ESTATE & TRUST PLANNING WITH THE NEW 3.8% TAX ON NET INVESTMENT INCOME First Run Broadcast: September 1, 2015 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) The new 3.8% tax on Net Investment Income has widespread consequences for trust and estate planners. The tax applies to some but not all trusts, to some trust income but not all income. There is also a complicated relationship between the 3.8%, fiduciary taxation, and capital gains. Though capital gains are subject to the 3.8% tax, there are planning opportunities to include capital gains in Distributable Net Income for fiduciary income tax purposes (even though these gains would otherwise be excluded) and reduce application of the 3.8% tax. There are also very important considerations for trust-owned family businesses and how those trusts can materially participate in business operations to avoid the 3.8% tax applying to business income. This program will provide you a practical guide to how the new 3.8% tax on NII applies broadly to trusts and discuss planning opportunities to eliminate or minimize the tax. Review of regulations and rules applying the new 3.8% tax on Net Investment Income (NII) to trusts and estates Treatment of grantor and non-grantor trusts under the new tax regime Determining which trusts and what income is subject to the 3.8% tax Important relationship between NII and Distributable Net Income (DNI) for fiduciary income tax purposes How capital gains can be included in DNI (even though it s ordinarily excluded) to reduce the 3.8% tax on NII How a trust that owns a family business can actively participate in operations to avoid NII on business income Speaker: Blanche Lark Christerson is a managing director at Deutsche Bank Private Wealth Management in New York City, where she works with clients and their advisors to help develop estate, gift, tax, and wealth transfer planning strategies. Earlier in her career she was a vice president in the estate planning department of U.S. Trust Company. She also practiced law with Weil, Gotshal & Manges in New York City. Ms. Christerson is the author of the monthly newsletter Tax Topics." She received her B.A. from Sarah Lawrence College, her J.D. from New York Law School and her LL.M. in taxation from New York University School of Law.
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3.8% TAX ON INVESTMENT INCOME: WHAT YOU MUST KNOW ABOUT SECTION 1411 OF THE INTERNAL REVENUE CODE Norman Lencz Venable LLP Baltimore (410) 244-7842 / nlencz@venable.com Jennifer Pratt Venable LLP Baltimore (410) 528-2883 / japratt@venable.com Chris Davidson Venable LLP Baltimore (410) 244-7780 / csdavidson@venable.com
Section 1411 Effective for tax years beginning in 2013, taxpayers with incomes above certain thresholds now face a new 3.8% Medicare tax on their investment income. This new tax is historic in that it represents the first time in history that employment-type taxes have applied to investment income. The tax may increase the overall tax due on certain types of ordinary investment income to as much as 43.4%. 2
Section 1411 (cont d) New 3.8% tax increases the overall tax due on capital gain income to 23.8%. New 3.8% tax increases the overall tax due on unrecaptured Section 1250 capital gain to 28.8%. New 3.8% tax increases the overall tax due on collectibles capital gain to 31.8%. The new tax is subject to individual estimated tax provisions. No portion of the new tax is deductible in computing any tax due under subtitle A of the IRC (relating to income taxes). 3
Section 1411 (cont d) Specifically, for individuals, the new tax applies to the lesser of (i) net investment income or (ii) the excess of modified adjusted gross income over a threshold amount. For estates and trusts, the new tax applies to the lesser of (i) undistributed net investment income or (ii) the excess of adjusted gross income over the dollar amount at which the highest tax bracket for trusts and estates begins (currently $12,300). 4
Section 1411 - Terminology Net investment income Threshold amount Modified adjusted gross income 5
Section 1411 Terminology (cont d) Net investment income means the (i) sum of (a) gross income from interest, dividends, annuities, royalties and rents (other than income from an active business for purposes of Section 469 [passive loss rules] unrelated to financial trading) (an Active Business ); (b) gross income from a passive activity for purposes of Section 469 or a financial trading business; and (c) net gain attributable to the disposition of property other than property from an Active Business; over (ii) the deductions properly allocable to such gross income or gain. 6
Section 1411 Terminology (cont d) Net investment income does not include: Active Business income Certain gain on the sale of an Active Business Distributions from qualified plans Income subject to self-employment tax Tax-exempt income (but reported gains in excess of the exclusion for principal residence sales under Section 121 could be taxed at 3.8%). Income earned by certain charitable trusts 7
Section 1411 Terminology (cont d) Threshold amount means (i) $200,000 for single individual taxpayers; (ii) $250,000 for married individual taxpayers filing a joint return; (iii) $125,000 for married individual taxpayers filing a separate return; and (iv) $12,300 for estates and trusts (top income tax bracket in 2015). These amounts are not indexed. Thus, with inflation, more and more taxpayers will become subject to Section 1411. 8
Section 1411 Terminology (cont d) Modified adjusted gross income means adjusted gross income increased by the excess of (i) the amount excluded under the Section 911 foreign earned income exclusion (the Section 911 Exclusion); over (ii) the amount of any deductions or exclusions disallowed due to the Section 911 Exclusion. 9
Section 1411 Example Example (Joint Filer) 3.8% Tax Calculation W-2 Income $300,000 NII $30,000 NII $30,000 AGI $330,000 Excess AGI $80,000 - Threshold ($250,000) $80,000 Lesser $30,000 x 3.8% $1,140 10
Section 1411 Active Business Non-Passive Activities 3.8% tax does not apply to trades or businesses that are not passive. A passive activity is a trade or business in which the taxpayer does not materially participate and this determination is made at the individual taxpayer level. Material participation requires that the taxpayer be involved on a regular, continuous, and substantial basis in the activity. The Regulations under Section 469 interpret this standard by providing that an individual must meet one (1) of seven (7) tests (three (3) in the case of limited partners in a partnership) in order to be considered to be materially participating in an activity. 11
Section 1411 Special Considerations for Rental Real Estate Real Estate Ventures As discussed above, Section 1411 includes rental income within the definition of net investment income. To determine whether Section 1411 will apply to rent derived from real estate, both the nature of the investment and the capacity in which the individual holds the investment must be analyzed. That is, Section 1411, will not apply if: The taxpayer is not passive with respect to the activity from which the income is derived; and The income is derived in the ordinary course of a trade or business. 12
Section 1411 Special Considerations for Rental Real Estate (cont d) Passive Activities Rental Activities Rental activities are not subject to the typical material participation rules (i.e., the 7 tests discussed above), but are generally treated as per se passive activities. There is an exception for when the taxpayer is a real estate professional. 13
Section 1411 Special Considerations for Rental Real Estate (cont d) Rental Income of Real Estate Professionals To qualify, a taxpayer must meet the following requirements: more than half of personal services performed during a given year are in real property trades or businesses in which the taxpayer materially participates; and the taxpayer performs more than 750 hours of services during that year in real property trades or businesses in which he materially participates. Aggregation election should be considered to meet material participation in rentals see grouping discussion in later slide. 14
Section 1411 Special Considerations for Rental Real Estate (cont d) Trade or Business Standard For purposes of Section 1411, the Regulations provide that the trade or business standard of Section 162 shall be applied. Supreme Court has stated two (2) requirements for an activity to constitute a trade or business under Section 162: (1) the activity must be conducted for profit; and (2) the activity must be engaged in with some regularity and continuity (even if not by the taxpayer personally). Regulations provide a safe harbor for real estate professionals if they participate in the rental real estate activity for more than 500 hours during the taxable year (or meet the 5 out of 10 year test on this basis). 15
Planning for Section 1411 How Do You Become Active? Consider recharacterizing activities as active, if possible. Consider combining activities to maximize potential for material participation. Grouping decisions are normally irrevocable (absent material changes in fact), but IRS will allow changes in light of new tax. How does a trust materially participate? 16
Section 1411 - Trusts Material Participation Trusts Regulations under Section 469 apply to individuals. Regulations have never been issued addressing material participation for trusts. There is limited guidance in the case law and IRS publications. 17
Section 1411 Trusts (cont d) Available Guidance Mattie K. Carter Trust v. U.S., 256 F. Supp. 2d 526 (N. D. Tex. 2003) TAM 200733023 TAM 201317010 Frank Aragona Trust et al. v. Comm r, 142 T.C. 9 (2014) Where does this leave us? 18
Section 1411 Sale of Pass-through Entity Sale of Pass-Through Entities Generally, sale of an interest in a pass-through entity is not considered property held in a trade or business and, thus, would be included in definition of net investment income. Under 2013 Proposed Regulations, transferor s gain (loss) for Section 1411 purposes is the lesser of (i) amount of gain recognized for chapter 1 purposes and (ii) the transferor s allocable share of net gain from a deemed sale of the passthrough entity s Section 1411 property. 19
Section 1411 Sale of Pass-through Entity (cont d) Sale of Pass-Through Entities Can compute gain (loss) on an activity by activity basis (as opposed to valuing each asset), which is a change from the 2012 Proposed Regulations. An optional simplified method is generally available if transferor s gain does not exceed (i) $250,000 or (ii) $5 million if the transferor s historic share (for the year of transfer and the two previous years) of items of income, gain, loss, and deduction that transferor would take into account in calculating the 3.8 tax is 5 percent or less of the total allocated to the transferor. 20
Section 1411 Special Considerations Tiered Partnerships and REITs As income from working capital will likely be net investment income even for a real estate professional, it will be necessary to properly allocate deductions between gross income from rental activities and from investment of working capital, which may be more difficult in tiered structures. Use of a REIT will cause what otherwise may be income exempt from Section 1411 to be captured as dividends. To avoid this result, fund managers may wish to hold any carried interest directly in the entities below the REIT. 21
Self-Rental Rule Section 1411 Self-Rental OWNER S CORP RENTAL INCOME S CORP BUILDING MEDICAL PRACTICE Heads I win, tails you lose rule of Reg. 1.469-2(f)(6) characterizes rental losses as passive, rental income as non-passive. 22
Planning for Section 1411 (cont d) Shift Investment Income to Self-Employment Income Ordinarily, it would never make sense to intentionally take steps to classify income as employment or selfemployment income. However, because no portion of the new 3.8% will be deductible for income tax purposes and the employer portion (that is 1.45%) of employment or selfemployment taxes will qualify for an income tax deduction; it actually may make sense in some cases to plan to have income qualify as employment or selfemployment income. 23
Planning for Section 1411 (cont d) Bifurcate Ownership in Partnerships For many years now, partners in certain partnerships have engaged in self-employment tax planning. Beginning in 2013, this planning may become more important for active partners. See next slides on structuring options. 24
Partnership Planning Structure #1 A B C 33% 33% 33% LLC A B C S Corp Management Co 1% 25
Partnership Planning Structure #2 A A B Class A Class B Class B C Class B LLC 26
Section 1411 Planning (cont d) Conversion to an S corporation Sale of C corporation stock is subject to Section 1411. If taxpayer is active in the business, consider conversion to S corporation prior to sale to avoid 3.8% tax. 27
FOR FURTHER INFORMATION Norman Lencz Venable LLP Baltimore, MD 410-244-7842 nlencz@venable.com Jennifer Pratt Chris Davidson Venable LLP Venable LLP Baltimore, MD Baltimore, MD 410-528-2883 410-244-7780 japratt@venable.com cdavidson@venable.com 28