Many fiduciaries will be surprised when preparing fiduciary income tax returns for 2013 because of the new 3.8 percent tax imposed on net investment income, sometimes known as the Medicare surtax. The 3.8 percent tax is imposed on the net investment income of trusts and estates with modified adjusted gross income that exceeds $11,950. The Internal Revenue Service released the final regulations under section 1411 of the Internal Revenue Code on November 26, 2013. Fiduciaries should consider these final regulations and the effects of the surtax during year-end tax planning.

Section 1411 was enacted in 2010, but became effective January 1, 2013. The newly issued final regulations are generally scheduled to become effective January 1, 2014. Since late 2012, the IRS has received numerous comments and inquiries regarding the proposed regulations under section 1411. Many of these comments were addressed in the final regulations, but other comments prompted the IRS to issue additional proposed regulations. Noteworthy changes found in the final regulations and the new proposed regulations are highlighted below.

Basic Structure of the Surtax . Section 1411(a)(1) imposes a 3.8 percent tax (the “surtax”) for individuals on the lesser of: (a) the individual’s “net investment income” for such taxable year, or (b) the excess (if any) of the individual’s modified adjusted gross income for such taxable year over the statutory threshold amount. For purposes of the surtax, an individual’s “modified adjusted gross income” is the individual’s adjusted gross income (gross income minus certain specified “above the line” deductions) increased by any excluded foreign earned income (not an adjustment affecting many individuals). The “threshold” for individual taxpayers for purposes of the surtax is $200,000 for a taxpayer filing single, $250,000 for married taxpayers filing jointly, and $125,000 for a married individual filing separately.

Example . Aaron, an unmarried individual, will report on his 2013 individual income tax return compensation of $175,000 (none of which was earned abroad), dividends of $20,000, interest income of $25,000, and royalties of $35,000. Aaron’s net investment income consists of the dividends, interest, and royalties totaling $80,000. The 3.8 percent surtax will not be imposed on the $80,000 of net investment income, but rather on only $55,000, the excess of his modified adjusted gross income of $255,000 over his threshold of $200,000.

(This simple example ignores itemized deductions which Aaron may be able to allocate to the net investment income to further reduce the surtax.)

For trusts and estates, section 1411 imposes the surtax on the lesser of (a) the undistributed net investment income of the trust or estate or (b) the excess of the adjusted gross income of the trust or estate over the “threshold” for the trust or estate. The threshold for a trust or estate is significantly lower than the threshold for an individual because it is the top inflation-adjusted bracket for estate and trust income taxwhich is only $11,950 in 2013 and will be $12,150 in 2014.

Calculating Net Investment Income. Generally, “net investment income” is the sum of gross income from interest, dividends, annuities, royalties, and rents, and income derived in the ordinary course of a trade or business which is a “passive activity” to the taxpayer, and the net gain attributable to the disposition of property other than certain property held in such a trade or business, minus deductions allowed in computing taxable income. In other words, the purpose of the surtax is to tax passive income not derived from the taxpayer’s business efforts. As a result, there will be an understandable link between what is a trade or business for purposes of section 1411 and the regulations relating to Code section 469 for passive activity losses. The IRS was clear in these final section 1411 regulations that the concepts of a passive activity for purposes of those two Code sections are not necessarily identical. Furthermore, despite strong pleas from a number of commentators, the IRS refused to use the platform of the finalization of the section 1411 regulations to clarify how a trust or estate can be “active” with respect to a trade or business. This topic remains under study by the Treasury. Rejecting the calls from many commentators, the IRS also declined to define the term “derived in the ordinary course of a trade or business” for section 1411 purposes because the IRS determined that the applicable definition under section 469 of the Code (related to passive activity losses), and related case law, is sufficient to define the term.

No Relief for Estimated Taxes for 2013. A number of commentators requested that the IRS provide some type of relief for individual, trust, and estate taxpayers who may be subject to underpayment of estimated tax penalties for 2013 because of section 1411. The IRS refused any such relief, but it will allow such a taxpayer to rely on the proposed section 1411 regulations where they differ from the final regulations for purposes of determining the estimated tax penalty.

U.S. Charitable Trusts and Estates. The 2012 proposed regulations for section 1411 excluded certain charitable trusts from the surtax. The final regulations expand this rule to also exclude estates with beneficiaries devoted to charitable purposes and activities only.

Foreign Trusts and Estates. Although section 1411 does not address the treatment of foreign estates and foreign non-grantor trusts specifically, the final regulations provide that foreign estates are excluded from the surtax. Nevertheless, this rule does not exempt U.S. beneficiaries from paying the surtax on distributions from foreign estates and trusts. Additionally, the IRS has suggested that the surtax should apply to U.S. beneficiaries receiving distributions of accumulated net investment income from a foreign trust rather than to the foreign trust itself. Therefore, the Department of Treasury will continue to study how the surtax should apply to accumulation distributions from foreign trusts to U.S. beneficiaries, and intends to issue further guidance on this topic at a later date. In the meantime, the surtax will not apply to distributions of accumulated income, as opposed to current income, from a foreign trust to a U.S. beneficiary.

Charitable Remainder Trusts. The final regulations revised the proposed regulations with respect to certain rules related to income and distributions from charitable remainder trusts (CRTs). Commentators raised concerns that the 2012 proposed regulations related to the calculation of a CRT’s net investment income were overly complex and suggested the recordkeeping and compliance burden on trustees would be too great. The final regulations attempt to simplify these calculations by employing a category and class system for a CRT’s accumulated net investment income that more closely reflects the tier system by which CRTs have historically allocated income for the calculation of the regular income tax on non-charitable CRT beneficiaries.

Deductions in Respect of a Decedent. The final regulations provide a deduction for items related to income in respect of a decedent (IRD). Net investment income may include items of IRD (such as annuities and outstanding payments on a promissory note) that may carry with them a corresponding deduction. Common deductions for items related to IRD include trustees’ fees, real estate agents’ commissions, and state income taxes paid. Each of these deductions would offset a taxpayer’s net investment income.

Estate and Trust Administration Expenses . Several commentators requested that the final regulations explicitly provide that properly allocable deductions under section 1411 include fiduciary commissions, legal and accounting fees, and other estate and trust administration expenses. Subject to the 2 percent floor on miscellaneous itemized deductions, the final regulations adopt this comment by amending the 2012 proposed regulations to provide that properly allocable deductions include, to the extent they are allocable to net investment income, amounts related to fiduciary fees and other administration expenses.

Net Operating Losses Deduction. A deduction from the surtax is also available for net operating losses (NOLs). The NOL deduction is limited by a calculation described in the final regulations such that the total NOL deduction does not exceed that portion of the NOLs attributable to the taxpayer’s net investment income.

Self-Charged Interest and Rental Income. The final regulations include special rules addressing self-charged interest and self-charged rental income. These special rules link the calculation of net investment income to the calculation of passive activity losses under section 469. Specifically, the final regulations provide that, in the case of rental income that is treated as non-passive under section 469, such rental income is deemed to be derived in the ordinary course of a trade or business for purposes of the surtax. Additionally, with respect to self-charged interest, the final regulations exclude an amount of interest income from net investment income that is equal to the amount of interest income that would have been considered passive income under the passive activity loss rules if the non-passive activity were considered passive activity.

New Proposed Regulations. In addition to releasing final regulations for section 1411, the IRS released new proposed regulations that recommend additions and modifications to the final regulations. Significant rules in the new proposed regulations include the following:

  • Charitable Remainder Trusts. The new proposed regulations would allow CRTs to choose between the simplified method described in the final regulations and the existing rules under section 664 to track net investment income. The new proposed regulations would also provide an example of how these two methods track a CRT’s net investment income.
  • Capital Loss Carry-Forwards. The new proposed regulations would create an annual adjustment to capital loss carry-forwards to prevent capital losses excluded from the net investment income calculation in the year of recognition from becoming deductible losses in future years. This annual adjustment would provide a method of identification and an ordering rule that eliminates the need for taxpayers to maintain a separate set of books and records for this item to comply with section 1411. The new proposed rule would require that taxpayers perform the calculation annually, regardless of whether they have a section 1411 tax liability in a particular year, to maintain the integrity of the rule’s carry-forward adjustment amounts for a subsequent year in which they are subject to liability under section 1411.
  • Qualified Subchapter S Trusts (QSSTs). Commentators have suggested that the disposition of S corporation stock by a QSST should be properly treated as a disposition of the stock by the income beneficiary of the trust for purposes of determining material participation (i.e., whether the activity is done in the ordinary course of a trade or business). The new proposed regulations would provide that, in the case of a QSST, the application of the surtax is made at the trust level.

Planning Opportunities. To minimize the impact of the surtax, taxpayers should consider overall income tax planning techniques such as triggering gains and losses in the same year or structuring deductions to maximize tax efficiencies. Additionally, individuals should be aware of the statutory thresholds that trigger the surtax and identify sources of income derived from passive activity, and where possible, materially participate so that income from trade or business is not passive.

Similarly, for trusts, trustees should be aware of the low statutory threshold that triggers the surtax and consider making distributions to beneficiaries, particularly if the net investment income of an individual beneficiary would be lower than the surtax thresholds for individuals. It is important to keep the surtax in perspective, however. The very rapid progression through the income tax brackets for trusts and estates has long been a factor favoring distributions from trusts and estates to individuals in lower income tax brackets. Nevertheless, the surtax and accelerated rates are only a few factors for trustees and executors to consider. Concern about the beneficiaries’ need for such distributed funds and the effect that such funds would have on the welfare of the beneficiaries may still be overriding factors that prompt the trustee or executor to retain such funds. In other words, trustees and executors should be mindful of the impact of the surtax, but not overreact.