Ever since the United States Supreme Court upheld the Affordable Care Act, most of the focus has been on how this increased tax effects individual taxpayers.  As determined by this decision, individual taxpayers with modified adjusted gross income over $200,000 (or $250,000 for married taxpayers) are subject to an increased 3.8%  Medicare surtax on certain investment income beginning in 2013.

Little focus has been given on how this increased Medicare surtax will increase tax liabilities for trusts and estates.  Income in an irrevocable trust is either taxed to the trust or to the trust beneficiaries.  If income in the trust or estate is accumulated at the trust or estate level, then the trust or estate pays the income tax.  If the income is distributed to the beneficiaries, however, the trust receives an income tax deduction for the amount of the distributable net income (DNI) and the beneficiaries report the taxable income. 

In the case of a trust or estate, the 3.8% Medicare surcharge is imposed on the lesser of either undistributed net investment income or the excess of adjusted gross income over the highest estate or trust income tax bracket.  For 2013, the highest trust income tax bracket begins at $11,950, and at a tax rate of 39.6%, this means that trusts with certain investment income over $11,950 will be paying a whopping 43.4% in federal taxes on this income.  “Net investment income” includes gross income from dividends, annuities, royalties, rents, capital gains, and passive trade or business income (one in which you do not materially participate).

For illustrative purposes,  let’s say you are the trustee of a trust that has $50,000 interest income and $15,000 in short-term capital gains.  Assuming that the income is not distributed out to the beneficiaries and there are no offsetting expenses, the trust will essentially have $65,000 in taxable income (not considering the trust exemption amount), of which $53,050 will be subject to the extra 3.8% Medicare surcharge ($65,000-$11,950= $53,050) at a 43.4% federal tax rate. Ouch! When making federal estimated tax payments for 2013, trusts and estates should be factoring in this increased tax.

The significant differential between when the additional 3.8% tax kicks in for trusts and estates ($11,950) versus individuals ($200,000 or $250,000) can provide trustees and beneficiaries with an extremely powerful tax savings tool when determining if discretionary distributions will be made to beneficiaries.  Since the threshold for trusts starts at a mere $11,950, it may be worth considering making distributions to beneficiaries to avoid this increased tax.  Please contact your tax advisor to discuss this tax planning strategy in greater detail.

Written by Carli Ortiz, CPA, Manager LinkedIn Profile