How the New Investment Income Surtax Affects Estates and Trusts

In order to finance the Patient Protection and Affordable Care Act, Congress has imposed a new 3.8% surtax on certain passive income starting in 2013. Typically, passive income includes interest, dividends, rents, royalties, capital gains, and other payments in which the investor does not actively participate in management. The surtax applies to home sales if the profit from a home sale is more than $250,000 ($500,000 for a married couple). For estates and trusts, the 3.8% surtax will be imposed on the lesser of (1) the undistributed net investment income of a trust or estate, or (2) the amount by which adjusted gross income exceeds the top inflation-adjusted bracket for estate and trust income, which is expected to be approximately $12,000 in 2013. The surtax applies to individuals who receive distributions of net passive income from trusts and estates. These rules do apply differently to grantor trusts because the income from grantor trusts passes directly through to the grantor’s tax return.

The surtax is lower for individual taxpayers, so the tax impact on an estate or trust will be substantially greater than on an individual. Because distributed net income is not taxed at the trust level, this may create an incentive to distribute the trust income out of the trust if the beneficiaries of the trust are below the threshold at which the surtax applies.

The simplest way to avoid the applicability of the new tax is to simply convert the passive income into active income. Income that is derived from an active trade or business, including real estate professionals, does not incur the 3.8% tax. However, aside from the active trade or business exception, the new tax will not apply to distributions from a qualified plan, like an IRA, or to trusts dedicated to a charitable purpose. Charitable remainder trusts allow a taxpayer to contribute appreciated assets to the trusts and subsequently sell the asset through the trust without recognizing a gain. The income attributable to the gain will not be recognized until payments are received from the trust. Therefore, the taxpayer could spread out the payments so he or she does not exceed the individual threshold to trigger the new surtax in any given year. It would not be surprising to see a rise in the amount of these trusts after 2013. The same result may be accomplished by using installment sales as opposed to a lump sum purchase when a taxpayer sells an asset. Purchasing a life insurance policy may also help alleviate the burden of the new surcharge tax. Also, it would not be surprising to see a rise in tax-free municipal bond investments, because, by virtue of the bond interest being tax free, it cannot be subject to the 3.8% surtax. Interestingly, despite the debate as to whether the capital gains rate should be raised above 15 percent (especially on dividends from domestic corporations), this new surtax does just that.

If you, or someone you know, wishes to avoid the new capital gains surtax through the use of a device, such as a charitable trust, the experienced team at Chepenik Trushin, LLP is more than happy to advise and assist you in achieving that goal. Please do not hesitate to contact us.