The benefits of trusts in managing one’s financial affairs, both during one’s life and after one’s death, are well documented and quite significant. Among the trade-offs for their benefit are the complexity of their tax structure and the highly compressed tax brackets that apply to them. In addition, it is important to note that estates are subject to most of the same tax treatment as trusts.
One of the major disadvantages of trust and estate income taxation is their highly compressed tax brackets resulting in their income being subjected at the highest tax brackets at much lower income levels than for individuals.
To illustrate this point, compare the point at which a married couple filing jointly enters the top (39.6%) tax bracket - $466,950 of taxable income – to the point at which a trust or estate enters the top bracket - $12,400 of taxable income! With this disparity in tax brackets, it is easy to see the value of shifting income from a trust or estate to its beneficiaries.
What happens, though, if the end of the year has passed and the trust has not distributed all the income it could to its beneficiaries? This is where the value of a tax election known as the 65 Day Rule can be quite significant.
Who can benefit from the 65 Day Rule?
The 65-day election can only be made for complex trusts or estates, because they, unlike simple trusts, are not required to distribute all of their income during a tax year.
A complex trust, in contrast, is one that is not required to distribute all of its income on an annual (or more frequent) basis. (Therefore, a simple trust that must distribute all of its income would not benefit from this election. In fact, a simple trust is deemed to distribute all of its income, whether it actually does or not).
Moving back to complex trusts and estates, how does this work? Generally speaking, distributions made to beneficiaries of trusts and estates pass income through to them. The trust or estate is then allowed to deduct these distributions in arriving at the trust’s taxable income, thereby reducing its taxable income. Normally, only distributions actually made within a taxable year would be considered in determining the amount of the distribution deduction, but, under this special rule, complex trusts and estates can distribute income to its beneficiaries within 65 days of the beginning of their taxable year and elect to treat it as having been made in the prior year. For the 2016 tax year, complex trusts and estates have until March 6, 2017, to make such distributions.
Please note that trusts are required to use a calendar year for tax purposes, whereby an estate can elect to use a fiscal year-end other than December 31. As you can see, the 65-day election, in effect, gives the trustee or executor some flexibility in shifting taxable income from the trust or estate to the beneficiaries after the close of the tax year-end.
Let’s look at an example:
A complex trust with a December 31, 2016, year-end has $20,000 of taxable income for the year, putting the trust into the highest (39.6%) tax bracket. The beneficiary of the trust is in the lowest income tax bracket. In this case, if the 65-day election is made, the trust can distribute some or all of the $20,000 to the beneficiary any time up to March 6, 2017. Making this election would reduce the trust’s 2016 taxable income by the amount of the distribution and would increase the beneficiary’s 2016 taxable income, saving overall tax dollars, since the amount distributed to the beneficiary will be taxed at his or her lower tax bracket.
There is another benefit to utilizing the 65-day rule. In addition to having more compressed income tax brackets than individuals, trusts and estates become subject to the 3.8% net investment income tax (instituted as part of the Affordable Care Act) at a much lower point than individuals. In such cases, the net investment income tax may also be reduced by utilizing the 65-day rule, thus shifting the income from the trust to the beneficiary.
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Since 1099s reporting investment income are typically not issued until mid-February to early March these days, it may be a good idea to review the year-end statement(s) of the trust or estate, since there may not be enough time between the issuance of forms 1099 and the March 6 deadline. While the income reported on the year-end broker statements may not agree with the 1099 100% of the time, it should be sufficiently close for the purpose of making the distribution within the 65-day deadline.
One final point to keep in mind is that the potential tax savings of implementing the 65-day rule may not be appropriate, if the intent of a trust, for example, is to retain all of its income for younger beneficiaries. In this case, you would not want the “tax tail to wag the dog”.
Trusts. Estates. Planning. It is a complex subject and can be confusing. I have helped many clients plan, prepare and better understand their trusts and estates to maximize savings and reduce taxes and am ready to help you. Please contact us at info@zinnerco.com or 216.831.0733 to learn more.