To help fund the Affordable Care Act, a 3.8 percent net investment income tax took effect in 2013. The tax, known as the NIIT, is imposed against individuals, trusts and estates on non-business income from interest, dividends, annuities, royalties, rents and capital gains above certain thresholds.
For the tax year 2016, the threshold for trusts and estates is $12,400. Thus, if a non-grantor trust has net investment income, the 3.8 percent tax may be applied to the lesser of the amount of the undistributed net investment income or the amount in excess of $12,400. For individuals, NIIT applies to amounts in excess of $250,000 of adjusted gross income for joint filers or $200,000 for non-married filers.
For grantor trusts, NIIT applies not at the trust level, but instead at the grantor level. This can be significant, not only because individuals have a much higher threshold but also because of the rules regarding material participation for determining whether a business activity is a passive activity, making income from that point possibly subject to NIIT.
There are several ways for a trust to minimize NIIT. First, the trust could invest in tax-exempt income. Secondly, the trustee could allocate indirect expenses to undistributed net investment income. For example, all or a portion of trustee fees could be allocated to capital gain that is not distributed by the trust, resulting in a reduction in undistributed investment income subject to NIIT.
Another way to minimize NIIT for a trust is for the trustee to make discretionary distributions of net investment income to the beneficiary. If the trustee knows the adjusted gross income of the beneficiary, the trustee could distribute net investment income to the beneficiary that would not cause that adjusted gross income to exceed the much higher individual threshold, and at the same time, reduce or eliminate the NIIT for the trust.
As part of such a planning strategy, the use of a one-pot trust could help provide more flexibility for distributions to multiple beneficiaries. However, evaluation of the standard for making distributions may need to be considered. In addition, the trustees will still need to consider not only whether such distributions are authorized or could cause a breach of the trustee’s fiduciary obligations, but also such factors as the maturity of the beneficiary, loss of creditor protection, future estate taxes or the future divorce of a beneficiary.