MARCH 25, 2013 VOLUME 20 NUMBER 12
You may have heard about a potentially significant new tax liability for special needs trusts. With adoption of the Patient Protection and Affordable Care Act (what is often referred to as “Obamacare”) Congress created a new tax intended for high earners to contribute to Medicare. A fairly complicated formula attempts to capture investment income (as distinct from income from employment) and impose a tax.
Enter the doctrine of unintended consequences — or at least we hope this consequence was unintended. Because of the definition of income subject to the tax, it is possible that some special needs trusts will end up paying a significantly higher tax. Here’s how it works:
The new tax is imposed on “net investment income.” That is defined as dividends, capital gains, interest, rents, royalties — pretty much income other than wages. It was intended to cover relatively higher-income individuals, so it will kick in only for the highest tax brackets for each category of taxpayer. That means, for instance, that a married couple will owe the 3.8% Medicare tax only if their total income (including that investment income) exceeds $250,000.
But here’s the problem: the highest tax bracket for trusts kicks in at a much, much lower figure — $11,950 in 2013. So a special needs trust subject to income taxation will pay an extra 3.8% on any investment income in excess of that amount.
Let’s use an illustration. Mildred’s will included a special needs trust for her daughter Diana. Mildred died in 2011, and the trust was funded with $500,000 of property from her estate. The trust is now invested in an appropriate mix of stocks and bonds, and last year it generated about 4% in interest, dividends, recognized capital gains, etc. That means income of about $20,000; the tax would be about $6,000 on that amount. Because of the 3.8% surtax, however, the tax bill will rise by almost another $1,000.
That’s not too bad, but of course the tax on Mildred’s trust is already much higher than it would have been had it been taxed to Mildred herself. The trust paid the highest marginal tax rate (39.6%) on nearly half of the total income — whereas Mildred herself would have still been in the 15% tax bracket if she were still alive in 2013. Now the total tax paid by the trust has gone from more than double to nearly three times Mildred’s individual tax burden.
Don’t panic. It’s not as bad as that. There are several reasons why the new Medicare tax will have an effect on special needs trust planning, but not that broad of an effect on the actual tax paid.
First, let’s clear up one confusion: the higher tax rates — both the Medicare tax and the highest, 39.6% rate on trust income — only applies to trusts set up by someone else to hold an inheritance or gift, and usually only after the death of the donor. A special needs trust set up to handle personal injury settlement proceeds does not have any separate tax effect at all — it is what is called a “grantor” trust, and is taxed as if it actually was the individual whose money went into the trust. The Medicare surtax, and the highest marginal tax rate, will only affect that kind of special needs trust if the total income is at least $200,000.
Next, even the “third-party” trust established by Mildred (the third party in the trust’s name) has a significant way out of paying high taxes. It just has to provide some benefits for Diana. If, for instance, the trust paid for a companion to take Diana out of her assisted living apartment once a week in 2013, the income tax gets paid by Diana and not the trust. The higher tax levels never kick in, because Diana’s income is not high enough to be subjected to the top level OR the Medicare tax.
It’s actually even better than that. Mildred’s trust is almost certainly a “qualified disability trust.” That means it gets to take the equivalent of a personal tax exemption, as if it was Diana — meaning that the first $3,900 of the trust’s income escapes taxation altogether. Plus the administrative expenses (trustee’s fees, some of the investment fees, lawyer’s and accountant’s fees) are all deducted from income. So Mildred’s trust’s $20,000 of income only gets reported on Diana’s return to the extent of about $5,000 — and Diana probably won’t pay any income tax at all.
Diana is lucky in another way, and Mildred’s trust shares that luck. Diana is pretty healthy, and does not have significant medical expenses. In another, similar trust with large medical payments, the ultimate tax paid can also be reduced simply by claiming large medical deductions on the beneficiary’s return.
Nonetheless, the new Medicare tax is a concern for trustees of third-party special needs trusts — especially very large trusts. Double the size of Mildred’s trust (or quadruple it) and it is easy to see that the tax burden might rise steeply. The trustee of a third-party trust with several million dollars might find it prudent to invest in assets that will appreciate in value but not throw off much income — presuming, of course, that the appreciating assets will not be sold during the beneficiary’s lifetime.