Jan 25, 2022

Potential Tax Benefits of Distributions in Early 2022 for Trusts and Estates

By Dalton Bradshaw, CPA

As the 2022 filing season quickly approaches, taxpayers may be considering options to reduce their upcoming tax liabilities. Due to the compressed tax brackets for trusts and estates, these considerations are of paramount importance. Typically, tax planning strategies are only applicable to the year in which the strategy is implemented, with no retroactive application. However, trusts and estates and their beneficiaries may find tax relief in Internal Revenue Code Section 663(b).

The referenced code section and Treasury Regulation Section 1.663(b)-1(a)(1), often referred to as the “65 Day Rule,” allow the fiduciaries of trusts and estates to elect to treat distributions to their beneficiaries within the first 65 days following the close of a taxable year, as being made on the last day of such taxable year. To implement this tax planning strategy for tax year 2021, the Trustee must issue distributions to the trust’s beneficiaries by March 6, 2022, and make an election on Page 3 of the trust’s 2021 Form 1041.

This rule enables some determination of how the taxable income should be allocated between the beneficiary and the trust to produce a lower aggregate tax, considering the respective tax brackets for the trust and its beneficiaries. By making these distributions, the income generated by the trust is shifted to the beneficiaries and is taxed at what tends to be the more favorable individual tax rates. While the concept of these distributions is rather simple, Trustees must carefully consider the amounts to distribute. To determine the proper amount to distribute, the Trustee must compare the taxable income and distributable net income of the trust with the taxable income of the trust’s beneficiaries. Since trusts enter the highest tax bracket (37%) once they exceed $13,051 of taxable income in 2021– individuals do not reach this bracket until their taxable income exceeds $628,301 for married filing jointly–many trusts will see a significant tax benefit from making these distributions.

To illustrate the benefits of these distributions, consider the following scenario of a complex trust with one beneficiary whose filing status is married filing jointly:

Trust Beneficiary
Distributable Net Income (DNI) $50,000 N/A
Taxable Year Distributions $10,000 N/A
Taxable Income $40,000 $180,000
Tax Bracket 37% 24%

 

As this trust currently stands, its tax liability is $11,764, assuming the taxable income is wholly attributable to ordinary income. In this situation, the most effective strategy would be to distribute, at a minimum, an additional $30,450 to the beneficiary during the 65-day window following the close of the trust’s taxable year. By making this distribution, the trust has shifted the portion of its taxable income that is in excess of the trust’s 24% bracket (income over $9,550 in 2021) to the beneficiary, while also preserving the remaining principal of the trust.

Once the distribution has been made, the outcome for this example would be as follows:

Trust Beneficiary
Distributable Net Income (DNI) $50,000 N/A
Taxable Year Distributions $10,000 N/A
663(b) Distributions $30,450 N/A
Taxable Income $9,550 $210,450
Tax Bracket 24% 24%

 

In this scenario, the trust’s tax liability is reduced by $9,971 to $1,793, while the beneficiary’s tax liability has only increased by $7,308. Therefore, the net tax savings between the trust and its beneficiary is $2,663.

While the tax savings in this example may be inconsequential to some, 663(b) distributions can provide much more significant tax savings for trusts with even higher income. Additionally, although the bulk of the tax burden shifts to the beneficiary in these situations, beneficiaries can use the additional distribution they receive to pay the additional taxes while retaining a portion of the distribution for themselves.

As with any tax strategy, the results are heavily dependent on your specific situation. Furthermore, considerations other than taxes may dictate that distributions should not be made regardless of the tax consequences. Even if this result is desirable from a tax standpoint, additional distributions may not be allowed according to the terms of the governing trust instrument, so remember to consult your trust attorney if you are unsure. If you have any questions or would like to analyze how utilizing these distributions could benefit you and your trusts, please contact your BMSS professional at (833) CPA-BMSS (272-2677).