net investment income tax on estates and...

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Net Investment Income Tax on Estates and Trusts

Instructor:Tracey Spivey

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ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY MONTGOMERY COSCIA

GREILICH LLP TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE

PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER

PARTY ANY MATTERS ADDRESSED HEREIN.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax

adviser.

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DATED MATERIAL

THE INFORMATION CONTAINED IN THESE COURSE MATERIALS IS CURRENT AS OF THE DATE PRODUCED. THE MATERIALS HAVE NOT BEEN AND WILL NOT BE

UPDATED TO INCORPORATE ANY TECHNICAL CHANGES TO THE CONTENT SINCE THE PRODUCTION DATE, WHICH IS INDICATED AT THE BOTTOM OF EACH

PAGE. YOU ARE RESPONSIBLE FOR VERIFYING WHETHER OR NOT THERE HAVE BEEN ANY

TECHNICAL CHANGES SINCE THE PRODUCTION DATE.

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Net Investment Income Tax

• Brief History

• Overview

• Calculation of NIIT for Estates and Simple/Complex Trusts

• Calculation of NIIT for ESBTs

• CRTs

• Grantor Trusts

• Foreign Estates and Trusts

• Trade or Business Activities

• Planning Considerations

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On March 30, 2010, President Obama signed into law the Health Care and Education Reconciliation Act of 2010, which created two new "Medicare" taxes, including the Net Investment Income Tax (“NIIT”) under IRC §1411

On June 28, 2012, the Supreme Court upheld the constitutionality of the Act in National Federation of Independent Business v. Sebelius

On December 5, 2012, IRS issued proposed regulations

On December 2, 2013, IRS issued final regulations and new proposed regulations

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For tax years beginning after December 31, 2012, a 3.8% Medicare tax applies to net investment income if modified adjusted gross income (for individuals) or adjusted gross income (for estates and trusts) exceeds certain thresholds:

• Married filed jointly: $250,000 • Married filed separately: $125,000 • Single: $200,000 • Estates and Trusts: $11,950 (2013) and $12,150 (2014)

The tax applies to the lesser of net investment income or the excess of (M)AGI over the threshold amount

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Generally applies to all estates and trusts (Treas. Regs. §1.1411-3(a)(1))

Select exceptions from NIIT:

• A trust or estate all of whose unexpired interests are devoted to charitable purposes (Treas. Regs. §1.1411-3(b)(1)(i))

• A trust exempt from tax under IRC §501 (Treas. Regs. §1.1411-3(b)(1)(ii))

• Charitable Remainder Trusts (Treas. Regs. §1.1411-3(b)(1)(iii))

• Grantor trusts (Treas. Regs. §1.1411-3(b)(1)(v))

• Foreign estates and trusts (Treas. Regs. §1.1411-3(b)(1)(ix) and (viii))

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Net investment income includes:

• Bucket 1 - Portfolio income (interest, dividends, royalties, rents and annuities) not derived in the ordinary course of a trade or business (IRC §1411(c)(1)(A)(i))

• Bucket 2 - Gross income from a passive activity (IRC §1411(c)(1)(A)(ii) and (2)(A))

• Bucket 3 - Net gains on dispositions of property not in an “active” trade or business (IRC §1411(c)(1)(A)(iii) and (2)(A))

• Bucket 4 - Gains from a trade or business of trading financial instruments or commodities (IRC §1411(c)(1)(A)(ii) and (2)(B))

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Net investment income does not include:

• Items excluded from gross income (Treas. Regs. §1.1411-1(d)(4)(i))

‒ Municipal bond interest‒ Gain on sale of principal residence

• Distributions from IRAs and qualified plans (IRC §1411(c)(5) and Treas. Regs. §1.1411-8))

• Self-employment income (IRC §1411(c)(5)) and Treas. Regs. §1.1411-9)

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Allowable deductions:

• Deductions reasonably allocable to net investment income (IRC §1411(1)(B))

‒ Net Operating Loss (IRC §172 and Treas. Regs. §1.1411-4(f)(2)(iv))

‒ Investment interest expense (IRC §163(d)(1) and Treas. Regs. §1.1411-4(f)(3)(i))

‒ Investment expenses (IRC §163(d)(4)(C) and Treas. Regs. §1.1411-4(f)(3)(ii))

‒ State, local and foreign income taxes (IRC §164(a)(3) and Treas. Regs. §1.1411-4(f)(3)(iii))

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• Deductions reasonably allocable to net investment income (IRC §1411(1)(B))

‒ Estate tax allocated to IRD (IRC §691(c) and Treas. Regs. §1.1411-4(f)(3)(v))

‒ Tax return preparation (and related) fees (IRC §212(3) and Treas. Regs. §1.1411-4(f)(3)(vi))

‒ Amortizable bond premium (IRC §171(a)(1) and Treas. Regs. §1.1411-4(f)(3)(vii))

‒ Fiduciary fees (Treas. Regs. §§1.212-1(i) and 1.1411-4(f)(3)(viii))

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• Miscellaneous deductions subject to the 2% floor for income tax purposes are allowed after the application of the 2% floor on (Treas. Regs. §1.1411-4(f)(7))

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The tax base is the lesser of the undistributed net investment income or the excess of the adjusted gross income over the dollar amount at which the highest marginal tax bracket begins for the tax year (IRC §1411(a)(2)(A) and (B))

Tax is calculated on Form 8960

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Example #1:

• In 2013 Trust had AGI of $240,000, made up of the following types of income:

‒ Taxable interest: $75,000‒ Dividends: $25,000‒ Net income from a passive activity: $40,000‒ Net income from a non-passive activity: $45,000‒ Long-term capital gain (allocated to principal): $55,000

Trust made no distributions in 2013

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Example #1:

• Calculate DNI

DNI - DNI - DNI -Total Beneficiary Trust

Taxable Interest 75,000 0 75,000

Dividends 25,000 0 25,000

Passive Income 40,000 0 40,000

Non-Passive Income 45,000 0 45,000

LTCG - - -

Totals 185,000 - 185,000

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Example #1:

• Calculate undistributed NII

NII - NII - NII -Total Beneficiary Trust

Taxable Interest 75,000 0 75,000

Dividends 25,000 0 25,000

Passive Income 40,000 0 40,000

Non-Passive Income - - -

LTCG 55,000 0 55,000

Totals 195,000 - 195,000

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Example #1:

• NIIT equals $7,410 ($195,000 X 3.8%)

‒ ($75,000 + $25,000 + $40,000 + $55,000) = $195,000

‒ ($240,000 - $11,950) = $228,050

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Example #2:

• In 2013 Trust had AGI of $240,000, made up of the following types of income:

‒ Taxable interest: $75,000‒ Dividends: $25,000‒ Net income from a passive activity: $40,000‒ Net income from a non-passive activity: $45,000‒ Long-term capital gain (allocated to principal): $55,000

Trust made distributions of $100,000 in 2013

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Example #2:

• Calculate DNI

DNI - DNI - DNI -Total Beneficiary Trust

Taxable Interest 75,000 40,540 34,460

Dividends 25,000 13,514 11,486

Passive Income 40,000 21,622 18,378

Non-Passive Income 45,000 24,324 20,676

LTCG - 0 -

Totals 185,000 100,000 85,000

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Example #2:


NII - NII - NII -Total Beneficiary Trust

Taxable Interest 75,000 40,540 34,460

Dividends 25,000 13,514 11,486

Passive Income 40,000 21,622 18,378

Non-Passive Income - - -

LTCG 55,000 - 55,000

Totals 195,000 75,676 119,324

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Example #2:

• NIIT equals $4,534 ($119,324 X 3.8%)

‒ ($34,459 + $11,486 + $18,378 + $55,000) = $119,324

‒ ($240,000 - $11,950) = $228,050

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ESBTs:

• S portion and non-S portion are treated as separate trusts for determining undistributed net investment income (Treas. Regs. §1.411-3(c)(1))

• Entire trust is treated as a single trust for purposes of determining the amount subject to the NIIT (Treas. Regs. §1.411-3(c)(1))

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ESBT Example (Treas. Regs. §1.1411-3(c)(3)):

• In 2013 ESBT received the following types of income:

‒ Taxable interest: $10,000‒ Dividends: $15,000‒ Long-term capital loss (allocated to principal): $5,000‒ Rental income (ESBT): $21,000‒ Long-term capital gain (ESBT): $7,000

Trustee’s fee of $1,000 is allocated 60% to non-ESBT portion and 40% to the ESBT portion

Trust made distributions of $9,000 in 2013

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ESBT Example:


Non-ESBT ESBT

Taxable Interest 10,000 -

Dividends 15,000 -

Rental Income - 21,000

LTCG/(L) (3,000) 7,000

Trustee's Fee (600) (400)

Distribution Deduction (9,000) -

Undistributed NII 12,400 27,600

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ESBT Example:


Undistributed NII - Non-ESBT 12,400

Undistributed NII - ESBT 27,600

Total Undistributed NII 40,000

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ESBT Example:

• Calculate AGI

Taxable Interest 10,000

Dividends 15,000

Rental Income -

LTCG/(L) (3,000)

Trustee's Fee (600)

Distribution Deduction (9,000)

ESBT Net Income 27,600

AGI 40,000

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ESBT Example:

• Calculate NIIT

NIIT equals $1,066 ($28,050 X 3.8%)

‒ ($12,400 + $27,600) = $40,000

‒ ($40,000 - $11,950) = $28,050

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CRTs:

• Net investment income received by a CRT and distributed to a beneficiary retains its character as net investment income in the hands of the beneficiary (Treas. Regs. §1.1411-3(d)(1))

• Accumulated Net Investment Income (“ANII”) of a CRT is equal to all of the net investment income received by the CRT after December 31, 2012 less the total amount of net investment distributed for all prior taxable years that begin after December 31, 2012 (Treas. Regs. §1.1411-3(d)(1)(iii))

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CRTs:

• Determination of net investment income distributed to beneficiary follows income tax characterization of distribution under “WIFO” tier system of IRC §664(b) (Treas. Regs. §1.1411-3(d)(2)(i))

‒ Form 5227, Part I-A

• An elective “simplified” method of determining NII distributed to a beneficiary is available (Prop. Regs. §1.1411-3(d)(3))

‒ Form 5227, Part I-B

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CRT Example (Treas. Regs. §1.1411-3(d)(2)(iii)):

• As of January 1, 2013 CRT has the following types of undistributed income:

‒ Taxable interest: $4,000 (39.6%)‒ Non-qualified dividends: $2,000 (39.6%)‒ Rental income: $8,000 (39.6%)‒ Qualified dividends: $10,000 (20.0%)‒ Short-term capital gain: $39,000 (39.6%)‒ Unrecaptured Sec 1250 gain: $1,000 (25.0%)‒ Long-term capital gain: $560,000 (20.0%)

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CRT Example:

• In 2013 CRT received the following types of income:

‒ Taxable interest: $7,000‒ Qualified dividends: $9,000‒ Short-term capital gain: $4,000‒ Long-term capital gain: $11,000

CRT made distributions of $50,000 in 2013

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CRT Example:

• Character of distributionIncome NII

Total Distributed DistributedOrdinary Income

Taxable Interest - 43.4% 7,000 7,000 7,000 Taxable Interest - 39.6% 4,000 4,000 - Net Rental Income - 39.6% 8,000 8,000 - Non-QDI - 39.6% 2,000 2,000 - QDI - 23.8% 9,000 9,000 9,000 QDI - 20.0% 10,000 10,000 -

Capital Gain

STCG - 43.4% 4,000 4,000 4,000 STCG - 39.6% 39,000 6,000 - Unrecaptured Sec 1250 Gain - 25.0% 1,000 - - LTCG - 23.8% 11,000 - - LTCG - 20.0% 560,000 - -

Totals 655,000 50,000 20,000

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CRT Example:

• Accumulated Income and Net Investment Income (“ANII”) as of January 1, 2014

TotalAccum. Income ANII

Ordinary Income

Taxable Interest - 43.4% - - Taxable Interest - 39.6% - - Net Rental Income - 39.6% - - Non-QDI - 39.6% - - QDI - 23.8% - - QDI - 20.0% - -

Capital Gain

STCG - 43.4% - - STCG - 39.6% 33,000 - Unrecaptured Sec 1250 Gain - 25.0% 1,000 - LTCG - 23.8% 11,000 11,000 LTCG - 20.0% 560,000 -

Totals 605,000 11,000

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Grantor Trusts:

• The grantor or other deemed owner will be subject to the NIIT on the grantor trust’s NII under the application of the NIIT to individuals (Treas. Regs. §1.1411-3(b)(1)(v))

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Foreign Estates and Trusts:

• Foreign Estates are not subject to the NIIT (Treas. Regs. §1.1411-3(b)(1)(ix))

• Foreign Trusts are not subject to the NIIT (Treas. Regs. §1.1411-3(b)(1)(viii))

• A U.S. beneficiary who receives a distribution from a foreign estate or trust that includes NII is subject to the NIIT on the NII included in the distribution (Treas. Regs. §1.1411-3(e)(3)(ii))

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NIIT and Trade or Business Activities:

• Bucket 2 of income included in NII

• Lack of consistent guidance on determining whether or not a non-grantor trust materially participates in an activity:

‒ Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003)

IRS argued that material participation is determined with respect to only the trustee’s participation

District Court concluded that material participation should be determined by reference to all persons who conduct business on the trust’s behalf, including employees

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‒ PLR 200733023

IRS concluded that the activities of “special trustees” would not be considered in determining if the trust materially participates if they did not have authority to commit the trust without the approval of the trustee

‒ PLR 201029014

IRS reiterated that a trust materially participates in a business if the trustee is involved on a regular, continuous and substantial basis

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‒ TAM 201317010

IRS concluded that the activities of a special trustee who could vote or sell S Corp stock were not regular, continuous or substantial

IRS distinguished activities of the special trustee between those as trustee and those of an employee of the S Corp

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‒ Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014)

Tax Court held that a trust can qualify for the real estate professional exception

IRS argued that activities of co-trustees were attributable to their status as employees and individual investors, rather than trustee

Tax Court held that the activities of the co-trustees are considered in determining material participation since MI state law requires a trustee to administer the trust solely in the best interest of the beneficiaries and does not relieve a trustee’s duty of loyalty when activities are conducted through entities controlled by the trust

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• In the first year that the NIIT applies, taxpayers may regroup their activities for purposes of the passive loss rules and the NIIT (Treas. Regs. §1.469-11(b)(3)(iv))

‒ Passive loss limitations encourage passive income and non-passive losses

‒ NIIT encourages non-passive income and passive losses

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• A distribution of NII to a beneficiary retains its character as NII in the hands of the beneficiary (Treas. Regs. §1.1411-3(e)(3)(ii))

‒ If a trust that does not materially participate in an activity distributes income from that passive activity to a beneficiary who materially participates in that activity, the income will retain its character as NII for purposes of the beneficiary’s NIIT calculation

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• A QSST is deemed to own the S Corp stock (rather than the beneficiary) for purposes of determining how much gain is excluded from NII upon the disposition of the S Corp stock (Prop. Regs. §1.1411-7(a)(4)(iii)(C))

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Planning Considerations:

• Consider making discretionary distributions to beneficiaries who may not be subject to the NIIT (and subject to a lower marginal income tax rate)

‒ Consider appropriateness of IRC §663(b) election

‒ Consider state income tax consequences

‒ Beneficiaries subject to “Kiddie Tax” may need to file their own income tax returns (as opposed to parents filing Form 8615)

‒ Consider non-tax factors, such as control, creditor protection, divorce etc.

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• Consider including net capital gain in DNI (Treas. Regs. §1.643(a)-3(b))

‒ If allocated to income

‒ If allocated to principal but treated consistently in the trust’s books, records and tax returns as part of a distribution to a beneficiary

‒ If allocated to principal but actually distributed to a beneficiary

‒ Use of partnership or LLC to hold assets (see Crisp v. United States, 34 Fed. Cl. 112 (1995))

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• ESBT v. QSST

‒ NIIT threshold for ESBT is significantly lower than that of QSST beneficiary

‒ QSST provisions are not as flexible as those of ESBT

‒ ESBT may not be as income tax efficient as QSST

‒ Would non-QSST grantor trust be a possibility?

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• Trade or Business Activities

‒ Reconsider grouping for “one-time” election (discussed previously)

‒ Consider involvement in trade or business activities owned by a trust when selecting fiduciaries

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• Estate Administration

‒ Funding pecuniary bequests or obligations with appreciated property will result in capital gain, which may be included in NII

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