Income Tax Considerations for Wealth Transfer Planning

Income taxes have become an increasingly important factor in wealth transfer planning since the passage of the American Taxpayer Relief Act of 2012. In the past, the federal estate, gift, and generation-skipping transfer taxes (“transfer taxes”) have been higher than combined federal and state income taxes, which meant wealthy families were more concerned about transfer taxes than income taxes. Currently, the maximum transfer tax is 40%, whereas combined federal and state income tax rates may be higher for certain individuals. For example, if you are a married Georgia resident who files jointly and your taxable income is greater than $457,600 in 2014, you will be subject to the top federal income tax rate of 39.6%, the top Georgia income tax rate of 6%, as well as possibly incurring the new 3.8% Medicare surtax on some of your income. As a result of these changes, planning for the 3.8% surtax, when feasible, has become part of the new normal.

For individuals, the 3.8% surtax is imposed on the lesser of (1) the taxpayer’s net investment income (i.e., interest, dividends, income from passive activities, etc., less any deductions attributable to such income), or (2) the excess of the taxpayer’s modified adjusted gross income (i.e., your gross income less certain deductions, such as those for alimony and health savings accounts) over $250,000 (if married and filing jointly). Thus, a married-filing-jointly taxpayer with $400,000 of modified adjusted gross income, of which $300,000 is net investment income, will pay an extra 3.8% on $150,000 of that income. This is because the lesser of net investment income ($300,000) or the excess of modified adjusted gross income over $250,000 ($400,000-$250,000=$150,000) is $150,000. This is an extra $5,700 in tax that you would not have paid prior to 2013.

The 3.8% surtax particularly affects those clients who are beneficiaries of trusts. The surtax likely will apply to a large percentage of the trust’s income. For trusts, the surtax applies to the lesser of (1) the net investment income that is not distributed to a beneficiary, or (2) the excess of a trust’s adjusted gross income over $12,150 (in 2014). If a trust has $200,000 of income, all of which is net investment income because it is derived from dividends and/or interest, and none of which is distributed to a beneficiary, almost the entire amount ($200,000-$12,150, as that is less than the net investment income of $200,000) is subject to the 3.8% surtax. This surtax matters especially if the trust holds interests in a closely-held business because the income derived from such a business will be deemed to be passive (and thus net investment income) unless the trustee “materially participates” in the business. The law is unsettled as to what constitutes material participation and exactly how many trustees need to be involved if there is more than one trustee. However, there are general guidelines. Accordingly, whom you wish to name as trustee of a trust that does, or will, ultimately hold closely-held business interests is even more important now.

We recommend reviewing your estate plan to see how the American Taxpayer Relief Act of 2012 may have affected your planning, particularly if you hold low-basis assets and/or interests in a closely-held business.

Any specific planning must be considered on an individual basis. The above discussion is not intended as a specific recommendation for you. Please contact us to discuss how we can help you take advantage of these and other opportunities.

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