The Net Investment Income Tax (“NIIT”) became law under the Patient Protection and Affordable Care Act[1] and the Health Care and Education Reconciliation Act of 2010.[2] The tax can have a significant impact on trust income because of the condensed tax brackets for trusts. This article touches on techniques that can be used to reduce the tax on trust income.

What Is The NIIT?

Since Jan.1, 2013, a new 3.8% tax has been imposed on the lesser of:

  1. An estate’s or trust’s undistributed net investment income.
  2. The excess (if any) of its adjusted gross income over the dollar amount threshold of the highest tax bracket to which estates and trusts are subject. In 2016, the threshold amount, indexed for inflation, is $12,400.

In general, net investment income includes portfolio-type income and income from passive activities. Therefore, any income of an estate or trust from these sources that is not distributed to beneficiaries or allocated to a charitable deduction generally is subject to the NIIT. Because estates and trusts often consist of assets such as stocks, bonds and other securities, or hold real estate on which rent is collected, the income of these entities frequently qualifies as net investment income. The application of the NIIT to the income of estates and trusts amounts to an additional 3.8% drag on the growth of trusts that primarily consist of these investment assets.

Planning to Mitigate the Effects of the NIIT

Below are a few planning strategies to consider to reduce the impact of the NIIT on a trust’s assets.

Material Participation

  • In general, 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.
  • Currently, there is no definitive guidance in the Internal Revenue Code or Treasury Regulations defining how a trust can satisfy the material participation test. In practice, the IRS’s position has been to look at the activities of the trustee to determine whether a trust materially participates in an activity.
  • 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 satisfy the “material participation” requirements for individuals, as set forth in the Treasury Regulations, and by participating in the activities of the trust on a regular, continuous and substantial basis.

One-Pot Trust

Establishing a one-pot trust, rather than separate trusts for beneficiaries, is another option for grantors wishing to lessen the impact of the NIIT on the growth of a trust.

  • A one-pot trust could give the trustee control over the timing of distributions, thus allowing the trustee to allocate income to those beneficiaries having a modified adjusted gross income under $200,000 (the threshold above which the NIIT is applicable to an individual’s income).
  • In this way, the trust would be able to decrease its undistributed net investment income on which the NIIT is imposed and at the same time avoid the imposition of the NIIT at the beneficiary level. The aggregate amount of distributions from separate trusts likely would not reduce the impact of the NIIT to the same degree.

Given the potentially large liability that trusts and estates may now incur due to the NIIT, individuals should review their trust and estate plans and consult with an attorney on whether it makes sense to adjust the terms of their instruments to allow flexibility to minimize the impact of the tax.