Sign On

Tax saving opportunities with trusts

The American Taxpayer Relief Act of 2012 (ATRA) changed the estate tax laws, making them permanent, and accomplished a similar feat on the income tax side. Just as the Bush-era tax cuts were set to expire, which would have resulted in across-the-board income tax hikes, Congress stepped in and froze the existing rates for most taxpayers, except for those in the highest income bracket.

Congress created a new top income tax bracket that would be taxed at the higher Clinton-era rates: for those individuals, the top rate on ordinary income, such as interest, increased from 35% to 39.6%, and the top rate on qualified dividends and long-term capital gains increased from 15% to 20%. If you also take into account ATRA’s itemized deduction phaseouts and the Affordable Care Act’s (ACA) 3.8% Medicare surtax, many highincome taxpayers can see a top marginal rate – depending on their state of residence – that can approach or even exceed 30% for capital gains and 50% for ordinary income.

Using strategic distributions from trusts for tax savings

ATRA does not change the fundamental planning strategies available to help high-income taxpayers reduce taxable income and their overall tax burden. However, there is one area that merits new thinking as a result of these tax changes: the taxation of trusts.

Trusts have always had more compressed tax brackets, but it was rarely the case that the tax incurred by a trust would be significantly higher than what would be paid by a beneficiary if the trust’s taxable income was distributed. But the combined effect of ATRA and the ACA means that trusts will be taxed at the top marginal rates on income in excess of $11,950 for 2013 (this amount, like other tax brackets, is indexed for inflation). This disparity in rates between trusts and individuals means that tax savings can be found by strategically distributing income.

For example, assume that Jane is the primary beneficiary of a $2 million bypass trust established by her late husband John. The trustee has the discretion to distribute the income to Jane or retain it in the trust. Her income outside the trust is $40,000 in 2013, and the trust has dividends of $40,000 and interest of $10,000. If the trust retained the income, it would owe approximately $10,900. If the trustee instead distributed the income to Jane, she would owe about $7,900. Overall, the family can save about $3,000 by distributing the income from the trust to the beneficiary.

Many trusts also have “spray” provisions that permit the trustee or a holder of a limited power of appointment to distribute income to other family members. By strategically distributing income to other family members that are in lower tax brackets, additional tax can be saved for the family.

Capital gains present another opportunity for tax savings. While a trust will be subject to federal tax of 23.8% in the top bracket starting at only $11,950, individuals who are below the top bracket of $450,000 of taxable income for a married couple will be taxed at only 15% and, provided their modified adjusted gross income is below $250,000, they will not incur the 3.8% Medicare surtax on investment income. Further, if they are in the two lowest tax brackets (below $70,700 for a married couple), their tax rate on long-term capital gains will be zero.

For example, Jane, the beneficiary of a $2 million bypass trust, has the power to appoint assets to her descendants and wants to direct $20,000 to a grandchild to help him pay for medical school. If the trust sells $20,000 of zero-basis stock to fund the distribution, it will owe about $4,760 to the IRS. If the trust permits Jane to appoint assets “in-kind,” on the other hand, she could distribute actual low-basis shares of stock. If the grandchild is in one of the two lowest tax brackets, there will be zero federal tax on the sale of the shares. This shifting of income may be achieved in other ways as well.

One challenge for strategically distributing capital gains from an existing trust is that capital gains are normally taxed to the trust and, unless the trustee has consistently treated distributions on the books, records and tax returns as coming from capital gains, or is able to deem them part of the net accounting income of the trust, the gain and the corresponding tax liability cannot be shifted to beneficiaries. Since most existing trusts were drafted and funded when there wasn’t such a stark difference between trust rates and individual rates, many trusts will not provide the trustee with the flexibility necessary to distribute the tax liability out with the principal, trapping the gains in the trust at higher rates.

For trusts that are still revocable, taxpayers have a clear opportunity to amend their documents to allow for more strategic distributions of gains to beneficiaries. In some situations, it may even be possible to amend already irrevocable trusts to adapt to these tax law changes. The savings can be tremendous.


Given the increased tax rate environment for those in the highest tax bracket, there is an opportunity to review current trust documents to determine if there are ways to reduce the overall tax burden for a family.

For more information, contact your Key Private Bank Relationship Manager.


Investment products are:


KeyBank does not give legal advice.  Since laws are always subject to interpretation and possible changes, KeyBank strongly recommends that you seek the counsel of an attorney and/or other qualified tax advisor as to the specific legal and tax consequences of all planning concepts as they apply to the facts of your particular situation.