Trusts face a double whammy when it comes to taxes for 2013 and beyond. And every day it seems, my inbox is full of alerts on how to manage trust taxes. The problem: a lot of the advice isn’t well-thought-out.

Here’s the situation: Starting with 2013, trusts will pay a 20% tax on capital gains (up from 15%) and a 39.6% top tax rate on other types of investment income (up from 35%). What’s more, these tax rates kick in at relatively low levels of income: whenever a trust’s taxable income exceeds $11,950 in 2013 ($12,150 for 2014).

But that’s not all. There’s also a new 3.8% surtax that applies to any “retained investment income” of a trust that is more than $11,950 ($12,150 for 2014).

The easiest way to understand the implications of higher trust taxes is through an example. Say the investments within “Prudent Trust” generated $103,000 in taxable investment income in 2013 ($73,000 from capital gains and $30,000 from interest and dividends). And each year, the trust pays out $20,000 to the beneficiaries.

Take a look at the “total tax” line. For 2013, there’s a 51% increase in the trust’s tax bill. A double-whammy indeed. There out, the tax increases are moderate – just 3.4% in 2014.

BEWARE EASY OUTS

Much of the advice I’ve seen lately suggests: wouldn’t it be great to at least eliminate the 3.8% surtax by distributing all the trust’s income to the beneficiaries each year? The distributions would then be taxed at the beneficiary level, but not at the trust level. This advice may sound good. But how practical is it? Or even how doable?

In fact, most experienced trustees know that this “distribute-all” advice doesn’t hold up well to analysis.

SOME IMPORTANT CONSIDERATIONS

What’s the tax situation of the beneficiaries? Keep in mind that a 3.8% surtax is also levied on the personal investment income of higher-income individuals (for 2013, singles with more than $200,000 in adjustable gross income; $250,000 for marrieds filing jointly). Say the beneficiaries’ income already makes them subject to this investment surtax. Then, a trust distribution will simply pass on the 3.8% tax bill to them and possibly bump them into a higher income tax bracket as well.

Can the realized capital gains be paid out as income? Usually the answer is no. Capital gains are generally not considered part of a trust’s “Distributable Net Income” (DNI). That’s because capital gains are appreciation in the value of the trust itself. So realized capital gains are typically kept within the trust and reinvested.

There are exceptions. A Unitrust, for example, is required to pay out a fixed percentage of its total value each year. If a Unitrust hasn’t generated enough income to make the required payout, it distributes some of its capital gains. Also, in certain circumstances, a trustee can choose to include capital gains as part of the income when making distributions to beneficiaries. But this choice is irrevocable. Once made, it cannot be changed.

What are the trustee’s obligations per the trust documents? The trustee must follow the instructions specified in the trust. And these instructions may not authorize the trustee to distribute income in order to avoid taxes. Also, the “remainder” beneficiaries (those who ultimately get the trust assets) might not be too happy if a discretionary distribution is made to an “income” beneficiary for the sole purpose of avoiding taxes. Those beneficiaries generally prefer that trust income be retained and reinvested for their future benefit, even if the trust’s tax bill ends up being higher.

A NOTABLE EXCEPTION

In one particular situation, though, it does usually make sense to maximize distributions. That’s while an estate is being administered — that is, before all the assets are transferred to the ultimate beneficiaries. During this time, an estate pays taxes just like a trust. So it would be subject to trusts’ higher income tax rates and the 3.8% investment surtax on retained income.

Therefore, executors of estates should consider distributing income to the beneficiaries even before the estate is officially settled, in order to minimize taxes for the estate.

Note the word consider. When should this suggestion NOT be followed?

Be very careful about making early distributions if the estate is contested in a way that might change either the identity of the beneficiaries or their share of the estate. Also, use care if the estate has unresolved liabilities or specific bequests in dispute.

Finally, consider whether the beneficiary of the estate is a high-income individual already subject to the 3.8% tax, or a trust. If it’s a trust, look at how it’s structured. As mentioned previously, some trusts aren’t allowed to make distributions to minimize taxes, and this could negate the hoped for tax savings.

WHY MARCH 6, 2014 IS IMPORTANT

Note that the decision to distribute trust income can be made up to 65 days AFTER the close of the year. So this year, trustees have until March 6, 2014 to make the trust’s 2013 income distributions, to be counted as part of the beneficiaries’ 2013 income.

This is thanks to the “65-day rule” in the Internal Revenue Code, Section 663(b), allowing the fiduciaries of complex trusts and estates a little breathing room.