How to Handle the NIIT for Trusts and Estates.
The impact of The Net Investment Income Tax ("NIIT") on trusts and estates cannot be understated. Because trusts tend to remain in existence far longer than estates, the overall tax consequences of this surtax on trusts is likely to be even more profound, and the following discussion will focus mainly on trusts.
NIIT is a 3.8 percent surtax enacted pursuant to The Health Care and Education Reconciliation Act of 2010. Unlike the Additional Medicare Surtax that is limited to individuals, estates and many trusts are also subject to the tax. Those not subject to the tax include charitable trusts, qualified retirement plan trust, grantor trusts, real estate investment trusts and common trust funds as set forth in Code section 1141(e)(2) and Treasury Regulations section 1.1411-3(b).
In operation, the 3.8 percent NIIT surtax is imposed on trusts and estates on the lesser of:
* "undistributed net investment income"; or
* the excess of adjusted gross income over the amount of the highest regular income tax bracket in effect for such taxable year.
Compared to the thresholds for individual taxpayers that are based on adjusted gross income, the threshold for trusts and estates is based on the highest tax bracket of those entities. Though the threshold for trusts and estates is indexed for inflation (unlike the thresholds for individual taxpayers), that is of little comfort to fiduciaries and beneficiaries. The highest regular income tax bracket for trusts and estates (above which the NIIT surtax is imposed) begins at an amount that is significantly lower than the NIIT thresholds for individuals.
For tax year 2015, the highest regular income tax bracket for trusts and estates (39.6 percent) begins with taxable income in excess of $12,300. The unindexed thresholds for individual taxpayers ($250,000 for joint filers) are much higher. Moreover, by their nature, most trusts and estates are likely to have only net investment income. This means that trusts and estates with relatively small amounts of net investment income may nonetheless be in the highest income tax bracket and be subject to the 3.8 percent NIIT.
As mentioned above, The NIIIT tax base of trusts and estates is "undistributed net investment income." In simple terms, undistributed net investment income is any net investment income--as defined by Code section 1411(c)(1)(A)--that is retained by a trust or an estate. Distributions retain their characterization as net investment income when distributed to a beneficiary. If the trust has net investment income that is distributed to a beneficiary, it will be characterized as net investment income for beneficiary.
The NIIT affects both simple and complex trusts. A simple trust is required to distribute all of its current fiduciary accounting income (FAI) to its beneficiaries. FAI is income derived from principal such as interest and dividends (as opposed to capital gains derived from the sale or disposition of principal). Since a simple trust is required to distribute all of its FAI to its beneficiaries each year, its undistributed net investment income is limited to the capital gain it generates.
Under Code section 662(a), a complex trust is not required to make mandatory distributions to its beneficiaries. Instead, complex trusts generally make discretionary distributions of FAI (and sometimes principal) to beneficiaries. A complex trust is likely to have a mix of net investment income that includes dividends, interest and capital gains. This income may or may not be retained by the trust.
In order to understand how to compute the undistributed net investment income of a trust, it is necessary to comprehend the meaning of distributable net income (DNI). Essentially, the DNI of a trust is the taxable income of a trust, with certain modifications. Distributions to beneficiaries are not included in DNI, effectively shifting the obligation to pay tax on the distributed income from the trust to the beneficiaries.
Similarly, for net investment income purposes, DNI that is distributed to a beneficiary is included in the beneficiary's net investment income, and is subject to the NIIT. Conversely, undistributed investment income included in DNI--as well undistributed investment income not included in DNI--is included in the net investment income tax base of the trust. The most notable exclusion of income from the computation of DNI is capital gain.
The following example from Treasury Regulations section 1.1411-3(e)(5) demonstrates how to compute net investment income for a complex trust, including calculations of DNI.
Example: Assume that in 2015 the trustee of this complex trust makes a discretionary FAI distribution of $10,000 to Beneficiary A.
Step 1: Determine the DNI of the trust. Code section 643(a) provides that the DNI of a trust is tentative taxable income ($105,000) minus capital gain. Excluding the $5,000 of capital gain, the DNI of the trust is $100,000.
Step 2: Determine the trust's distribution deduction. According to Code section 661(a), the distribution deduction of a complex trust is equal to the amount distributed (here, $10,000).
Step 3: Determine the extent to which the amount distributed is deemed to be net investment income. Code section 661(b) provides that the character of the amount distributed to the beneficiary "shall be treated as consisting of the same proportion of each class of income entering into the computation of distributable net income." In this example, the distribution of $10,000 is equal to 10 percent of $100,000, the total amount of DNI. Thus, the beneficiary is deemed to have received 10 percent of each type of income included in DNI.
Step 4: Determine the amount of net investment income in DNI that is retained by the trust. In this case, most of the retained income is net investment income. The only exception is the IRA distribution. Pursuant to Code section 1411(c)(5), distributions from IRAs are excluded from net investment income.
Step 5: Determine the total amount of net investment income retained by the trust. This should include any undistributed item of net investment income not included in DNI. Here, the $5,000 of capital gain excluded from DNI (clearly net investment income) is added to the $22,500 of net investment income retained by the trust. Thus, the total amount of undistributed net investment income is $27,500.
Step 6 -- Compute the NIIT. The 3.8 percent NIIT surtax is imposed on the lesser of:
* undistributed Net Investment Income ($27,500): or
* $92,700, which is the excess of the adjusted gross income ($105,000) over the amount of the highest regular income tax bracket ($12,300).
In this example $27,500 is less than $92,700, so the NIIT would be 3.8 percent of $27,500, or $1,045.
How Can Trusts Minimize the NIIT?
Unfortunately, many of the ways that individuals can minimize NIIT liability--such as contributing to qualified retirement plans ort materially participating in a business--are unavailable to trusts. However, there are some strategies that can help to minimize the NIIT burden on the trust's income.
1. Create tax-exempt income. Any investment type income that is excluded from gross income is also excluded from the NIIT base. Consequently, an investment in state and local bonds would yield income that is exempt from both regular and net investment taxes.
2. Allocate indirect expenses to undistributed net investment income. The regulations allow for the allocation of the deduction of items indirectly attributable to any particular type of income to be allocated in any way, including the total allocation of the deduction to capital gain. For example, by allocating all or part of trustee fees to capital gain not distributed by the trust, the amount of undistributed net income subject to NIIT would also be reduced.
3. Make discretionary distributions of net investment income items to beneficiaries who are not subject to the NIIT. Assuming a trustee is aware of the amounts of adjusted gross income of the trust beneficiaries, discretionary distributions of net investment net income could be made in amounts that would not cause the recipient beneficiary's adjusted gross income to exceed the applicable threshold and thus not be subject to NIIT. By doing so, the trustee could reduce NIIT within the trust without subjecting the beneficiary to the surtax.
However, the trustee must be mindful to not make distributions that would be contrary to the terms of the trust or otherwise be considered a breach of his or her fiduciary obligations. Moreover, even if the distribution would not cause the beneficiary's adjusted gross income to exceed the applicable NIIT threshold, the increase in income may deprive the taxpayer of some other tax benefits.
For example, a higher adjusted gross income would reduce or potentially eliminate the deductibility of miscellaneous itemized deductions subject to the 2 percent of adjusted gross income floor. Also, the taxation of social security benefits could be triggered by an increase in adjusted gross income. There are many other examples of similar adverse tax consequences potentially triggered by an increase in adjusted gross income.
For more information about tax planning issues involving trusts and the NIIT, see The Tools & Techniques of Estate Planning, 17th Edition, and The Tools & Techniques of Income Tax Planning, 4th Edition, from National Underwriter for a comprehensive source of information on tax and estate planning issues.
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|Date:||Mar 10, 2015|
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