Affordable Care Act: Impact on Trusts and Estates

The impact of the Affordable Care Act, known colloquially as Obamacare, is still being sorted about across many segments of the American economy. One such area is the income taxation of trusts and estates. The Affordable Care Act levied a 3.8% surtax on Net Investment Income, which generally includes interest, dividends, annuities, royalties and rent, passive income and certain capital gains.

Intended to help pay for health care reform, the surtax is targeted at wealthy taxpayers, and is assessed only on joint filers with more than $250,000 in taxable income and individuals with more than $200,000 in income.

So what does this have to do with trusts and estates? Many people know that assets inherited from an estate or distributions of trust principal are not taxable to the recipient as income. But to the extent those assets generate income while in the hands of the trustee or executor (in the form of interest, dividends, gains, rents, etc.), someone has to pay tax on that income.

Trusts and estates are considered separate taxpaying entities under the Internal Revenue Code, with their own subchapter and a unique hybrid pass-through tax system. In some cases, trusts and estates pay income tax like corporations, and in other cases they pass out income like partnerships. Unlike individuals, trusts and estates pay top tax rates on all income over $12,300. The result is that the Net Investment Income surtax hits trusts and estates especially hard.

First, trusts and estates commonly hold financial assets and earn precisely the type of investment income that is subject to the surtax, so in many cases, most if not all of their taxable income will be considered Net Investment Income.taxes

Second, trusts and estates quickly race through the income tax brackets to the top rate. Consequently, on all income over $12,300, a trust or estate is paying the top income tax rate of 39.6%, and the surtax is likely to apply, totaling up to a top tax rate of 43.4%.

Another open question is what constitutes passive income for an estate or trust? Passive income is income from an activity in which the taxpayer does not materially participate.

But what does material participation mean in the case of a trust or estate? Earlier this year the IRS promised guidance on this issue. Stay tuned. (Kevin Birkhead, Esq., October 15, 2015)