The compression
An individual passes through several brackets before reaching the top federal rate, and the journey takes several hundred thousand dollars of taxable income. A non-grantor trust makes the same journey in a few thousand.
The same compression applies to the net investment income surtax, which reaches trusts at a correspondingly low threshold. A trust with a modest amount of retained investment income is therefore frequently paying at the highest combined rate available while its beneficiaries, individually, are not.
How income moves to the beneficiary
A trust that distributes income generally receives a deduction for the amount distributed, and the beneficiary includes it. The amount is limited by distributable net income, which caps both sides of the transaction.
Distributable net income does more than set the ceiling. It determines the character of what the beneficiary receives. Tax-exempt interest carries out as tax-exempt interest, qualified dividends as qualified dividends. The beneficiary does not simply receive cash, they receive a proportionate slice of the trust's income composition.
Capital gains are the significant exception. In most trusts, capital gains are allocated to corpus and remain taxable to the trust rather than carrying out, unless the governing instrument or a consistently applied exercise of the trustee's discretion provides otherwise. A trust holding appreciating assets can therefore distribute all of its income and still face the compressed brackets on its gains.
Sixty-five days of hindsight
The most useful provision in this area is also among the least used. A distribution made within the first sixty-five days of a tax year may be elected to be treated as though it had been made on the last day of the preceding year.
The practical effect is that the retain-or-distribute decision does not have to be made blind. The trustee can wait until the year has closed, see what the trust actually earned and what the beneficiaries' own positions look like, and then decide.
| Deciding in December | Deciding under the 65-day election | |
|---|---|---|
| Trust income known | Estimated | Final |
| Beneficiary's own income known | Estimated | Substantially known |
| Rate comparison | Made on projections | Made on figures |
| Risk | Distributing into a beneficiary's own high year, or retaining into the compressed brackets unnecessarily | Materially reduced |
What the trustee is actually weighing
Rate arbitrage is only one input, and a trustee who optimizes for it alone is not discharging their duty.
- 01The terms of the instrument. Distribution authority is bounded by the document, and a standard that permits distributions for health, education, maintenance and support does not permit distributions for rate management.
- 02The beneficiaries' circumstances. A distribution that saves tax and puts assets in the hands of someone facing a claim, a divorce, or a substance problem has defeated the purpose of the trust.
- 03Asset protection. Assets distributed leave the trust's protection permanently. Tax saved in one year is a poor trade for protection surrendered indefinitely.
- 04State taxation of the trust itself. States tax trusts on varying bases, including the settlor's residence, the trustee's location, and the beneficiaries' residence. Where a trust is taxed is a question with more than one answer and is worth establishing deliberately rather than by accident of which trustee was convenient.
General information only. This article describes law and practice as we understand them at the time of writing. It is not tax, legal, accounting, or investment advice, it does not consider your circumstances, and it does not create an advisor-client or attorney-client relationship. Odyssey Strategic Advisors LLC is not a law firm and is not a CPA firm. Confirm any position with your own tax professional before acting on it. See our disclosures.