Inequitable Taxation of Estates and Trusts

By Moy, Doug H. | The National Public Accountant, August 1994 | Go to article overview

Inequitable Taxation of Estates and Trusts


Moy, Doug H., The National Public Accountant


The present draconian policy of Congress toward the income taxation of estates and trusts is against public policy. For tax years beginning after 1992, the income of estates and trusts is subject to five income tax brackets -- 15, 28, 31, 36 and 39.6%. [I.R.C. 1(e)] This is a significant change from pre-TRA '86 law in which estates and trusts were subject to 14 different tax brackets. Unfortunately, however, while the five brackets are the same for individuals, estates and trusts, the amount of income subject to each income tax bracket is significantly more for estates and trusts than for unmarried individuals.

In effect, this means that income accumulated by estates and trusts, and not currently distributed to a beneficiary, may be subject to a greater amount of income tax than the same income would be if it were distributed and taxed to the individual beneficiary. This draconian policy designed and passed by Congress for the taxation of estate and trust income will have a greater practical impact on estates and trusts that generate smaller amounts of taxable income than estates and trusts that produce larger amounts of income.

The present inequitable taxation of estate and trust income may be illustrated by comparing the amount of income tax an unmarried individual would pay on gross income of $250,000 with the income tax that an estate or trust would pay on the same amount of gross income. The unmarried individual taxpayer would pay income tax of $79,772, while the estate or trust would pay $2,125, plus 39.6% of the excess over $7,500, for a total income tax of $98,155. While the 39.6% bracket only taxes the individual's gross income in excess of $250,000, the same 39.6% bracket taxes the income of an estate or trust in excess of $7,500; consequently, more of the income of the estate or trust is subject to the maximum 39.6% bracket rate.

ESTATE PAYS 88% MORE

Looking at middle America in our analysis, let's compare the income tax that an unmarried individual could expect to pay on, say, $36,000 of gross income compared with the amount of income tax that an estate or trust would pay on the same amount of gross income. The unmarried individual taxpayer would pay $3,315, plus 28% of the excess over $22,100, for a total of $7,207. On the other hand, the estate or trust would pay $2,125, plus 39.6% of the excess over $7,500, for a total of $13,411 on the same $36,000 of gross income. That amounts to an 86% increase, or $6,204 more income tax on the same amount of income!

Relatively speaking, the additional income tax differential in the $36,000 gross income illustration is a greater percentage increase than in the $250,000 gross income illustration. In that illustration, the difference in total income tax was only $18,383 ($98,155 less $79,772) or a relative increase of only 23%!

Whether it is an individual, estate or trust, it is easier to pay $18,383 more income tax when there is $250,000 available from which to pay the tax than to pay $6,204 more income tax when there is only $36,000 available from which to pay the additional tax. Moreover, the $18,383 and $6,204, respectively, will not be available to increase the trust corpus (principal) for a beneficiary's education fund or to increase a special needs fund for a handicapped beneficiary or to be more prudently applied on behalf of a spendthrift beneficiary.

Admittedly, these examples may be oversimplified as they do not take into account any exemptions, deductions, depletion allowances, depreciation deductions or tax credits. However, one cannot deny the inequity in the base rates that are being applied.

CONGRESS DEALS BLOW TO BENEFICIARIES

As part of the Tax Reform Act of 1984 (TRA '84), Congress added subsection (e) to I.R.C. 643 [now designated as I.R.C. 643(f)] to discourage taxpayers from creating multiple trusts to reduce income tax liability. This provision was enacted because Congress perceived that taxpayers were abusing the tax system by creating multiple trusts, thereby obtaining unwarranted exemptions and reducing the amount of income tax otherwise due by creating more taxpayers. …

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