Like individuals, trusts must pay taxes on earnings. Yet trusts vault into the highest bracket much quicker than individuals do: In 2014, trusts pay the maximum rate on any earnings above $12,150, while individuals can make as much as $406,750 before the top rate kicks in.
In addition, many trusts face a bigger income-tax bite when they file this year because of new higher rates on top earners that took effect in 2013. The maximum rate for trusts is 43.4%, now that the highest tax bracket has risen to 39.6% and there is also a new 3.8% surtax on net investment income for high earners.
As a result, trustees and financial advisers are aiming to lower their tax liability by increasing their distributions to beneficiaries, who are often in a lower tax bracket than the trust itself.
"It makes a whole lot more sense than usual to look at this," says Larry Maddox, president of Horizon Advisors, a Houston-based firm that manages around $230 million.
Trusts often are set up by deep-pocketed individuals to reduce or eliminate gift or estate taxes while passing on wealth to children or other beneficiaries. American families have long used trusts to pass assets to heirs; high-profile examples include the Rockefeller family trusts of 1934.
But trusts also pay tax on income from stock dividends, interest and other earnings.
Moving some of that income-tax liability to a beneficiary can generate big savings, experts say. For instance, a trust with $30,000 in taxable income that is set up for the benefit of a single individual with taxable income of $100,000 would owe $32,217 in combined 2013 taxes, if the trust made no distribution to the beneficiary, Mr. Maddox says.
But if the trust paid out $20,000 to the beneficiary, the total income-tax bill for the trust and the individual together would amount to $29,340, he says.
The trust's income-tax bill would fall from $10,923, paid at the 43.4% rate, to $2,446, paid at a lower 33% rate because the trust has less taxable income. The beneficiary would pay more in individual income tax—$26,893, as compared with $21,293. But because the beneficiary is in the 28% income-tax bracket, the combined savings to the trust and the beneficiary would be $2,877.
It can be important for trustees to run the numbers early in the new year, Mr. Maddox says, because the Internal Revenue Service allows trusts and beneficiaries to count any distribution made in the first 65 days of the year as income for the prior tax year.
Michael Puzo, a partner at Boston law firm Hemenway & Barnes who frequently serves as a trustee, says he and his fellow trustees will shift some trust income to individual beneficiaries, especially those in lower tax brackets, if a trust permits the move and a shift is otherwise in a family's interests.
At the same time, experts say, distributing funds from a trust could have consequences that overwhelm the benefit of potential tax savings.
Any strategy to pay out more to a beneficiary ought to take into account other current beneficiaries, and balance their needs with those of anyone who stands to inherit later on, they say. These may include future grandchildren, for example, or so-called remaindermen—those who stand to inherit whatever assets are left after current beneficiaries die.
Moreover, increasing payments to a child or college student could create new tax-filing obligations and raise questions about how the beneficiary will handle the money, says Michael Scherer, an adviser at Summit Financial Strategies, a Columbus, Ohio, firm that manages about $800 million.
Mr. Scherer says his firm is "absolutely" looking more closely at trust distributions, and in at least one case, it will recommend a bigger distribution for a trust beneficiary who dropped into a lower tax bracket.
Still, he says, "I feel it's more important to respect the purpose of the trust overall than to just make distributions for tax savings' sake."
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