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Estates and Trusts with 3.8% Medicare Surtax

The Supreme Court’s decision upholding the Affordable Care Act confirmed that trusts and estates will be subject to a new 3.8% Medicare surtax when net investment income exceeds a threshold amount. This year presents an unprecedented opportunity for you to differentiate your firm and services and show that you provide significant value to your clients by having all of their financial planning needs in mind, including retirement, estate, tax, investment and insurance planning. With so many unknowns in 2013 compounded by an election year, your clients need to take advantage of many financial planning avenues now to avoid missing crucial opportunities to protect their nest egg and increase their net worth. Listen to a recent podcast below from Bob Keebler, CPA, in which he points out issues surrounding this new surtax and how to plan for trusts and estates. Access other resources to help you educate your clients and proactively plan now in preparation for 2013.

Estates and Trusts with the 3.8% Medicare Surtax

Robert S. Keebler, CPA, MST, DEP, Partner, Keebler & Associates, LLP. Bob is a 2007 recipient of the prestigious Distinguished Estate Planners award from the National Association of Estate Planning counsels. From 2003 to 2006, Bob was named by CPA Magazine as one of the top 100 most influential practitioners in the United States. He is the past Editor-in-Chief of CCH's magazine, Journal of Retirement Planning and a member of CCH's Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration.  

This audio webcast was originally recorded July 10, 2012.


ROBERT KEEBLER:  On behalf of the PFP Division of the AICPA, welcome to Estates and Trusts and the 3.8% Medicare Tax.  I'm Bob Keebler, and I'll be your host for today's podcast.

On June 28th, we heard from the United States Supreme Court regarding the health care decision.  An important part of that law is the 3.8% Medicare surtax.  Until the Supreme Court announced its decision, most of us hadn't realized just how serious the 3.8% health care surtax would be in the context of estates and trusts.  Most of us were focused on tax planning for individuals and not on how it will affect the estates and trusts we help administer.

Recognize that trusts and estates are separate taxable entities.  They receive income and pay expenses.  Most trusts are on a calendar year, while an estate can be on a fiscal or a calendar year.  A trust is allowed to make an election pursuant to Section 645 of the Internal Revenue Code that it can be taxed on either a fiscal or a calendar year.  By electing to be treated as an estate, this gives a trust the flexibility of picking the year end of its choice.

Income is taxed to either the trust or to the trust beneficiaries.  If income is accumulated at the trust or estate level, then the income is taxed to the trust or estate.  However, if income is distributed, then the trust or estate receives an income tax deduction or DNI deduction, and the beneficiaries report the taxable income.

There are a number of types of trusts.  One type is a grantor trust that is ignored for tax purposes, or there is a standard Subchapter J trust that is respected for tax purposes and will be required to pay the surtax if its net investment income exceeds approximately $12,000.  Charitable trusts will also play an important role in planning to beat the surtax.  Many of your clients will look at executing charitable remainder trusts to spread gains out over a long period of time, and may even enter into charitable lead trust transactions in order to allow the 642-C deduction to offset net investment income.

Distributable net income determines the amount of an estate or trust's income distribution deduction.  It's this import -- This is important, because it determines how much the beneficiaries must report as taxable income on their returns.  It also determines the character of taxable income in a beneficiary's hands.

So the concept of DNI most of you are familiar with.  In the world of the Medicare surtax to these, to the extent the estate makes a distribution to a beneficiary, the beneficiary is going to be taxed on that for not only regular income tax and AMT purposes, but for purposes of the surtax.  If the beneficiary can keep their income below the threshold amounts, they will not be subject to the surtax.

Under the law, normally, capital gains and losses are trapped at the trust or estate level.  However, in the year of termination of an estate, the capital gain or loss is paid out to the beneficiaries.  Capital gains will likely be subject to the 3.8% surtax if they are trapped inside a trust.  It's also important to remember that specific bequests do not carry out DNI, so they will not carry out surtax income.

Finally, all of you are aware of this.  Finally, most of us are aware of the 65-day rule under IRC Section 663-B.  This applies to both estates and complex trusts, and it allows a fiduciary to treat distributions made within 65 days after year end as if they were made on December 31st of the prior year.  This will be an excellent planning tool in that CPAs will be able to prepare the tax returns for the beneficiaries of the trust in draft, looking at how much room they have to accept further income from the trust to mitigate the surtax.

This election must be made by the due date of the tax return, and remember, it's 65 days, not two and a half months.  So typically, March 4th, 5th, 6th, somewhere in there that you'll hit your 65-day mark.  Keep in mind, specific bequests do not carry out DNI.  They're not taxable to the estate or trust beneficiaries.  Also, keep in mind that under the law, specifically Code Section 642-C, a trust can take a charitable deduction.  This is not always an easy deduction to obtain, and there are specific regulations governing the ability to take this deduction.  Many practitioners are beginning to believe this deduction will also offset surtax income in the context of an estate or trust, but not in the contest of an individual.

Now, a number of planning strategies have developed in wake of the new 3.8% Medicare surtax.  So recognize, beginning on January 1st, 2013, a 3.8% Medicare surtax is going to apply to the trusts and estates you represent.  This new surtax will in essence raise the marginal income tax rate for these taxpayers.  Thus, a trust in a 39.6% bracket -- i.e., the highest potential marginal rate in 2013 -- will have a marginal rate of 43.4%.  This is a jump of 8 -- 8.4% from today's rate, raising many questions, important questions, about when you should recognize gain or loss.

For most individuals, they'll -- even absent the repeal of the Bush tax cuts, or the expiration of the Bush tax cuts, they'll see the 3.8% surtax come into play.  Now, in the context of estates or trusts, the surtax will be applied by calculating 3.8% times the lesser of undistributed net investment income for the taxable year, or the excess, if any, of adjusted gross income over approximately a $12,000 threshold amount.

Now, there are three critical terms that we need to work with.  One of those terms is net investment income.  The other term is threshold amount, and the final term is modified adjusted gross income.  We'll cover each of those specifically in the context of trusts and estates.

Very common, a trust or an estate will have interest, dividends, perhaps annuity distributions, rents, royalties, income derived from passive activities, or capital gain from the disposition of property.  Those are all items, that investment income, for purposes of the surtax.  However, salaries, wages or accrued bonuses on the date of death will not be subject to the surtax.  Distributions from IRAs or qualified plans will not become subject to the surtax.  So these are the things that we have to focus on.

Now, during your life, the gain of a sale of an active interest in a partnership or S corporation also would not be subject to the surtax.  Given that there will be a step up in basis at death, the gain on a sale of an active interest in a partnership subsequent -- or S corporation subsequent to death should be minimal.  However, such a gain may be subject to the surtax, depending whether you're an active or passive investor.

Again, income subject to the surtax: interest, dividends, annuity, passive royalties and rents.  Income exempt from the surtax: wages, exempt income, active royalties, IRA distributions, 401(k) distributions, pension income, RMDs or Social Security income.

Now, very important to remember, an estate or trust is going to have the surtax issue if their adjusted gross income exceeds about $12,000.  The number's not out yet for 2013.  For single taxpayers, that threshold is 200,000, and for married taxpayers that threshold is $250,000.

Now, again -- So we have to focus on re -- possibly reducing two things, modified adjusted gross income and also we need to focus on reducing NII, or net investment income.  For most estates and trusts, the focus, because the threshold is so low, will be on reducing net investment income.

Now, a couple examples.  In the context of a single taxpayer, very much alive, he has $100,000 of salaries, $50,000 of net investment income.  In this context, his modified adjusted gross income is $150,000.  He's below the $200,000 threshold, and he does not have to worry about the surtax.  Because he's below the threshold, the surtax would not apply.  However, you represent Linda's estate.  Her estate has zero in employment income, but 225,000 of net investment income.  What's going to happen if that net investment income is trapped in the estate?  A 3.8% surtax is going to apply to $213,350.  Again, a little break for the threshold amount, but after that, this is going to apply.  It's going to be roughly $8,000.

Now, you also represent the Perrys' estate.  $100,000 of salary, which is RID.  Even though you're above the $11,600 threshold, there is no surtax because wages are exempt from the surtax.

You represent Peter's estate.  He has $11,650 of salary income, $50,000 of net investment income, for a total of $61,650.  His threshold amount is $11,650.  Now, he's going to pay tax on net investment income of $50,000.  So basically, you take his adjusted gross income at the estate level or at the trust level, you subtract from that the threshold amount, and there you're going to pay tax on $50,000.

Now, let's say you had an estate, and an estate poured into a trust, and you expected that estate to have about $20,000 of undistributed income.  What you would probably do is distribute, give or take half of that out to the trust.  It would carry the DNI to the trust, and then you'd be below the threshold at the trust level and below the threshold at the estate level.

Let's say the trust broke into a QTIP trust, or let's say the trust broke into three separate trusts for each child.  You could distribute out approximately $33,000, 11,000 to each trust.  Every trust would be below the threshold amount, and you'd trap another $11,000 back at the estate, and in that instance, you would then avoid the surtax.  So there's a lot of planning that's going to have to happen here.  And I think it's really incumbent upon you to take a real hard look at the estates you currently administer.

Now, you represent David's estate.  He receives a $100,000 lump-sum pension distribution, $150,000 of IRA income and $25,000 from tax-exempt bonds.  In that case, the surtax is not going to apply because of the type of income.  The type of income is pension income, IRA income and tax-exempt income.  The surtax simply doesn't apply.

Now, you represent the estate of John Smith.  The estate of John Smith has $51,000 of net investment income.  It has made no distributions.  In that case, you'd take 51,000 minus your exemption of 11,650 for this year.  You would have 39,350 of income that would be subject to the surtax.  So basically, you've trapped that income, and now you have to pay, you know, an extra $1,500 in tax.  If you distribute that out, the beneficiaries may not have paid that tax.  That's what's so important here.

Now, if you were in that situation, you could also look at investing in municipal bonds.  You might look at investing in master limited partnerships, REITs, oil and gas, life insurance, annuities, any place in the Code where you're going to find tax shelter.  So it's very important to look inside the Code and see where you're going to find tax shelter.

Now, you represent the Anita Jones trust.  The trust has $100,000 of net investment income and has made a distribution of 100% of its income to the beneficiaries.  In that case, nothing is taxable in the trust, but potentially it's going to be taxable to the beneficiaries.

Now, the first thing we have to think about is, how are we going to reduce net investment income?  Then how are we going to reduce MAGI?  And finally, what type of year-ends should we choose, and should we make distributions from a trust or from an estate?  Let's start here.

The easiest way to avoid the surtax would be to invest in tax-exempt bonds.  Now, whether that makes sense or not, you'll have to run the math to determine the effective rate.  Tax-deferred annuities can also make sense, because what's going to happen with a tax-deferred annuity, in the right circumstance, a tax-deferred annuity can be owned by a trust, and you're going to receive deferral.  You won't pay the income tax up front.  Now, you might be buying yourself a larger problem later, but we can think through that.

Now, life insurance can also be an excellent investment for conservative investors.  So you represent -- So you represented this couple.  Husband died.  He and his wife each have quite a bit of property.  $5 million goes into his bypass trust, and then his wife comes to you, and she says, "I'm never going to need to touch this bypass trust.  It's for my children and grandchildren.  I really don't want to take dollars out of there."  But on the other hand, this 40-some percent tax rate is going to be crushing on the income tax side.

And you say to her, "Well, what if we were to look at some of the tax shelters that are already inside the Internal Revenue Code?"  The easiest tax shelter for them to invest in is life insurance.  And perhaps she invests, of the 5 million she puts a million and a half dollars into a life insurance policy, which gives her about a 6% or 5% return until the day she dies.  Incredible return, all tax-free.  And arguably, if you're at a really good company with a high Comdex rating, a C-O-M-D-E-X, and that goes from 0 to 100, the best companies are going to be higher rated.  Most of the names you'd expect are way up there on top.

Now, you might also look at rental real estate because of the depreciation tax yield.  Oil and gas investments may make sense in the right circumstances, if allowed by the trust instrument.

When you're working with someone that died in 2012 -- this is really important -- most people that died in 2012 -- Strike that.

For most people that died in 2012, their executor or their trustee should probably elect -- make a 645 election, and basically elect an 11/30/2012 year end.  Now, the beauty of that is that the surtax only applies to years beginning on or after January 1st, 2013.  Okay?  So it's critical that that -- You would have, for the first 11 months of 2013, you would not be subject to the surtax.  I think that gives us a lot of opportunities.

We also have to look at the timing of estate and trust distributions.  This will be critical going forward.  If it wasn't in the past, it's going to be even more critical now that we get that right.

And finally, when you're working with a trust or estate, if you see a bequest in the will that says something like, "that dollar amount which results in no federal estate tax" -- that's often called a pecuniary bequest, and when you have a pecuniary bequest like that, what's going to happen is gain is accelerated when you transfer property from the estate or the administrative trust to the subsequent trusts or to the beneficiaries.  And in that instance, you would have to pay capital gains tax.

Now, if you do that, if you can execute that funding, if you could work it out that you could fund that in 2012, then that gain is going to be recognized at a 15% rate, okay?  However, if you recognize it in a year subject to the surtax, you're going to be at least at 18.8, potentially at 23.8% if we have the repeal of the Bush tax cuts plus the 3.8% health care surtax.  Watch out for these pecuniary funding clauses.  Extremely dangerous.

So if we look at these strategies a little bit closer, a tax-deferred annuity is going to give you additional deferrals.  So if there's a way of using tax-deferred annuities, both for individual clients or for trusts or estates, or for a trust in particular, that is going to make sense, because you're going to try to be reducing -- it goes to reducing both net investment income and modified adjusted gross income in the context of an individual, or adjusted gross income in the context of a trust.

Now, life insurance.  One of the nice things about life insurance is all the growth when I'm alive is tax-deferred.  When I die, all the proceeds are tax-free under current law.  And finally, and most importantly, if I ever want to take dollars out of the policy, I can recover my basis.  Unless the policy is a modified endowment contract, I can recover my basis without paying a penny of tax.  Further, after the policy has grown, I can even borrow against the policy.

Now, one thing that we talked about a little bit was rental income.  Whether it is appropriate for an estate or trust depends upon the trust document and how much risk people are willing to take.  It may be -- It might even be more conservative than other alternatives, or it might be just part of a large portfolio.  But basically, why real estate works is because of the depreciation tax shield.  The depreciation will offset any income you have for rents, providing you with tax-free cash flow not subject to income tax and not subject to the surtax.  Now, I realize at some point in time that turns around.  But in the short run, it's going to give you some tax shelter.

Oil and gas works very well because you're allowed to reduce your adjusted gross income so that that is a critical planning issue.  Further, you're also going to, in the right situation, if your modified adjusted gross income hits below that threshold amount, you will not be subject to net investment income.

Now, the other thing that we want to be careful of, and I spoke to this a little bit, but for all the estates you're currently involved with, quickly look at what year ends you're going to pick and do some additional surtax planning.  Look at what incomes come in.  What can you do to reduce the immediate impact of the surtax on those trusts and estates?  And a lot of that, that's going to require a lot of extra planning in the next six months.  This gives you an opportunity to look very, very good in front of the lawyers that bring you in on these cases.

This is going to give you the opportunity to look very, very good in front of the lawyers and financial advisors that bring you in on these fiduciary cases.  So what you want to do is just be way out in front of this.  Be the idea person.  Bring those ideas to the group and take credit for them.  I mean, you're the one putting the time in to become super-educated on those issues.

So we covered a lot of ground.  I realize that Andrea Miller has committed to covering this topic thoroughly.  So on behalf of the PFP group of the AICPA, I'm Bob Keebler.  Thank you for joining us today.


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