Everybody probably knows by now that in December, the Tax Cuts and Jobs Act (“Tax Act”) was signed into law. Significant changes were made to the tax code, benefiting almost all United States citizens for at least one year and at least 1% of United States citizens for at least 7 years.
In addition to the significant changes affecting individuals, the Tax Act also resulted in significant changes with respect to trust income. Before the Tax Act was signed, trust income that did not exceed $12,400 was not taxed by the Federal government. Trust income that did exceed $12,400 was taxed at the highest marginal rate, which was 39.6% in 2017. Now, with the Tax Act, the threshold has disappeared, meaning that all trust income not distributed in the year in which it was accrued is taxed at the highest marginal rate, which is now 37%.
But before we get our knickers twisted, let’s parse this out a bit:
Does this tax apply to all trusts?
Good question. Generally, revocable living trusts are named such because the Grantor or Settlor – the person creating the trust – can change the trust whenever they want or even revoke the whole thing. Since the Grantor has this right, the assets in the trust, including all income, are considered to belong to the Grantor. So, because the assets and income belong to the Grantor, the income is generally taxed via the Grantor’s income tax return, the 1040, not an estate tax return, i.e., a 1041.
John Ross retained the firm, Hamilton & Associates to establish a revocable living trust for John, leaving his wife, Betsy, everything he owns upon his death; if Betsy dies before John, the assets will go to his nephew. John owns a house in Pennsylvania, life insurance from Lloyd’s of London, and a 49% share in Betsy’s flag-making business (Betsy’s Flags), which generates about $1,000 a year in income. After the JR Revocable Living Trust is established, John’s home is transferred to the trust because he doesn’t want Betsy to go through probate and, for some reason, he also transferred his 49% interest in Betsy’s Flags to the trust. However, the JR Revocable Living Trust is revocable and all assets still belong to John as Grantor and Trustee, so the trust pays no income tax because John pays the taxes … to the King.
John unfortunately dies while in service to his country. Upon his death, the JR Revocable Living Trust becomes irrevocable; it can’t be changed. And Betsy decides to leave John’s 49% interest in Betsy’s Flags in the trust and resigns as Trustee, letting Hamilton & Associates act as Trustee. The business is booming because several rogues, who were well acquainted with John, decided to start a war with the King and ordered a ton of flags from Betsy as a symbol of unity. So she’s quite happy with her 51% and really doesn’t have time to administer the trust. John’s trust is now a “non-Grantor” trust because the Grantor is dead and the trust owns the assets. So any income generated by the 49% of Betsy’s Flags may be subject to the King’s income tax.
Revocable Living Trust Tax
|Federal Income Tax||-0-||-0-|
Irrevocable Trust Tax
|Federal Income Tax||-0-||$ 370|
Of course, one may distribute the income before the end of the year and deduct the payment from the trust’s tax return. However, scenarios exist where such distributions are neither desired nor advisable. Then what?
Make sure your estate planning attorney, accountant, and financial advisor know and respect each other.
Does this apply to all income?
Another good question. One of the changes that the Tax Act also heralded in was a deduction for income earned by certain small businesses. Thus, the income generated by the 49% of Betsy’s Flags may actually be $296.00 instead of $370.00.
What do you mean by certain small businesses?
That’s a question for another article. So stay tuned…