Implications of the Proposed Surtax on Non-Grantor Trust Income

Take-Away: The proposed surtaxes on non-grantor trust income in the Build Back Better Act poses a real hardship on irrevocable trustees and trust beneficiaries while possibly also frustrating the settlors purpose for the Trust.

Background: The proposed Build Back Better Act, passed by the House of Representatives and now pending before the Senate, includes an income surtax of 5% on taxable income (technically modified adjusted gross income, or MAGI) above $10 million, and an 8% surtax on taxable income above $25 million for individuals. Obviously, these surtaxes target society’s ultra-wealthy. However, the current language in the proposed Act applies the same 5% surtax to taxable income above $200,000 of a non-grantor Trust, and the same 8% surtax to a trust’s taxable income above $500,000. These surtaxes would apply regardless of the wealth or taxable income of the trust beneficiaries, such as the settlor’s children, who may not be wealthy. The big picture is that, as currently drafted, the Act sets the taxable income level for an individual at 50 times that of a non-grantor trust.

• Policy Choice: The Congressional policy behind the imposition of high income tax rates on Trusts, e.g. 37% on accumulated income above $13,050.00,  is that high earners would otherwise shelter taxable income using a Trust’s lower marginal income tax bracket. Hence, the very high, very compressed, federal income tax rates imposed on accumulated trust income. The apparent goal is to force a trustee to make distributions, which carry out taxable income, so that the taxable income will be taxed to the trust beneficiary. But that policy presumes that all non-grantor trusts are used to avoid income taxes, while ignoring other non-tax purposes where a trust might be warranted.

Surtax Implications: Should these proposed surtaxes become part of the Tax Act if the Senate passes the Build Back Better Act as it is currently written, they will have a dramatic impact on trustees and trust beneficiaries, while possibly frustrating trust settlors. Consider the following:

• Trustees: The confiscatory surtaxes, added on top of the marginal 37% federal income tax rate, and the 3.8% Medicare tax, and a state income tax [37%+3.8%+ 5%+ 4.25%= 50.05%], will definitely affect the trustee’s decisions about how much to distribute to the trust beneficiaries each year.

What if the non-grantor trust was created to address young or financially irresponsible or spendthrift beneficiaries? A trustee will struggle with having to decide to make a distribution to the beneficiaries who are in the much lower marginal income tax brackets to offset the risk of giving them too much.

Trustees would also have to re-evaluate their investment strategy and investment policies.  Perhaps a trustee will now buy life insurance (policy dividends are tax deferred). Tax-free bonds, low dividend paying stocks and exchange traded funds may now become part of the trust portfolio. A trustee might now consider the purchase of depreciating assets, where the depreciation deduction can be used to offset taxable income.

Or, will trustees do more borrowing on margin rather than selling capital assets to raise cash?

• Beneficiaries: While some beneficiaries may resent the existence of a trust in their lives, often a trust beneficiary actually will welcome the fact that their inheritance is held in trust, if there are creditor concerns or pending divorces, or bankruptcy is on the horizon. Forcing the trustee to distribute trust income from the Trust in order to escape the onerous income taxation of the Trust’s income will expose those distributions to creditors or other predators.

Or, consider a special needs trust beneficiary, where the discretionary trust is used to enable the beneficiary to receive governmental benefits; forced distributions of income to avoid the high income taxation otherwise imposed on the trust may cause the disabled trust beneficiary to lose their governmental assistance.

• Settlors: Some parents and grandparents explicitly establish non-grantor trusts because they do not want their children or grandchildren to become ‘trust fund babies.’ They do not want to give their beneficiaries too much to cause them to lose their incentive to become productive members of society. Distributions of trust income in order to avoid much higher income tax rates, will frustrate the settlor’s purpose for the trust.

Or the settlor may have been worried about the beneficiaries’ level of sophistication to manage wealth and they viewed a trust as an excellent device to manage an inheritance that the beneficiary is incapable of competently managing. Saving income taxes was not a high priority when the settlor thought was to use a trust to accumulate wealth to assist the beneficiaries and their issue throughout their lifetimes.

Conclusion: Hopefully Congress will give more thought to the imposition of the proposed surtaxes on non-grantor trusts. Not all non-grantor trusts are abusive tax shelters that are  intended to avoid payment of income taxes. Not all trust beneficiaries are ultra-wealthy who use trusts to circumvent paying their ‘fair share’ of the nation’s revenue needs. Not all trust beneficiaries are capable of managing substantial taxable distributions from a trust. Some trust beneficiaries, particularly the disabled, need a trust to assure their access to governmental benefits. Some trust settlors legitimately worry about the impact of ‘sudden wealth’ on the choices their beneficiaries make, or their lifestyles to which they aspire. To say that the proposed 5% on $200,000 and 8% $500,000 surtaxes, regardless of the number of beneficiaries of the particular trust in question, surtaxes are draconian and without much (if any) thought to the purpose behind the use of the trust.