The Net Investment Income Tax (“N IIT”) became law under the Patient Protection and Affordable Care Act1 and the Health Care and Education Reconciliation Actof 2010.2 The tax can have a significantimpacton trustincome because of the condensed tax brackets for trusts. This article touches on techniques thatcan be used to reduce the tax on trustincome.
Changing Tax Landscape
Net Investment Income Tax (“NIIT”)
Since Jan.1,2013,a new 3.8 % tax has been imposed on the lesser of a taxpayer’s “net investment income”or any modified adjusted gross income (“modified AGI”) over certain threshold amounts.3 In general, net investment income includes portfolio-type income and income from passive activities.4 Under Internal Revenue Code § 469,5 business activities are treated as passive activities unless the taxpayer“materially participates”in the activity.6
In the case of estates and trusts, the 3.8 % tax is imposed on the lesser of the entity’s undistributed netinvestmentincome or the excess (if any) of its adjusted gross income (“A GI”) over the dollar amount threshold of the highest tax bracket to which estates and trusts are subject.7 , 8 The undistributed netinvestmentincome of an estate or trustis its netinvestmentincome less the share of thatincome thatis distributed to beneficiaries and the share of thatincome allocated to a charitable deduction of the estate or trust.The AGI of an estate or trustis computed in the same manner as for individuals except deductions are limited to:(1) costs that are paid or incurred in connection with the administration of the estate or trustwhich otherwise would not have been incurred if the property were notheld by an estate ortrust;(2)the personalexemption deduction of $600 for an estate,$100 for a complex trustand $300 for a simple tru st;9 and (3) distributions of income to beneficiaries, so long as the distributions are not in excess of distributable netincome (“DNI”).10
Implications forTrusts and Estates
Because estates and trusts often consistof assets such as stocks,bonds and other securities,or hold realestate on which rentis collected,the income of these entities frequently qualifies as net investmentincome.Therefore,the application of the N IIT to the income of estates and trusts amounts to an additional 3.8 % drag on the growth of trusts that primarily consist of these investmentassets.
The challenge facing practitioners wishing to implementstrategies to minimize the impactof the NIIT is that these strategies often involve current distributions of net investment income to beneficiaries thatdo nothave modified AGIabove the threshold amountforindividualtaxpayers and to which the N IIT willtherefore notapply.However,the trade-off of this strategy is thatthe currentdistribution of netinvestmentincome willultimately impede the long-term growth of the trustassets.Therefore,both the drafting attorney and the fiduciary mustweigh the pros and cons of implementing any of the planning techniques mentioned below in order to reduce the impact of the NIIT.
Strategies and Planning Techniques
Today mostclients prefer to establish separate trusts for each individualbeneficiary.Grantors often view these structures as more equitable because they provide each beneficiary with financialstability withoutimpacting the interests of the other beneficiaries and they can lead to less tension between family members down the road.However,with the implementation of the NIIT,one-pottrusts may become more popular as away to mitigate the impactof the tax.For example,a one-pot trust could give the trustee controlover the timing of distributions,thus allowing the trustee to allocate income to those beneficiaries under the individualmodified AGI threshold .11 In this way,the trust would be able to decrease its undistributed net investment income on which the NIIT is imposed and atthe same time avoid the imposition of the N IIT at the beneficiary level.12 The aggregate amountof distributions from separate trusts likely would notreduce the impactof the NIIT to the same degree.
Netinvestmentincome includes gain from the disposition of property (i.e.,capitalgain income) unless the property was used in atrade orbusiness thatis nottaxable underthe trade orbusiness provision of the C ode.13 Therefore,where a trustowns a capitalassetwith built-in gain and has the option to either sell the asset and distribute the cash or distribute the asset directly,a distribution of the assetto the beneficiary can reduce the amountof N IIT by notforcing the trust to recognize capitalgain upon the sale of the asset.
The distribution of the asset, rather than cash, will only make sense in certain situations, depending on the beneficiary’s financialposition.For example,a distribution in-kind would be appropriate if:(i)the beneficiary plans to sellthe assetand is able to offsetthe gain with capital losses;(ii) the beneficiary plans to sellthe assetbutthe gain would notincrease his or her AGI over the individualN IIT threshold amount;(iii) the beneficiary plans to hold on to the asset;or (iv)the beneficiary agrees to sellthe assetand incur the N IIT so the trust,and ultimately the otherbeneficiaries,willnothave to bearthe burden.
Including Capital Gain in Distributable Net Income (“DNI”)
Rather than distributing the assetin-kind,another option is to allocate the capitalgain from the sale of the assetto the netincome distributed to the beneficiaries.Generally,capitalgains are credited to the trustprincipalforaccounting purposes and cannotbe allocated to distributable net income by the trustee without explicit authority under the governing trust instrument or applicable state law.Consequently,because trusts are subjectto such a low threshold amount, often the gain from the sale of atrust-owned investmentassetwillbe subjectto the NIIT.
Capitalgains are includable in DNIto the extentthey are:(i) allocated to income;(ii) allocated to corpus buttreated consistently by the fiduciary on the trust’s books,records and tax returns as partof a distribution to a beneficiary;or (iii) allocated to corpus butactually distributed to the beneficiary or used by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary.14 So long as the trust instrument allows, the impact of the NIIT on the growth of the trust can be reduced by allocating capital gains to the income distributed to beneficiaries rather than to the corpus. Furthermore, so long as the beneficiaries receiving the distribution do not have AGI exceeding the individual threshold amount, NIIT on the capital gain will be avoided entirely, at both the trust and the individual level.
As mentioned above, if a taxpayer materially participates in a trade or business, the income generated from that business will not be net investment income and therefore will not be subject to the NIIT. Section 469(h)(1) states that a taxpayer materially participates in an activity when the taxpayer is involved in its operations on a regular, continuous and substantial basis. Neither the section 469 nor section 1411 regulations provide guidance on how an estate or trust can satisfy the material participation test.
In enacting section 469 as part of the Tax Reform Act of 1986,15 the Senate Finance Committee stated “[a]n 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.”16 In general, the IRS’s position has been consistent with that of the Senate Finance Committee and looks to the activities of the trustee to determine whether a trust materially participates in an activity.17 Until the IRS chooses to enact further guidance defining material participation as it relates to estates and trusts, trusts may be able to avoid accumulating net investment income by having the trustee participate in an activity of the trust on a regular, continuous and substantial basis and satisfying one of the seven material participation tests found in Temporary Treasury Regulation §1.469-5T(a).18
The increased burden that the NIIT places on estates and trusts can be a significant incentive to grantors to seek out alternative planning techniques in order to reduce its impact on the longterm growth of a trust. The selection of a fiduciary and the language of the governing document will both play a substantial role in determining the options available to a fiduciary in mitigating the NIIT liability. During the planning process, the client and attorney can work through the options available and tradeoffs that might be required to capture both non-tax and tax intentions for the trust.