Private Client Services Update – Minimizing the Impact of the New 3.8% Medicare Surtax on Trust Income

    By Robert C. Goodman Jr., Alison V. Lennarz, Estate, Trust & Wealth Transfer

    Effective January 1, 2013, the Internal Revenue Code imposes a tax of 3.8% on estates and trusts on the lesser of (A) their undistributed “net investment income” or (B) the excess of (i) their adjusted gross income over (II) the dollar amount at which the highest bracket begins for such taxable year. For 2013 the highest tax bracket for trust income begins above $11,950. In plain English, this means that a trust or estate may pay the Medicare surtax on even modest amounts of investment income if that income is retained in the trust or estate. For convenience, we will call both “trusts”.

    Net investment income means gross income from:

    • interest, dividends, annuities, royalties, and rents,
    • other gross income derived from a trade or business to which the tax applies, and
    • net gain attributable to the disposition of property (other than property held in a trade or business to which the tax does not apply);

    less deductions allocable to the gross income or net gain. A trade or business is one “to which the tax applies” if it is either (A) a passive activity (B) a trade or business of trading in financial instruments or commodities.

    Individual trust beneficiaries may also be subject to the 3.8% Medicare surtax on the income distributed to them, depending upon the nature and amount of their total income. The 3.8% is imposed on of the lesser of (B) an individual’s net investment income for the tax year, or (B) the excess of the individual’s modified adjusted gross income for the tax year, over a threshold amount, as follows:

    • $250,000 for a joint taxpayer or surviving spouse;
    • $125,000 for a married taxpayer filing a separate return; and
    • $200,000 for any other case.

    Therefore, if a trust’s beneficiaries are in lower income tax brackets than the trust, and the trust has income subject to the Medicare surtax, distributing the net investment income to the beneficiaries would result in the payment of less or no Medicare surtax.

    Some trusts automatically distribute all of their net income to the trust beneficiaries, while other trusts contain provisions that prevent the distribution of net income. If a trust is a shareholder of S-corporation stock and it elects to be treated as a qualified subchapter S trust (QSST), then it would distribute all of its net income to the trust beneficiaries and avoid the Medicare tax at the trust level. In order to make the election, the trust must have a single income beneficiary and a single beneficiary entitled to distributions of principal. If the trust does not meet this requirement, the trustee may consider reformation of the trust under one or more provisions of the Uniform Trust Code.

    In addition to regulations or provisions governing trust distributions, characterization of trust income affects a trust’s liability for payment of the Medicare surtax. As noted above, the Medicare surtax applies to trades or businesses if they are “passive activities.” The Internal Revenue Code defines “passive activity” to mean any activity which involves the conduct of any trade or business, in which the taxpayer does not materially participate. If the trust “materially participates” in a trade or business which does not include trading in financial instruments or commodities, the trust will not be liable for the Medicare surtax on income generated by that trade or business. In order to be treated as materially participating in an activity, the trust must be involved in the operations of the activity on a basis which is regular, continuous, and substantial.

    At present, the treasury regulations do not address material participation of trusts and estates, and the specific requirements for trusts seeking to claim material participation and avoid the Medicare surtax are unclear. There is however some favorable case law.

    It is now more important than ever for advisers to examine the alternatives in asset selection, and distributions from trusts to achieve tax saving. Such consideration will affect drafting of provisions as well as administration. Much of the same analysis will also apply to entity selection for other investments.

    Robert C. Goodman Jr. is a partner at Kaufman & Canoles. His practice focuses on commercial transactions including mergers and acquisitions, sales of businesses, commercial and land leases, formation of business entities, major system procurements, and split-up of family businesses. In addition to his commercial work, he works closely with families and family businesses in generational and estate tax planning, other tax issues, family dynamics, and charitable objectives.

    Alison V. Lennarz is of counsel at Kaufman & Canoles in the firm’s Williamsburg office. Her practice includes estate planning and administration, tax planning, tax compliance and tax controversy. Her clients include U.S. citizens with property outside the United States, U.S. residents and non-citizens. She studied law in both France and the United States, and she is fluent in French.

    The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2024.