Trusts and estates - year-end planning.

• Author: Nager, Ross W.

By substantially narrowing trust and estate income tax brackets, the Revenue Reconciliation Act of 1993 (RRA) encourages income distributions to lower-bracket beneficiaries. Although potentially a valid tax-saving strategy, there are numerous issues that should be addressed which may outweigh any potential income tax savings. Distributions in excess of a trust's current-year income can trigger an accumulation distribution and associated "throwback" tax calculation. The tax is based on the beneficiary's marginal income tax brackets for the five years preceding the throwback year. With many beneficiaries' brackets rising after 1992, it may be beneficial to accelerate accumulation distributions into 1994 and/or the next few years. With year-end approaching, note that trusts (but not estates) may elect under the "65-day" rule to treat distributions made through Mar. 6, 1995 as 1994 distributions to the extent of 1994 trust income, but these post-year-end distributions cannot trigger 1994 accumulation distributions.

Distributions to equalize brackets

The RRA dramatically narrowed income tax brackets for trusts and estates relative to those of individuals. For example, trusts and estates reach the 39.6% bracket at a mere $7,500 of taxable income. If a beneficiary's marginal rate is lower, a net income tax savings can be achieved by distributing trust/estate income.

However, there are numerous additional considerations that may prevent or outweigh the income tax savings of the rate differential:

* The trustee must have authority to make the distribution.

* Depending on the governing document's terms, accumulated income may pass to the beneficiary's descendants free of estate and gift tax, while distributed income adds to the beneficiary's estate. The transfer tax cost can far exceed the annual income tax savings.

* The "kiddie tax" applies to income distributed to children under age 14, but does not apply to income accumulated by the trust/estate.

* Distributed funds may be subject to a beneficiary's spending, creditors or, possibly, a spouse in divorce.

Accumulation distributions

If a trust accumulated income in prior years and distributes cash or property in excess of current-year income, generally an accumulation distribution occurs. An accumulation distribution is taxed to the beneficiary at the beneficiary's marginal tax rates in three of the five years immediately preceding the distribution year. (The highest and lowest taxable income years...