In certain cases, it may be beneficial to shift the tax burden of capital gains from the trust to the beneficiary. Once a trust reaches $12,150 of taxable income, capital gains will be taxed at a marginal rate of 20%. Investment income (including capital gain) that is not distributed to the beneficiaries will be subject to an additional 3.8% Net Investment Income Tax. In contrast, individual taxpayers enjoy a 15% marginal rate on long-term capital gains and qualified dividends until income exceeds $413,201 if single, or $464,850 if married filing jointly. Furthermore, an individual is not subject to the Net Investment Income Tax until income exceeds $200,000 if single, or $250,000 if married filing jointly. As a result, a shift of capital gains from a trust to its beneficiaries could reduce the total marginal tax rate on the income by as much as 8.8% for 2015.
In a fiduciary context, capital gains are considered receipts of principal by default. If you are thinking about funding a new trust and wish to provide your trustee with the flexibility to distribute capital gains to your beneficiaries, your trust agreement should specify that the trustee has the discretion to distribute income, principal, or income and principal in whatever way he or she feels is appropriate. Alternatively, your trust agreement may provide that capital gains are to be included in income by default. Both options should be carefully considered and analyzed before your new documents are finalized and the trust is funded.
Whether the trustee of an existing trust can distribute capital gains to its beneficiaries depends on the terms of the trust agreement. If the trust agreement specifies that the trustee may distribute principal as he or she sees fit or must distribute principal if income is insufficient to fund the required distribution for the year, capital gains may be distributed to the beneficiaries. If the trust agreement is completely silent on the topic of the distribution of principal the trustee is able to rely on the Uniform Principal and Income Act (UPIA), which gives the trustee the discretion to distribute capital gains as he or she sees fit.
The Internal Revenue Code provides that capital gains may be passed out to the beneficiary and be taxed at the beneficiary level if:
- Under the trust agreement or local law, capital gains are considered trust income;
- The trust agreement or local law allocates capital gains to principal, but they are consistently treated as part of distributions to the beneficiaries on the trust’s books, records, and tax returns; or
- The trust agreement or local law allocates capital gains to principal, but they are actually distributed to the beneficiaries or utilized by the trustee in determining the beneficiaries’ distributions.
Bear in mind that in order to pass out capital gains, you must pass out cash or property to the beneficiaries. Consider the non-tax economic consequences of distributions very carefully – a few dollars of tax may be a small price to pay for keeping the trustor’s goals for his or her assets on track.
If you have questions about how capital gains might be distributed from your trust or want to discuss whether passing them out makes sense in your situation, please don’t hesitate to contact us.