On Aug. 8, 2013, the Internal Revenue Service published a series of Questions and Answers (the Q&A) explaining the basics of the new 3.8 percent net investment income tax (the NII tax), which took effect on Jan. 1, 2013. The NII tax is imposed under Section 1411 of the Internal Revenue Code, a new provision added to the IRC by Section 1402 of Title X of the Patient Protection and Affordable Care Act.1 The IRS previously published proposed regulations with detailed explanations in December 2012,2 but the Q&A provides a more concise description of: (1) who must pay NII tax, (2) what’s included in NII, and (3) how the tax is reported and paid.
Who Must Pay
Questions 3-6 of the Q&A explain who’s required to pay the NII tax. The NII tax is applicable to individual taxpayers whose modified adjusted gross incomes are over an applicable threshold amount: $250,000 for married taxpayers filing jointly or a surviving spouse with dependent children; $125,000 for married taxpayers filing separately; and $200,000 for all other individual taxpayers, including single taxpayers or taxpayers filing as head of household.3As noted in Question 3, the threshold amounts aren’t indexed for inflation.
Estates and ordinary trusts are subject to the NII tax: if (1) they have undistributed NII, and (2) their adjusted gross income is greater than the dollar amount at which the highest income tax bracket for trusts and estates begins.4 For 2013, the threshold amount is $11,950.5 The NII tax will be equal to 3.8 percent of the lesser of: (1) the undistributed NII for the tax year, or (2) the excess of the gross income over $11,950. Because most income generated by estates and trusts will count towards NII, affected estates and trusts are likely to experience a 3.8 percent increase in their marginal tax rate on income in excess of $11,950.
In general, the NII tax is applicable only to trusts that are subject to fiduciary income tax under Part I of Subchapter J of Chapter 1 of Subtitle A of the Code. This excludes trusts that aren’t classified as “trusts” for income tax purposes, including business trusts (which are generally taxed as entities), as well as common trust funds, designated settlement funds and other trusts subject to specific taxation regimes.6 In addition, trusts that are generally exempt from income tax, such as charitable trusts and qualified retirement plan trusts, are exempt from the NII tax. There are special rules for the calculation of NII with respect to charitable remainder trusts and electing small business trusts that own interests in S corporations.7
As noted in Question 6 of the Q&A, trusts that are treated as “grantor trusts” for income tax purposes aren’t directly subject to the NII tax. Rather, a grantor trust’s NII, like all of the trust’s income taxes, deductions and credits, will be includible in the computation of the grantor's income tax.8
Additionally, Question 5 notes that estates and trusts must only pay NII tax on undistributed net income. This is consistent with the fiduciary income tax rules, which allow for deductions of distributable net income that’s required to be distributed or otherwise properly paid to beneficiaries. Instead, such income (including any items that may be considered NII) is included in the gross income of the beneficiaries who received distributions.9
Questions 7-13 discuss which items are included in NII. As a general rule, NII includes various types of income and gain that are generated by investment activities such as interest, dividends, capital gains, rental and royalty income and non-qualified annuities. In addition, income from businesses involved in trading financial instruments and commodities, as well as income from businesses that are considered “passive activities” with respect to the taxpayer (within the meaning of IRC Section 469), is also NII. As noted in Question 9, capital gains includes gains from the sale of stocks, bonds, mutual funds, investment real estate and interests in partnerships and S corporations.
When considering potential NII tax liability, fiduciaries should keep in mind that the tax is imposed on net investmentincome. As noted in Question 12, deductions that are properly allocable to investment income are allowable as deductions for computing NII tax liability as well. This may include state and local income taxes properly allocable to items included in NII.
How Tax Reported
Questions 14-17 discuss the manner in which NII is reported and tax thereon is paid. For estates and trusts, NII is reported on, and paid with, the trust's Form 1041. In addition, as noted in Question 15, NII tax is subject to estimated tax provisions. Fiduciaries should adjust their withholdings and estimated tax payments accordingly.
Income Tax Planning Opportunities
Both the nature of the NII Tax and the differences between its application to trusts and to individuals provide opportunities for income tax planning. In deciding whether a trust should be created as a grantor trust for income tax purposes, practitioners should consider the potential income tax benefits of having certain items of income attributed to the grantor. In some cases, items that would otherwise be considered NII with respect to a trust might be exempt from NII tax with respect to the grantor. For example, income generated in the due course of operating a business in which the grantor is actively engaged may not be subject to NII tax in the hands of the grantor.10
Considerations related to the NII tax might also influence the nature and timing of distributions to beneficiaries. Trustees may make distributions to shift income to beneficiaries whose modified adjusted gross income is less than the threshold amount. In addition, there may be advantages to distributing certain types of income producing assets (such as interests in active businesses) to beneficiaries with respect to whom the income generated wouldn’t be considered NII.
The NII tax adds another layer to an already complex body of tax provisions that are applicable to estates and trusts. Estate planners and tax practitioners must give careful consideration to ways in which this new set of rules might affect their clients’ tax planning needs.
1. Pub. L. No. 111-148, 124 Stat. 119 (2010).
2. Net Investment Income Tax; Proposed Rule, 77 Fed. Reg. 72,612 (Dec. 5, 2012).
3. Internal Revenue Code Section 1411(a)(1), (b).
4. IRC Section 1411(a)(2).
5. Revenue Procedure 2013-15.
6. See Part 4.A of the preamble to the proposed regulations. 77 Fed. Reg. at 72,615.
7. See Part 4.B.iii and Part 4.B.iv of the preamble to the proposed regulations. 77 Fed. Reg. at 72,618.
8. See Part 4.B.ii of the preamble to the proposed regulations. 77 Fed. Reg. at 72,616.
9. See IRC Sections 652, 662.
10. The rules related to the “ordinary course of a trade or business” exception are complex and beyond the scope of the Q&A and of this article. For a more extensive treatment of these issues refer to part 5.A.vi of the preamble to the proposed regulations. 77 Fed. Reg. at 72,618.