The 3.8% NII tax and its effect on trusts and estatesArticle added by Julius Giarmarco on February 18, 2014
Julius Giarmarco

Julius Giarmarco

Troy, MI

Joined: July 07, 2008

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Effective for tax years beginning after December 31, 2012, trusts and estates are subject to the new 3.8 percent net investment income (NII) tax under IRC Section 1411. Grantor trusts are exempt from the NII tax, because the grantor is responsible for the tax.

The NII tax is 3.8 percent of the lesser of (1) the undistributed net investment income for the tax year, or (2) the excess of (a) the adjusted gross income for the tax year, over (b) $12,150 (for 2014). The NII tax is subject to the estimated tax provisions, so fiduciaries must consider it when filing their quarterly estimated tax payments.

Besides portfolio income and net gain from the disposition of property, NII includes income from a passive trade or business activity, income from trading in financial instruments, and net gain from property held in either of these types of businesses. However, NII does not include income and net gain from the disposition of property held in an active trade or business. The final regulations under IRC Section 1411 issued on November 26, 2013, did not address how a trust or estate “materially participates” in the conduct of a trade or business. Both the Treasury and the IRS believe that guidance would be addressed more appropriately in the IRC Section 469 (passive activities) regulations at a later date.

A simple solution is for the trustee to distribute the income to beneficiaries in lower tax brackets. But making distributions could subject the after-tax income (and the appreciation thereon) to the spendthrift habits of the beneficiaries and make those funds available to the beneficiaries’ creditors, including ex-spouses. It could also remove the after-tax income from a GST-exempt trust, thereby possibly exposing the after-tax income to estate taxes in the beneficiary’s estate.

Under IRC Section 469(h)(1), 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. Thus, for an estate or trust to obtain active status for a trade or business, a fiduciary (that has discretion to act on behalf of and bind the trust) must be involved in the operation of the activity on a regular, continuous and substantial basis. See PLR 201229014 and TAM 200733023.
If a trust owns an interest in an active trade or business, a potential way to avoid the NII tax might be to name some individual who is actively involved in the trade or business as a trustee or co-trustee. However, the IRS questioned that strategy in TAM 201317010 (released April 26, 2013). To summarize, the IRS’s position for trust taxpayers is that the activities of a trustee as an employee of the business cannot be considered to determine the trust’s material participation in the business. In other words, the trustee (acting in his/her fiduciary capacity and not as an employee of the business) must materially participate in the business.

The IRS rejected a Texas District Court holding in The Mattie K. Carter Trust, which held the activities of all employees of a trust, whether for the benefit of the trust or otherwise, counted to determine material participation. The court held in the alternative that the trustees’ level of involvement as fiduciaries met the IRS’s regular continuous and substantial criteria.

In conclusion, most trusts and estates that do not distribute their income to their beneficiaries will be subject to the new 3.8 percent NII tax. If the income is distributed, a beneficiary is not subject to the NII tax until his/her modified adjusted gross income exceeds $250,000 if married filing jointly, or $200,000 if filing as a single individual. Thus, in order to avoid the NII tax, fiduciaries must consider making distributions to the beneficiaries when permissible and advisable; investing in tax-exempt securities, life insurance and annuities (if such investments are appropriate under the circumstances); and adding a trust fiduciary that materially participates in trade or business activities held by the trust or estate (or by pass-through entities held by the trust or estate).

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
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