Net Investment Income Tax Final Regulations - Application to Trusts and Estates

Application to Trusts and Estates

Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010. [Pub. L. 111-152, 124 Stat. 1029] added IRC § 1411 effective for taxable years beginning after December 31, 2012.  IRC § 1411 imposes a 3.8 percent tax on certain individuals, estates, and trusts. On November 26, 2013, the IRS published final regulations interpreting and applying IRC § 1411. These regulations are generally effective for tax years beginning after December 31, 2013 but taxpayers may, subject to some limitations, apply these regulations for tax years beginning after December 31, 2012. [Treas Reg § 1.1411-1(f). But see Treas Reg § 1.1411-3(d) which specifically provides that Treas Reg § 1.1411-3(f) 

applies to the taxable years of charitable remainder trusts that begin after December 31, 2012.]

In the case of an estate or trust, IRC § 1411(a)(2)  imposes a tax (in addition to any other tax imposed by subtitle A of the Internal Revenue Code) for each taxable year 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 (as defined in IRC § 67(e)) for such taxable year, over (ii) the dollar amount at which the highest tax bracket in IRC § 1(e) begins for such taxable year. With regard to this dollar amount, in the case of an estate or trust that has a short taxable year, the dollar amount is not reduced or prorated. [Treas Reg § 1.1411-3(a)(2).] For 2013, the highest tax bracket for an estate or trust is 39.6 percent and the estate's or trust's taxable income begins to be taxed at that rate once it exceeds $11,950. [IRC § 1(e).]

Congress did not provide a rule specifying the particular trusts subject to I.R.C. Section 1411. The final regulations, however, specifically provide that I.R.C. Section 1411 and the regulations thereunder "will apply to all estates and trusts that are subject to the provisions of Part I of Subchapter J of Chapter 1 of Subtitle A of the Internal Revenue Code, unless specifically exempted." [Treas Reg § 1.1411-3(a)(1).] The regulations [Treas Reg § 1.1411-3(b)(1)] specifically provide that [certain] trusts are not subject to the tax imposed by IRC § 1411[.]

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Special Rules for Charitable Remainder Trusts

As noted above, charitable remainder trusts are not subject to I.R.C. Section 1411. Charitable remainder trusts' annuity and unitrust distributions, however, may be net investment income to the non-charitable recipient beneficiary thus subjecting the beneficiary to the tax. In this regard, the final regulations provide that, if one or more items of net investment income comprise all or part of an annuity or unitrust distribution from a charitable remainder trust, those items shall retain their character as net investment income in the hands of the recipient of the annuity or unitrust distribution. [Treas Reg § 1.1411-3(d)(1)(i). Note, Treas Reg § 1.1411-3(f) provides that provisions of Treas Reg § 1.1411-3(d) are applicable to the taxable years of charitable remainder trusts beginning after December 31, 2012.] For charitable remainder trusts with multiple annuity or unitrust beneficiaries, the trust must 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. [Treas Reg § 1.1411-3(d)(1)(ii).] The final regulations categorize and distribute net investment income based on the I.R.C. Section 664 category and class system. [Treas Reg § 1.1411-3(d)(2).] See Treas Reg § 1.664-1(d)(1)(i)(B).]

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Computation of Net Investment Income and Undistributed Net Investment Income

... IRC § 1411(c)(1) provides that net investment income means the excess (if any) of (A) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply, (ii) other gross income derived from a trade or business to which the tax applies, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply; over (B) the deductions allowed by subtitle A which are properly allocable to such gross income or net gain.

Undistributed net investment income is an IRC § 1411 term used solely for estates and trusts (and not individuals). Congress did not define the term. The final regulations, however, conform the taxation of estates and trusts under IRC § 1411to the rules of Part I of Subchapter J thereby avoiding the double taxation of net investment income and the taxation of amounts distributed to charities. The final regulations, consistent with the provisions of Subchapter J, treat an estate or trust as a conduit by computing undistributed net income by reducing the estate's or trust's taxable net investment income to take into account distributions of net investment income to beneficiaries and the charitable deduction under 
IRC § 642. Specifically, the final regulations provide that undistributed net investment income of an estate or trust is its net investment income reduced by the share of net investment income included in the deductions of the estate or trust under I.R.C. Section 651 or IRC § 661, and the share of net investment income allocated to the IRC § 642(c) deduction of the estate or trust in accordance with Treasury Regulations Section 1.642(c)-2(b) and the allocation and ordering rules under Treasury Regulations Section 1.662(b)-2. [Treas Reg § 1.1411-3(e)(2), (3), (4).]

Information referenced herein is provided for educational purposes only. For legal advice applicable to the facts of your particular situation, you should obtain the services of a qualified attorney licensed to practice law in your state.

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