Trusts and the 3.8% Medicare Surtax

Welcome to the wacky world of the new 3.8% Medicare Surtax! Did you know it also applies to trusts?

As we have previously reported, a 3.8% “Medicare Surtax” on net investment income (NII) has been in place since January 1, 2013. Income that just last year was taxed no higher than 35% could reach a new top tax rate of 43.4%, and dividend and capital gain income that was taxed at a maximum 15% rate last year will now be taxed at 23.8% for top income earners.

Today we want to address how the surtax will impact trusts, and suggest some planning alternatives specifically for the trust environment.

We have written about the types of income reported by individuals that are subject to this surtax (investment income, passive income) and are not subject to it (wages, retirement plan distributions, tax-exempt income). And, we have described the income limits over which the surtax applies: single individuals whose AGI exceeds $200,000, joint filers whose AGI is more than $250,000, and married-filing-separately filers with more than $125,000 in AGI. (Technically, the limit is “modified” AGI, but the “modifications” involve only specific types of foreign income, and won’t affect most of those reading this post.)

The surtax applies to certain trusts and estates in much the same way as for individuals but there are some unique differences and planning opportunities.

What kind of estates and trusts are subject to the surtax?

  • Irrevocable or non-grantor trusts, and estates taxed as trusts, that have undistributed net investment income (defined the same as for individuals) and whose AGI exceeds $11,950.
  • Grantor trusts are not subject to the surtax. Instead, the individual grantor is.
  • Charitable and other tax-exempt trusts are generally not subject to the surtax; however, distributions from these trusts to individuals are included in the recipient’s NII.

How is the NII surtax calculated for trusts?

As with individuals, the additional 3.8% tax is imposed on the lesser of undistributed NII or AGI, minus the threshold amount of $11,950. Note how much lower the AGI threshold is for trusts than it is for individuals. This is a significant difference that could unexpectedly trap many trusts into paying the surtax.

How do the material participation standards apply to trusts?

An individual who materially participates in a pass-through activity such as a partnership or S corporation would not be subject to the additional tax because that income would not be considered part of NII. However, if a trust owns rental property or an interest in a partnership or S corporation, the material participation rules are not well defined. The IRS has taken the position that the trustees themselves must materially participate in the activity, whereas courts have been more lenient in looking through to the activity and whether the people conducting the activity on behalf of the trust are materially participating. To date this remains a gray area.

What planning opportunities do trusts have to reduce or eliminate the NII surtax?

Because the surtax is applied to undistributed trust NII, and the threshold is so low at just $11,950, the planning emphasis should be on reducing NII below the trust threshold:

  • Make distributions to beneficiaries that reduce AGI below the trust threshold if permitted by the trust agreement. While distributions generally pull out taxable income that must be reported by trust beneficiaries (known as “DNI”), it can often be accomplished at levels below the income levels at which individuals become subject to the surtax.
  • Take advantage of the “65-day rule” to make distributions after year-end if more time is needed to properly determine NII for the prior year; beneficiaries must also take these distributions into account in the prior year.
  • Capital gains can also be included in distributions to beneficiaries – but only if permitted by the trust agreement or state law.
  • Expenses properly allocable to NII are permitted in much the same way as for individuals.
  • Other expenses like trustee fees and professional fees can reduce trust AGI.
  • Trusts and estates can also claim charitable deductions that reduce NII if permitted by the trust agreement, which is not possible for individuals under the NIIT rules.
  • Consider different investment strategies that favor growth over income or tax-free income to minimize NII.

In conclusion, clients and their advisors must become aware of and understand the new Medicare Surtax regime and how they may be subject to the new 3.8% tax. They should also be cognizant of planning opportunities that may exist to reduce or eliminate the impact of the surtax.  If you have any questions, you are more than welcome to contact us. We’ll be happy to help!

This blog post is a summary and is not intended as tax or legal advice. You should consult with your tax advisor to obtain specific advice with respect to your fact pattern. Based on the most recent “best practice” standards for tax advisors issued by the Treasury Department, commonly referred to as Circular 230, we wish to advise you that this blog post has not been prepared to be used, and cannot be used, to provide assurance that penalties which may be assessed by the IRS or other taxing authority (including specifically section 6662 understatement penalties) will not be upheld.