We all know that the fiscal cliff legislation, officially known as the American Taxpayer Relief Act of 2012 (“ATRA”) made the estate, gift, and generation-skipping tax exclusion “permanent” (whatever that means in Washington) at $5 million (inflation adjusted). But, the legislation also included increases in income tax rates for high-earners. In fact, for couples earning more than $450,000, the top ordinary income tax rate went up to 39.6% and the rate for long-term capital gains and qualified dividends went to 20%.

In addition to the fiscal cliff changes, the 3.8% surcharge from “Obamacare” brings the new capital gains tax for high-earners in 2013 to 23.8% from only 15% in 2012. This is nearly a 59% increase in the tax rate, literally overnight. How can you help your clients in examining the existing laws to minimize the hit of these new taxes?

One way is to educate them on the availability of a Charitable Remainder Trust (“CRT”). A CRT is a tried and true strategy. This is not some newfangled, risky strategy. It is officially recognized in the tax code as a way to encourage giving to charity. With a CRT, an asset can be contributed and a charitable deduction is obtained, within limits.

Also, the income tax on any built-in gains is deferred. Of course, the gains are deferred until you sell the asset or otherwise trigger realization anyway. With a CRT, the gains are deferred even after the realization would have been triggered. This can be particularly attractive to clients now, when capital gains rates have just increased.

A CRT is a tax exempt entity and pays no tax itself. However, when distributions are made, they are taxed to the non-charitable beneficiary, who is ordinarily the client during the term of the trust. The distributions are “flavored” or “characterized” based on the history of what would have been taxed to the trust, had it been an ordinary taxpayer. So, if the trust sold a stock and recognized a capital gain, the distribution would be taxed to the non-charitable beneficiary as capital gain income. I’ll look at a more detailed example in my next blog posting.

However, this is a way to defer the recognition of income for many years. If the client / taxpayer is going to be retiring or otherwise will reduce their income in the future, the capital gain income might be taxed at a lower rate in future years. This might also be advantageous if the client were moving from a state with a high state income tax (like New York or California) to a state with no state income tax (like Florida or Nevada).

Clients may be particularly interested in hearing more about this strategy this year, when the sting of the newly increased tax rate is still smarting.

Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (800) 846-1555
www.aaepa.com