3.8% “Medicare Surtax” Encourages Us to Revisit an Old Friend – The 65-Day Rule

By Jean McDevitt Bullens December 1, 2013

The new-for-2013 net investment income tax applies not only to individual taxpayers but also to estates and most types of non-grantor trusts.  While the tax relative to estates and trusts is similar to that of individuals, the threshold amounts and certain key mechanics differ.

For estates and trusts, the 3.8% surtax is levied against the lesser of undistributed net investment income, or the excess of adjusted gross income over the amount at which the highest tax bracket begins for the tax year. For 2013, the bracket threshold is $11,950, which is substantially less than the threshold for individuals.

As we approach tax filing season, we should recall from our arsenal of tools the IRC Section 663(b) election – referred to colloquially as the “65-day rule.” The election allows a trustee to treat distributions to beneficiaries made within 65 days following the close of the tax year as being paid on the last day of that tax year.  This allows one last opportunity to manage the income of the trust, which could be a particular advantage with respect to minimizing the net investment income tax.  The election must be made on Form 1041 and the return must be timely filed by the due date, including extensions.  The election, once made, is irrevocable.

An overall tax advantage will be gained if the trustee makes distributions to beneficiaries – assuming the individuals will not be personally subject to the surtax.  It is important to view the total impact of the decision—decrease in trust tax liability compared to increase in individual liability—when making the final decision.  In addition, there may be non-tax reasons that would argue for retaining assets within the trust even if there is a higher tax cost in doing so.

Essential to the discussion of the 65-day rule is an understanding of what constitutes undistributed net investment income.  Undistributed net investment income equals net investment income less beneficiary distributions.  To be advantageous, the distributed amounts must be includible in the computation of Distributable Net Income (DNI).  Not all distributions from the trust will be includible as part of DNI.

Capital gains are often retained as principal and unable to be treated as part of DNI.  These gains become trapped at the trust level and will be subject to the surtax unless they can be both distributed to beneficiaries and included in DNI.  Capital gains may be included in DNI in the following instances:

1. The governing instrument or state law provides that capital gains are included in trust income;
2. capital gains are allocated to principal but the trustee makes a regular practice of treating the proceeds as part of the beneficiary’s allowable distribution by recording it as such in the trust’s records, consistently treating it as such on the trust’s tax returns, and utilizing the amount of the net proceeds to calculate the beneficiary’s allowable distribution;
3. the governing instrument requires the trustee to sell trust property and distribute the proceeds;
4. the distributions are in full or partial liquidation of the trust; or
5. the capital gains flowing from a partnership Schedule K-1.

If capital gains are treated as distributable to the beneficiary for DNI purposes, the income is passed from the trust to the individual and taxed at the individual level.

The 65-day rule allows the trustee to compute DNI for the prior year and compare that amount to distributions already made during the year. If DNI for the year exceeds the distributions made during the calendar year, the balance may be made to beneficiaries by way of this election.  For the 2013 tax year, a distribution by March 6, 2014 will be treated, if properly elected, as having been made on the last day of 2013.

If you are interested in discussing the impact of this strategy, please contact Jean McDevitt at 1.800.244.7444.