Taxation of Trust Capital Gains
Hold on to your hats because this is a tough subject. If your estate plan involves irrevocable trusts, understanding how long-term capital gains are taxed inside the trust is important.
In general, federal income taxation is segregated into three broad categories: income, short-term capital gain, and long-term capital gain. An example of income would be wages, interest, and dividends. An example of capital gain would be a stock bought for $100 and later sold for $150. The $50 gain would be classified as short term if the stock was held for a year or less and long term if held over a year.
Income and short-term capital gain generated by an irrevocable trust gets taxed at high rates. At just $13,050 in taxable income, trust tax rates are 37% plus the 3.8% tax imposed with the Affordable Care Act. However, long term capital gain generated by a trust still maxes out at 20% plus the 3.8% when taxable trust income exceeds $13,050. State taxes are in addition to the above.
Trust capital gain can get caught in the trust and taxed at trust tax rates. Savvy financial planners and CPAs handle the high tax on trust income by distributing out the income to trust beneficiaries and issuing K-1s. Planners will avoid short term capital gain. The long-term capital gain is not a big problem because the tax rates, while compressed, are the same as for an individual and max out at 20% plus the 3.8%. A typical strategy is to distribute out the taxable income, defer capital gain recognition, pay the tax on any long term capital gain at the trust level, and accumulate the net within the trust. The trust will increase in value and usually increase estate tax free for several generations.
This is all about to change. The only question is by how much. I started watching this issue back in May with all the talk about increasing capital gain tax on high income individuals. Combining federal and state proposals, the maximum long term capital gain rate would range from about 45% to 60% depending on the state. Remember that trust long term capital gain rates mirror individual rates, just highly compressed. So, when the news blurb states that the proposed tax will only apply to those with adjustable gross income above $400,000, where does that kick in for a trust where the top rate kicks in at $13,050? Back in May, I thought the higher rates would kick in at the $13,050 level. I see some articles now indicating that the maximum rates would kick in at $100,000 in trust taxable income.
Some of you with irrevocable trusts may say, this isn’t how our trust works. The trust creator or grantor pays the tax at the grantor’s individual rates. First, the above is a very general discussion of a complex topic with many variations and exceptions. Second, many irrevocable trusts are written so that the grantor pays the tax at the grantor’s individual rates. That is also about to change. In the future, the grantor will not be able to pay the tax and still have the property excluded from their taxable estate at death.
This could be a perfect storm that nobody seems to be watching. Through several different pieces of legislation both past and proposed, the ability to accumulate wealth may be drastically restricted and wealth currently in irrevocable trusts heavily taxed. For example, the Secure Act requires retirement accounts be distributed over 10 years unless the beneficiary is the spouse. There is legislation pending to end not just 1031 exchanges on real estate, but other like kind or in-kind exchanges including Electronically Traded Funds (EFTs). Elimination of the step up in tax basis at death. Capital gain recognition on GST trust assets at least every 50 years. Reduction of the estate tax exemption and GST tax exemption. Elimination of life insurance trusts.
Contrary to popular belief, irrevocable trusts are not just for the mega rich. Irrevocable trusts are used by deceased spouses to provide for the surviving spouse while ensuring property passes on to the chosen beneficiaries, families with special needs individuals, medicaid planning, and irrevocable trusts are used to protect assets from divorce, creditors, and theft.
So, what to do? Well, until the laws are passed and fleshed out through the rulemaking process, it is hard to know what to do. In the meantime, be aware of all the pending tax law changes and how that might impact your estate planning.
