Trust Investment Income subject to Medicare Surcharge


The Health Care and Education Reconciliation Act of 2010 imposes a Medicare contribution tax of 3.8% on unearned income of individuals, estates, and trusts. The net investment income tax applies to most trusts and estates beginning January 1, 2013. Trusts that are treated as business entities, certain state-law trusts, tax-exempt trusts, and grantor trusts are exempt from the tax.

  • For estates and trusts, the tax is 3.8% of the lesser of (1) the undistributed net investment income for the tax year or (2) the excess (if any) of (a) the Adjusted Gross Income (AGI) for the tax year, over (b) the dollar amount at which the highest tax bracket in Internal Revenue Code § 1(e) begins for the tax year ($11,950 for 2013). An individual beneficiary of the trust, however, is not subject to the tax until his or her Modified Adjusted Gross income (MAGI) exceeds $250,000 if married filing jointly, or $200,000 if filing as a single individual.
  • Besides portfolio income and net gain from the disposition of property (other than from property held in an active trade or business), net investment income includes income from a passive trade or business activity and from a trade or business of trading in financial instruments or commodities and net gain from property held in either of these two types of trades or businesses.
  • Undistributed net income of a trust or estate is its net investment income reduced by the share of net investment income included in deductible distributions.

The American Taxpayer Relief Act of 2012 also raised the maximum marginal tax rate on ordinary income and capital gains of trusts with taxable income exceeding $11,950 to 39.6% and 20%, respectively. (An individual beneficiary of a trust is not subject to these higher marginal tax brackets until his or her taxable income exceeds $450,000 for married filing jointly or $400,000 filing as a single individual.) Trustees may receive pressure from beneficiaries to make distributions to reduce or eliminate the tax and reduce the overall effective tax rate on trust income. Trustees need to remember to consider the maturity of the beneficiary, potential loss of creditor protection, potential exposure to future estate taxes, and risk of loss related to future divorce of a beneficiary.

The income tax expense of trusts and estates retaining taxable income at the trust level has increased significantly on net investment income. Fiduciaries must consider reconfiguring investments in light of after-tax returns on current holdings. Actions they might consider include investing in tax-exempt securities and adding a trust fiduciary that materially participates in trade or business activities held by the trust or pass-through entities it owns.