The impact of the net investment income tax on estates and trusts.

• Author: Williamson, Donald T.

The enactment of Sec. 1411(1) has attracted widespread attention and planning with respect to its impact on individuals but surprisingly little comment regarding its consequences on estates and trusts. This article describes the calculation of the Sec. 1411 net investment income tax on estates and trusts, demonstrating that the additional complexity and burden of the tax may give tax professionals pause in advising that a trust is a viable means for accumulating and preserving wealth from one generation to the next.(2) At the very least, the tax adds to the responsibility of fiduciaries to distribute sums to income beneficiaries in a way that reduces the immediate tax burden of the trust, but potentially at the expense of having less to distribute to remainder beneficiaries at the trust's termination.

This article also points out that the passive activity rules of Sec. 469, upon which Sec. 1411 relies to derive the tax base of net investment income, leave unanswered questions of when an estate or trust is materially participating in an activity and offers suggestions for defining material participation by such entities. Finally, the article suggests how and when accumulation distributions from foreign trusts under the "throwback" rules of Secs. 665-668 should be taxed under Sec. 1411.

Statutory Overview

In the case of an individual, Sec. 1411(a) (1) imposes a 3.8% tax (in addition to any other income tax)(3) on the lesser of:

* The individual's net investment income (defined below) for the tax year; or

* The excess (if any) of the individual's modified adjusted gross income' (MAGI) for the year over a threshold amount, i.e., $250,000 for married taxpayers filing a joint return; $200,000 for taxpayers filing single or head of household; and $125,000 for married individuals filing separately.(5)

Example 1: X and Y, married filing jointly, have income of $500,000, all of which is salary. The surtax does not apply because they have no net investment income.

Example 2: X and Y, married filing jointly, have $500,000 of salary and $50,000 of net investment income.

The surtax applies to the $50,000 of net investment income because it is less than the excess of MAGI over the threshold (i.e., $550,000 - $250,000 = $300,000).

Example 3: X, a single filer, has $275,000 of net investment income and no other income. The surtax applies only to the $75,000 that exceeds the $200,000 threshold for single filers.

Example 4: X and Y, married filing jointly, have $225,000 of salary income and $125,000 of net investment income. The surtax applies to $100,000, the difference between their threshold ($250,000) and MAGI ($350,000), which is less than their net investment income of $125,000.

For an estate or trust, Sec. 1411(a)(2) imposes the tax on the lesser of:

* The entity's undistributed net investment income, or It

* The excess (if any) of its adjusted gross income (AGI) over the dollar amount threshold of the highest tax bracket to which estates and trusts are subject, i.e., $12,150 for 2014.(6)

The AGI of an estate or trust is computed in the same manner as for an individual, except deductions are permitted only for (1) costs in connection with the administration of the estate or trust that would not have been incurred if the property were not held by an estate or trust; (2) the personal exemption under Sec. 642(b) of $600 for an estate, $300 for a simple trust, and $100 for a complex trust; and (3) distributions of income to beneficiaries not in excess of distributable net income (DNI).(7)

Therefore, almost every estate or trust must for each tax year determine its net investment income and the portion, if any, of net investment income that is not distributed to beneficiaries.(8)

Example 5: A trust may pay income and principal as needed to its beneficiary, a single individual who has no other income. In 2014, the trust has dividend and interest income of $150,000 and net capital gain of $300,000. The trust makes no distributions and has AGI of $450,000. Because the highest tax bracket for a trust is $12,150 in 2014, the trust's net investment income is $437,850 ($450,000 - $12,150).

Example 6: If, in the preceding example, the $150,000 of dividend and interest income is distributed to the trust's beneficiary, the trust's net investment income is $287,850 ($450,000 - $150,000 - $12,150). Because the surtax threshold for a single individual is $200,000, the beneficiary is not subject to the tax on the $150,000 distributed.

In the above examples, the trust or estate with net investment income is subject to estimated tax payment requirements and penalties for underpaying estimated tax.(9)

Net Investment Income

As the above examples illustrate, the starting point for calculating the tax is the derivation of net investment income. The net investment income of an estate or trust is determined in the same way as for an individual (10) and consists of the following three categories of taxable income, less deductions properly allocable to such income: (11)

* Interest, dividends, annuities, royalties, and rents that are not derived from a trade or business that is not a passive activity under Sec. 469 or a trade or business of trading in financial instruments or commodities; (12)

* Other income derived from a trade or business that constitutes a passive activity to the taxpayer under Sec. 469 or a trade or business of trading in financial instruments or commodities, (13) and

* Net gain attributable to the disposition of property that is not held in a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities. (14)

Net investment income also includes income attributable to an investment in working capital' but excludes income subject to self-employment taxi (16) and distributions from qualified plans under Sec. 401(a), 403(a), 403(b), 408, 408A, or 457(b).(17)

Because estates and trusts often consist of a portfolio of stocks, bonds, and other securities or hold real estate on which rent is collected, their income will frequently fall within the definition of net investment income. However, as discussed below, determining whether a trust or estate materially participates in a trade or business allows fiduciaries

EXECUTIVE SUMMARY

* In addition to applying to individuals, the net investment income tax applies to estates and trusts: however, the threshold for applicability of the Sec. 1411 tax to trusts and estates is much lower ($12,150 for 2014) than the threshold for individual taxpayers.

* Net investment income for an estate or trust is determined in the same way that it is for an individual. Whether income is net investment income depends on whether the income is derived from a trade or business and, if so, if the trade or business is a passive activity or trading in financial instruments or commodities.

* Trusts and estates determine their undistributed net investment income similar to the way they determine distributable net income (DNI) and the income distribution deduction for income tax purposes.

* Foreign estates are not subject to the tax, although U.S. beneficiaries generally are subject to it on distributions from foreign trusts. However, whether the net investment income tax applies to distributions of accumulated income from foreign trusts under the "throwback" rules remains an open question.

* The IRS has not issued regulations that explain how an estate or trust meets the material participation requirement for purposes of the passive activity rules. The IRS continues to take the position that only the activities of a fiduciary of a trust are taken into account in the material participation determination: however, a district court has held that the activities of agents or employees of a trust should also be taken into account in the determination. substantial flexibility in determining whether income from a trade or business received by an estate or trust is subject to the surtax.

Interest, dividends, rent, etc., that might otherwise be net investment income are not taken into account if such income is derived in the ordinary course of a trade or business that is not a passive activity or trading in financial instruments or commodities.(18) Although the final regulations to Sec. 1411 define a trade or business for this purpose only by reference to Sec. 162, (19) their preamble refers to the Supreme Court case of Higgins, (20) which held that whether a taxpayer is engaged in a trade or business is determined on a case-by-case basis. (21)

But the Supreme Court in Groetz-inga (22) also made clear that for an activity to be a trade or business, it must be conducted regularly and continuously. Similarly, in Moller) (23) the Federal Circuit stated:

In determining whether a taxpayer who manages his own investments is a trader, and thus engaged in a trade or business, relevant considerations are the taxpayer's investment intent, the nature of the income to be derived from the activity, and the frequency, extent, and regularity of the taxpayer's securities transactions.(24)

And in Liane (25) the Tax Court held that investors hold financial instruments for appreciation in value and income, while traders buy and sell "with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis." (26)

For individuals, estates, and trusts (and disregarded entities owned by the taxpayer), whether an activity is conducted with sufficient regularity and continuity to be a trade or business is determined at the owner level. In contrast, if the activity is conducted through a partnership or S corporation, whether the activity and, consequently, its income are derived from a trade or business is determined at the entity level.(27)

Temp. Regs. Secs. 1.469-2T(c)(3)(ii) (A) through (G) describe the following cases where interest, dividends, royalties, and annuities are treated as derived from a...