Minimizing the Impact of the 3.8% Medicare Surtax on Estates and Trusts Final Regulations

Minimizing the Impact of the 3.8% Medicare Surtax on Estates and Trusts Final Regulations Jeremiah W. Doyle IV BNY Mellon Wealth Management Boston, MA July, 2014 1 Agenda Background AGI of an estate or trust Undistributed net investment income Net investment income 3.8% surtax examples Allocating expenses Capital gains Passive income Passive income S corporations Sale of S Corporation Stock or Partnership Interest Passive v. active activities Passive income Estates and Trusts Structuring investments to avoid the surtax Planning ideas to avoid the surtax Distribution alternatives Discretionary distributions 65 day rule election Include gains in DNI In-kind distributions under 643(e) Estimated taxes 2 1

Agenda State income tax considerations Special Situations Grantor Trust Qualified Subchapter S Trust (QSST) Electing Small Business Trust (ESBT) Foreign Estates and Trusts Charitable Remainder Trusts Pooled Income Funds Charitable Lead Trusts Non-grantor Grantor Charitable Gift Annuity Charitable Planning 3 Background 1411 imposes 3.8% surtax on net investment income of individuals, estates and trust for taxable years beginning after 12/31/2013. The surtax is in addition to all other taxes imposed by Subtitle A (income taxes), including the alternative minimum tax. 1411(a)(1). For estates and trusts, the surtax applies to the lesser of: Adjusted Gross Income (AGI) in excess of the highest income tax bracket threshold ($12,150 in 2014), or Undistributed net investment income. 1411(a)(2) The highest income tax bracket for estates and trusts is indexed for inflation each year whereas the threshold for individuals is fixed at $250,000 (married filing joint and surviving spouses), $200,000 (single and head of household) and $125,000 (married filing separately). 1(f); 1411(b). For purposes of Subchapter J, forming multiple trusts to take advantage of multiple thresholds prohibited by 643(f) which aggregates multiple trusts if they have substantially the same trustees and beneficiaries. 4 2

Background Net investment income is reduced by allocable deductions. 1411(c)(1)(B); Reg. 1.1411-4(f) or (g) Net investment income tax is not reduced by credits such as the foreign tax credit or general business credit. Reg. 1.1411-1(e). The net investment income tax is subject to estimated taxes and included as a tax for purposes of 6662 (underestimation penalty), 6694 (return preparer penalties) and 6601 and 6611 (interest on underpayments/overpayments) 5 Background Surtax doesn t apply to fully charitable trusts or estates. 1411(e)(2); Congressional Joint Committee on Taxation, JCX-18-10 p. 135. Reg. 1.1411-3(b)(1)(i). Surtax doesn t apply where all of the unexpired interests are devoted to one or more of the following purposes: religious, charitable, scientific, literary, or educational purposes or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children and animals. Surtax doesn t apply to charitable remainder trusts (CRT) because they are exempt from income tax under 664. Income earned by a CRT before 1/1/2013 is exempt from the surtax. The net investment income of the beneficiary attributable to the beneficiary s annuity or unitrust distribution is subject to the surtax at the beneficiary level Surtax does apply to non-grantor charitable lead trusts (CLT) but it may be partially or entirely avoided by the required annual distributions to charities. 6 3

Background The surtax does not apply to grantor trusts the applicability of the surtax is determined at the grantor level. Reg. 1.1411-3(b)(1)(v). The goal of the surtax is to tax income that would not be subjected to the Medicare hospital insurance tax under FICA and SECA. 7 AGI of Estate or Trust Determined under 67(e) Computed in same manner as for an individual except deductions are allowed for: The personal exemption ($100, $300, $600) Distributions to beneficiaries Administration expenses which would not have been incurred if the property were not held in the estate or trust i.e. which would not commonly be incurred by an individual. 8 4

Undistributed Net Investment Income (UNII) Not defined in the Code Defined in Reg. 1.1411-3(e)(2) Generally, calculated in the same manner as for an individual. UNII = NII reduced by: distributions of NII to beneficiaries deductible under 651 and 661 and the NII attributable to the charitable deduction under 642(c). Trustee may want to make distributions to beneficiaries if they would not be subject to the surtax (their income is below the $250,000/$200,000/$125,000 thresholds) or are in a lower tax bracket than the estate or trust. 9 Undistributed Net Investment Income (UNII) Note: the amount of NII deducted by the estate or trust is the amount of NII included in income by the beneficiary Note: If the 642(c), 651 and 661 deduction includes NII and non-nii Income, the deduction must be apportioned between NII and non-nii income 10 5

Net Investment Income (NII) The 3.8% surtax is imposed on three classes of income: Gross income from interest, dividends, rents, royalties and annuities (provided this income is not derived in the ordinary curse of an active trade or business), Gross income from: passive activity, or A trade or business of trading in financial instruments or commodities, and Net gain (other than gain from an active trade or business) 11 Net Investment Income Includes: Interest Dividends Annuity distributions Rents Royalties Net capital gain derived from the disposition of property (other than property held in a trade or business) Trade or business income from a passive activity Income or gain from the investment of working capital Income from trade or business of trading in financial instruments or commodities LESS: properly allocable expenses. 1411(c)(1). Does NOT include: Salary, wages or bonuses Distributions from IRAs or qualified plans. 1411(c)(5). Any income subject to selfemployment tax. 1411(c)(6). Income from active business Gain on the sale of an active interest in a partnership or S corporation Items otherwise excluded or exempt from income under the income tax law, such as interest from tax-exempt bonds, capital gain excluded under 121 and veteran s benefits. Note: a trade or business under 1411 refers to a trade or business within the meaning of 162 rather than 469. 12 6

Bottom Line Simple trusts all accounting is distributed so NII, except capital gain, is subject to tax at the beneficiary level if over the applicable threshold. Capital gain subject to 3.8% surtax at the trust level Complex trusts and estates subject to 3.8% surtax on accumulated income and capital gain Grantor trust 3.8% surtax determined at the beneficiary level 13 3.8% Surtax - Examples 3.8% x the lesser of: 1. Undistributed net investment income for such taxable year, or 2. The excess (if any) of AGI (as defined in 67(e)) for such taxable year, over the dollar amount at which the highest bracket in 1(e) begins for such taxable year ($12,150 in 2014). 14 7

3.8% Surtax Example 1 Estate: $225,000 net investment income No distributions 3.8% surtax = $8,088 Net investment income/agi $225,000 Threshold (12,150) Excess $212,850 Lesser of net investment income ($225,000) or AGI over $12,150 is $212,850 15 3.8% Surtax Example 2 Estate: $100,000 wages (IRD) No distributions No 3.8% surtax Wages Exempt 16 8

3.8% Surtax Example 3 Estate: $12,150 wages (IRD) $50,000 net investment income No distributions 3.8% surtax = $1,900 AGI $62,150 Threshold (12,150) Excess $50,000 Surtax applies to $50,000 Lesser of net investment income ($50,000) or AGI over $12,150 is $50,000 17 3.8% Surtax Example 4 Estate: $100,000 pension lump sum $150,000 IRA $25,000 tax-exempt interest No distributions AGI $275,000 Threshold (12,150) Excess $262,850 No 3.8% surtax All income exempt Lesser of net investment income (0) or AGI over $12,150 ($262,850) is 0 18 9

3.8% Surtax Example 5 Trust: $51,000 investment income No distributions AGI $51,000 Threshold (12,150) Excess $38,850 3.8% surtax = $1,476 Lesser of net investment income ($51,000) or AGI over $12,150 ($38,850) is $38,850 19 3.8% Surtax Example 6 Trust: $100,000 investment income Distributes all of DNI to beneficiary AGI $ 0 Threshold (12,150) Excess $ 0 No 3.8% surtax to trust Beneficiary must account for $100,000 investment income and determine if he is subject to 3.8% surtax Lesser of net investment income ($100,000) or AGI over $12,150 ($0) is $0 20 10

3.8% Surtax Prop. Reg. - Example 7 Trust: $100,000 investment income $ 50,000 of IRA income Distributes $90,000 (60% of DNI to beneficiary) DNI deduction of $60,000 NII $40,000 NII trapped in trust and subject to 3.8% surtax ($100,000 NII - $60,000 Distribution = $40,000 UNII) Income Beneficiary Trust NII $100,000 $60,000 $40,000 IRA $ 50,000 $30,000 $20,000 Total $150,000 $90,000 $60,000 $60,000 AGI $12,150 Threshold $47,850 Excess $40,000 NII X.038 $ 1,520 surtax to trust $1,520 surtax to trust Beneficiary must account for $60,000 investment income and determine if he is subject to 3.8% surtax 21 3.8% Surtax Reg. 1.1411-3(e)(5), Ex. 1 2014 Trust: $15,000 dividend income $10,000 interest income $5,000 capital gain (allocated to principal) $75,000 IRA distribution $10,000 mandatory distribution to A (10% of DNI) $27,500 UNII trapped in trust and subject to 3.8% surtax in trust DNI deduction of $10,000 22 11

3.8% Surtax Reg. 1.1411-3(e)(5), Ex. 1 Trust Income DNI A s share of DNI (10%) Trust s total NII A s share of NII (10%) Trust s UNII Dividends $15,000 $15,000 $1,500 $15,000 $1,500 $13,500 Interest $10,000 $10,000 $1,000 $10,000 $1,000 $9,000 Capital gain $5,000 $5,000 $5,000 IRA $75,000 $75,000 $7,500 Total $105,000 $100,000 $10,000 $30,000 $2,500 $27,500 Trust AGI: Total income $105,000 Less: IDD ($10,000) Less: exemption ( $100) Trust AGI $94,900 Less: Threshold ($12,150) $82,750 Lesser of undistributed net investment income ($27,500) or AGI over $12,150 ($82,750) is $27,500 3.8% surtax is $1,045 Surtax applies to $27,500 23 3.8% Surtax Reg. 1.1411-3(e)(5), Ex. 2 2014 Trust: $15,000 dividend income $10,000 interest income $5,000 capital gain (allocated to principal) $75,000 IRA distribution $30,000 mandatory distribution to A (30% of DNI) $10,000 distribution to charity ( 642(c)) (10% of DNI) $20,000 discretionary distribution to B (20% of DNI) $15,000 UNII trapped in trust and subject to 3.8% surtax in trust DNI deduction of $50,000 642(c) deduction of $10,000 24 12

3.8% Surtax Reg. 1.1411-3(e)(5), Ex. 2 Trust Income DNI A s share of DNI (30%) Charity s share of DNI (10%) 642(c) B s share of DNI (20%) Trust s total NII A s share of NII (30%) Charity s share of NII (10%) B s share of NII (20%) Trust s UNII Dividends $15,000 $15,000 $4,500 $1,500 $3,000 $15,000 $4,500 $1,500 $3,000 $6,000 Interest $10,000 $10,000 $3,000 $1,000 $2,000 $10,000 $3,000 $1,000 $2,000 $4,000 Capital gain $5,000 $5,000 $5,000 IRA $75,000 $75,000 $22,500 $7,500 $15,000 Total $105,000 $100,000 $30,000 $10,000 $20,000 $30,000 $7,500 $2,500 $5,000 $15,000 Trust AGI: Total income $105,000 Less: IDD ($50,000) Less: 642(c) ($10,000) Less: exemption ( $100) Trust AGI $44,900 Less: Threshold ($12,150) $32,750 Lesser of undistributed net investment income ($15,000) or AGI over $12,150 ($32,750) is $15,000 3.8% surtax is $570 Surtax applies to $15,000 25 Properly Allocable Deductions Reg. 1.1411-4(f)(3) State income taxes allocable to net investment income Section 165 losses subject to limitations e.g. $3,000 capital loss allowed under 1211(b) Deductions allocable to rents and royalties Business deductions subject to limitations Penalties for early withdrawal Investment interest expense Investment expenses Deductions for unused loss carryover and excess deductions on termination of estate or trust 26 13

Properly Allocable Deductions Reg. 1.1411-4(f)(3) Fiduciary expenses (trustees, legal and accounting fees and other estate and administrative expenses) to extent passed to beneficiaries and allocable to NII 691(c) deduction to the extent allocable to NII Expenses associated with the determination, collection or refund of tax to the extent allocable to NII Only amounts paid or incurred to produce income or net gains that are part of NII may be deducted in determining NII Deductions cannot exceed NII, but deductions allowed to be carried over for income tax purposes may be carried over for NIIT purposes If a deduction is not explicitly enumerated in the NIIT regulations, it is not deductible e.g. 170 charitable deduction and 163(h) mortgage interest deduction not allowed 27 Allocating Expenses Miscellaneous itemized deductions subject to the 2% floor will not reduce the surtax Reason: they are not deductible in computing AGI Regulations govern the allocation of other deductions. Reg. 1.652(b)-3. Direct expenses must be allocated to the class of income to which they relate e.g. rental expenses to rental income Indirect expenses may be allocated to any class of income as long as a portion is allocated to tax-exempt income. Reg. 1.652(b)-3. Regs. list trustee fees, safe deposit box rental and state income and personal property taxes as examples of indirect expenses. Reg. 1.652(b)-3(c). Planning idea: allocate indirect expenses to income subject to the surtax. First to interest and other income taxed as ordinary income (43.4%), then to IRA income (39.6%) and then to qualified dividends taxed at a favorable 23.8% rate. Whatever allocation method is used for regular tax purposes will be respected for NIIT purposes. Can t allocate 100% of fiduciary fees to IRA for regular tax but allocate 100% of fiduciary fee to qualified dividends for NIIT purposes 28 14

Practical Problems Caution: the NII distribution deduction can be less than or equal to the regular tax income distribution deduction Non-NII deductible expenses cause UNII to be greater than taxable income In the final year of an estate or trust there could be a NIIT due even though there are excess deductions on the final return. Reason: NII is higher than taxable income because of non-allocable deductions and the income distribution deduction is capped at the regular tax amount that includes those deductions, and The trust has a positive AGI (but negative taxable income) in the final year 29 Components of DNI 30 15

Components of DNI 31 Capital Gains Funding Pecuniary Bequests Trap for the unwary Funding a pecuniary bequest with appreciated property results in gain recognition to the estate or trust The gain resulting from funding a pecuniary bequest with appreciated property is NII potentially subject to the 3.8% surtax 32 16

Capital Gains Capital gains are part of both AGI and undistributed net investment income for surtax purposes As a general rule, capital gains are accumulated and taxed at the estate or trust level. Thus, capital gains are trapped at the entity level and subject to the surtax unless they can be included in distributable net income (DNI) and distributed to the beneficiaries. Exception: in year of termination, gains are included in DNI Exception: Reg. 1.643 (a)-3 states 3 ways gains can be included in DNI Exception: Reg. 1.643(a)-3(c) states that capital gains paid, permanently set aside or used for charitable purposes for which a fiduciary income tax charitable deduction is allowed under 642(c) for those gains must be included in DNI It will now become more important for an estate or trust to harvest losses before the end of the year. 33 Passive Income Passive income is included in both AGI and net investment income. If income is classified as active, it avoids the definition of net investment income. Passive income is trade or business income in which the taxpayer does not materially participate. 469(c). Rental income is per se passive. 469(c)(2). However, the rental income can be offset by depreciation deductions. Planning point: a trust with passive income might consider investing in passive loss activities to shelter its passive income. Consider the self-rental rule of Reg. 1.469-2(f)(6) Where this rule applies, the income from rental activities is characterized as active, despite the fact that it is rental property 34 17

Passive Income S Corporations If the dividend recipient from an S corporation is an active participant in the S corporation, the dividend will not be net investment income. If the dividend recipient from an S corporation is a passive participant, the dividend will be considered net investment income. If the trustee materially participates in the S corporation s activities, the income will be active. If the dividend is distributed to an individual beneficiary, it is most likely to be passive as to that beneficiary but the AGI threshold to test the application of the 3.8% surtax is that applicable to the beneficiary i.e. $250,000/$200,000/$125,000. If the beneficiary is a Qualified Subchapter S Trust (QSST), the income must be distributed to the QSST beneficiary and the income is taxed to the QSST beneficiary so AGI threshold to test the application of the 3.8% surtax is that applicable to the beneficiary i.e. $250,000/$200,000/$125,000. If the beneficiary is an Electing Small Business Trust (ESBT), the 3.8% surtax applies to the NII of the trust unless the trustee of the ESBT can prove that he materially participated in the activities of the S corporation. 35 Sale of S Corporation Stock or Partnership Interest 2012 Prop. Regs. had complex multi-step method to calculate gain or loss on every assets sold to determine what portion of the gain was subject to the surtax Regs were re-proposed in 2013 2013 Prop. Regs. state that the amount of net gain from the sale of S corporation stock or a partnership interest is the lesser of: The seller s overall gain or loss on the sale of the stock or membership interest determined under regular income tax (Chapter 1) principles or The seller s share of the hypothetical asset sale gain that would be included in net investment income because the assets were not used in a trade or business or the activity was passive as to the seller i.e. include gain or loss in net investment income only to the extent of the gain or loss on the deemed sale of the entity s passive assets. The 2013 Prop. Regs. offer an optional simplified method for qualifying taxpayers. There are two ways to qualify for this simplified method. 36 18

Passive v. Active Activities Trade or business activities of an estate or trust may be owned directly or indirectly through pass-through entities. In order to deduct losses incurred by these activities the trustee must materially participate in the activity. 469(h)(1). Regs. have been issued explaining how individuals can meet the material participation requirements, but there have been no regs. issued dealing with material participation by estates and trusts. Reg. 1.469-8 (applying the PAL rules to estates and trusts) and Reg. 1.469-5T(g) (defining material participation of trusts and estates) has been marked as reserved. T.D. 8417 (May 12, 1992). Individuals can meet one of seven safe harbor tests in Reg. 1.469-5T(a)(1)- (7) in order to materially participate in an activity for purposes of deducting passive losses. Temp. Reg. 1.469-5T, T.D. 8175 (Feb. 19, 1988). Limited partners may only use three of the seven tests in order to be deemed materially participating in the activity. Members of limited liability companies are considered general rather than limited partners and may therefore rely on one of the seven tests for material participation. Hegarty v. Commissioner, T.C. Summ. Op. 2009-153 (October 6, 2009); Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009); Thompson v. United States, 87 Fed. Cl. 728 (July 20, 2009). 37 Passive Income Estates and Trusts For estates and trusts, who must materially participate the trustee, the beneficiaries or the trust s agents? IRS position: the trustee himself must meet the material participation test. TAM 200733023. See also PLR 201029014 and TAM 201317010 in which the IRS maintains that the only way for a trust to materially participate in a trade or business is for the fiduciary to be involved in the operations of the activity on a regular, continuous and substantial basis. Court: material participation should be determined by reference to all the persons who conducted the business on the trust s behalf, including the trustee, the trust s employee and its agents. Maggie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003). Court: services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust. Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014) 38 19

Structuring Investments to Avoid the Surtax Tax-exempt bonds Not added to AGI Not net investment income Investments with tax deferral features Life insurance whole life inside build up not taxable Growth stocks Tax-deferred annuities Deferred compensation Qualified retirement plans Tax-free exchanges Installment sales Charitable remainder trusts Assets with depreciation components e.g. real estate, oil and gas Tax efficient mutual funds Individually managed stocks and bonds i.e. buy and hold strategy 39 Planning Ideas to Avoid the Surtax Make distributions to beneficiaries Select investments that reduce NII such as tax-exempt bonds Adopt a buy and hold approach Invest in growth stocks Capital loss harvesting Distribute assets that generate NII outright to individual beneficiaries while funding trusts with assets that do not generate NII If a trust includes business assets, chose a trustee who materially participates in the business so the business income avoid the classification as NII Place NII generating investments inside a pass-through entity so that capital gains recognized from such investments can be distributed out of the entity to the trust, classified as accounting income, and distributed from the trust as part of the trust s distributable net income. See Crisp v. United States, 34 Fed. Cl. 112 (1995). Allocate indirect expenses to most-highly taxed income first (e.g. taxable interest. Reg. 1.652(b)-3(b). Create trust as grantor trust to have NII subject to the grantor s threshold 40 20

Planning Ideas to Avoid the Surtax Sell appreciated property inside a CRT to stretch the gain over the term of the payments to the non-charitable beneficiary, taking advantage of the noncharitable beneficiary s higher NII threshold. Use a non-grantor charitable lead trust to minimize the NIIT If NII is earned by an individual outside a trust, the individual s MAGI cannot be reduced by a 170 charitable deduction (it is a below- the-line deduction) If the same NII is earned inside a non-grantor charitable lead trust, the NII will be reduced by the 642(c) deduction for the required payment to charity 41 Distribution Alternatives Discretionary distributions 65 day rule election Include gains in DNI In-kind distributions under 643(e) 42 21

Discretionary Distributions Determine if trust instrument allows complex trusts to make discretionary distributions. If so, distributions from a trust whose AGI exceeds $12,150 (in 2014), will cause the income to be taxed to the trust beneficiary, which if an individual, will most likely have a modified AGI under the $250,000/$200,000/$125,000 threshold. Spreads out the NII of the trust among multiple beneficiaries 43 Discretionary Distributions Collateral Damage Unintended consequences of increasing beneficiary s income: Distribution from by-pass trust to spousal beneficiary might increase surviving spouse s taxable estate Pease limitation may phase-out additional itemized deductions Increased MAGI may affect ability to contribute to a Roth IRA Deductibility of contributions to a traditional IRA affected by AGI Increased AGI affects taxability of social security benefits Amounts that can be contributed to a Coverdell education savings account phased-out if MAGI above certain thresholds Interest income recognized on redemption of Series EE bonds that can be excluded from income for higher educations costs phased out if AGI above certain thresholds Increased AGI limits medical expense deduction Increased AGI increases 2% limitation on miscellaneous itemized deductions Increased AGI may phase-out $25,000 PAL allowance for active real estate investors 44 22

Discretionary Distributions Advantages Increased AGI means larger income tax charitable deduction limits Additional investment income may increase investment interest expense limitation If recipient beneficiary subject to AMT, DNI carried out to beneficiary may be taxed at a maximum tax rate of 28% 45 65 Day Rule Election Elect to treat all or part of a distribution made within the first 65 days of the taxable year as if paid on the last day of the preceding taxable year. 663(b); Reg. 1.663(b)-1(a)(1). Year by year election Election is made by checking box at the bottom of page 2 of the Form 1041 Once made the election is irrevocable. The election is limited to the greater of DNI (reduced by any amounts deductible for such year on account of other amounts paid, credited or required to be distributed in such year other than those amounts considered paid or credited in a preceding taxable year by reason of a section 663(b) election) or trust accounting income not otherwise distributed for that year. Reg. 1.663(b)-1(a)(2). 46 23

Include Capital Gains in DNI The regulations describe 3 circumstances under which capital gains can be included in DNI. Reg. 1.643(a)-3. Gains are included in DNI where they are, pursuant to the governing instrument and applicable local law, or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law): Allocated to income (but if income under the state statute is defined as, or consists of, a unitrust amount, a discretionary power to allocate gains to income must also be exercised consistently and the amount so allocated may not be greater than the excess of the unitrust amount over the amount of DNI determined without regard to this subparagraph 1.643(a)-3(b)); Allocated to corpus but treated consistently by the fiduciary on the trust s books, records and tax returns as part of a distribution to a beneficiary; or Allocated to corpus but actually distributed to the beneficiary or utilized by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary. 47 Include Capital Gains in DNI In addition to those circumstances mentioned in the regulations, capital gains flowing from a partnership or S corporation K-1 are included in DNI. Crisp v. United States, 34 Fed. Cl. 112 (1995). Planning point: the trustee may want to consider investing through a partnership so that capital gains can be distributed and escape the surtax. Investment p/ship K-1 with gains Trust DNI with p/ship gains Beneficiaries 48 24

In-Kind Distributions Under 643(e) An estate or trust does not recognize gain or loss on the in-kind distribution of property to a beneficiary. 643(e). The distribution carries out DNI at the lesser of the property s basis or it fair market value. The beneficiary takes a carryover basis in the property. 643(e)(1). The fiduciary may elect to recognize gain as if the property was sold at its fair market value. 643(e)(3) If so, DNI is carried out to the extent of the fair market value of the property distributed and the beneficiary takes a basis in the distributed property equal to the estate or trust s basis plus any gain or minus any loss recognized on the distribution. The election is made year by year and applies to all property distributed during the year. 643(e) allows the fiduciary to determine where the gain will be recognized: at the entity level or at the beneficiary level. This may allow the beneficiary to time the recognition of gain to a time when he will not be subject to the 3.8% surtax. A beneficiary who holds the property until death will get a step-up in basis and avoid the tax on the gain altogether. 49 Estimated Tax If surtax applies at the estate or trust level, the estate or trust must make sure that the surtax is taken into consideration when computing the estimated tax payments. If the surtax applies at the beneficiary level, the beneficiary must make sure that the surtax is taken into consideration when computing the estimated tax payments. 50 25

State Income Tax Considerations Making distribution from a trust in a no tax state (FL, DE, WA, TX, SD) to avoid the surtax at the estate or trust level may cause the beneficiary to incur a state income tax if the beneficiary s state imposes an income tax. 51 Grantor Trust All income and expenses reported by the trust beneficiary. Reg. 1.1411-3(b)(1)(v). NII from grantor trust and application of the 3.8% surtax is determined at the beneficiary level. Planning point: Make trust a grantor trust to get individual $200,000/$250,000 threshold Planning point: if parents want to gift an interest in a business in which they materially participate but in which their children do not, parents should consider gifting to a grantor trust Interest will constitute active income to parents, avoiding the surtax. 52 26

Qualified Subchapter S Trust (QSST) QSST is a grantor trust. 1361(d)(1)(A). All income and expenses reported by the trust beneficiary NII from QSST and application of the 3.8% surtax is determined at the beneficiary level Higher individual threshold will apply rather than the lower estate or trust threshold Funding S stock into a QSST as soon as possible will remove the net investment income from the estate or trust and move it to the individual beneficiary of the QSST who may be below the MAGI threshold 53 Electing Small Business Trust (ESBT) S portion and non-s portion treated as separate trusts in computing UNII Each portion calculates its own NII and then adds them together to determine the ESBT s UNII S portion and non-s portion treated as a single trust in determining the AGI threshold in determining amount subject to the 3.8% surtax This rule applies a single 1(e) threshold so that ESBTs don t receive a benefit (two thresholds) not available to other taxable trusts 54 27

Electing Small Business Trust (ESBT) Calculation the tax for an ESBT 3 Step process: STEP 1: Compute UNII for S portion and non-s portion and combine these amounts to calculate ESBT s UNII STEP 2: Compute ESBT s AGI (solely for purposes of 1411) ESBT s AGI is the non-s portion s AGI +/- net income or loss of S portion STEP 3: ESBT pays tax on lesser of: ESBT s total UNII, or Excess of ESBT s AGI over $12,150 (for 2014) Reg. 1.11411-3(c) 55 Electing Small Business Trust (ESBT) Example Step 1 Non-S Portion Dividends $15,000 Interest 10,000 Capital Loss (5,000)* Trustee s Fee ( 600) Net 21,400 Distribution ( 9,000) Non-S UNII 12,400 S Portion Net Rental $21,000 Capital Gain 7,000 Trustees Fee ( 400) S UNII 27,600 Total UNII $40,000 * Capital loss is $5,000 in example but only $3,000 is deductible 56 28

Electing Small Business Trust (ESBT) Example Step 2 Non-S Portion Dividends $15,000 Interest 10,000 Capital Loss (3,000) Trustee s Fee ( 600) Net 21,400 Distribution ( 9,000) Non-S UNII 12,400 S Portion Net Rental $21,000 Capital Gain 7,000 Trustees Fee ( 400) S UNII 27,600 Total UNII $40,000 ESBT s AGI $40,000 57 Electing Small Business Trust (ESBT) Example Step 3 1. $40,000 (combined UNII computed in Step 1), or 3.8% x the lesser of: 2. $40,000 (ESBT s AGI as defined in 67(e) and computed in Step 2) over $12,150 (the dollar amount at which the highest bracket in 1(e) begins for such taxable year - $12,150 in 2014). Surtax = $1,058 ([$40,000 less $12,150] x 3.8%) 58 29

Foreign Estates and Trusts Surtax does not apply to foreign estates. Reg. 1.1411-3(b)(1)(ix). Surtax will apply to distributions from foreign estates to U.S. beneficiaries Surtax applies to U.S. beneficiaries that receive distributions of net investment income from a foreign trust but not to the foreign trust itself IRS is continuing to study how the surtax should apply to accumulation distributions from foreign trusts to U.S. beneficiaries and intends to issue subsequent guidance on this issue 59 Charitable Remainder Trust CRT is exempt from tax. 664(c). CRT income beneficiaries are subject to tax under a 4 tier system on the income earned by the CRT. 664(b). CRTs are not subject to the 3.8% surtax. Reg. 1.1411-3(b)(1)(iii). However, annuity and unitrust distributions may be net investment income to the non-charitable beneficiary Thus, CRT income beneficiaries are subject to the 3.8% surtax to the extent their distributions are considered NII. Reg. 1.1411-3(d). 60 30

Charitable Remainder Trust Only NII realized by a CRT after December 31, 2012 is included in the CRT s NII and subject to the 3.8% surtax when distributed to the CRT income beneficiaries. Thus, any NII realized by a CRT in a taxable year prior to January 1, 2013 is never subject to the 3.8% surtax regardless of when it is considered distributed to the non-charitable beneficiaries If the CRT has more than one income beneficiary, the reportable NII is apportioned between the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the CRT for that taxable year. Reg. 1.1411-3(d)(1)(ii). 61 Charitable Remainder Trust Regs. allow two methods: Include NII in existing tier system under 664 Simplified method The method adopted indicates that the amount includable in a beneficiary s NII (i.e. the amount subject to the 3.8% surtax) is the lesser of: The total amount distributed for the year, or The current and accumulated net investment income of the trust. Reg. 1.1411-3(d)(3). 62 31

How Beneficiary Is Taxed Tier System - 664(b) Order of Character of Income: Ordinary Income Capital Gain (Short Term First) Other Income (Tax Exempt) Return of Capital 63 Ordinary Income CRT Tier System of Taxation Other ordinary income (ordinary income tax rates) Qualified dividends - 20% rate Capital Gains Short-term capital gains (ordinary income tax rates) 28% gain on collectibles and 1202 gains 25% 1250 unrecaptured gain All other long-term gain Qualified 5 year gain (post 12/31/00 and pre-5/6/03, revived after 12/31/08)) Tax Exempt Income Return of Corpus CATEGORY 64 32

Ordinary Income CRT Tier System of Taxation Other ordinary income (ordinary income tax rates) Qualified dividends - 20% rate Capital Gains Short-term capital gains (ordinary income tax rates) 28% gain on collectibles and 1202 gains 25% 1250 unrecaptured gain All other long-term gain Qualified 5 year gain (post 12/31/00 and pre-5/6/03, revived after 12/31/08)) Tax Exempt Income Return of Corpus CLASS The final Section 1411 regulations create a NII subclass within each class 65 Category Class Excluded/ NII Ordinary Income CRAT Distribution = $50,000 2012 Income 2013 Income Tax Rate 2013 $50,000 Dist NII In 2013 Dist Interest NII $7,000 43.4% $7,000 $7,000 Amt C/O to 2014 Interest Excluded $4,000 39.6% $4,000 Net Rental Excluded $8,000 39.6% $8,000 Income Non Qualified Excluded $2,000 39.6% $2,000 Dividends Qualified NII $9,000 23.8% $9,000 $9,000 Dividends Qualified Excluded $10,000 20% $10,000 Dividends Capital STCG NII $4,000 43.4% $4,000 $4,000 Gains STCG Excluded $39,000 39.6% $6,000 $33,000 1250 Gain Excluded $1,000 25% $1,000 LTCG NII $11,000 23.8% $11,000 LTCG Excluded $560,000 20% $560,000 Total Excl income $624,000 1/1/2013 Total Dist $50,000 $20,000 66 33

Charitable Remainder Trust Simplified Method The final regulations on the simplified version are marked reserved. However, the following slides on the simplified method illustrate how the proposed regulations explained the operation of the simplified method. The Treasury has reserved the right in the final regulations to eliminate the simplified method in the future. Accumulated net investment income is defined as the total amount of net investment income received by a CRT for all taxable years that begin after December 31, 2012, less the total amount of net investment income distributed for all prior taxable years of the trust that begin after December 31, 2012. Reg. 1.1411-3(d)(2). Note: the accumulated net investment income will have to be tracked Thus, items of net investment income realized by the trust before January 1, 2013 are not includible in accumulated net investment income and are not subject to the 3.8% surtax even if distributed many years later. 67 Charitable Remainder Trust Simplified Method NOTE: the amount of net investment income reported to the beneficiary is a separate and distinct computation from the determination of the tax character of CRT distribution under the four-tier system. See the preamble to Prop. Reg. 1.1411 at 4.B.iv. Thus, current and accumulated net investment income is distributed in a different sequence than income accumulated under the four-tier system. Current and accumulated net investment income is deemed to be distributed before amounts that are not items of net investment income for purposes of 1411, notwithstanding the four-tier system otherwise applicable in determining the taxation of CRT distributions Capital loss ordering rules are different that Section 664 68 34

Charitable Remainder Trust Simplified Method Consider simplified method if: New CRT when all income is NII CRT is nearing the end of its stated term CRT has unrealized NII includable losses CRT has non-nii deductible expenses 69 Charitable Remainder Trust Simplified Method - Example 1 Tier Income 2012 2013 Interest income 2,500 22,000 STCG 750 0 LTCG 500,000 44,000 2013 distribution: $50,000 70 35

Charitable Remainder Trust Simplified Method - Example 1 Tier Income 2012 2013 Interest income 2,500 22,000 STCG 750 0 LTCG 500,000 44,000 Income Under Tier System Current and Accumulated NII Interest income 24,500 22,000 STCG 750 LTCG 24,750 28,000 Total 50,000 50,000 71 Charitable Remainder Trust Simplified Method - Example 1 Takeaways: The amount of NII reportable by the CRT beneficiary cannot exceed the amount they receive as a distribution. Despite the fact that under the four-tier system $2,500 of interest and $750 of STCG were accumulated during years prior to 2013, all of the amount distributed was subject to the 3.8% surtax because the 2013 NII exceeded the amount distributed in 2013. The amount of NII reported to the CRT beneficiary is a separate calculation from the determination of the tax character of CRT distributions under the four-tier system. 72 36

Charitable Remainder Trust Simplified Method - Example 2 (Same as Example 1 but LTCG in 2013 is $15,000) Tier Income 2012 2013 Interest income 2,500 22,000 STCG 750 0 LTCG 500,000 15,000 Income Under Tier System Current and Accumulated NII Interest income 24,500 22,000 STCG 750 LTCG 24,750 15,000 Total 50,000 37,000 73 Charitable Remainder Trust Simplified Method - Example 2 Takeaway: The amount of the NII subject to the 3.8% surtax the beneficiary must report is $37,000, the lesser of the amount distributed ($50,000) and the current and accumulated NII ($37,000). $13,000 of the amount distributed from pre-2013 NII is not subject to the 3.8% surtax. The tax preparer will have to maintain separate schedules for the amount of current and accumulated income subject to the four-tier system and the amount of current and accumulated NII they can be different. 74 37

Charitable Remainder Trust Planning Give appreciated asset to CRT Sell appreciated asset in CRT CRT exempt from income tax, including 3.8% surtax No gain recognized Annuity or unitrust payments carry out NII to non-charitable beneficiaries Spreads NII passed out to beneficiary over multiple years Subjects the NII to the higher thresholds applicable to individuals Minimizes, or at least defers, the 3.8% surtax 75 Pooled Income Funds A pooled income fund distributes all its income to the fund s income beneficiaries The fund won t be subject to tax on the fund s income but the individual fund beneficiaries may be subject to the 3.8% surtax A pooled income fund s capital gains are never paid to the beneficiaries Thus, the beneficiaries aren t potentially subject to the 3.8% surtax on capital gains LTCG aren t taxable to a pooled income fund under normal rules. The are permanently set aside for charity so they shouldn t be subject to the 3.8% surtax at the fund level or the beneficiary level STCG are taxable to the fund under normal rules Question: are STCG in excess of the surtax threshold ($12,150 for 2014) subject to the 3.8% surtax at the fund level? They shouldn t be as STCG are also permanently set aside for charity The preamble to the final regulations indicate that STCG of a pooled income fund is subject to the 3.8% surtax even though they are held for ultimate distribution to charity 76 38

Pooled Income Funds Treasury s rationale: A pooled income fund s undistributed STCG are subject to income tax under Chapter 1 of the Internal Revenue Code, even though they are held for ultimate distribution to charity Treasury and the IRS recognize that imposing tax on the pooled income fund will reduce the amount of property going to charity on expiration of the income interest However, Section 1411 limits its exclusion to wholly charitable trusts and that exclusion does not include either CRTs or PIFs Even though CRTs are excluded from Section 1411 by the express language of Section 664, there is no comparable provision excluding PIFs The 3.8% surtax is limited to undistributed STCG PIF will receive an income distribution deduction for the income paid to the income beneficiaries and any LTCG will be offset by the Section 642(c) charitable set aside deduction. 77 Charitable Lead Trusts Non-Grantor CLT Net investment income in excess of amount distributed to the charitable lead beneficiary and the threshold amount ($12,150 in 2014) is subject to the 3.8% surtax Non-grantor CLT is allowed a deduction for the portion of its NII that is allocated to amounts allowed as a charitable deduction under 642(c) The 642(c) deduction allowable to the CLT reduces the CLT s undistributed NII and shifts the NII into the hands of the a tax-exempt beneficiary that is not subject to the 3.8% surtax Grantor CLT Grantor is taxable on all the trust income and capital gains even though it may be paid to charity The CLT isn t subject to the 3.8% surtax because all of its income and gains flow through and are taxed to the grantor. The grantor will be subject to the 3.8% surtax on the income and gains earned by the CLT if that income plus the grantor s other net investment income exceeds the threshold applicable to the grantor. Thus, a grantor CLT is not particularly useful in planning for the 3.8% surtax 78 39

Charitable Gift Annuity Income on funds held by charity for gift annuity program not taxable unless they violate 514(c)(5) (relating to CGA and acquisition indebtedness) and 501(m) (relating to commercial insurance) Annuity payments (in excess of the excludible amounts which are deemed a return of principal) are NII to the annuitant Any capital gain triggered by the transfer of appreciated assets for the CGA as determined under the bargain sale rules is NII to the donor. CGA allows annuity payments and recognition of gain to be spread out over multiple years and subject to the higher thresholds applicable to individuals and may minimize, or at least defer, the 3.8% surtax 79 Charitable Remainder Annuity Trust v. Charitable Gift Annuity CGA favorable: Same charitable deduction available for CGA and CRT CGA not subject to 5% exhaustion test CGA not subject to the onerous governing instrument and administration requirements of a CRAT CRAT favorable: Where there are doubts concerning the charity s ability to make the annuity payments CGA for a term of years or for more than two lives are not permitted whereas they are for CRAT 80 40

Charitable Planning Charitable contributions of NII producing property to a 501(c)(3) organization will shift the NII attributable to the property to the charity thereby exempting the NII from the 3.8% surtax. Provides another reason to give away the gain Donors wishing to retain control over their charitable contributions (rather than making an unrestricted gift) can make the contribution to their private foundation or a donor-advised fund of a public charity of which the donor is an advisor 81 Thank You! 82 41

Mattie K. Carter Trust v. U.S., 256 F. Supp. 2d 536 (N.D. Tex. 2003) Trustee of trust that owned 15,000 acre cattle ranch managed all of the assets of the trust, including the Carter Ranch Trustee employed a full-time ranch manager and some part-time employees Day-to-day management of ranch subject to trustee s approval Court identified the trust, not the trustee, as the taxpayer Court held that in determining material participation for trusts, the activities of the trust s fiduciaries, employees and agents should be included in determining whether the trust s participation is regular, continuous and substantial Court said the absence of regulations and case law does not make a statute ambiguous Alternatively, court found the trustee s activities, standing alone, were regular, continuous and substantial. 83 Summary of IRS Position No regulations on how PAL rules apply to estates and trusts IRS position: The material participation rules applicable to individuals (the 7 material participation tests) do not apply to estates and trusts Only the participation of the trustee, in his capacity as such, can be counted for purposes of material participation Activities of employees, agents, shareholders do not count The trustee s participation must be regular, continuous and substantial 84 42

TAM 200733023 Testamentary Trust Special trustee (can t bind trust) LLC (p/ship) 85 TAM 200733023 Testamentary trust owns LLC interest taxed as a partnership Special trustee appointed to manage LLC Special trustee can t legally bind trust Section 469(h)(1) says a taxpayer materially participates in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous and substantial For individuals, the qualitative test of Section 469(h)(1) has largely been replaced by the more qualitative regulatory tests of Temp. Treas. Reg. 1.496-5T(a)(1)-(7) The Treasury Department has not yet issued regulations addressing the material participation requirement for trusts and estates Until regulations are issued, Section 469(h)(1) remains the sole standard for determining whether a trust or estate satisfies the material participation requirement of Section 469. The statutory standard for material participation can be applied in the absence of regulations 86 43

TAM 200733023 Legislative history says an estate or trust is treated as materially participating in an activity if an executor or fiduciary, in his capacity as such, is so participating. S. Rep. No. 99-313, at 735. The Joint Committee Blue Book accompanying the 1986 Tax Reform Act took a different approach, providing that [n]o special rule is provided for determining material participation by a trust. Conclusion: Trust materially participates if the fiduciaries of the trust participate in the operations of the activity on a basis which is regular, continuous and substantial. Special trustees are not fiduciaries of the trust for purposes of Section 469 so only the activities of the trustees court toward the material participation requirement for the trust. 87 PLR 201029014 A: Trustee and Beneficiary Trust materially participate in D? Complex Trust P/ship B C D 100% 100% Ruling: Trust may materially participate in D s activities if the trustee, in this case A, is involved in the operations of D s activities on a regular, continuous and substantial basis. Thus, a trust could materially participate in the activities of a multi-tiered subsidiary through the activities of its trustee even though the trustee had no direct authority to act with respect to the business in its capacity as trustee because of the remote relationship of the trust to the subsidiary. The IRS seems to have ignored the in such capacity language in the legislative history. The ruling seems to imply that you can take into account the trustee s role as an employee of the business entity rather than being limited to the trustee s role as trustee alone as the only way the trustee could be involved in the third tier entity would be as an employee due to the lack of direct ownership of that entity by the trust. In this PLR, no opinion was expressed concerning whether A in fact materially participated in D s activities. 88 44

Issue: Did Trust A and Trust B materially participate in the activities of Company X? TAM 201317010 Note: A is a special trustee, an individual shareholder and President of Company Y. Taxpayer argues that A s total in all 3 capacities should be considered. Settlor C B Trustee Settlor D Individual A Trust A A Special Trustee Trust B According to the language of the TAM, the individual serving as the president and special trustee was unable to differentiate time spent as president, special trustee and shareholder. President Company X (S corp) Company Y (QSub) 100% Ruling: Trust A and Trust B did not materially participate in the activities of Company X because the trustee and special trustee, in their capacities as trustees of Trust A and Trust B, were not involved in the operations of Company X s relevant activities on a regular, continuous and substantial basis. A s time spent as an employee (president) of Company Y does not count in determining the trust s material participation. Activities of a co-trustee who was the president of a business was not counted in determining the trust s material participation. The Aragona Trust case seems to rebut the IRS position that the trustee s activity as an employee can t be considered. 89 Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014) Paul, Frank, Annette Trustees Employees Trust Holiday Enterprises LLC Summary of holding: (1) Court did not decide whether activities of non-trustee employees or agents count toward material participation (2) Activities of trustees as employees are counted toward material participation (3) Activities of trustees who individually also co-own minority interests in the business are counted toward material participation. No need to apportion participation between trustee and personal owner services as both trustee and personal owner counted for purposes of determining material participation. Ruling: Tax Court looked only to trustee s activities and not the non-trustee employee s activities to determine if the trust materially participated. (Court said in a footnote that they didn t need to decide in this case whether the activities of the trust s non-trustee employees should be considered. Thus, the court didn t reach the key issue in the Carter case: whether the activities of the non-trustee full time ranch manager and other non-trustee employees could be counted for material participation purposes.) The Tax Court did not distinguish between the trustee s activities as trustee and their activity as employees of an LLC owned by the trust which managed some of the real estate. Court said trustee s work as employees should be considered. Activities by two co-trustees who also owned minority interests in some of the rental entities were not apportioned between the trust and their personal portions of the business. The Aragona Trust case seems to rebut the IRS position that the trustee s activity as an employee can t be considered. 90 45