Trusts generally have the highest marginal tax rates in the US tax system, but there are ways to save with good tax planning and thoughtful timing. A very important date for a tax-saving opportunity is fast approaching, and the holiday I use to remind myself to look to take advantage of every year happens to be Valentine’s Day.
March 6, 2022 is the deadline for making distributions to beneficiaries under the “65-day rule” to avoid much higher trust tax rates, and if you want to take advantage of that, you should start soon. It is generally beneficial for trust income to be taxed to individual beneficiaries whenever possible. And the 65-day rule can help with that. (Note that this article is for those with non-granting, usually irrevocable, trusts that are subject to income tax.)
How the 65 day rule works
Often when we look back on our lives, we wish we had a “redo”. Section 663(b) of the Internal Revenue Code (“IRC”) provides exactly that. IRC Section 663(b) simply provides that a distribution from a trust or estate within the first 65 days of the tax year may be effective from the last day of the year. previous tax. For example, a distribution of trust income by the trustee to a beneficiary made on or before March 6, 2022 may be treated for income tax purposes as if it had been made on the last day of 2021.
Why do we care? The main benefit is a unique (and often overlooked) opportunity to save income tax. A trust, estate or individual all pay income at graduated rates up to a maximum rate of 37%. For 2021, this maximum rate for individuals is only triggered when income exceeds $628,300 for married taxpayers or $523,600 for single taxpayers (for 2022, the limits are $647,850 and $539,900, respectively). For a trust or estate, however, for 2021, the top marginal tax rate is triggered with any income over just $13,050 (for 2022 it’s only $13,450). To throw salt on the wound, an additional 3.8% Medicare surtax may also apply to a trust or estate, creating an effective marginal tax rate of 40.8%.
There is, however, a way to avoid this high tax rate of trusts. Non-granting trusts are taxed on undistributed income at the end of the year. Trusts can use an income sprinkling deduction, so that income distributed to a beneficiary is deducted from the trust’s taxable income. This effectively shifts the tax liability for the income from the heavily taxed trust to the individual beneficiary, who is taxed at a much lower marginal rate.
This tax saving allows you to buy a batch of roses for your loved ones.
The problem that the 65-day rule solves
The problem with this tax-saving strategy of distributing trust income to the beneficiary is that it is difficult to execute before the end of the year. Indeed, trustees often don’t even know the amount of income until December 31st. The 65-day rule gives trustees more time, allowing them to better plan and allocate income.
For example, a trust with income of $100,000 would pay $40,800 in federal income tax. If this income was distributed to the beneficiary by the trust before the end of the year, the beneficiary would then pay tax at the beneficiary’s lower individual rate! If this were the only income received by the single, unmarried beneficiary, the tax would be $18,021, a savings of $22,779. (This calculation is based on 2021 tax rates.)
Note that an irrevocable election must be filed to allocate income tax payments (but unfortunately no income tax withholding) to the beneficiaries for the previous year. The election is usually made on IRS Form 1041-7 with the trust’s tax return (IRS Form 1041). If the trust tax return is not yet prepared, then, 1041-7 can be filed alone, if filed alone, then Form 1047 must be filed by March 8, 2024.
Proper planning of trust income can provide substantial tax savings each year. So…for Valentine’s Day this year, also mark your calendar for the March 6, 2022 deadline, and think “Tax Savings!
Founder, Goralka Law Firm
Founder of Goralka Law Firm, John M. Goralka helps business owners, real estate owners, and successful families achieve their enlightened dreams by better protecting their assets, minimizing income and estate taxes, and solving messes and transitions to preserve , protect and enhance their legacy. John is one of the few California attorneys certified as specialists by the California State Bar’s Board of Legal Specialization in tax and estate planning, trusts and probate.