There is a provision in "Round 2" of the Build Back Better Act which, if passed, appears to discourage the use of trusts to pass wealth down to future generations at the lowest estate tax cost.
The proposed law imposes a 5% surtax on the income of trusts in excess of $200,000, and an 8% surtax on trust income in excess of $500,000. The like income levels for individuals are $10 million and $25 million, respectively (for both single individuals and married couples filing jointly), or 50 times higher than the proposed level for trusts. The proposal is consistent with the way trusts are already taxed for federal income tax purposes, where the 37% maximum trust income tax rate is reached at only $13,050 of taxable income, whereas for single individuals the maximum income tax rate is not reached until $523,601 of taxable income, or 40 times higher than trusts, and for married couples filing jointly, $628,301, or 48 times higher than trusts.
While annual trust income levels in the past may have seldom approached the above numbers, as a result of the SECURE Act passed at the end of 2019, which forces beneficiaries (including trusts) of IRAs and 401(k)s to withdraw the same over a maximum of 10 years after the account owner's death, they may now easily do so. If the account owner should desire to pay his IRA or 401(k) account balance to trusts for his spouse, children and/or more remote descendants after his death, in order to minimize estate taxes on the same (and also to protect the proceeds from creditors and the rights of a divorced or new spouse), he needs to be aware that the income tax penalty for doing so, at least on its face, would appear to be prohibitive.
Assume, for example, that the account owner leaves his $3 million IRA in trust for his son and succeeding generations. Assume also that the trustee of the trust withdraws the IRA in pro rata amounts over the 10-year period (i.e., 1/10th, 1/9th, etc.), but assuming also that the IRA and its proceeds grow by 10% per year. Even assuming the trust has no other income, in year 2 the income of the trust would be $363,333 ($333,333 IRA distribution for 1/9th of the $3 million balance at the beginning of year 2, plus $30,000 in income generated from the $300,000 distributed to the trust at the end of year 1). Ignoring, for purposes of this analysis, the 3.8% Medicare tax (which also applies at much earlier levels for trusts than it does for individuals), the trust's income tax on this amount would be $140,917.36, using 2021 tax rates, and including the 5% surtax on the trust's income in excess of $200,000.
Had the IRA instead been paid outright to a married individual beneficiary earning an independent household income of $200,000 at the time, the marginal tax on the IRA distribution would be $110,212.94, or a difference of $30,704.42. The trust would be paying 27.86% more than what a married individual filing jointly would pay on the same annual IRA distribution, in this example. Depending on the particular facts, the income tax differential could be even larger, and would continue for at least 10 years after the account owner's death.
Regardless of whether this is Congress's intent, these 40 to 50 times higher maximum income tax bracket levels for individuals versus trusts has and will have a chilling effect on paying IRA and 401(k) benefits to trusts and retaining the unused proceeds in the same for estate tax and other protection purposes. Owners of significant IRAs and 401(k)s therefore have been and will continue to be unwittingly incentivized by Congress to increase the size of their spouses' and/or descendants' taxable estates, and to expose IRA and 401(k) receipts to creditors of the beneficiaries as well as to the rights of new or ex-spouses of the beneficiaries. Especially given the sunset of the current large federal estate tax exemption in the year 2026, or earlier, as well as the smaller estate tax exemptions existing now in many states, this disparity in income tax treatment in trusts versus individuals, which began 35 years ago, has and will become a significant estate planning issue for many.
There is a potential solution, however. Under an underutilized section of the Internal Revenue Code (Section 678), trust instruments may be drafted to cause the income of the trust to be taxed to the individual beneficiary, as part of his or her personal income, without actually distributing the income to the beneficiary.