Proposed Treasury regulations give guidance under new Internal Revenue Code Section 1411 for taxable years beginning after Dec. 31, 2012. The proposed regulations can affect individuals, trusts and estates.
Highlighted here are the provisions dealing—directly or indirectly—with charitable remainder trusts, pooled income funds, charitable lead trusts and charitable gift annuities. The end of this article tells how to make your views known.
Background—on 3.8 Percent Medicare Surtax
• For an individual. Starting in 2013, in addition to any other tax, a 3.8 percent tax is imposed on the lesser of: (A) the individual’s net investment income for the taxable year, or (B) the excess (if any) of (i) the individual’s modified adjusted gross income for the taxable year, over (ii) the threshold amount. The threshold amount(s) are: (1) for a taxpayer filing a joint return or as a surviving spouse, $250,000; (2) for a married taxpayer filing a separate return, $125,000; and (3) in any other case, $200,000. For most taxpayers, modified adjusted gross income is their adjusted gross income. “Modified” applies only to taxpayers living abroad and using the foreign earned income exclusion.
What is net investment income? Simply stated (ifs, ands, buts abound), net investment income is gross income from interest, dividends, annuities, rents and net capital gains. Excluded from net investment income are items such as tax-exempt bond interest, excludable gain on the sale of a principal residence and qualified retirement plan distributions.
• For an estate or trust. A tax (in addition to any other tax for each taxable year, starting in 2013, is imposed equal to 3.8 percent of the lesser of: (A) the estate’s or trust’s undistributed net investment income, or (B) the excess (if any) of (i) the estate’s or trust’s adjusted gross income for the taxable year, over (ii) the dollar amount at which the highest tax bracket in IRC Section 1(e) begins for the taxable year. Translation. That threshold amount for 2012 is $11,650 (indexed for inflation).
ALERT. An additional 0.9 percent medicare tax is imposed if an individual’s wages, compensation or self-employment income exceeds the threshold amount for the individual’s filing status. Net investment income (the subject of this article) is not subject to the 0.9 percent additional medicare tax. A description of the additional medicare tax follows this article.
Charitable Remainder Trusts
Although charitable remainder unitrusts and charitable remainder annuity trusts aren’t subject to the 3.8 percent medicare surtax (IRC Section 1411), annuity and unitrust distributions may be net investment income to the non-charitable recipient beneficiary. Proposed Reg. Section 1.1411-3(c)(2) provides special rules that maintain the character and distribution ordering rules of Reg. Section 1.664-1(d) for purposes of IRC Section 1411. The Treasury Department and the Internal Revenue Service say that they “are proposing these rules to determine whether items of income allocated to annuity or unitrust payments constitute net investment income to the recipient beneficiary.”
Amount potentially subject to the 3.8 percent tax. Proposed Reg. Section 1.1411-3(c)(2)(i) provides that “distributions from a charitable remainder trust to a beneficiary for a taxable year consist of net investment income in an amount equal to the lesser of the total amount of the distributions for that year, or the current and accumulated net investment income of the charitable remainder trust.
For charitable remainder trusts with multiple annuity or unitrust beneficiaries, the trust shall apportion the net investment income among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the trust for that taxable year.”
Accumulated net investment income is “the total amount of net investment income received by a charitable remainder trust for all taxable years beginning after Dec. 31, 2012, less the total amount of net investment income distributed for all prior taxable years beginning after Dec. 31, 2012.” Proposed Reg. Section 1.1411-3(c)(2)(ii).
Thus, Treasury says, “current and accumulated net investment income of the trust is deemed to be distributed before amounts that are not items of net investment income for purposes of Section 1411. This classification of income as net investment income or non-net investment income is separate from, and in addition to, the four tiers under Section 664(b), which continue to apply.”
Another possible method. The Treasury and the IRS say that they “considered an alternative method for determining the distributed amount of net investment income in which net investment income would be determined on a class-by-class basis within each of the Section 1.664-1(d)(1) enumerated categories. Under this alternative method, trustees would need to account for additional classes of income within each category, consistent with Section 1.664-1(d)(1)(I), for taxable years beginning after Dec. 31, 2012. The alternative method would create a sub-class system of net investment income and non-net investment income within each class and category of the Section 664 framework. Although differentiating between net investment income and non-net investment income within each class and category might be considered more consistent with the structure created for charitable remainder trusts by Section 664 and the corresponding regulations, the Treasury Department and the IRS believe that the record-keeping and compliance burden that would be imposed on trustees by this alternative would outweigh the benefits.”
Planning Pointer: Dec. 31, 2012 Deadline
For high net-investment-income taxpayers, distributions of a CRT’s post Dec. 31, 2012 net investment income will be potentially subject to the 3.8 percent surtax. But income and gains realized in 2012 and earlier won’t be subject to that tax, even though distributed to the beneficiaries after 2012.
• If now is otherwise a good time to sell, take capital gains before the end of 2012.
• If possible, accelerate dividends, interest and other income into this year.
• Defer losses, if possible, to after 2012.
• Before worrying about any of this, determine whether the beneficiary’s net investment income will be above the applicable threshold.
Pooled Income Funds
Other than stating that pooled income funds are subject to the 3.8 percent tax, the proposed regulations are silent. Here’s my take: A pooled income fund distributes all its income to the fund’s income beneficiaries. Thus, that income doesn’t subject the fund itself to the 3.8 percent tax. High net-investment-income beneficiaries may be subject to the 3.8 percent tax under the rules on an individual’s net investment income discussed earlier.
What about a pooled fund’s capital gains? They are never paid to the beneficiaries. So the beneficiaries aren’t potentially subject to the 3.8 percent tax on capital gains.
Does a pooled income fund itself have net investment income on capital gains? Long-term capital gains aren’t taxable to a pooled income fund under the “regular” income tax rules. And they are permanently set aside for charity, so they shouldn’t be subject to any type of federal tax to any one in sight.
A pooled income fund’s short-term capital gains are taxable to the fund under the “regular” income tax rules. Are the short-term gains over $11,650 (indexed for inflation) for the year subject to the 3.8 percent tax? Short-term capital gains as well as long-term capital gains are added to the fund’s principal for ultimate distribution to the charitable remainder organization.
The proposed regulations, as noted, give no details other than to say that pooled income funds are subject to the 3.8 percent tax. We have just seen—according to my analysis—that pooled income funds aren’t taxable on income paid to the fund’s income beneficiaries. They aren’t taxable on long-term capital gains permanently set aside for charity. So, are short-term gains (taxable to the fund) subject to the 3.8 percent tax? Under the broad language of the proposed regulations, short-term gains of pooled income funds seem to be subject to the 3.8 percent tax. But those gains, as noted, are permanently set aside for charity. Thus, in my view, those gains shouldn’t be subject to the 3.8 percent tax—even though they are taxable to the fund under the “regular” rules.
Bottom line. I believe that Treasury and the IRS should be strongly urged by many charities to state in the final regulations that pooled income funds are not subject to the 3.8 percent tax on their short-term capital gains. Pooled income funds are known as the “poor man’s charitable remainder trust.” Most donors have contributed relatively small amounts to the fund because their gifts are not large enough to be separately invested in a charitable remainder unitrust or annuity trust. For public policy reasons, the final regulations should clarify that a pooled fund’s short-term gains aren’t subject to the 3.8 percent tax. Taxes on those gains would, in effect, be a tax on the charities. And if Congress had intended that a pooled income fund’s short-term gains be subject to the 3.8 percent tax, it would have specifically so provided in IRC Section 1411.
Non-Grantor Charitable Lead Trusts
Although not specifically identified, those trusts are subject to the 3.8 percent tax on any net investment income that isn’t distributed to the charitable lead beneficiaries. And remember the low $11,650 threshold.
Grantor Charitable Lead Trusts
The donor to a grantor trust is taxable on trust income and capital gains even though paid to the charity. The charitable lead trust itself isn’t subject to the 3.8 percent tax, but a donor will be subject to that tax on any trust net investment income—together with other net investment income—that exceeds the applicable net-investment-income threshold.
Charitable Gift Annuities.
Earnings of funds held by charities for their gift annuity programs aren’t taxable unless the charity runs afoul of the rules under IRC Sections 514(c)(5) and 501(m). But annuity payments (other than the excludable amount—the deemed return of principal) are net investment income to the annuitant. And any capital gain triggered by the transfer of appreciated assets for the gift annuity (under the bargain sale rules) is net investment income to the donor (who may or may not be an annuitant).
Effective date of proposed regulations. Although the tax is imposed starting in 2013, the effective date is Jan. 1, 2014. But the IRS says that taxpayers may rely on the proposed regulations for compliance purposes until final regulations are published (anticipated in 2013).
Comments and Public Hearing. Before the proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight copies) or electronic comments that are timely submitted to the IRS. The Treasury Department and the IRS request comments on all aspects of the proposed rules. All comments will be available for public inspection and copying. Written or electronic comments must be received by March 5, 2013.
A public hearing has been scheduled for Tuesday, April 2, 2013, beginning at 10:00 a.m. in the Auditorium, Internal Revenue building, 1111 Constitution Avenue NW, Washington, DC. Due to the building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts.
Persons who wish to present oral comments at the hearing must submit electronic or written comments by March 5, 2013, an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight copies) by March 5, 2013. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available at the hearing.
Addresses: Send submissions to: CC:PA:LPD:PR (REG-130507-11), Room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-130507-11), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC, or sent electronically, via the Federal eRulemaking portal at www.regulations.gov (IRS REG-130507-11).
For further information concerning the proposed regulations, contact Michala Irons, (202) 622-3050, or David H. Kirk, (202) 622-3060; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Oluwafunmilayo (Funmi) Taylor, (202) 622-7180.
ADDITIONAL 0.9 PERCENT MEDICARE TAX
An individual is liable for the new 0.9 percent additional medicare tax if his or her wages, compensation, or self-employment income exceed the threshold amount for the individual’s filing status.
Filing Status Threshold Amount
Married filing jointly $250,000
Married filing separately $125,000
Head of household (with qualifying person) $200,000
Qualifying widow(er) with dependent child $200,000
Effective. Jan. 1, 2013.
Additional medicare tax not due on all wages, compensation, etc., but just on the wages, compensation, etc. above the threshold for the individual’s filing status.
Wages that are not paid in cash, such as fringe benefits, are subject to the 0.9 percent additional medicare tax.
Reminder. The new 3.8 percent tax imposed on an individual’s net investment income (discussed earlier) is not applicable to FICA wages, or self-employment income.
© Conrad Teitell 2012. This is not intended as legal, tax, financial or other advice. So, check with your adviser on how the rules apply to you.