With the passing of April 15th, many people are likely paying more income taxes than in previous years. The increase in income tax is directly caused by four factors: 1) an increase in the top marginal rate for ordinary income from 35% to 39.6%; 2) an increase in the tax rate of net capital gains from 15% to 20% for taxpayers subject to the 39.6% rate on ordinary income; 3) limitations on certain itemized deductions; and 4) the 3.8% tax on net investment income. The increase in tax rates and the advent of the 3.8% tax on net investment income could dramatically increase the tax liability of trusts. Therefore, proper planning is vital to minimize the potential increase in taxes on trust income.
The Affordable Care Act (ACA) became law in 2010 and authorized an additional tax of 3.8% on net investment income (NII). The 3.8% tax on NII, which became effective in 2013, applies to taxpayers that have both NII and adjusted gross income above a certain threshold amount. There are four different threshold amounts.
- Unmarried Taxpayer – $200,000
- Married Taxpayer Filing Jointly – $250,000
- Married Taxpayer Filing Separately – $125,000
- Estate or Trust – $12,150
NII includes interest, dividends, annuities, royalties, rents, and other passive activity income. Thus, if a person owns an interest in a business but the person is not considered to materially participate in the activities of the business, the business income is subject to the 3.8% tax on NII. NII does not include active income from a trade or business, distributions from qualified retirement plans, and income exempt from tax, such as interest from municipal bonds.
The 3.8% tax will apply to the lesser of 1) the total amount of a person’s NII for the year, or 2) the difference between a person’s modified adjusted gross income and the threshold amount. The 3.8% tax does not apply to a person who does not have NII or who has an adjusted gross income below the threshold amount.
The rules for the application of the 3.8% tax on NII for trusts that are non-grantor trusts are slightly different from the rules for individuals. The biggest difference is the very low $12,150 threshold amount at which the tax applies. The second difference is that it is a trust’s “undistributed NII” that is taken into account in determining the application of the tax. Undistributed NII is the NII of the trust reduced by certain distributions pursuant to the accounting rules applicable to trusts. Distributing NII to a trust’s beneficiaries reduces the trust’s undistributed NII and therefore reduces the amount of the tax imposed on the trust.
The 3.8% tax on NII for a non-grantor trust is imposed on the lesser of 1) the undistributed NII of the trust, or 2) the difference between the trust’s adjusted gross income and $12,150. Proper distributions of income reduce a trust’s gross income. Unless there are overriding non-tax reasons to retain NII, it will be beneficial for a trustee of a non-grantor trust to make distributions to the trust beneficiaries, thus shifting the 3.8% tax to a recipient with a higher threshold amount.
Additionally, the Tax Court recently ruled that a trustee’s activities, in a non-fiduciary capacity (i.e. as an employee), of a business that is held in trust count for measuring material participation. If the trustee of a non-grantor trust is considered to materially participate in the business, then business income distributed to the trust will avoid the imposition of the 3.8% tax on NII. Therefore, it is important an important planning point to ensure that the trustee’s activities with the business are sufficient to satisfy the material participation standard. The trustee should keep a detailed record of all the activities the trustee performs in relation to the business, even if those duties are not performed as part of the trustee’s duties as trustee.
If a trust is structured as a grantor trust, the trust is ignored for income tax purposes and the grantor pays the income tax for the trust. Accordingly, the rules for the 3.8% tax on individuals will apply to a grantor trust, which will present some planning opportunities. First, the threshold amount is much higher for individuals ($125,000 to $250,000 depending on filing status) than for trusts ($12,150). Thus, the individual grantor will be able to absorb more NII without the imposition of the tax. Second, if a business is held in trust, the grantor’s activities relative to the business will be used to measure material participation. Accordingly, if the grantor is active in a trade or business held by the trust, the income earned by the trade or business that is payable to the trust will not be subject to the 3.8% tax on NII.