There is a 3.8% additional Medicare tax imposed on trusts and estates that have net investment income over a threshold amount (Code Sec. 1411). This tax is called the net investment income (NII) tax. Final regulations issued in November of 2013 and corrected last month provide some guidance for fiduciaries of estates and trusts (T.D. 9644, 11/26/13; corrections 2/24/14). The regulations generally are effective for tax years beginning after December 31, 2013. However, for 2013, the year for which the NII tax first applies, taxpayers can rely on proposed regulations issued in 2012.
Overview of the NII tax
The NII tax is imposed on the lesser of the trust or estate’s net investment income or the excess of its adjusted gross income over a threshold (Code Sec. 1411(a)(2)). The threshold is the dollar amount for the start of the highest tax bracket for trusts and estates ($11,950 for 2013; $12,150 for 2014).
Adjusted gross income for a trust or estate is generally figured in the same way as for individuals. Special rules apply to certain costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate (Code Sec. 67(e)). Deductions are provided under Code Secs. 642(b) for personal exemptions (e.g., $600 for estates, $300 for simple trusts, and $100 for complex trusts). Special rules apply to the computation of distributable net income (DNI) under Code. Sec. 651, and for distributing accumulated income or corpus under Code. Sec. 661.
Exempt trusts
Certain domestic trusts are not subject to the NII tax. These include charitable remainder trusts exempt from tax under Code. Sec. 664 and qualified retirement plan trusts exempt under Code Sec. 501(a). The following are also exempt:
- Trusts where all of the unexpired interests are devoted to charitable purposes (Code Sec. 170(c)(2)(B))
- Grantor trusts (Code Secs. 671-679)
- Electing Alaska Native Settlement Funds (Code Sec. 646)
- Perpetual Care (Cemetery) Trusts (Code Sec. 642(i))
- Trusts not treated as such for federal income tax purposes, such as real estate investment trusts (REITs) and common trust funds
Net investment income
Most trusts and estates will have adjusted gross income over the threshold amount, so they likely will be subject to the NII tax. The amount of tax depends on the entity’s net investment income. Net investment income is simply investment income reduced by investment expenses.
Investment income. It includes such income items as interest, dividends, capital gains (from the sales of stocks, bonds, and mutual funds; mutual fund distributions; and gains from investment property sales), rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities.
Investment income does not include wages, unemployment compensation, operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends, and distributions from qualified retirement plans and IRAs (those described in Code Sections 401(a), 403(a), 403(b), 408, 408A, or 457(b)).
Whether business income is investment income generally follows the passive activity loss rules (Code Sec. 469). Unless there is material participation, the activity is passive and the income is investment income for purposes of the NII tax. The issue of material participation for estates and trusts is currently under study by the Treasury Department and the IRS and likely will be addressed in regulations under Code Sec. 469 for the passive activity loss rules (Preamble to T.D. 9644; Reg. Sec. 1.469-8 is reserved for this purpose). In the absence of regulations, trusts and estates have only conflicting guidance to review in determining whether material participation should be based solely on the activities of fiduciaries or can take activities of beneficiaries and employees into account.
- IRS position: The participation of a beneficiary or anyone else, other than a trustee with suitable discretion, is not taken into account for purposes of determining material participation and whether the business income is passive (investment) income. For example, one trust named a “special trustee” who happened to be the president of the S corporation owned by the trust. The IRS said that the participation of this special trustee is not taken into account because his activities as president were not in the role as fiduciary (TAM 201317010; see also TAMs 200733023 and 201029014). There are seven tests for material participation (Reg. Sec. 1.469-5T(a). Moreover, special rules apply for “real estate professionals” (the 750-hour test). At present, it is unclear whether the same test would apply to a fiduciary. Instead, the fiduciary must be involved directly in the operations of the business on a “regular, continuous, and substantial” basis.
- Court position: Where a trust owned a ranch and the trustee hired a ranch manager and employees, a district court said that there was material participation for purposes of the passive activity loss rules where the trustee had ultimate decision making authority over the financial matters for the ranch (the case pre-dates the NII tax and did not consider the issue in the context of the NII tax) (Mattie K. Carter Trust, DC TX, 256 F Supp.2d 536 (2003)). The court said “[c]ommon sense dictates that the participation of Carter Trust in the ranch operations should be scrutinized by reference to the trust itself, which necessarily entails an assessment of the activities of those who labor on the ranch, or otherwise in furtherance of the ranch business, on behalf of Carter Trust.”
Note: The Tax Court may weigh in soon in the case of Frank Aragona Trust (Doc.
No. 15392-11) in which the taxpayer argued that in determining material participation with respect to rental properties the trust can perform personal services for purposes of Code Sec. 469 through the personal efforts of a non-trustee.
Investment expenses and other deductions. Investment income is reduced by deductions properly allocable to investment income, such as investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in net investment income.
Carryovers allowed for regular tax purposes, such as excess net investment income and unused passive activity losses, can be used as well for the NII tax (special rules apply to net operating losses). However, tax credits that can be used only to offset the regular tax, such as the foreign tax credit and the general business tax, cannot be used to offset the NII tax. If the entity opts to treat foreign taxes as a deduction rather than as a credit, then this item reduces net investment income.
Special computational rules for certain entities
Certain trusts require special computations for the NII tax:
Qualified funeral trusts. Each beneficiary’s interest in that beneficiary’s contract is treated as a separate trust but one consolidated Form 8960 can be completed for all beneficiary contracts subject to the NII tax. Instructions to Form 8960 provide details about the computation.
Electing small business trusts (ESBTs). ESBTs in S corporations figure the NII tax in three steps:
1. The ESBT separately figures the undistributed net investment income of the S portion and non-S portion according to the general rules used for income tax purposes and then combines the undistributed net investment income of the S portion and non-S portion.
2. The ESBT determines AGI for purposes of the NII tax by adding the net income or net loss from the S portion to the AGI of the non-S portion as an income item of income or loss.
3. The ESBT compares the combined undistributed net income with the excess of its AGI over the threshold for the year (e.g., $12,150 for 2014) to determine whether the NII tax applies.
Bankruptcy estates of an individual. The estate of an individual debtor is treated as an individual for purposes of the NII tax. The applicable threshold for the NII tax is the applicable amount for a married person filing separately ($200,000), regardless of the debtor’s actual tax filing status.
Foreign trusts and estates. Distributions to a U.S. person of income from a foreign entity are included in the net investment income calculation of this person (beneficiary). However, distributions of accumulated income from a foreign trust are not taken into account.
Planning strategies
In view of the NII tax, which is a nearly 4% tax on net investment income, it may be helpful to employ certain strategies that can reduce or eliminate the tax.
Grantors with multiple beneficiaries may, in certain circumstances, prefer to set up separate trusts for each beneficiary. This will allow each trust to keep no more than the triggering amount of taxable income ($12,150 in 2014) and, thus, avoid the NII tax. On the other hand, a single trust reduces administrative costs and may enable better property management. Separate trust shares should be considered. Thus, tax savings from using multiple trusts should be balanced against the cost and practicalities of a single trust.
An important tax savings strategy for existing trusts and estates is to distribute the income to lower-bracketed beneficiaries. This shifts the onus of the NII tax to beneficiaries who, because of their personal tax status, may not be subject to this tax. If the beneficiaries are exempt from the NII tax, there may be added pressure on fiduciaries to make income distributions in the situation where they have the discretion, under the governing instrument and state law, to do so. Fiduciaries must continue to follow state law rules and the terms in the governing instrument (a trust document or last will and testament) regarding discretionary distributions. Attention should be given to the rules under the Uniform Principal and Income Act and the applicable state law.
Fiduciaries should also maximize the use of the discretionary allocation of expense rule under Reg. Sec. 1.652(b)-3(b)). This allows the fiduciary to allocate expenses to any class of income after the required allocation of direct expenses to the associated income category and the required allocation of a share of indirect expenses to tax-exempt income. For example, if expenses for fiduciary fees, accounting fees, and legal fees can be allocated to categories of income that are investment income, the NII tax exposure is reduced. If the entity holds a business that is considered active (see the discussion of material participation above), not allocating expenses to the category of business income is beneficial because it means the expenses can be allocated to investment income categories. These rules will likely be addressed in forthcoming treasury regulations.
Be sure to factor the NII tax into estimated tax payments for trusts and estates. Estates are not required to pay estimated taxes during the first two years of their existence. Thus, it may be helpful for a revocable living trust of a deceased taxpayer to make a Sec. 645 election to be treated as a qualified revocable trust. This makes the trust part of the estate, for at least two years following the decedent’s death, exempt from aying estimated taxes. The election is made on Form 8855.
Conclusion
Despite lengthy regulations issued last year and extensive instructions to Form 8960 released on February 27, 2014, there are still many open questions regarding the NII tax applicable to trusts and estates, such as how to determine material participation and the deduction allocation provisions. Watch for further guidance from the IRS on this topic.
Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.
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