An important trustee responsibility is filing tax returns, and with that responsibility comes a duty to minimize income taxes. With a few days remaining in 2020, a trustee can still employ tax-saving strategies.
Fiduciary tax brackets are compressed. For 2020, trusts pay tax at the maximum income tax rate when taxable income exceeds $12,950. In addition, the same threshold applies to the additional 3.8 percent net investment income tax. In comparison, a single individual taxpayer is subject to the highest tax rate at $518,400 of taxable income, and the NIIT applies modified adjusted gross income in excess of $200,000. That’s why it’s important to pursue trust-specific tax mitigation strategies. Here are some strategies to consider:
- Pay deductible expenses before year end — taxes up to $10,000, fiduciary fees, attorney fees and accountant fees.
- Review investment holdings for any unrealized losses that could be liquidated before year-end to offset capital gains. A trust is permitted to deduct up to $3,000 of net capital losses in a tax year.
- Consider whether capital gains can be distributed to beneficiaries (who may be in a lower tax bracket). Trusts pay the highest capital gains tax rate when taxable income exceeds $13,150 (compared to $441,450 for a single individual). Be aware that the decision to treat capital gains as part of a distribution must be consistently administered, so if you pass capital gains out to the beneficiary now, you must also do this going forward.
- Distribute trust income to beneficiaries if permitted in the trust document. Trustees can elect to treat distributions made within 65 days following the close of the tax year as being paid on the last day of that tax year. This election (under Section 663(b)) is made by the trustee on a timely filed tax return (including extensions).
- Consider the timing of any retirement plan distributions if it makes sense to accelerate income into 2020. Note that 2020 required minimum distributions were waived under the CARES Act.
- Confirm estimated tax payments have been made if you anticipate a fiduciary tax liability in order to mitigate underpayment of estimated tax penalties. Trusts avoid paying a penalty if at least 90 percent of the current year’s tax liability is paid via timely quarterly tax payments or through withholding. Note that withholding is deemed to be paid in evenly throughout the year regardless of the actual remittance date or dates.
Examples
The following examples highlight the compression of the fiduciary income tax brackets and tax savings of distributing trust income to the beneficiary. Example 1 serves to set a baseline, then Example 2 applies some tax-mitigation strategies to reduce income taxes.
Example 1: No beneficiary distributions. The trustee of an irrevocable trust has discretion to distribute income, including capital gains. The trust has the following 2020 sources of income and deduction:
- Interest income — $20,000
- Dividends (non-qualified) — $60,000
- Long term capital gain — $40,000
- State tax — $(2,000)
- Trustee fees — $(4,000)
- Legal fees — $(1,000)
- Accountant fees — $(1,000)
- Beneficiary distributions — -0-
- Exemption —$ (100)
Total income of the trust is $120,000 and deductions (before exemption) are $8,000, leaving $112,000 of adjusted total income. The taxable income of the trust is $111,900, which comprises $71,900 subject to ordinary income tax rates (up to 37 percent) and $40,000 subject to capital gains tax rates (20 percent). In addition, the trust is subject to the 3.8 percent NIIT on approximately $107,000 of net investment income. The total fiduciary tax liability is approximately $37,000.
Example 2: All income and capital gains distributed to beneficiary. Assume the same facts above, except the trustee distributes $112,000 to the beneficiary and has elected to include capital gains in distributable net income. Also assume that the beneficiary is a single taxpayer and has no other sources of taxable income or deduction, other than the 2020 standard deduction of $12,400.
Similar to Example 1, the trust has adjusted total income of $112,000. The trust receives a deduction for the $112,000 distributed to the beneficiary leaving the trust with no taxable income. The trust issues a Schedule K-1 to the beneficiary reporting the following items of income (net of applicable deductions):
- Interest income — $18,000
- Dividends (non-qualified) —$54,000
- Long term capital gain — $40,000
The beneficiary has $112,000 of adjusted gross income. After applying the standard deduction of $12,400, taxable income of $99,600 remains. Of this, $59,600 is subject to ordinary tax rates (up to 22 percent) and $40,000 is subject to capital gains tax rates (15 percent). Since modified AGI is less than $200,000 the beneficiary is not subject to the 3.8 percent NIIT.
The total individual tax liability is approximately $15,000, a savings of $22,000 when compared to Example 1 where all income taxes were imposed on the trust.
