shifting money

For certain discretionary trusts, distributions paid within 65 days after year end can, with the trustee’s election, be treated in whole or in part as if paid in the previous year. This election is referred to as the “65-day rule.” Making beneficiary distributions under the 65-day rule may allow for significant tax savings due to the differences in the trust and individual income tax brackets.

Trusts are subject to the highest tax rate of 37% when taxable income exceeds $13,050 for the tax year. In contrast, a single individual is subject to this highest Federal tax rate when his or her 2021 taxable income exceeds $523,600 for the year. The taxable income threshold is even higher for married couples who file a joint return, at $628,300.

Substantial differences in the tax brackets between individuals and trusts provide trustees with an opportunity to pass a trust’s income to beneficiaries who may be subject to lower tax rates. Income leaves a trust and passes out to beneficiaries in the form of distributions. Beneficiary distributions reduce the taxable income of the trust, and the beneficiary receives a share of the trust’s income and deductions reported on a Form K-1.

65 day-rule distributions give the trustee an advantage in the planning process by allowing him or her to review the trust and beneficiaries’ taxable income after the close of the tax year. The trustee can calculate the income for the trust and each beneficiary, determine the amount of beneficiary distributions for the year, and pay the distributions that will carry out the income to the beneficiaries. These distributions can reduce the trust’s income for the tax year so long as the distributions are paid within 65 days of the trust’s year-end (March 6, 2022). The trustee must also make an election on the trust’s income tax return. When reviewing planned 2022 distributions, the trustee should consider making larger distributions during the first 65 days of the year. This approach gives the trustee flexibility in working with the tax return preparer to determine the optimal allocation of distributions between the 2021 and 2022 tax years.

There are other important non-tax factors to consider before using this strategy. The trustee should review the trust instrument in detail to ensure that there are no restrictions on the nature and amount of the beneficiary distributions. Some trust instruments restrict the amount that can be distributed each year and set up classes of beneficiaries who are entitled to different benefits. It may be necessary for the trustee to consult with a trust or estate planning attorney to ensure that the distributions are permitted by the trust instrument. It may also be necessary for the trustee to work with a CPA to calculate the trust’s taxable income for the year and to determine which items may pass to beneficiaries. For example, capital gains generally remain taxed at the trust level and do not pass to beneficiaries.

65-day rule distributions are an effective strategy for reducing a trust’s tax burden. Executing this strategy requires a thorough understanding of the trust instrument as well as an accurate assessment of the trust and beneficiaries’ taxable income for the tax year. Please let us know if you are interested in learning more about 65-day rule distributions or if we can be of any help if you decide to take advantage of this opportunity.