For many years, nongrantor trusts have suffered an income tax disadvantage as compared to individuals. These trusts move much quicker to the highest marginal income tax rate on undistributed income then individuals. Compare this table with this table. In 2013, a trust or estate will be subject to the maximum 39.6% rate after $11,950 of taxable income. A single person doesn’t hit the maximum rates until over $400,000 in income.
This problem has been exacerbated in 2013 by the overall increase in rates, including increases in the maximum capital gains rate and qualified dividend income rate from 15% to 20%. Trusts and estates are subject to the 20% rate again after about $12,000 in income, while individuals don’t suffer it until after $400,000 in income.
Further, the new Obamacare 3.8% tax on investment income applies to trusts after MAGI of about $12,000, while single individuals do not suffer it until MAGI of $200,000.
Lastly, these rate differentials may be further exacerbated by applicable state income taxes.
Putting aside trust taxation of capital gains which are not included in DNI, these rate differentials are not an issue for nongrantor trusts that require all income be distributed to the beneficiary, since that distribution will result in the beneficiary being taxed on the trust income instead of the trust (aside from the above capital gains). Nor is this an issue for grantor trusts when the income is already taxable to an individual other than the trust. Thus, this tax issue is principally an issue for trusts that have discretionary income standards, including those that distribute income only on an ascertainable standard, since that will open the door to years when all income may not be distributed to beneficiaries and will be taxable to the trust.
One approach to this problem is to draft the trust to give the beneficiary a power to withdraw trust income beyond the above $12,000 (as adjusted each year) thresholds. If exercised, this will shift the income over to the beneficiary to be taxed at the beneficiary’s tax rates, which should be at worst the same as the trust maximum rate, but hopefully lower based on the other income of the beneficiary. The maximum withdrawal amount will be limited by the 5 by 5 power limitations of Section 2514, so that the maximum withdrawal each year can be no more than the greater of $5,000 or 5% of the value of the trust. This will avoid a taxable gift if the power is not exercised – i.e., the lapse of the power will not be a taxable gift by the beneficiary to the other trust beneficiaries.
Interestingly, if the power of withdrawal is not exercised, the problem diminishes somewhat as the portion of the trust that is not withdrawn will be treated as a grantor trust and taxed to the non-withdrawing beneficiary in future years (and thus not to the trust). As an aside, trusts funded with Crummey withdrawal power gifts that are not exercised will also see this benefit as to the portion of the trust not so withdrawn each year that a contribution is made.
Putting aside the foregoing income tax benefits of this power of withdrawal, such a power of withdrawal in a discretionary trust or an ascertainable income standard trust may be problematic, for many reasons. First, the settlor may not want all of that income to be automatically distributed to the beneficiary – otherwise, the grantor would not have used a discretionary or ascertainable standard for income distributions. Second, the beneficiary may not be in a good position to receive that income – either due to age, disability, drug and other personal issues, marital and creditor issues, or other of the many reasons for not distributing assets to a beneficiary. Third, such distributions may defeat desired accumulations of income in the trust – especially when the trust is GST or estate tax exempt at the death of the beneficiary or future beneficiaries. Fourth, the failure to withdraw may constitute a contribution to the trust for local creditor protection laws and divorce laws – thus potentially exposing the nonwithdrawn assets and other trust assets to increased creditor and divorce risk.
Assuming the foregoing objections are not enough to overcome the desires to implement this type of income tax planning, note that when distributions are made to the beneficiary they will draw out a prorata portion of all classes of income of the trust. Since capital gains and qualified dividend income are subject to much lower maximum rate than ordinary income, it would be nice if the trustee could cherry pick or maximize which items of income are distributed (the ordinary income items) and leave behind in the trust those items that are taxed at relatively lower rates (the capital gains and the qualified dividend income). Unfortunately, Subchapter J does not work that way.
However, James G. Blase in the June 2013 issue of Estate Planning Journal discusses a formula power of withdrawal approach that he believes would allow for the distribution of only the highly-taxed ordinary income items. His proposed distribution language is quite lengthy, and whether the IRS would respect his interpretation is unknown at this point. For those with an interest, I highly recommend his article, entitled Drafting Tips That Minimize the Income Tax on Trusts – Part 1 since it has an extended discussion about these issues.