Planning for the 2021 tax year has passed, as most taxpayers have filed or are preparing to file their income tax returns. But for estates or trusts, there is still time to make a distribution that will count toward the previous tax year.
According to Section 663(b) of the Internal Revenue Code, any distribution by an estate or trust within the first 65 days of the tax year can be treated as having been made on the last day of the preceding tax year. Fiduciaries of trusts and estates have up until March 6 to determine if they can benefit from a distribution made within that time.
The 65-Day Rule, as it is known, not only provides estates and trusts flexibility in planning, but also an opportunity for big tax savings, said attorney Garrett Reuter, co-leader of the Greensfelder’s Trusts & Estates Practice Group in Belleville, Ill.
Reuter said that a trust pays graduated income tax rates like an individual. A typical trust, he said, might require all income earned on the trust to be distributed to the beneficiary either on an annual, semi-annual or quarterly basis. But if the beneficiary is receiving an annual income from the trust, the trustee or the advisor may not know exactly how much income is earned as of Dec. 31 because they often will not have gotten the statement or information they need until after the new year, he said.
Reuter said once the trustee gets the information and figures out the income for the prior year, “any income that’s distributed out might get a deduction or it actually passes through to the beneficiary,” he said.
He explained that if a trust does not distribute income out to a beneficiary, then the trust will pay tax on that income. But under the tax rule, trusts and estates can get a deduction on any income that is distributed from a trust to a beneficiary. The beneficiary will pay the tax on that income rather than the trust.
That is where the tax savings come in, Reuter said. Trusts and estates, and individuals, all pay a top tax rate of 37%. But trusts and estates hit the top rate with taxable income exceeding $13,000. Individuals, meanwhile, have a threshhold of $523,600 ($628,300 for married filing jointly).
In some cases, there also is a 3.8% net investment income tax of estates and trusts that may apply and could result in a total marginal tax of 40.8%, Reuter noted.
That's why its advantagous to trusts and estates to push income out to beneficiaries, he said. As an example, Reuter said if you have $100,000 inside a trust and you let the trust pay the tax on it, that will be $37,000 at the 37% bracket. However, if the trust distributes the income to the beneficiary and the beneficiary is in the 20% tax bracket, the beneficiary will pay $20,000.