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Strategies for Reducing Income that Individuals and Trustees Can Use Now


The Wealth Counselor, Volume 9, Issue 10

Knowing the ins and outs of reducing income in view of the new tax laws will add value to your client relationships. In this issue you will learn how:

  • Charitable trust-based planning can be used by individual clients to reduce their taxable income.
  • Distributions, trust reformation or decanting, and investment shifting can be used by Trustee clients to reduce the taxable income of a trust.

If you would like to learn more about these strategies and how they can benefit your clients, please call our office.

A Quick Review of the Federal Income Tax Laws

Several significant changes to federal income tax laws went into effect in early 2013, including:

1. Raising the top tax bracket from 35% to 39.6%. In 2014, this top rate applies as follows:

  • Married couples filing jointly or qualifying surviving spouses with taxable income above $457,600
  • Heads of households with taxable income above $432,200
  • Married individuals filing separately with taxable income above $228,800
  • Single individuals with taxable income above $406,750
  • Trusts and estates with taxable income above $12,500

2. Increasing the long-term capital gains rate on the top tax bracket from 15% to 20%

3. Applying a 3.8% surtax on the lesser of net investment income or modified adjusted gross income for individual taxpayers earning as follows:

  • Married couples filing jointly or qualifying surviving spouses, $250,000
  • Married individuals filing separately, $125,000
  • Single individuals or heads of households, $200,000

4. Applying a 3.8% surtax on trusts and estates on the lesser of undistributed net investment income or adjusted gross income over $12,500 (in 2014)

This means that the top tax rate could be as high as 43.4% for certain taxpayers. Therefore, it is important to understand how these new laws impact you and what can be done to reduce your income tax liability.

Planning Tip: Now is the time for high-income individuals and Trustees to begin looking at strategies to reduce their 2014 income tax bill. Each client’s tax situation must be evaluated individually since this type of planning is not one size fits all, or even most. We are here to discuss the options available to your clients for reducing their tax burden.

Charitable Trust-Based Tax Reduction Strategies

While you may be familiar with Charitable Remainder Trusts (CRTs) as an estate planning technique used to minimize estate taxes, CRTs are also effective in reducing income taxes under the right circumstances.

A CRT is a type of irrevocable trust that pays an annual distribution to one or more individual beneficiaries for a term of years, after which the balance of the trust passes to one or more charitable organizations.

The income tax deduction rules for CRTs are complex and the amount of the deduction is limited based on several factors, primarily an individual’s adjusted gross income, other charitable giving, and what type of assets are being used to fund the CRT. Aside from being able to take this limited income tax deduction over a five year period for the value of the property transferred into a CRT, a CRT can be used to reduce a client’s income tax bill as follows:

  • Avoiding a Large Capital Gain. For clients who will recognize a large capital gain on an appreciated asset, such as the sale of a business, the asset can be transferred into a CRT which then sells it. No capital gain is recognized on the sale. In addition, payment of the annual distribution is only taxed when the client receives it, which spreads the income over a number of years. Spreading the gain out might help avoid having a one year “bump” into a higher bracket for some taxpayers.
  • Shifting Income to the Next Generation. Clients who do not need the income can provide an income stream for their children or other beneficiaries by transferring income-producing property into a CRT. This shifts the taxable income from the client down to the younger generation, which is most likely in a lower tax bracket.
  • Planning for Retirement Income. A Net Income with Makeup Charitable Remainder Trust (NIMCRUT) can be used to invest for tax-deferred growth while the client is still working and does not need investment income. After the client retires, the trust assets can be invested to produce income.

Planning Tip: Aside from having charitable intent, CRTs are for clients who have substantial investable assets that are expected to increase in value and the client will not need to rely on the income from the assets. If you have clients who fit this profile, call our office now so that we can help determine if any of these CRT strategies will benefit these clients.

How to Avoid the Income Tax Squeeze on Trusts

Trustees of irrevocable, non-grantor trusts (such as Bypass Trusts and Dynasty Trusts) must take into consideration their fiduciary responsibilities and plan carefully to minimize the impact of the compressed trust income tax brackets (remember, the top 39.6% tax rate kicks in at only $12,500 of trust income in 2014) and the 3.8% surtax is likely to impact all or nearly all trust income.

Since trust income distributed to the beneficiaries is not taxed at the trust level, distributions may be made to beneficiaries who are not in a high income tax bracket and/or subject to the surtax. Of course, any distributions aimed at reducing a trust’s income tax liability must be made within the parameters established in the trust agreement and applicable state law.

With these limitations in mind, income-reducing strategies that Trustees should consider include:

  • Distributing income to beneficiaries so that the income is taxed in the beneficiaries’ lower bracket
  • Making in-kind distributions of low basis assets to beneficiaries
  • Invoking the 65-day rule and distributing trust income to beneficiaries by March 6, 2015, which will allow the trust to deduct the income as a 2014 distribution
  • Exploring options to permit capital gains to pass to beneficiaries, such as reforming or decanting the trust to broaden the Trustee’s discretion to allocate between income and principal
  • Shifting investments to minimize taxable income and gains
  • Merging or terminating small, uneconomic trusts

Planning Tip: Trustees must weigh the tax benefits of making distributions or changes to a trust against the grantor’s intent, the needs of the current beneficiaries, and what will be left for the remainder beneficiaries. We can help your Trustee clients analyze their trust’s 2014 tax liability and evaluate their options for minimizing taxes.

Final Advice for Individuals and Trustees

Planning to reduce income taxes is a balancing act. The needs of the individual taxpayer or trust beneficiary must be carefully weighed against the overall tax savings. In addition, income, gains, losses, and tax brackets must be reviewed annually since the needs of the individual or beneficiary will change from year to year. We are available now to answer your income-tax planning questions and to work with you and your clients to reduce their income tax bills.