Avoiding the Squeeze: Trusts, Estates, and the New ATRA Tax Regime: Higher Income Tax Rates and the Net Investment Income Tax Change the Rules for Trust and Estate Planning

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Trusts and estates are recognized as separate taxable entities for federal income tax purposes. The estate or trust must file a return on Form 1041, US. Income Tax Return for Estates and Trusts, on or before the 15th day of the fourth month following the close of the tax year if it has gross income of $600 or more. A trust generally must have a calendar tax year, but an estate may have a fiscal year.

An estate or trust is generally regarded as a conduit of its income and is allowed a deduction for the portion of income that is currently distributable or distributed to the beneficiaries. Income allocated to a beneficiary is taxed to the beneficiary, retaining the same character that it had in the estate or trust. This concept of income's retaining its character in the hands of trust and estate beneficiaries is very important under the provisions of the American Taxpayer Relief Act of 2012 (ATRA), PL. 112-240.

It is important to understand how tax able income is computed for an estate or trust. Gross income is reduced by (1) deductions for expenses paid or incurred in connection with the administration of the trust or estate that would not have been incurred if the property were not held in a trust or estate, (2) deductions for income distributions to beneficiaries, and (3) personal exemptions. Income is determined under the governing instrument and local law. The regulations recognize the importance of local state provisions in determining the income of a trust or estate (Regs. Sec. 1.643(b)-l).


ATRA raised tax rates on individuals, estates, and trusts by raising the maximum tax bracket from 35% to 39.6%. The capital gains tax on the highest income tax bracket increased from 15% to 20%. These maximum brackets are effective for individual taxpayers once taxable income exceeds $400,000 for an individual and $450,000 for taxpayers married filing jointly. The threshold for head-of-household filing status is $425,000, and for married couples filing separately it is $225,000 (Sec. 1).

In contrast, the income tax brackets for trusts and estates are extremely condensed. For 2014, once the estate or trust has taxable income in excess of $12,150, the top rates of 39.6% for ordinary income (Sec. 1(e) and Rev. Proc. 2013-35) and 20% for long-term capital gains apply (Sec. 1(h)).

In addition, the Health Care and Education Reconciliation Act, PL. 111-152, (part of 2010's health care reform legislation) ushered in a complicated new unearned income Medicare contribution tax of 3.8% on net investment income in excess of certain thresholds. The tax is effective for tax years beginning after Dec. 31,2012. For most trusts, the tax will generally be effective for the year beginning Jan. 1, 2013. An estate, which can have a fiscal year, can adopt, for example, a Nov. 30 year end, in which case the 3.8% surtax would not be imposed until the tax year beginning Dec. 1, 2013.


Net investment income consists of gross income from interest, dividends, annuities, royalties, and rents, other than those arising in the ordinary course of a trade or business other than a trade or business that is a passive activity or a trade or business ^ of trading in financial instruments or commodities (Sec. 1411(c)(1)). It also includes other gross income from a passive activity or a trade or business of trading in financial instruments or commodities (Sec. 1411(c)(2)). In addition, it includes net gain attributable to the disposition of property other than property held for use in a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities. Deductions that are properly allocable to this income or gain are allowed to reduce the amount subject to tax.

For taxpayers who are married filing joint returns, the threshold for the net investment income tax is $250,000. …


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