Advisor opportunity: Taxable trusts

In my discussions with advisors on tax-managed investing, one of the ideas that frequently comes up is taxable trusts. Why? Because the current progressive IRS tax rates can make the value of tax-managed investing an excellent fit for these types of accounts. In turn, taxable trusts can be an excellent area for advisors to look for new business. However, before launching headlong into pursuing these potential opportunities, it helps to brush up on a few of the basics.

The purpose of taxable trusts

Trusts are often established in an effort to assist families reduce the gift or estate taxes incurred when passing wealth to children, grandchildren, or other beneficiaries. Many trusts have to pay tax on the income generated from stocks, bonds, mutual funds, etc. that is not distributed to the beneficiaries. These tax rates are much more progressive than those paid by individuals and are an attempt by the IRS to keep people from sheltering assets. This is why tax-managed investing can be such a great solution to help fulfill the fiduciary duty on these accounts. Advisors may not only significantly benefit from being on the look-out for taxable trusts and related opportunities, but these opportunities  may  be easier to find than many advisors assume. In 2014, over 3.2 million trust tax returns were filed with the IRS.¹ That’s more than the number of C-Corp (IRS Form 1120) filings in the same year. Odds are good that many advisors already have a client or a prospect who is thinking about setting up a trust (the grantor), who is the fiduciary or a beneficiary of a trust, or the tax preparer of taxable trusts (IRS Form 1041).

How taxable trusts are taxed

Source: Internal Revenue Service Consider the following regarding the progressive nature of these rates:

• The trust hits the 25% marginal rate at income above $2,500. A married couple filing jointly would not touch this rate until taxable income of $74,901.
• The trust hits the top marginal rate (39.6%) at income above $12,300. A married couple filing jointly would not touch this rate until taxable income of $464,851.
• Note, the tax rates above do not include the 3.8% additional tax on net investment income tax associated with the Affordable Care Act. For a married couple, this 3.8% applies to modified adjusted gross income (MAGI) above $250,000. Trusts get the pleasure of paying the 3.8% at MAGI above $12,300.

The impact to investment accounts

At these low taxable income levels for the top rates, the trust investment size does not need to be that large to hit the top rate. Consider the following example:

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¹ Source: Internal Revenue Service. Most current available: 2014.