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The little-known tax provision that every estate planner should know about

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As the close of 2014 neared, many estate planners and their clients were probably getting nervous about what moves they needed to make before end of year. With the holidays at hand, December was not an especially propitious time to be executing, for example, distributions from trusts.

Fortunately, there’s a fair amount of leeway for many of these transactions. The so-called 65-day rule — originally enacted as part of the Taxpayer Relief Act of 1997 — allows some trust distributions to be made into the New Year and still apply toward 2014.

It’s important for clients to recognize the benefits of this provision, not just before the tax year ends but into the first couple of months of the New Year, when they can still make changes that will affect their 2014 planning. Clients who are considering setting up a trust may also want to be apprised of the flexibility they can potentially have.

One especially useful tax planning strategy for trustees of irrevocable trusts is to make distributions to trust beneficiaries who are in lower income tax brackets. For a non-grantor trust, the portion of annual income retained in the trust is taxed to the trust.

If that income is distributed to the beneficiaries, those beneficiaries are taxed on that income. Capital gains are generally taxed as part of the trust whether or not the proceeds are distributed to the beneficiary.

This is particularly important because trusts have such compressed income tax brackets. The graduated tax rate for a non-grantor trust reaches the highest possible marginal tax rate of 39.6 percent at just $12,150 of taxable income, at 2014 rates. The 3.8 percent Medicare surtax applies to this income as well, so the total marginal tax charged to the trust would be 43.4 percent. 

Individual filers don’t reach that level until their income levels get very high: less than 1 percent of all individual taxpayers would meet that threshold. Married individuals filing a joint return reach this maximum tax rate at $457,600 in the 2014 tax year, while single individuals reach this maximum threshold at income of $406,750.

A key factor guiding the determination on whether to make distributions is the beneficiaries’ tax bracket. The 65-day rule allows the trust to wait 65 days from the start of the New Year — until March 5th — to decide whether such distributions would be useful. That should be more than enough time for a beneficiary’s accountant to determine that person’s tax rate for 2014.

It’s not automatic that the trust should want to distribute a much income as possible. Due to certain rules that apply to individuals but not to trusts, the maximum tax bracket for individuals is slightly higher than the maximum tax bracket for trusts. When the beneficiary falls into that top bracket, it may work out better for the trust to pay tax on the income than for the beneficiary. The 65-day rule makes conducting that cost/benefit analysis easier.

A few other simple principles to remember when dealing with this rule:

  • The 65-day rule is potentially the most useful in a year when the tax rates have increased, as we saw when 2012 turned into 2013. That’s not the case this year.

  • The rule applies only to complex trusts. With simple trusts, the distributions are made as often as the trust documents require them to be. Complex trusts provide more leeway to the trustee.

  • There may also be state tax consequences arising from the distribution from the trust. Before any distributions are made in that 65-day window, it would be important to consider the state tax implications as well.

The 65-Day rule is one of those little-discussed provisions that can make a big difference in end-of-year tax and estate planning. Proactive estate planners should make sure their clients are aware of this useful tactic — even those who are still considering whether to establish a trust. The more weapons there are in one’s arsenal, the better.