- Effective for tax years beginning after Dec. 31, 2012, the Sec. 1411 net investment income tax generally applies to estates and trusts. 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 for the tax year, over (b) the dollar amount at which the highest tax bracket in Sec. 1(e) begins for the tax year ($11,950 for 2013).
- 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 Health Care and Education Reconciliation Act of 20101 created new chapter 2A of the Code, imposing the net investment income tax, a Medicare contribution tax of 3.8% on unearned income of individuals, estates, and trusts. This article discusses how the new tax applies to trusts and estates.
In December 2012, the IRS published proposed regulations2 on Sec. 1411, which imposes the tax. At the time this article was written, the IRS was hoping to finalize the regulations during 2013. Until the final regulations are issued, taxpayers are permitted to rely on the proposed regulations, with the understanding that the IRS may review and challenge transactions that manipulate net investment income to avoid the new tax.
The net investment income tax applies to trusts and estates for tax years beginning after Dec. 31, 2012. Since almost all trusts are required to have a calendar year, most trusts became subject to the new tax on Jan. 1, 2013. Since estates are permitted to have a fiscal year, some portion of the unearned income of an estate during 2013 might not be subject to the tax. For example, an estate with a fiscal year end of Nov. 30 would not be subject to the tax until Dec. 1, 2013.
Estates and Trusts to Which the Tax Applies
The tax applies to estates and trusts that are subject to the provisions of part 1 of subchapter J of chapter 1 of subtitle A of the Code, governing general taxation of estates, trusts, and beneficiaries. Thus, business trusts that are treated as business entities are not subject to Sec. 1411 at the entity level. Also excluded are certain state-law trusts that are subject to specific taxation regimes in chapter 1 other than part 1 of subchapter J, including, for example, common trust funds and designated settlement funds. Sec. 1411 does apply, however, to pooled income funds, cemetery perpetual care funds, qualified funeral trusts, and certain Alaska native settlement trusts. (The Treasury Department and the IRS are requesting comments on whether there are administrative reasons to exclude one or more of these types of trusts from the application of Sec. 1411.)3
Because Sec. 1411 is in subtitle A of the Code, any trust, fund, or other special account that is exempt from taxes imposed under subtitle A is exempt from the tax Sec. 1411 imposes. This exclusion applies even if such a trust may be subject to unrelated business taxable income and even if that unrelated business taxable income contains net investment income.
Examples of such trusts are those that are exempt from tax under Sec. 501(a), such as charitable organizations formed as trusts and qualified plan trusts. Charitable remainder trusts also fall within this category. (Although a charitable remainder trust itself is exempt from the application of Sec. 1411, distributions from the charitable remainder trust to individuals are subject to Sec. 1411 to the extent such distributions consist of net investment income, as discussed below.)
Sec. 1411(e)(2) specifically excepts from the application of Sec. 1411 a trust, all of the unexpired interests in which are devoted to one or more of the purposes described in Sec. 170(c)(2)(B).4
Foreign Estates and Trusts
In general, Sec. 1411 does not apply to foreign estates and foreign trusts that have little or no connection to the United States. Treasury and the IRS have indicated, however, that they believe net investment income of a foreign estate or foreign trust should be subject to Sec. 1411 to the extent such income is earned or accumulated for the benefit of or distributed to U.S. persons. Treasury and the IRS have requested comments on this topic.5
Since distributions from foreign estates to U.S. beneficiaries in general are not subject to income tax in the United States (except for U.S.-source income), it would be more consistent with federal income tax principles for the distributions not to be subject to the net investment income tax. On the other hand, distributable net income of a foreign trust does include both U.S.-source and non-U.S.-source income. Accordingly, current-year distributions from a foreign trust to U.S. beneficiaries should be subject to Sec. 1411 to the extent such distributions consist of net investment income. Distributions from foreign trusts that consist of prior-tax-year accumulations of income arguably should not be subject to Sec. 1411 because such distributions lose their character for purposes of calculating the accumulation distribution tax. The final regulations will reveal Treasury’s position on this.
The tax under Sec. 1411 is not imposed on a grantor trust. If the grantor or another person is treated as the owner of all or a portion of the trust, any items of income, deduction, or credit that are included in computing taxable income of the grantor or other person are treated as if the items had been received by the grantor or other person for purposes of calculating such person’s net investment income.6
Estimated Tax Payments
The Sec. 1411 tax is subject to the estimated tax provisions, so fiduciaries should consider it when making their quarterly estimated tax payments.
Computation of the Tax for Estates and Trusts
In the case of an estate or trust, the Sec. 1411 tax is imposed for each tax year at a rate of 3.8% on 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 Sec. 1(e) begins for the tax year.7 For 2013, the highest tax bracket for estates and trusts begins at $11,950.
This threshold is much lower for estates and trusts than it is for individuals: modified AGI (MAGI) of $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all others.8 Thus, estates and trusts clearly operate at a disadvantage. Most trusts have only unearned income, and, thus, even modest-size trusts that retain income at the trust level rather than making distributions to beneficiaries probably are subject to the 3.8% tax.
Adjusted Gross Income
The AGI of a trust or estate is defined in Sec. 67(e) and computed in more or less the same manner as for an individual. Deductions, however, are permitted to estates and trusts for (1) personal exemptions, (2) the amount of any distributable net income distributed to beneficiaries, and (3) costs paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in such trust or estate.
The latter exception has been the subject of considerable controversy, with a Supreme Court decision holding that only expenses considered “uncommon or unusual” for a hypothetical individual to incur qualify for the Sec. 67(e) exception.9 In September 2011, the IRS issued Prop. Regs. Sec. 1.67-4 containing guidelines on how to apply the Court’s decision.10 One issue raised by these proposed regulations is how to deal with “bundled fiduciary fees.” The IRS would like to have trustees allocate a portion of their fees as an itemized miscellaneous deduction subject to the 2%-of-AGI floor under Sec. 67(a). In Notice 2011-37,11 the IRS indicated that taxpayers are not required to determine the portion of a bundled fiduciary fee that is subject to the 2% floor for any tax year beginning before the date the final regulations are published in the Federal Register. Since the regulations had not been finalized as this article was written in 2013, calendar-year trusts are not obligated to allocate bundled fiduciary fees for 2013.
Since a significant portion, if not all, of the income of most trusts is investment income, the excess of the trust’s AGI over the threshold will often determine the amount of the tax. For this reason, practitioners must be diligent when advising fiduciaries concerning issues and decisions with respect to computing AGI.
Net Investment Income
The other major factor in computing the tax for a trust or estate is undistributed net investment income. Defining “undistributed net investment income” requires an understanding of the meaning of “net investment income.”
Sec. 1411(c) defines net investment income as the excess of the sum of gross income or net gain from the following sources, over the deductions allowed by subtitle A (income taxes) that are properly allocable to such gross income or net gain:
Interest, dividends, annuities, royalties, and rents (nongain investment income) other than such income derived in the ordinary course of a trade or business not described in No. 2 or No. 3;
Income from a trade or business that is a passive activity (within the meaning of Sec. 469) with respect to the trust or estate (passive activity trade or business income);
Income from a trade or business of trading in financial instruments or commodities (as defined in Sec. 475(e)(2)) (trader income from financial instruments or commodities); and
Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in No. 2 or No. 3 (net gain income).
A full exploration of the meaning of net investment income is beyond the scope of this article. Many estates and trusts simply have interest, dividends, and capital gains. It is important to note that tax-exempt interest, such as interest earned on state and municipal bonds, is excluded from net investment income. Furthermore, Sec. 1411 specifically excludes from net investment income distributions from certain qualified plans, individual retirement accounts (IRAs), Roth IRAs, and certain deferred compensation plans of state and local governments and tax-exempt organizations.12 Also excluded from net investment income are any items taken into account in determining self-employment income upon which a tax is imposed under Sec. 1401(b).13
If a trust holds certain active (as opposed to passive) interests in partnerships and S corporations, gain from disposition of those interests is taken into account in net investment income only to the extent of the net gain that would have been so taken into account by the trust if all the property of the partnership or S corporation were sold for fair market value immediately before the disposition of the interest.14
Passive Activity of Estates or Nongrantor Trusts
It is important to consider in the context of a nongrantor trust or estate whether a trade or business activity is considered passive or active. If the estate or trust does not materially participate in the trade or business activity, the activity is considered passive. Sec. 469(h)(1) provides that a taxpayer materially participates in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. The instructions for Form 1041, U.S. Income Tax Return for Estates and Trusts, simply note that “[m]aterial participation standards for estates and trusts have not been established by regulations.”15
The Senate Finance Committee report for the Tax Reform Act of 1986,16 enacting Sec. 469, states, “Special rules apply in the case of taxable entities that are subject to the passive loss rule. An estate or trust is treated as materially participating in an activity (or as actively participating in a rental real estate activity) if an executor or fiduciary, in his capacity as such, is so participating.”17 The IRS position of looking to the activity of the trustee to determine material participation is consistent with the committee report, as reflected in Letter Ruling 20102901418 and Technical Advice Memorandum (TAM) 200733023.19
In Mattie K. Carter Trust,20 a district court held that a trust materially participated in its ranching activity, concluding that it was unnecessary to resort to the legislative history of the statute because the statute was clear on its face. The court reasoned that the taxpayer in this case was the trust, not the trustee, and that the statute and common sense dictated that the trust’s participation in the business operation should be scrutinized by reference to the trust itself. It logically followed that all the activities of those who labored in the business activity on behalf of the trust (not just the trustee) should be considered when determining whether the material participation requirement had been satisfied.
The IRS letter ruling and TAM clearly indicate the IRS will not follow the Carter Trust decision and will look to the activity of the trustee in applying the Sec. 469 tests. Ideally, therefore, if an estate or trust desires to obtain active status with respect to a trade or business, a fiduciary that has discretion to act on behalf of and bind the trust should be involved in the operations of the activity on a regular, continuous, and substantial basis.
Undistributed Net Investment Income
Undistributed net investment income of an estate or trust is its net investment income reduced by the share of net investment income included in deductions of the estate or trust under Sec. 651 or 661 for distributions to beneficiaries, and the share of net investment income allocated to a charitable deduction under Sec. 642(c) of the estate or trust. Thus, generally, to the extent that distributions of net investment income are made to noncharitable and charitable beneficiaries, the net investment income subject to the tax at the trust or estate level is reduced.
In computing the estate’s or trust’s undistributed net investment income, net investment income is reduced by distributions of net investment income made to beneficiaries. The deduction is limited to the lesser of the amount deductible to the estate or trust under Sec. 651 or 661, as applicable, or the net investment income of the estate or trust. In the case of a deduction under Sec. 651 or 661 that consists of both net investment income and “excluded income,” the distribution must be allocated between net investment income and excluded income in a way similar to the distribution deduction rules under Regs. Sec. 1.661(b)-1, as if net investment income constituted gross income and excluded income constituted amounts not includible in gross income. In other words, the computation of undistributed net investment income is comparable to the computation of the distribution deduction and, therefore, must take into account items included in the distribution that are not a part of net investment income.
This is analogous to the treatment of tax-exempt interest. The portion of the distribution to the beneficiary that includes tax-exempt interest is not included in the distribution deduction that reduces the income retained at the trust level. “Excluded income” means items of income excluded from gross income under chapter 1 of the Code, such as tax-exempt interest; items of income not included in net investment income as determined under Sec. 1411(c) and Prop. Regs. Sec. 1.1411-4, such as gain or loss attributable to property held in an active trade or business; and items of gross income and net gain specifically excluded by Sec. 1411, the regulations, or other guidance published in the Internal Revenue Bulletin.
Examples adapted from the proposed regulations21 illustrate the concepts:
Example 1. Calculation of undistributed net investment income (with no deduction under Sec. 642(c)): In year 1, Trust has dividend income of $15,000; interest income of $10,000; capital gain of $5,000; and $60,000 of taxable income relating to a distribution from an IRA. Trust has no expenses. Trust distributes $10,000 of its current-year trust accounting income to A, a beneficiary of Trust. For trust accounting purposes, $25,000 of the distribution from the IRA is attributable to income. Trust allocates the remaining $35,000 of taxable income from the IRA and the $5,000 of capital gain to principal, and, therefore, these amounts do not enter the calculation of Trust’s distributable net income for year 1.
Trust’s distributable net income is $50,000 ($15,000 in dividends + $10,000 in interest + $25,000 of taxable income from the IRA), from which the $10,000 distribution to A is paid. Trust’s deduction under Sec. 661 is $10,000. Under Regs. Sec. 1.662(b)-1, the deduction reduces each class of income constituting distributable net income on a proportional basis. The $10,000 distribution equals 20% of distributable net income ($10,000 ÷ $50,000). Therefore, the distribution consists of dividend income of $3,000, interest income of $2,000, and ordinary income attributable to the IRA of $5,000. Because the $5,000 of capital gain allocated to principal for trust accounting purposes did not enter into distributable net income, no portion of that amount is included in the $10,000 distribution, nor does it qualify for the deduction under Sec. 661.
Trust’s net investment income is $30,000 ($15,000 in dividends + $10,000 in interest + $5,000 in capital gain). Trust’s $60,000 of taxable income attributable to the IRA is excluded from net investment income. Trust’s undistributed net investment income is $25,000, which is Trust’s net investment income ($30,000) less the amount of dividend income ($3,000) and interest income ($2,000) distributed to A. The $25,000 of undistributed net investment income comprises the capital gain allocated to principal ($5,000), the remaining undistributed dividend income ($12,000), and the remaining undistributed interest income ($8,000).
A’s net investment income includes dividend income of $3,000 and interest income of $2,000 but does not include the $5,000 of ordinary income attributable to the IRA because it is excluded from net investment income.
Example 2. Calculation of undistributed net investment income (with deduction under Sec. 642(c)): Assume the same facts as in Example 1, except that Trust is required to distribute $30,000 to A. In addition, Trust has a $10,000 deduction under Sec. 642(c) (deduction for amounts paid for a charitable purpose). Trust also makes an additional discretionary distribution of $10,000 to B, another beneficiary of Trust.
As in Example 1, Trust’s net investment income is $30,000 ($15,000 in dividends + $10,000 in interest + $5,000 in capital gain). In accordance with Regs. Secs. 1.661(b)-2 and 1.662(b)-2, the items of income must be allocated among the mandatory distribution to A, the discretionary distribution to B, and the $10,000 distribution to a charity.
For purposes of the mandatory distribution to A, Trust’s distributable net income is $50,000. Trust’s deduction under Sec. 661 for the distribution to A is $30,000. Under Regs. Sec. 1.662(b)-1, the deduction reduces each class of income constituting distributable net income on a proportional basis. The $30,000 distribution equals 60% of distributable net income ($30,000 ÷ $50,000). Therefore, the distribution consists of dividend income of $9,000, interest income of $6,000, and ordinary income attributable to the IRA of $15,000. A’s mandatory distribution thus consists of $15,000 of net investment income and $15,000 of excluded income.
Trust’s remaining distributable net income is $20,000. Trust’s remaining undistributed net investment income is $15,000. The $10,000 deduction under Sec. 642(c) is allocated in the same manner as the distribution to A, where the $10,000 distribution equals 20% of distributable net income ($10,000 ÷ $50,000). For purposes of determining undistributed net investment income, Trust’s net investment income is reduced by $5,000 (dividend income of $3,000, interest income of $2,000, but with no reduction for amounts attributable to the IRA of $5,000).
With respect to the discretionary distribution to B, Trust’s remaining distributable net income is $10,000. Trust’s remaining undistributed net investment income is $10,000. Trust’s deduction under Sec. 661 for the distribution to B is $10,000. The $10,000 distribution equals 20% of distributable net income ($10,000 ÷ $50,000). Therefore, the distribution consists of dividend income of $3,000, interest income of $2,000, and ordinary income attributable to the IRA of $5,000. B’s distribution consists of $5,000 of net investment income and $5,000 of excluded income.
Trust’s undistributed net investment income is $5,000 after taking into account distribution deductions and Sec. 642(c). To arrive at Trust’s undistributed net investment income of $5,000, Trust’s net investment income of $30,000 is reduced by $15,000 of the mandatory distribution to A, $5,000 of the Sec. 642(c) deduction, and $5,000 of the discretionary distribution to B.
Including Capital Gain in Distributable Net Income
As a general rule, the capital gains of a trust are allocated to principal and therefore are not part of the distributable net income distributed to beneficiaries. For this reason, a trust with capital gains often may be subject to the tax on net investment income regardless of the size of the distributions to the beneficiaries.
Regs. Sec. 1.643(a)-3(b) provides guidance on the circumstances in which capital gain can be included in distributable net income. Capital gains are included in distributable net income to the extent they are, pursuant to the terms of the governing instrument and applicable local law or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with the power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law):
- Allocated to income;
- Allocated to corpus but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of the distribution to a beneficiary; or
- Allocated to corpus but actually distributed to the beneficiary or used by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.
Accordingly, CPAs should coordinate with the fiduciary and legal counsel to determine options available with respect to allocating capital gains either to income or corpus in such a way that they could be included in distributable net income when otherwise appropriate under the circumstances.
Application of Sec. 1411 to Electing Small Business Trusts
An electing small business trust (ESBT) is a unique type of trust that holds S corporation stock. It must satisfy requirements that include having made an election to be taxed as an ESBT. The unique aspect of an ESBT is that the portion of the trust that consists of S corporation stock is treated as a separate trust and is taxed at the highest rate on the taxable income determined for that portion.22 The non-S portion of the ESBT is likewise taxed as a separate trust consistent with the normal rules for part 1 of subchapter J of chapter 1 of subtitle A of the Code.
The proposed regulations under Sec. 1411 preserve the treatment of the ESBT as separate trusts for computational purposes but consolidate the ESBT into a single trust for determining the AGI threshold for the ESBT.23 Thus, the unfairness of being able to use two thresholds for what is really one trust is avoided by consolidating the undistributed net investment income of the two portions to apply a single Sec. 1(e) threshold.
The proposed regulations accomplish this calculation in three steps. First, the ESBT separately calculates the undistributed investment income of the S portion and non-S portion in accordance with the general rules for trusts under chapter 1 and combines the undistributed net investment income of the S portion and the non-S portion. Second, the ESBT determines its AGI solely for purposes of Sec. 1411 by adding the non-S portion’s AGI to the net income or net loss of the S portion (after taking into account all deductions, carryovers, and loss limitations applicable to the S portion) as a single item of ordinary income or loss. Third, the ESBT compares the combined undistributed net investment income with the excess of its AGI over the Sec. 1(e) threshold to determine whether the ESBT is subject to Sec. 1411, and if so, the Sec. 1411 tax base.24
An example adapted from the proposed regulations25 illustrates the concept:
Example 3. Calculation of an ESBT’s tax for purposes of Sec. 1411: In year 1, the non-S portion of Trust, an ESBT, has dividend income of $15,000, interest income of $10,000, and capital gain of $5,000. Trust’s S portion has net rental income of $21,000 and a capital loss of $7,000. The trustee’s annual fee of $1,000 is allocated 60% to the non-S portion and 40% to the S portion. Trust makes a distribution from income to a single beneficiary of $9,000.
Step 1: (A) Trust must compute the undistributed net investment income for the S portion and non-S portion. The undistributed net investment income for the S portion is $20,600, determined as shown in Exhibit 1.
(B) No portion of the capital loss is allowed because, pursuant to Prop. Regs. Sec. 1.1411-4(d)(2), net gain cannot be less than zero, and excess capital losses are not properly allocable deductions under Prop. Regs. Sec. 1.1411-4(f). In addition, pursuant to Regs. Sec. 1.641(c)-1(i), no portion of the $9,000 distribution is allocable to the S portion. The undistributed net investment income for the non-S portion is $20,400, determined as shown in Exhibit 2.
(C) Trust combines the undistributed net investment income of the S portion and non-S portion from paragraphs (A) and (B) to arrive at Trust’s combined undistributed net investment income (see Exhibit 3).
Step 2: (A) The ESBT calculates its AGI as the non-S portion’s AGI, increased or decreased by the net income or net loss of the S portion.
(B) The AGI for the ESBT is $38,000, determined as shown in Exhibit 4.
(C) The S portion’s single item of ordinary income used in the ESBT’s AGI calculation is $17,600. This item of income is determined by starting with net rental income of $21,000 and reducing it—
(1) By the S portion’s $400 share of the annual trustee fee; and
(2) As allowed by Sec. 1211(b)(1), $3,000 of the $7,000 capital loss.
Step 3: Trust pays tax on the lesser of:
(A) The combined undistributed net investment income ($41,000, calculated in Step 1(C)); or
(B) The excess of AGI ($38,000 calculated in Step 2(B)) over the dollar amount at which the highest tax bracket in Sec. 1(e) applicable to a trust begins for the tax year.
As in the discussion above concerning whether a trade or business activity is passive or active in relation to the trust, an essential element of computing the net investment income of the S portion of an ESBT is determining whether the trust materially participates in any trade or business activities of the S portion.
Applying Sec. 1411 to Charitable Remainder Trusts
As stated previously, charitable remainder trusts are exempt from the Sec. 1411 tax on unearned income. Nevertheless, net investment income may be included in the distributions to the beneficiaries from the charitable remainder trust. The net investment income of the beneficiary includes an amount equal to the lesser of (1) the total amount of distributions for that year, or (2) the current and accumulated net investment income of the charitable remainder trust.26
The accumulated net investment income of a charitable remainder trust is the total amount of net investment income the trust received for all tax years beginning after Dec. 31, 2012, less the total amount of net investment income distributed for all prior tax years of the trust that began after Dec. 31, 2012. If a charitable remainder trust has multiple beneficiaries, the net investment income is apportioned among the beneficiaries based on their respective shares paid by the charitable remainder trust for that tax year.27
Under this method of taxing beneficiaries of charitable remainder trusts, current and accumulated net investment income of the trust is deemed to be distributed before amounts that are not items of net investment income for purposes of Sec. 1411. As a result, the classification of income as net investment income or non–net investment income is separate from, and in addition to, the four tiers under Sec. 664(b). Thus, Sec. 1411 requires trustees of charitable remainder trusts to keep track of an entire new classification of income, namely, current and accumulated net investment income. In addition, distributions of current and accumulated net investment income to beneficiaries will need to be reported to the beneficiary on his or her Schedule K-1 (Form 1041), Beneficiary’s Share of Income, Deductions, Credits, etc.
Fortunately, charitable remainder trusts existing prior to Jan. 1, 2013, need not concern themselves with accumulations of net investment income before that date. By definition, accumulated net investment income includes only net investment income received by a charitable remainder trust for all tax years beginning after Dec. 31, 2012.
Example 4: During 2013, a charitable remainder unitrust is required to pay out 5% of its beginning-of-the-year value of $10 million, or $500,000. As a carryover from calendar year 2012, the charitable remainder trust had $100,000 of ordinary income in tier 1, consisting of interest income on corporate bonds, and $9 million of long-term capital gain in tier 2. During 2013 the charitable remainder trust earned interest income on corporate bonds at the rate of 2%, or $200,000.
The $500,000 distribution to the beneficiary is classified as $300,000 of ordinary interest income (consisting of the $100,000 of interest carryover from 2012 and the $200,000 of interest income earned during 2013) and $200,000 of long-term capital gain from tier 2. Although interest income and capital gains are included within the definition of net investment income, only $200,000 of the $500,000 distribution is considered net investment income for purposes of computing the Sec. 1411 tax for the beneficiary. This is because the net investment income of the beneficiary equals the lesser of (1) total distributions to the beneficiary, in this example, $500,000, or (2) the sum of the current net investment income ($200,000) and the accumulated net investment income. Accumulated net investment income is zero in this case because it accumulated prior to Jan. 1, 2013. Since $200,000 is less than $500,000, the amount included in the net investment income of the beneficiary from the charitable remainder trust for 2013 is $200,000.
As indicated above, taxpayers may rely on the proposed regulations for the purpose of compliance with Sec. 1411 until the effective date of final regulations. The proposed regulations are effective for tax years beginning after Dec. 31, 2013, except that the portion of the proposed regulations dealing with charitable remainder trusts is proposed to apply to tax years beginning after Dec. 31, 2012.
Controlled Foreign Corporations and Passive Foreign Investment Companies
If a trust or estate holds investments in controlled foreign corporations and/or passive foreign investment companies, the trustee/executor and his or her tax advisers need to be aware that, absent an election by the trustee/executor, income from these investments is treated differently for purposes of computing the Sec. 1411 tax than for computing taxable income under chapter 1. As currently proposed, an estate or trust that wants to make the election generally must do so for the first tax year beginning after Dec. 31, 2013, during which (1) the estate or trust owns an interest in a controlled foreign corporation or passive foreign investment company, and (2) the estate or trust is subject to tax under Sec. 1411 or would be subject to tax under Sec. 1411 if the election were made.28
Most trusts became subject to the new tax on net investment income on Jan. 1, 2013. Because the threshold for trusts and estates in 2013 is AGI exceeding $11,950, many trusts and estates retaining income at the trust or estate level are subject to the new 3.8% tax. An individual beneficiary of the trust, however, is not subject to the tax until his or her MAGI exceeds $250,000 if married filing jointly, or $200,000 if filing as a single individual.
In addition to the tax on net investment income, the American Taxpayer Relief Act of 201229 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. As a result, 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. Other factors to consider, however, include the maturity of the beneficiary, loss of creditor protection, 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 passthrough entities it owns.
1 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
3 Preamble to REG-130507-11.
4 That is, “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.”
5 Preamble to REG-130507-11.
6 Prop. Regs. Sec. 1.1411-3(b)(5).
7 Sec. 1411(a)(2).
8 Secs. 1411(a)(1) and (b).
9 Knight, 552 U.S. 181 (2008).
11 Notice 2011-37, 2011-20 I.R.B. 785.
12 Sec. 1411(c)(5).
13 Sec. 1411(c)(6).
14 Sec. 1411(c)(4).
15 Instructions for Form 1041 (2012) at 21.
16 Tax Reform Act of 1986, P.L. 99-514.
17 S. Rep’t No. 99-313, 99th Cong., 2d Sess., at 735 (1985).
18 IRS Letter Ruling 201029014 (7/23/10).
19 IRS Technical Advice Memo. 200733023 (8/17/07).
20 Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003).
21 Prop. Regs. Sec. 1.1411-3(f), Examples (1) and (2).
22 Sec. 641(c).
23 Prop. Regs. Sec. 1.1411-3(c)(1)(i).
24 Prop. Regs. Sec. 1.1411-3(c)(1)(ii).
25 Prop. Regs. Sec. 1.1411-3(f), Example (3).
26 Prop. Regs. Sec. 1.1411-3(c)(2)(i).
27 Prop. Regs. Secs. 1.1411-3(c)(2)(ii) and (iii).
28 Prop. Regs. Sec. 1.1411-10(g)(3).
29 American Taxpayer Relief Act of 2012, P.L. 112-240.
John M. Nuckolls is national director, private client tax services, and Michael Campbell is partner, both with BDO in San Francisco; Jaclyn Jang is senior tax director with BDO in Melville, N.Y. For more on this article, contact Mr. Nuckolls at email@example.com.