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March 6th Deadline! Distribute Your Trust/Estate Income or Pay Medicare Tax

1.6.2014

I am one of four beneficiaries of a (modest) trust my father established for his children. Up until recently, our trust owned family farmland that had been rented at a rate sufficient to pay taxes and insurance on the property. The farmer tenant approached the trustees about purchasing the property, and we agreed to sell it, closing in January 2013. As a tax attorney, I began to think about the tax implications of the deal for myself and my siblings, and it occurred to me that, hey, we might have that nasty Medicare tax to deal with…

As most of us have heard by now, Medicare tax that previously applied to only wages and self-employment now applies to net investment income, or "NII," at a rate of 3.8%. NII includes interest, dividends, royalties, and rents, and it also includes business income and capital gains that do not qualify for the ordinary course of business exception, meaning not derived in an active trade or business through material participation. While most certainly capital gains from our trust's sale of rented farmland was not capital gains derived in an active trade or business through material participation, your client's trust could have a trustee who materially participates in the operations of the trust, allowing the trust's NII to qualify for this exception and avoid the 3.8% Medicare tax.

The Medicare tax is applicable to NII of individuals, trusts and estates. The 3.8% tax applies to the lesser of (1) modified adjusted gross income (or "MAGI") over the applicable threshold, or (2) the NII. So if the taxpayer is below the MAGI threshold, no 3.8% tax. The threshold is $200,000 for singles, $125,000 for married filing separately, and $250,000 for marrieds, which figures are NOT indexed for inflation. BUT, trusts and estates have an $11,950 MAGI threshold for 2013. (This figure IS indexed for inflation and is $12,150 for 2014.) If you have a trust or estate that has not or is not planning on distributing out its 2013 income, be aware that if that income constitutes NII, and the trust or estate has more than $11,950 in MAGI, it will pay an additional 3.8% tax on the lesser of its MAGI over $11,950 or its NII. Perhaps you have a trust that has spendthrift beneficiaries or beneficiaries going through a divorce, or that needs operating reserves. In that instance, there is a nontax reason not to distribute the trust's NII to the beneficiaries. But, because the MAGI threshold for trusts is so low, if there is no non-tax reason not to distribute a trust's NII to its beneficiaries, and the trust beneficiaries have "room" before they hit their individual MAGI thresholds or have lower NII, the overall tax burden borne by the trust and its beneficiaries can be reduced by the trust distributing its NII.

Trusts and estates have a special rule that applies in determining what income is taxed to the trust or estate and what income is taxed to its beneficiaries. Any income distributed from the trust or estate within 65 days after year-end to its beneficiaries will be considered in the beneficiaries' income tax computation for the prior year. In other words, trusts and estates have until March 6, 2014 to make distributions of income to their beneficiaries and have that income included in the beneficiaries' 2013 income for all purposes, including this nasty 3.8% Medicare tax. If we all hustle to determine our trusts' and estates' taxable income in advance of March 6, 2014, we may be able to avoid or mitigate this tax.

Craig Dalton, an attorney no longer with Poyner Spruill, was the original author of this article.

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