In an August 8, 2013 publication of “questions and answers”, see http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs, the IRS explained basics of the new 3.8% “net investment income tax” (“the NII tax”). The NII tax is imposed under Section 1411 of the Internal Revenue Code, a new provision added to the Code by Obamacare (Section 1402 of Title X of the Patient Protection and Affordable Care Act). The IRS previously published proposed regulations with detailed explanations in December 2012, but these “questions and answers” provide detail regarding who must pay NII tax, what’s included in NII, and how the tax is reported and paid.
Who Must Pay the NII
Questions 3-6 of the Q&A explain who’s required to pay the NII tax. The NII tax is applicable to individual taxpayers whose modified adjusted gross incomes are over the applicable threshold amount: $250,000 for married taxpayers filing jointly or a surviving spouse with dependent children; $125,000 for married taxpayers filing separately; and $200,000 for all other individual taxpayers, including single taxpayers or taxpayers filing as head of household.3As noted in Question 3, the threshold amounts aren’t indexed for inflation.
Estates and ordinary trusts are subject to the NII tax: if (1) they have undistributed NII, and (2) their adjusted gross income is greater than the dollar amount at which the highest income tax bracket for trusts and estates begins. For 2013, the threshold amount is $11,950. The NII tax is equal to 3.8 percent of the lesser of: (1) the undistributed NII for the tax year, or (2) the excess of the gross income over $11,950. Most income generated by estates and trusts will count towards NII and thus planning for these taxpayers is essential. In general, the NII tax is applicable only to trusts that are subject to “fiduciary income tax”. This excludes trusts that aren’t classified as “trusts” for income tax purposes, including business trusts (which are generally taxed as entities), common trust funds, designated settlement funds, and other trusts subject to specific taxation regimes. Further, trusts that are generally exempt from income tax, such as charitable trusts and qualified retirement plan trusts, are exempt from the NII tax. There are special rules for the calculation of NII with respect to charitable remainder trusts and “electing small business trusts” (“ESBTs”) that own interests in S corporations.
Question 6 of the Q&A provides that trusts that are treated as “grantor trusts” for income tax purposes are not directly subject to the NII tax. Rather, a grantor trust’s NII, like all of the trust’s income taxes, deductions and credits, will be includible in the computation of the grantor’s income tax.
Additionally, Question 5 notes that estates and trusts must only pay NII tax on undistributed net income. This is consistent with the “fiduciary” income tax rules, which allow for deductions of distributable net income (“DNI”) that’s required to be distributed or otherwise properly paid to beneficiaries. Instead, such income, including NII items, is included in the gross income of the beneficiaries receiving distributions.
What’s Included in NII
Questions 7-13 discuss which items are included in NII. Generally, NII includes various types of income and gain that are generated by investment activities such as interest, dividends, capital gains, rental and royalty income and non-qualified annuities. In addition, income from businesses involved in trading financial instruments and commodities as well as income from businesses that are considered “passive activities” is also NII. Question 9 states that capital gains includes gains from the sale of stocks, bonds, mutual funds, investment real estate and interests in partnerships and S corporations. The tax is on “net” investment income; thus, deductions that are properly allocable to investment income are allowable as deductions for computing NII tax liability as well. This may include state and local income taxes properly allocable to items included in NII.
How the NII Tax is Reported
Questions 14-17 discuss the manner in which NII is reported and tax paid. For estates and trusts, NII is reported on and and paid with the trust’s Form 1041. Per Question 15, NII tax is subject to estimated tax provisions, so fiduciaries should adjust their withholdings and estimated tax payments accordingly.
Income Tax Planning Opportunities presented by the NII Tax
While the imposition of a new significant tax can be daunting to taxpayers, the new law presents various options to limit the impact of the law. Many of those techniques are used by Dymond Reagor Colville in planning for their clients. For instance, trust makers may find it advantageous not to create a grantor trust but instead to create flexibility in a trust with various techniques spreading income among beneficiaries. Likewise, grantor trusts must consider when to make distributions, needs of beneficiaries and tax levels of beneficiaries. Some trusts can more effectively use distribution rules to avoid the tax altogether. Each family and each situation where the NII tax may apply presents a different and unique planning opportunity for a family.