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65-Day Rule for Trusts

65-Day Rule for Trusts

One of the significant disadvantages of trust income taxation is their highly compressed tax brackets resulting in their income being subjected to the highest tax brackets at much lower income levels than individuals. This includes falling into the Net Investment Income Tax bucket sooner than individuals.

To illustrate this point, compare the point at which a married couple filing jointly enters the top (37%) tax bracket ($628,300 of taxable income in 2021) to the point at which a trust enters the top bracket ($13,051 of taxable income)!

With this disparity in tax brackets, it is easy to see the value of shifting income from a trust to beneficiaries. Of course, income shifting (providing distributions to beneficiaries) is not always appropriate (i.e., the trust design is intergenerational or the beneficiaries are spendthrifts).

the-what-why-and-how-of-trustsBIZ TIP: The What, Why, and How of Trusts

The value of this tax election can be significant. With proper planning, “discretionary” distributions might be able to be made after year-end that allow for shifting income between a trust and its beneficiaries within 65 days after year-end as long as the 65-day Rule is elected.

The reason this election is allowed within our tax system is the trust income is not always known prior to year-end to be able to plan out discretionary distributions.

Who Can Benefit From the 65-Day Rule?

The 65-day election can only be made for complex trusts to make the applicable discretionary distributions. Unlike simple trusts, they are not required to distribute all their income during a tax year.

How Does It Work?

Generally speaking, distributions made to beneficiaries of trusts carry income out to them.  The trust or estate can then deduct these distributions in arriving at the trust’s taxable income, thereby reducing its taxable income.

Typically, only distributions made within a taxable year would be considered in determining the amount of the distribution deduction but, under this special rule, complex trusts can distribute income to their beneficiaries within 65 days of the beginning of their taxable year and elect to treat it as having been made in the prior year.

As you can see, the 65-day election, in effect, gives the trustee or executor some flexibility in shifting taxable income from the trust or estate to the beneficiaries after the close of the tax year-end.

Example:

A complex trust with a December 31, 2021 year-end has $20,000 of taxable income for the year, putting the trust into the highest (37%) tax bracket. The beneficiary of the trust is in the lowest income tax bracket.

In this case, if the 65-day election is made, the trust can distribute some or all of the $20,000 to the beneficiary at any time up to March 6, 2022.

Making this election would reduce the trust’s 2021 taxable income by the amount of the distribution and would increase the beneficiary’s 2021 taxable income, saving overall tax dollars since the amount distributed to the beneficiary will be taxed at his or her lower tax bracket. This same strategy can reduce the overall 3.8% net investment income tax.

estate-planning-basics-when-why-and-howBIZ TIP: Estate Planning Basics: When, Why, and How

Planning is done similarly to year-end planning, predicting income/expenses (and distributions already made) from the best available information (for the trust and beneficiaries).

One final point bears repeating, keep in mind that the potential tax savings of implementing the 65-day Rule may not be appropriate, for instance, if a trust intends to retain all of its income for younger beneficiaries. In this type of case, you would not want the “tax tail to wag the dog.”

If you have questions about your trust and estate planning, contact SVA.

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Biz Tip Topic Expert: Richard Kollauf - JD, CPA, CFP, AEP

Richard Kollauf - JD, CPA, CFP, AEP

Richard is a Principal for SVA Certified Public Accountants and has more than 35 years of experience working in financial, accounting, and legal operations. Richard’s expertise in the multi-faceted financial environment includes business succession planning, tax, investments, finance, mergers and acquisitions, estate planning, and trust administration. He also has experience in estate planning and distribution for complex operational and investment multi-state businesses. Richard provides income tax consulting services to closely-held and family-owned businesses, as well as high net worth individuals.

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