Editor: Kevin D. Anderson, CPA, J.D.
Estates, Trusts & Gifts
This item discusses how the net investment income tax under Sec. 1411 applies to charitable remainder trusts (CRTs) and their beneficiaries. The IRS published final regulations under Sec. 1411 in November 2013, which had been originally proposed in 2012. Simultaneously with the issuance of the final regulations (T.D. 9644), the IRS issued additional proposed regulations (REG-130843-13) that are also relevant to CRTs.
The net investment income tax applies to trusts and estates for tax years beginning after Dec. 31, 2012. Since CRTs are required to have a calendar year, to the extent applicable, individual beneficiaries of CRTs became subject to the new tax commencing Jan. 1, 2013.
CRTs Are Exempt
The Sec. 1411 tax applies to decedents' estates and trusts that are subject to the provisions of part 1 of subchapter J of chapter 1 of subtitle A of the Code. 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 imposed under Sec. 1411. This exclusion applies even if such a trust may be subject to a tax on unrelated business taxable income (UBTI) and even if that UBTI contains net investment income. This category of trusts includes trusts that are exempt from tax under Sec. 501(a), such as charitable organizations formed as trusts (Sec. 501(c)) and qualified plan trusts (Sec. 401(a)). CRTs also fall within this category. Although a CRT in and of itself is exempt from the application of Sec. 1411, distributions from the CRT to individuals are subject to Sec. 1411 to the extent such distributions consist of net investment income.
Taxation of Beneficiaries of CRTs—Initial Proposed Regulations
Solely for purposes of the Sec. 1411 tax, the proposed regulations issued in late 2012 (REG-130507-11) provided special computation rules for the classification of the income of, and the distributions from, CRTs. In effect, the special rule would have required a new and separate category of the CRT's current and accumulated net investment income. The proposed rules provided that distributions from a CRT to a beneficiary for a tax year would consist of net investment income equal to the lesser of the total amount of the distributions for that year or the current and accumulated net investment income of the CRT. "Accumulated net investment income" (ANII) means the total amount of net investment income received by a CRT for all tax years beginning after Dec. 31, 2012, less the total amount of net investment income distributed for all prior tax years beginning after Dec. 31, 2012.
Although Treasury and the IRS acknowledged that the new category for Sec. 1411 purposes deviated from the existing Sec. 664 category and class system, the government felt that the simplified method spelled out in the proposed regulations was justified to reduce the recordkeeping and compliance burdens on trustees. Comments received by the government, however, expressed a preference that the final regulations follow the existing rules under Sec. 664 that create subclasses in each category of income as the tax rates on certain types of income are changed from time to time. The comments indicated that the trustees of CRTs are already maintaining the appropriate records and are familiar with the existing rules, so compliance would be less complicated if the existing rules consistent with Sec. 664 were followed rather than the simplified method set forth in the proposed regulations. The final regulations adopted the commenters' request to categorize and distribute net investment income based on the existing Sec. 664 category and class system.
The rules in the final regulations for keeping track of a CRT's net investment income apply to tax years that begin after Dec. 31, 2012. However, for a CRT that relied on the proposed regulations for returns filed before the publication of the final regulations in the Federal Register, the CRT and its beneficiaries do not have to amend the returns to comply with the rules set forth in the final regulations. As a practical matter, only CRTs terminating with a short tax year in 2013 fall within this exception.
The final regulations reserve a section, however, for rules allowing the CRT to elect between the simplified method in the proposed regulations and the Sec. 664 method in the final regulations. The companion notice of proposed rulemaking provides rules to enable a CRT to choose between the simplified method described in the proposed regulations and the existing rules under Sec. 664. The companion proposed regulations are generally proposed to be effective for tax years beginning after Dec. 31, 2013, but taxpayers may apply them to tax years beginning after Dec. 31, 2012.
Elections to Adopt the Simplified Method
Although it was certainly a welcome development for Treasury and the IRS to provide trustees of CRTs the option to use the simplified method in the 2012 proposed regulations, as a practical matter, trustees will likely file 2013 tax returns applying the Sec. 664 method. The government has indicated that, after consideration of all comments received about the proposal to permit an election into the simplified method, if there is no significant interest among taxpayers in having that option, Treasury and the IRS may omit the option for taxpayers to make the election when the proposed regulations are finalized. It is not clear what adjustments would have to be made by a CRT opting into the simplified method if ultimately the election is omitted from the final regulations.
The proposed regulations provide that a CRT established after Dec. 31, 2012, must make the election to adopt the simplified method for the tax year in which the CRT is established. In the case of a CRT established prior to Jan. 1, 2013, the CRT's election must be made on its income tax return for its first tax year beginning on or after Jan. 1, 2013. Thus, the trustee of a CRT faces a dilemma in that the election to adopt the simplified method should accompany the 2013 tax return despite the uncertainty that the election will remain in the final regulations. CRTs may, however, make the election on an amended return for a given year if neither the tax year for which the election is made nor any tax year that is affected by the election, for both the CRTs and their beneficiaries, is closed by the period of limitation on assessment under Sec. 6501.
Given that the Sec. 664 method can provide better results for the beneficiaries of the CRT and given the uncertainty of the future availability of the election to adopt the simplified method, most trustees of CRTs will likely apply the Sec. 664 method to 2013 returns. If, ultimately, the final regulations do contain the election to use the simplified method, an amended return could be filed for the 2013 tax year opting into the simplified method, assuming the statute of limitation has not expired.
Sec. 1411 Taxation of Charitable Remainder Beneficiaries Applying Sec. 664 Rules
Consistent with the 2012 proposed regulations, the final regulations confirm that net investment income earned by a CRT prior to 2013 will not be subject to the Sec. 1411 tax when distributed to beneficiaries. Net investment income earned after 2012 that is considered part of a distribution from the CRT will retain its character as net investment income in the hands of the beneficiary. If a CRT has more than one beneficiary, the net investment income will be apportioned among the beneficiaries based on their respective shares of the total amounts paid by the CRT for that tax year.
The determination of whether a distribution from a CRT contains net investment income follows the regime spelled out in Regs. Sec. 1.664-1(d). Net investment income classified as ordinary income falls within the ordinary income category; net investment income that constitutes capital gain falls within the capital gain category; and net investment income not assigned to the first two tiers falls within the other-income category. Income within the various categories is assigned to different classes depending on the tax rates applicable to that income.
Net investment income assigned to a particular category is assigned to a separate class within the category by assigning a tax rate equal to the income tax rate applicable to that item of income under chapter 1 of the Code plus the tax rate under Sec. 1411. Thus, an item of ordinary taxable interest income earned after 2012 would be assigned to the ordinary income category with a separate class of a combined tax rate of 43.4% (39.6% + 3.8%); an item of qualified dividend income after 2012 would be assigned to the ordinary income category with a separate class of a tax rate of 23.8% (20% + 3.8%); an item of short-term capital gain would be assigned to the capital gain category with a separate class of a tax rate of 43.4% (39.6% + 3.8%); and an item of long-term capital gain would be assigned to the capital gain category with a separate class of a tax rate of 23.8% (20% + 3.8%).
An example from the final regulations (Regs. Sec. 1.1411-3(d)(2)(iii), Example (1))best illustrates how the Sec. 664 rules apply in relation to the distribution of post-2012 net investment income to the beneficiaries of a CRT:
Example 1: In 2009, A formed CRT as a charitable remainder annuity trust. The trust document requires an annual annuity payment of $50,000 to A for 15 years. For purposes of this example, assume that CRT is a valid CRT under Sec. 664 and has not received any UBTI during any tax year.
As of Jan. 1, 2013, CRT has the items of undistributed income within its Regs. Sec. 1.664-1(d)(1) categories and classes as shown in Exhibit 1.
Pursuant to Regs. Sec. 1.1411-3(d)(1)(iii), none of the $624,000 of undistributed income is ANII because none of it was received by CRT after Dec. 31, 2012. Thus, the entire $624,000 of undistributed income is excluded income (as defined in Regs. Sec. 1.1411-1(d)(4)).
During 2013, CRT receives $7,000 of interest income, $9,000 of qualified dividend income, $4,000 of short-term capital gain, and $11,000 of long-term capital gain. Prior to the 2013 distribution of $50,000 to A, CRT has the items of undistributed income within its Regs. Sec. 1.664-1(d)(1) categories and classes after the application of Regs. Sec. 1.1411-3(d)(2) as shown in Exhibit 2. The $50,000 distribution to A for 2013 includes the amounts shown in Exhibit 3. The amount included in A's 2013 net investment income is $20,000. This amount is composed of $7,000 of interest income, $9,000 of qualified dividend income, and $4,000 of short-term capital gain.
As a result, as of Jan. 1, 2014, CRT has the items of undistributed income within its Regs. Sec. 1.664-1(d)(1) categories and classes as shown in Exhibit 4.
CRTs Investing in CFCs and PFICs
Treasury and the IRS believed that special rules were necessary to apply the Sec. 664 category and class system to certain distributions made to CRTs that own interests in controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs). The reason for these special rules is that, absent an election under Regs. Sec. 1.1411-10(g), the income recognition for purposes of the Sec. 1411 tax could be different than income recognition for purposes of chapter 1 of the Code. Accordingly, the final regulations reserve a section for special rules in this area. The companion proposed regulations contain special rules relating to CFCs and PFICs and are generally proposed to apply for tax years beginning after Dec. 31, 2013, but taxpayers may apply the rules to tax years beginning after Dec. 31, 2012.
CRTs rarely own CFCs or PFICs. The ownership of CFCs and PFICs in regular trusts as well as CRTs has always been problematic because the complex rules that apply to CFCs and PFICs can attribute the ownership of shares in those entities to the beneficiaries. A discussion of those issues and the details set forth in the proposed regulations is beyond the scope of this item.
CRTs are exempt from paying the Sec. 1411 tax. Nevertheless, the trustee must keep track of the income subject to the Sec. 1411 tax so as to determine the distributions to beneficiaries that are subject to the tax. As a result of comments received in response to the 2012 proposed regulations, the final regulations call for keeping track of the items of income subject to the Sec. 1411 tax, consistent with the three historical categories of income used to track the distributions subject to tax under chapter 1 of the Code.
Income earned by a CRT prior to Jan. 1, 2013, is exempt from the Sec. 1411 tax. The proposed regulations permit a CRT to elect to adopt a different method of keeping track of the items of income subject to the Sec. 1411 tax. That election should be made for the CRT's 2013 filings. An election may be permitted on certain amended returns. Because of the uncertainty surrounding whether the election of the simplified method will ultimately be implemented and because beneficiaries may benefit from not making the election, most trustees probably will simply follow the final regulations.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.