Trials and Tribulations of Nongrantor Trusts

Chuck Rubin has a great article on his blog in which he reviews the high tax rates that nongrantor trusts pay on their undistributed income.

In addition, he discusses some intriguing solutions to the withdrawal problem of these trusts; be forewarned that he attempts to cover the “5 by 5” power — don’t say I didn’t warn you!

2013 TAX INCREASES EXACERBATE THE INCOME TAX NEGATIVES OF NONGRANTOR TRUSTS

Passive Income: Good or Bad?

Passive activity loss rules are complicated and require careful attention. In general, their purpose is to limit or prevent taxpayers from deducting passive losses, unless the taxpayer has offsetting passive income.

Previously, passive income had been a positive: a taxpayer without passive losses would recognize the passive income regardless; a taxpayer with passive losses could offset the passive losses with passive income.

But starting in 2013, the recognition of passive income has a down side: the Medicare Tax on Net Investment Income (MTNII) [IRS §1411]. “Excess” passive income, that is passive income left after offsetting passive losses, may be subject to an additional 3.8% excise tax.

Taxpayers must take time to review their passive income, and investigate the options available for reducing or eliminating “excess” passive income. If a taxpayer can change his involvement with the activity (see the material participation rules in Regs. §§1.469-5T(a)(1)-(7)), he may be able to reduce his passive income and his exposure to the MTNII.

Fiduciaries will be hard-pressed to avoid the MTNII, since it is generally difficult for a fiduciary to demonstrate material participation. Combined with the trust’s low threshold, any trust which does not distribute out its net investment income will likely be subject to the excise tax.

WSJ on Reducing a Trust’s Income Taxes

The WSJ recently addressed the idea of a trust reducing its income taxes in this Wealth Management article.

The article two main suggestions are to:

  • Restructure the trust’s investments portfolio, to eliminate or reduce the assets that generate the kind of income subject to the highest tax rates; and
  • Review the distributions from the trust, with the objective of moving the taxable investment income to beneficiaries who might be in lower tax brackets.

These are good, general suggestions for managing a trust’s income tax liability.  The higher tax brackets in 2013, combined with the new Medicare Tax on Net Investment Income (MTNII), do not change the tax planning concepts; they just change the magnitudes.

Estimated Tax Payments: 1/15/2013

Estimated tax payments for individuals, trusts, and calendar year estates are due next week.

You may have completed your year-end tax planning last month. And you may have paid your state estimated tax payments before 12/31/2012 (if you did not expect to be subject to the AMT).

Now your Federal (and maybe state) estimated tax payments must be mailed to the government on or before next Tuesday, January 15, 2013.

Year-end planning (2012)

December is the season… for year-end tax planning.

Trusts, like individuals, are required to make estimated tax payments. Now is a good time to review a trust’s income and deductions, and estimate its 2012 income tax liability. Fourth quarter estimated income tax payments are due January 15, 2013; however, trusts not subject to AMT might benefit from making state estimated tax payments by December 31.


In addition, a prudent trustee can begin to prepare for the Medicare Tax on Net Investment Income (MTNII) for 2013. Ordinary simple and complex trusts will be subject to this tax beginning next month. And the threshold for trust is Very low (approximately $12,000).