2020 individuals can effectively exclude the first $12,400 ($24,800, if married) of income, whereas trusts can effectively exclude only the first $100 ($300, if a simple trust). Individuals are also taxed at significantly lower ordinary income tax rates than trusts, at the same level of taxable income. This gap in income tax treatment has widened considerably as a result of the 2017 year-end tax changes.
For example, an individual with $172,925 of interest income, and no deductions, paid $32,748.50 of federal income tax in 2019, while married couples with the same level of interest income paid only $24,392.50 of federal income tax in 2019. Complex trusts with the same amount of interest income, and no deductions (including the distribution deduction), on the other hand, paid $68,389.90 of federal income tax in 2019 [$62,303.25 regular tax + $6,086.65 net investment income tax]. These differences under the new tax law are obviously staggering. A trust pays well over twice as much federal income tax as a single individual with the same amount of interest income, and almost three times as much as a married couple with the same amount.
For comparison purposes, before the 2017 year-end tax changes a single individual with the same amount of interest income paid $38,488.75 of federal tax in 2017, and a married couple paid $29,508.75. A complex trust paid $73,714 in 2017. Thus, utilizing the above example, as a result of the 2017 year-end tax changes the single individual’s federal taxes went down 17.5% while the married couple’s federal taxes went down 21%. Complex trusts, on the other hand, saw their taxes go down by only 7.8%. Simply put, this means that the relative disparity between trust income tax treatment and individual income tax treatment grew even greater as a result of the 2017 year-end tax changes. If the same trust income were instead spread between or among two or more children beneficiaries of the trust, the disparity between the trust and individual income tax brackets would become even more apparent.
Individuals also enjoy a substantial benefit over trusts when it comes tothe income taxation of capital gains and qualified dividends. A trust may only have $2,900 (in 2020) of taxable income and still be taxed at 0% on its capital gains and qualified dividends. The comparable level for single individuals is almost 14 times higher, or $40,000 (in 2020), which, when combined with the single beneficiary’s $12,400 standard deduction, means that a single individual (including a minor child) could have up to $52,400 in qualified dividends, annually, without paying any federal income tax, subject to the potential application of the Kiddie Tax rules. A trust with a like amount of qualified dividend income, on the other hand, would pay approximately $10,750 in income tax (applying 2018 rates), including approximately $1,500 in net investment income tax. The same annual amount compounded at 4%, over 20 years, would equal approximately $320,000, which can certainly help pay for college.
A similar but more dramatic result would occur if there were two or more beneficiaries of the trust. As long as each beneficiary’s taxable income was less than $52,400, they would each pay no federal income tax on the capital gains and qualified dividends. Thus, there could be over $150,000 of qualified dividends and capital gains inside of a trust, which if taxed equally to three single individual beneficiaries, with no independent income of their own, would result in $0 federal income tax. The annual federal income tax to the trust, on the other hand, including the net investment income tax, would be approximately $34,000 (applying 2018 tax rates). Compounded annually at 4% over 20 years again, this annual income tax difference would equal over $1 million! Similar larger tax gaps between trusts and individuals occur at the 15% and 20% capital gainrates, as well as at ordinary income tax rates.
