Time to Revisit the Family Trust

Time to Revisit the Family Trust

by A. Scott White, CFP®, ChFC®, CLU®
President, Scott White Advisors

For many generations, family trusts have been established to help protect heirs from estate taxes, creditors, divorce, and poor spending habits, and to provide expertise in managing money. One of the greatest and often underappreciated attributes of these trusts is their ability to capture the magic of compounding interest over a long period of time. Quite a few of my clients’ families have established family trusts. Often, a mother or father created the trust using language in their will that says something like: “At my death, create a trust and pay all the income to my children and grandchildren and, at their death, distribute the proceeds to their offspring.” As a matter of fact, these trusts have proven so effective that many states now limit the number of generations these trusts can exist. Florida limits a trust life to 360 years.

But this is not an article about how a family trust can provide for heirs. This is an article about how previous tax changes will affect these trusts. The net investment income tax went into effect on January 1, 2013. According to the Internal Revenue Service in 2020, it is a 3.8 percent surtax on a portion of your modified adjusted gross income (MAGI) over certain thresholds. The Joint Committee on Taxation estimated this surtax would generate an additional $210.2 billion in tax revenues over a 10-year period ending in 2019.

The net investment income tax applies to estates and trusts when their adjusted gross incomes for the year exceed the dollar amount at which the highest tax bracket begins. Its thresholds for 2019 are $200,000 if you’re single or file as head of household, $250,000 if you’re married and filing jointly, or $125,000 if you’re married filing separately. These amounts aren’t indexed for inflation. They can increase in future years, but they won’t unless Congress specifically changes them through new legislation.

Because these trusts are multi-generational, in the past, unless a beneficiary really needed income, it was generally recommend that family trust investments focus on long term growth. After all, since the 2001 Bush tax cuts the highest long term capital gain rate for trusts was the same as the rate for individuals. But with the tax law changes, we need to revisit family trusts because they can pay much more in taxes than an individual on the same amount of income. Since the trust is responsible for taxes only on income not distributed, perhaps it makes sense to distribute more income to the beneficiaries. The beneficiaries will not be impacted by these taxes until much higher income levels, possibly reducing the overall tax the IRS ultimately collects.

Unfortunately, not all trusts allow for the distribution of the entire tax liability to beneficiaries. Often a trust created by a person’s will is categorized as a “simple trust” which only allows income (dividend and interest) to be distributed. Capital gains income is forced to be recognized on the trust’s tax return. Another type of trust, called a “complex trust”, allows for the distribution of the capital gains too. This makes it much easier to pass more of the tax liability from the trust to the beneficiary. If your family trust is a simple trust and you want to change it to a complex trust, it might be possible to amend the trust to provide some relief.

It’s a good time to review your family trusts to learn what your options are to minimize the effect of these new taxes. And while you’re at it, review your entire estate plan and make sure your goals are being addressed. As always, I welcome your questions about this topic or any other estate or financial planning matter.

The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Scott White Advisors and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.