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Surtax for Estates and Trust

For tax years beginning January 1, 2013, the tax law imposes a 3.8 percent surtax on certain passive investment income of individuals, trusts and estates. For trusts and estates, the amount subject to the tax is the lesser of (1) undistributed net investment income or (2) the excess of the trust/estate’s adjusted gross income (AGI) over the dollar amount at which the highest estate or trust income tax bracket begins. The highest bracket for 2013 will be $11,950.

Net investment income includes dividends, rents, interest, passive activity income, most capital gains, annuities and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions and income from charitable remainder trusts.

This 3.8% surtax will not apply to any of the following trusts:

  1. A simple trust

  2. A trust all the unexpired interests of which are devoted to a charitable purpose

  3. A grantor trust

  4. A trust treated as owned by a person other than the grantor under IRC § 678

  5. A charitable remainder trust

  6. A trust exempt from tax under IRC § 501(c)

  7. Most foreign trusts

  8. Common trust funds

  9. Any other trust that is statutorily exempt from tax

  10. Archer MSAs,

  11. Health Savings Accounts,

  12. Qualified tuition programs,

  13. Coverdell Education Savings Accounts;

Fortunately, there are effective strategies to reduce AGI and/or net investment income and reduce the base on which the surtax is paid. These strategies generally involve managing trust distributions and managing a trust or estate’s investments. This letter will briefly introduce these strategies.

Managing Distributions

Trusts and estates are subject to the surtax only on undistributed net investment income, not on income that is distributed to beneficiaries. Thus, fiduciaries may be able to reduce or eliminate surtax by managing income distributions.

Before making distributions to avoid or reduce the surtax, however, trustees must look at all the facts and circumstances to make sure increased distributions are permissible under the governing instrument and that they produce an overall benefit, taking into account both tax and non-tax factors. For example, distributions may not be appropriate despite tax savings in the case of a special needs beneficiary or a beneficiary with creditor problems.

Managing the Trust or Estate’s Investments

Adjusting an estate or trust’s investment portfolio and its management style may be appropriate to reduce the surtax. Because income from tax-exempt and tax-deferred assets are not included in net investment income, shifting the entity’s investments towards such vehicles should be considered. This might mean investing less in corporate bonds and high dividend paying stocks and more in municipal bonds, deferred annuities, life insurance ETFs. Fiduciaries might also wish to employ a more passive management style to minimize capital gains. Again, the overall economic effect must be taken into account and not just the surtax savings.

Please contact our office to discuss. We would be happy to explain how these and other strategies might save you large amounts of surtax beginning in 2013.

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