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George F. Bearup, J.D. Senior Legal Trust Advisor

28-May-19

Irrevocable Trust Taxation

Take-Away: While the popular press is filled with reasons to use an irrevocable non-grantor trust to work-around the limits imposed by the 2017 Tax Act with regard to itemized deductions you need to keep in mind that an irrevocable non-grantor trust is taxed much differently than an individual.

Background: An irrevocable trust that is not classified as a grantor trust for income tax reporting purposes is treated as a separate income tax paying entity. The income tax rules that are associated with an irrevocable trust are much different from for an individual.

  • Personal Exemption: An irrevocable trust (or estate) has a $600 per year personal exemption; [IRC 63(d) (2).]
  • Standard Deduction: There is no standard deduction available to an irrevocable trust unlike there is for individuals; [IRC 63(a).]
  • Compressed Income Tax Brackets: An irrevocable trust that accumulates income, and does not distribute its income to its beneficiaries, and thus retains taxable income, faces different income tax brackets than an individual. Those brackets are the following:
    • (i) income not over $2,600- 10% or $260 tax;
    • (ii) income between $2,600 and $9,300, $260 tax plus 24% of the excess over $2,500;
    • (iii) income between $9,300 and $12,750,  $1,868 tax plus 35% of the excess over $9,300; and
    • (iv) any income amount over $12,750, $3,075.50 tax plus 37% of the excess over $12,750. [IRC 1(j) (2) (E).]

For a comparison, an individual who reaches the 37% marginal federal income tax bracket must have reportable taxable income over $500,000.

  • Capital Gains Rate: If an irrevocable trust reports taxable income in excess of $12,950 it is subject to the higher 20% capital gains tax rate; [IRC 1(j)(2)(E); Revenue Procedure 2018-18.] It is important to remember that under the Michigan Uniform Principal and Income Act capital gains are not automatically distributed as part of the trust’s income to trust beneficiaries. [MCL 555.804(b).] Capital gains are not normally part of distributable net income (DNI) that shifts taxable income to trust beneficiaries when income is distributed from the trust to the trust beneficiaries. [IRC 643.]
  • Net Investment Income Tax: Like individuals, an irrevocable trust’s income will be exposed to the net investment income tax (NIIT) of 3.8%. However, this tax which applies to net investment income is imposed once the trust’s taxable income exceeds $12,750. [IRC 1411.] An individual taxpayer does not have to deal with the NIIT until after their income exceeds $200,000.

Conclusion: The upshot of these basic income tax rules is that an irrevocable trust that accumulates income is subjected to extremely harsh income taxation at the federal level. Consider the compressed income tax brackets, where the irrevocable trust finds itself at the highest 37% marginal income tax bracket once its accumulated and undistributed income exceeds $12,750 in a calendar year. Add to that high marginal income tax rate the 20% capital gain tax on undistributed long-term capital gain income (gains which are normally added to trust principal under the UPIA and which are not part of DNI that is distributed to the trust beneficiaries, trapping the capital gains at the trust level.) Add to those taxes the 3.8% NIIT tax that is imposed on every accumulated investment income dollar in the trust in excess of $12,750. Finally, add to all of those federal taxes the state’s income tax rate (4.25 %.)  It should come as no surprise that the purpose of these harsh income tax rules is to prevent the use of an irrevocable trust to reduce income taxes paid by the trust beneficiaries by accumulating the taxable income in the trust. While the trustee can accumulate income in the trust and not distribute the taxable income to the trust beneficiary, it does so at a very expensive tax cost [37% + 3.8% + 4.25% = 45.05%.]

While an irrevocable trust can be exploited to avoid the $10,000 per year limit on the deductibility of state and local taxes, (SALT) balanced against that shifting of the deduction to the trust is the very high incidence of income taxation of that same trust.