Applying the new net investment income tax to trusts and estates.

• Author: Nuckolls, John M.

he Health Care and Education Reconciliation Act of 2010 (1) created 1 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.

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In December 2012, the IRS published proposed regulations (2) 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, husincss trusts that are treated as business entities are not subject to Sec. 141 1 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 suhchapter 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.

Grantor Trusts

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 (MAC) 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...