WEALTH STRATEGY REPORT The 3.8% Surtax on Investment Income - Trusts INTRODUCTION Beginning in 2013, net investment income (NII, as defined in the statute) is subject to an additional 3.8% surtax to the extent your modified adjusted gross income exceeds certain thresholds. This surtax was enacted as part of the Health Care and Education Reconciliation Act of 2010, but its effective date was 2013. The IRS issued proposed regulations in November of 2012 (the 2012 Proposed Regulations ), and those were summarized in our Tax Alert 2012-07: New Regulations for 3.8% Medicare Surtax Answer Several Questions, Leave Others Unanswered. A year later, in November of 2013, the IRS issued final regulations (the Final Regulations ) and a new set of proposed regulations (the 2013 Proposed Regulations ). This Wealth Strategy Report focuses on trusts. We have a separate Wealth Strategy Report that gives an overview of this surtax and how it applies to individuals: The 3.8% Medicare Surtax on Investment Income - Individuals. This report on trusts is a complement to that and assumes you are familiar with that overview. The surtax applies to individuals, trusts and estates. For trusts and estates, the 3.8% surtax is imposed on the lesser of: (1) undistributed net investment income, (2) or the excess of adjusted gross income over the dollar amount at which the highest trust/estate income tax bracket begins ($11,950 for 2013; $12,150 for 2014). Net investment income will be referred to as NII. TAX-EXEMPT TRUSTS The surtax does not apply to tax-exempt trusts, even if the trust might be subject to income tax on unrelated business taxable income that includes NII. The Regulations list several trusts that fall under this exemption: Charities and retirement plans (e.g., IRAs); Charitable Remainder Trusts (discussed further below); Archer Medical Savings Accounts and Health Savings Accounts; Qualified Tuition Programs (529 Plans); and Coverdell Education Savings Accounts. GRANTOR TRUSTS Many trusts that are commonly used in estate planning are grantor trusts for income tax purposes. 1 This means that the income, gain, deductions and losses of the trust are deemed to be the grantor s for income tax purposes. That the same approach applies for purposes of the surtax. That is, the NII of a grantor trust will be considered to be the grantor s NII for surtax purpose. 1 Examples of grantor trusts include revocable trusts, Grantor Retained Annuity Trusts (GRATs), Intentionally Defective Grantor Trusts (IDGTs), and most Irrevocable Life Insurance Trusts (ILITs).
CHARITABLE REMAINDER TRUSTS (CRTs) The surtax does not apply to a CRT. However, distributions from a CRT to a beneficiary can have surtax consequences to the beneficiary. The Final Regulations follow the tier system that applies to CRT distributions for regular tax purposes. Under the tier system, a CRT s income is categorized into: (1) ordinary income; (2) capital gain; (3) other income; (4) principal. Within each of the first three categories, a hierarchy of classes of income is created based on the highest federal income tax rate that can be imposed on that class. Distributions from the CRT are deemed to carry out income based on the so-called highest-taxed in first out (HIFO) system. That is, distributions are considered to come from the highest numbered category until it is exhausted, and distributions from within a category are considered to come from the highest-taxed class within that category until that class is exhausted. For each class of income, the Final Regulations simply create an additional class: income that is NII received after 2012. For purposes of classifying income in the tier hierarchy just described, the tax rate for each class of income that is NII received after 2012 is simply increased by 3.8%. Such income received by the CRT prior to 2013 would not constitute NII. With that, the usual rules of the tier system apply. Example 1. You created a Charitable Remainder Annuity Trust before 2013 and funded it with appreciated long-term stock that was sold by the CRT for long-term capital gain of $1MM. Assume your annual annuity payment is $50,000. The CRT reinvested the sales proceeds, and during 2013 the CRT received investment income of $20,000 of qualifying dividends, $10,000 of taxable interest, and $10,000 of long-term capital gain. That would produce the following tiers and classes of income: Tier Income Top Rate/Class Amount Distributed Balance Tier 1 Income Tier 2 Gain Interest (NII) 43.4% (39.6% + 3.8%) $ 10,000 $ 10,000 $ 0 Qualified dividends (NII) 23.8% (20% + 3.8%) $ 20,000 $ 20,000 $ 0 Long-term capital gain (NII) 23.8% (20% + 3.8%) $ 10,000 $ 10,000 $0 Long-term capital gain (not NII) 20% (pre-2013) $ 1,000,000* $ 10,000 $ 990,000 Total $ 50,000 * This is the capital gain from the sale of the initially-contributed stock. It was sold before 2013 and so the gain is not NII. Under the tier system, the 2013 distribution of $50,000 would be deemed to consist of (1) $10,000 of interest received in 2013 (which is NII); (2) $20,000 of qualified dividends received in 2013 (which is NII); (3) $10,000 of long-term capital gain received in 2013 (which is NII); and (4) $10,000 of long-term capital gain received before 2013 (which is not NII). NON-GRANTOR IRREVOCABLE TRUSTS There are many irrevocable trusts that are commonly used in estate planning. Many are grantor trusts, which were discussed above. This section will focus on non-grantor trusts. One example is a trust established under an estate plan that is shielded by the decedent s estate tax exemption. This trust is often referred to as The Family Trust or The Bypass Trust. Another example is a multi-generational trust such as a so-called dynasty trust. 2
The Income Tax Treatment of Irrevocable Non-Grantor Trusts: Distributable Net Income (DNI) For irrevocable trusts such as these, for regular tax purposes, taxable income is taxed just once, either to the trust or to the beneficiaries, depending on whether it is retained or distributed. To determine whether a trust has retained or distributed income, a trust keeps track of its Distributable Net Income, or DNI. For most trusts, DNI is the same as taxable income, with some exceptions. Two well-known exceptions are: (i) municipal bond interest is not included in taxable income but is included in DNI, 2 and (ii) amounts allocated to trust principal, such as capital gains, are in taxable income but generally are not included in DNI. 3 Once DNI is calculated, distributions to beneficiaries generally carry out DNI, and the components of income that make up the DNI are reported by the beneficiaries on their income tax returns. The 3.8% Surtax Treatment of Irrevocable Trusts. The introduction to DNI in the preceding paragraph is necessary because the DNI results for regular income tax purposes determine the 3.8% surtax results. The Final Regulations adopt the following approach. 1. A trust calculates its DNI under the existing rules; 2. A trust must now also track whether each item of income in DNI is NII or not; 3. Items of income that both (i) are distributions of DNI under established rules, and (ii) are items of NII, will be considered distributions of NII (the maximum amount of NII that can be considered distributed is capped at DNI); 4. The beneficiary includes distributed NII in his/her NII; and 5. The trust s undistributed NII will be the total NII of the trust less the amounts deemed distributed under #3. Example. The following example is from the Final Regulations. Assume a trust has the following income net of expenses: Total Dividend income $ 15,000 In DNI In NII Income Taxable Interest income $ 10,000 Capital gain $ 5,000 Dividend $15,000 $15,000 $15,000 IRA taxable distribution $ 75,000 Interest $10,000 $10,000 $10,000 TOTAL $105,000 The trust makes a discretionary distribution of $10,000 to A, a beneficiary. Steps 1 and 2: The trust calculates its DNI under the existing rules; the trust also tracks whether each item of income in DNI is NII or not. The chart at the right summarizes these first two steps. Capital Gain $ 5,000 $ 5,000 IRA Distribution $75,000 $75,000 TOTAL $105,000 $100,000 $30,000 Step 3: Items of income that both (i) are distributions of DNI under established rules, and (ii) are items of NII, will be considered distributions of NII. From the chart above, only the dividends and interest are both in DNI and NII. Therefore, to the extent a distribution carries out these dividends and interest for regular income tax purposes, those same dividends and interest are considered distributed for surtax purposes. 2 This allows the tax-exempt nature to pass through to a beneficiary. 3 If certain conditions are met, it is possible for a trust to include capital gain in DNI. 3
In this example, there is a $10,000 discretionary distribution to the beneficiary. That is 10% of the total DNI of the trust. Under the DNI rules, that is considered to be a distribution of 10% of each item of income that comprises DNI. As a result, for regular income tax purposes, the beneficiary includes in income $1,500 of dividends, $1,000 of interest, and $7,500 of IRA distribution. Steps 4 and 5. For surtax purposes, the beneficiary includes $1,500 of dividends and $1,000 of interest in his/her NII. (The $7,500 IRA distribution is not NII.) The trust s undistributed NII will be the total NII of $30,000, less the $2,500 considered distributed, or $27,500. The following chart summarizes what is considered distributed for income tax/dni purposes, and that in turn determines what is considered distributed for surtax/nii purposes. Income tax (DNI) results Surtax (NII) results In Trust s DNI Distributed Total Distributed (beneficiary s NII) Retained (Trust s NII) Dividend $15,000 $ 1,500 $15,000 $ 1,500 $13,500 Interest $10,000 $ 1,000 $10,000 $ 1,000 $ 9,000 Capital Gain $ 5,000 $ 0 $ 5,000 IRA Distribution $75,000 $ 7,500 TOTAL $100,000 $10,000 $30,000 $ 2,500 $27,500 PASSIVE ACTIVITY NII includes passive activity income, which generally is income from a trade or business in which you do not materially participate (i.e., you are passive). This would include business income from closely-held family businesses operating as an S corporation, a partnership, or a limited liability company (LLC) taxed as a partnership, where some family members own units/shares but are not actively involved in the business (i.e., they are passive under the tax rules). The business income that flows through to the non-involved family members would be passive income and therefore would be NII. Although there are lengthy regulations addressing how an individual determines whether s/he is a passive investor, 4 there is no statute or regulation addressing how to determine whether a trust is passive. A 2003 district court case held that you would look to the participation of the trustee, as well as employees and agents of the trustee. However, the IRS has not followed that case; its position is that only the trustee s participation determines whether the trust is engaged in a passive activity. While it is clear that passive income of a trust will be treated as NII, the surtax Final Regulations do not offer any guidance on how to determine whether a trust s income from a trade or business is active or passive income. 4 The passive activity rules have been a part of the regular income tax rules since 1986. 4
CHARITABLE DISTRIBUTIONS If certain conditions are met, a trust will be able to deduct amounts distributed to charity for regular income tax purposes. One example of such a trust is a charitable lead trust, and we have a separate Wealth Strategy Report: Charitable Lead Trusts. Before the surtax regulations were issued, there was a question as to whether a charitable deduction would be allowed to a trust for purposes of the surtax. (In the case of an individual, charitable contributions do not factor into the calculation of the surtax.) The Final Regulations clarify that a trust that receives a charitable income tax deduction for amounts paid to charity will also be able to deduct those amounts when calculating the trust s NII. If the trust has both NII and income that is not NII, the charitable deduction must be apportioned between those two categories of income, and only the amount apportioned to NII can be deducted for purposes of calculating the 3.8% surtax. PLANNING IDEAS Some trusts might present few planning opportunities. For example, consider one common form of marital trust, a so-called QTIP 5 trust, that is conservatively invested and generates interest and dividends but little/no capital gains. As a QTIP trust, it must distribute all income to the surviving spouse. If all of the income (i) is in DNI; (ii) is NII; and (iii) must be distributed, there is little planning available. The NII (other than nominal gains) will be fully distributed each year. For trusts that are not as simple as this example, below are some planning ideas. Distribute NII to beneficiaries Given the very low surtax threshold for trusts ($11,950 for 2013; $12,150 for 2014), a trust can easily have NII that, if retained by the trust, will be subject to the surtax. One planning consideration is to make a discretionary distribution to the beneficiaries if their higher thresholds would result in less tax. 6 Of course, such distributions must be consistent with the terms of the trust and the trustee s fiduciary duties. In addition, one must be aware of the law of unintended consequences. Increasing a beneficiary s income via a distribution can have other tax consequences, such as the following; The non-income tax consequences must be considered. For example, by making a discretionary distribution from a bypass trust to a surviving spouse, that might increase the surviving spouse s taxable estate. In 2013 the Pease limitations returned. These limitations phase-out the deductibility of certain itemized deductions and personal exemptions when adjusted gross income (AGI) exceeds certain thresholds. Increasing the beneficiary s AGI by could cause additional itemized deductions to be phased-out. The ability to contribute to a Roth IRA is phased out as modified AGI exceeds certain thresholds. (The ability to convert a traditional IRA to a Roth is not affected by modified AGI.) Increasing the beneficiary s AGI could magnify this phase-out. The deductibility of contributions to a traditional IRA can be affected by AGI. Medicare premiums for Parts B and D are increased when AGI exceeds certain limits. The taxability of Social Security benefits is affected by AGI. 5 QTIP is an acronym for Qualified Terminable Interest Property. 6 The various thresholds and their role in the calculation of the surtax are discussed in our Wealth Strategy Report: The 3.8% Medicare Surtax on Investment Income Individuals. 5
Amounts that can be contributed to a Coverdell education savings account (formerly known as an Education IRA) are phased out if modified AGI exceeds certain thresholds. The interest income recognized on the redemption of EE bonds can be excluded from income if used to pay higher education expenses and if other requirements are met. This exclusion is phasedout if AGI exceeds certain thresholds. For regular income taxes, medical expenses are deductible as an itemized deduction only to the extent they exceed a floor of 7.5% of AGI. (Beginning in 2013, this threshold for medical expense deductions is scheduled to increase to 10% of AGI, unless you or your spouse is 65 as of the end of the year.) A distribution from a trust could increase the recipient s floor. For regular income taxes, miscellaneous itemized deductions are deductible only to the extent they exceed 2% of AGI. A distribution from a trust could increase the recipient s floor. Up to $25,000 of passive losses from real estate can be deducted against non-passive income if you are active and other requirements are met. This exclusion is phased out if AGI exceeds certain thresholds. Such a distribution could also have beneficial tax consequences, such as the following: The ability to deduct charitable contributions as an itemized deduction is limited based on AGI. An increase in AGI could allow a larger charitable income tax deduction. Investment interest is deductible only to the extent of net investment income (defined differently in that statute). A distribution of NII from the trust could allow a larger investment interest deduction for the beneficiary if that NII is also net investment income under Section 163. If the recipient beneficiary is subject to alternative minimum tax, any DNI being carried out by the distribution might be income taxed at a 28% rate, which might be lower than what the trust would pay had there not been a distribution. Distributions in kind as a planning opportunity Assume the trustee of a trust wants to make a $10,000 discretionary distribution to a beneficiary, and assume the trust owns stock with a value of $10,000 and basis of $7,500. Consider the following two choices. 1. The trustee could sell the stock to raise the $10,000 to make the distribution, and recognize $2,500 of capital gain. If the trustee then distributes the $10,000, the $2,500 of capital gain recognized would be NII that likely would remain in the trust for surtax purposes. 7 2. Alternatively, the trustee could distribute the stock. The $2,500 of capital gain would not be recognized and would not be NII to the trust; the recipient will have a carryover basis of $7,500. The second choice might be appropriate if: The beneficiary plans to sell the stock but has capital losses to offset that gain; The beneficiary plans to sell the stock but has capacity to recognize NII without triggering the surtax because of the beneficiary s higher threshold (though beware of the unintended consequences mentioned earlier); The beneficiary plans to sell the stock and will pay the surtax, but that spares the trust from incurring that surtax, which could be a benefit for the other trust beneficiaries; or The beneficiary does not plan to sell the stock. 7 The rules for determining whether capital gain can be included in DNI and therefore considered distributed are beyond the scope of this summary; this example assumes the capital gains remain trapped inside the trust regardless of distributions. 6
65 day rule Generally, in order for a distribution from a trust to carry out DNI, the distribution must occur during the tax year in question. However, a trust can choose to treat any discretionary distribution made within 65 days after the end of the trust s tax year to be taxed as if made on the last day of the tax year. This 65-day rule lets a trust with a calendar-year tax year accurately determine its income by March 5th or 6th (depending on whether it is a leap year) and then make a distribution that is treated as having occurred in the prior tax year (carrying out the prior year s DNI). The alternative is for that income to remain in, and be taxed to, the trust. For 2013 and later years, the 65-day rule will allow a trust to make an informed decision about making distributions to minimize the surtax. Fiscal Years/Short Years The new surtax is effective for tax years beginning after 12/31/2012. Most trusts have a calendar year tax year. Estates, however, can choose a fiscal year. For those estates (and a very small number of unusual trusts) with fiscal years, this could allow for some planning opportunities. Example. Assume a decedent dies in November 2012. A fiscal year ending (f/y/e) 10/31/13 is chosen. If NII is retained in the estate during its first fiscal year, then the NII received by the estate through 10/31/13 will not be subject to the surtax, pursuant to the effective date provision. Example. Assume a decedent dies in January 2014. A fiscal year ending January 31 is chosen. This results in a very short first tax year and a second tax year from 2/1/14 through 1/31/15. An estate s distribution is deemed to be distributed on the last day of its fiscal year. Therefore, NII received by the estate and distributed during f/y/e 1/31/15 is deemed to be distributed to the beneficiaries on 1/31/15 and would be NII to the beneficiaries in 2015, providing a one-year deferral. Example. Assume a decedent dies in January 2014. The estate s portfolio is $1,500,000. It is invested in a money market fund yielding 2% annually, which is $30,000 annually or $2,500 monthly. After 4 months, the portfolio has generated $10,000 of NII for the estate. Therefore, a fiscal year ending May 31 is chosen. This means the estate s NII for that first fiscal year is less than the threshold, so there will be no surtax due (assuming no distributions). Going forward, the fiscal year will allow the estate s NII, if distributed, to be deferred by the recipient beneficiaries. 2503(c) Trusts Named for the section of the tax law authorizing it, this is a special gift trust for one beneficiary. By having the trust meet certain requirements, contributions qualify for the annual gift tax exclusion ($14,000 in 2014) without having to give the beneficiary a withdrawal right. To qualify as a 2503(c) trust, the trust must provide: 1. principal and income must be available for distribution at the trustee's discretion while the beneficiary is under the age of 21; 2. all accumulated principal and income must be distributed to the beneficiary at age 21, terminating the trust; and 3. if the beneficiary dies before reaching age 21, all principal and income must be paid either to the beneficiary's estate or to the beneficiary's appointee pursuant to a general power of appointment. Such a trust might grant the trustee discretion to distribute. In that case, the NII of the trust might be retained or distributed. If retaining the NII inside the 2503(c) trust would expose it to the surtax, the trustee could consider distributing the NII (or enough so that the trust s retained NII is not exposed to the surtax) to an UTMA account in the beneficiary s name. For income tax purposes, an UTMA s income is the child s income. This 7
would allow the NII to be the child/beneficiary s NII, and the child/beneficiary would have the benefit of a higher threshold ($200,000 for a single taxpayer). Note that for regular income tax purposes, the child s income might be taxed at the parent s marginal income tax rate under the so-called kiddie tax. However, the income tax brackets for trusts are very condensed (the highest rate is reached at taxable income of $11,950 in 2013; $12,150 in 2014), and a trust s income is subject to the highest marginal rate very quickly. Therefore, having the child s income tax rate for regular income tax purposes be the highest rate might be no worse than if the income had been retained by the trust. National Wealth Planning Strategies Group Any examples are hypothetical and are for illustrative purposes only. Note: This is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations. Information in this material is not intended to constitute legal, tax or investment advice. You should consult your legal, tax and financial advisors before making any financial decisions. If any information is deemed written advice within the meaning of IRS Regulations, please note the following: IRS Circular 230 Disclosure: Pursuant to IRS Regulations, neither the information, nor any advice contained in this communication (including any attachments) is intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. U.S. Trust operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. 2014 Bank of America Corporation. All rights reserved. ARFE2B94 012014 8