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February 26, 2013

The Impact of the New Medicare Tax on Trusts and Estates (article)

The 3.8% Medicare tax is a tax on the net investment income of high income taxpayers, as well as trusts and estates. This tax is imposed by Internal Revenue Code Section 1411 and becomes effective for tax year 2013. Net Investment Income generally includes interest, dividends, capital gains, rental income, and passive activity income. Tax-exempt income is not included in net investment income.

Trusts and estates will be subject to the Medicare tax on the lesser of (1) undistributed net investment income, and (2) adjusted gross income over the amount at which the highest tax bracket for a trust or estate begins ($11,950 in 2013). As shown in the table below, this "threshold amount" for trusts is very low compared to the threshold amounts for individuals:

Filing Status Threshold Amount
Married filing jointly $250,000
Married filing separately $125,000
Single $200,000
Head of household (with qualifying person(s)) $200,000
Qualifying widow(er) with dependent child(ren) $250,000
Trusts and Estates $11,950

Keep in mind that if the trust (or estate) distributes income to beneficiaries, this could affect the total net investment income of the beneficiaries, and thus potentially increase their exposure to the Medicare tax. This could also be a planning opportunity. If the trustee has the discretionary power to increase distributions to trust beneficiaries, the trustee may want do so to mitigate the impact of the Medicare tax within the trust.

The monetary benefits of the analysis are dependent upon the adjusted gross income and net investment income of each trust beneficiary before trust distributions. If the beneficiaries are all high income/high threshold taxpayers, then the potential net tax savings of increased distributions will be relatively small — between zero and $9,046. If the beneficiaries are not high income taxpayers, then the net tax benefits are significantly greater. The savings, assuming all beneficiaries are single, are approximately $7,146 multiplied by the number of trust income beneficiaries.

The real value of such an analysis, however, is dependent upon far more than a mathematical equation. The virtues of such planning, or lack thereof, will be found in the trust instrument. One should determine the trust creator's (the "settlor") purpose in forming the trust and the intent for planned distributions of trust income thereafter.

For example, was the intent of the settlor to:

  • Protect the assets of the trust from beneficiaries' creditors, or possibly from a beneficiary's perceived poor judgment? If so, increased distributions may be contrary to the expressed intent of the settlor.
  • Preserve assets for the benefit of future generations? It is common for trust remaindermen to be unnamed, to allow for the inclusion of unknown or unborn off-spring as beneficiaries. Would a distribution today impact the intended inheritance of those yet to be born?
  • Provide for the living expenses of financially strapped beneficiaries? If so, discretionary allocations of income and expenses between income and principal may be an intended opportunity to provide additional resources to the settlor's loved ones.

Potential tax savings may seem paltry when compared with the risks a trustee assumes upon exercise of a discretionary power, especially when the trust has multiple beneficiaries with diverging interests in trust income and principal. The trustee risks backlash from disgruntled beneficiaries for perceived inequities. Tax savings may be further devalued by consulting fees paid for the annual analysis of the risks and monetary rewards.

With these issues in mind, is Medicare tax planning a worthwhile endeavor for trustees? The only certainties of this query are these:

  • Trustees and trust accountants must read and understand the trust instrument to try and make sure the intent of the settlor is fulfilled to the extent possible.
  • Trustees and trust accountants must understand and comply with governing state laws.

Settlors often allow a lot of leeway in trust instruments for the determination of trust distributions and for tax planning. When a trust instrument permits discretion on the part of the trustee, trustees should review trust accounting income calculations to ensure they comply with the governing instrument and local law. As a corollary, trust accountants should consult trustees for directions when discretionary allocations can be made. Any permissible allocation and tax plan, however, should be consistent with the intent of the settlor.

To determine whether Medicare tax planning makes sense in your situation, consult with your CBIZ MHM tax professional.

Copyright © 2013, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that—unless specifically indicated otherwise—any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC and other Financial Services subsidiaries of CBIZ, Inc. (NYSE: CBZ) that provide tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies.

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