Income Sprinkling to Minimize Tax Liability

Jan 28, 2017 8:45:19 AM

Learn more about how income sprinkling minimizes tax liability.

Trusts are taxed differently than individuals and are subject to different tax guidelines. It is important for estate planning professionals to be mindful of the tax implications of trusts and to work to ensure that their clients’ assets receive the best available and most appropriate taxation per the IRS guidelines.

In our current tax environment, income and capital gains in trusts may be subject to very high tax rates. Portioning out the accumulated trust income among trust beneficiaries, or income sprinkling, is one method of minimizing the taxation of trust income.

Why might this be a good strategy?

A New Paradigm: Compressed Taxation

Consider that the tax paradigm for trusts has shifted. In the late 80s and early 90s, trusts were taxed at a much lower rate than individuals, while the estate tax threshold was significantly low. This resulted in assets being held in trust to shield them from taxes.

Today, the opposite is true. We are in a tax paradigm where the estate tax threshold has been raised to a point where it applies to very few, and trusts are subject to a compressed tax rate. This compressed tax rate means that tax brackets for trust income increase at a much faster rate than for individuals.

For instance, income in trusts exceeding $12,400 is currently taxed at a compressed tax rate of 39.6%. Compare this rate to a single filer: one would need to earn upwards of $415,050 in income to be subject to this maximum tax bracket.

Categories of Trusts: Simple and Complex

Furthermore, how a trust is categorized also affects how it is taxed. A trust can either be classified as simple or complex. Simple trusts are required to distribute all income each year to a beneficiary. A simple trust pays taxes on capital gains remaining in the trust. Complex trusts are permitted to accumulate income, but may also retain the discretion to distribute this income among beneficiaries.

Similarly, capital gains distributions usually remain within the trust and are subject to higher tax rates. With complex trusts, however, it is possible to pass such capital gains or losses onto the beneficiaries. Depending upon state guidelines and the stipulations of the trust, some capital gains may be considered beneficiary income as well.

Depending on the year, a trust can shift between simple and complex. A trust is complex if it is allowed, but not required, to distribute principal in the years it actually does distribute principal. It is considered simple in any year it does not. Conversely, a trust that has the flexibility to either distribute or accumulate income is always a complex trust even in the years when no distribution is made.

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Income Sprinkling

Income sprinkling is often a good strategy to avoid such high tax rates. In such a scenario, the income accumulated in a trust is distributed before December 31st of the year, and it is counted as income for the beneficiary. Unless the beneficiary is also in the same high tax bracket, there will usually be significant tax savings.

As we can see, not all trusts are taxed equally. It’s important to know these taxation guidelines for trusts because they can have significant implications for your client’s assets. We recommend partnering with a CPA or other tax professional on an annual basis to determine the best course of action to minimize tax liability for your client.

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