Mastering NIIT for Trusts and Estates: Net Investment...

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Mastering NIIT for Trusts and Estates: Net Investment

Income Tax Planning Strategies to Minimize Surtax

WEDNESDAY, OCTOBER 19, 2016, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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Oct. 19, 2016

Mastering NIIT for Trusts and Estates

Matthew E. Rappaport, Esq., LL.M.

New York

[email protected]

Michele Schlereth, CPA, J.D., MST, Senior Tax Manager

Baker Tilly Virchow Krause, Melville, N.Y.

[email protected]



Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

MATTHEW E. RAPPAPORT,

Esq., LL.M.

Baker Tilly refers to Baker Tilly Virchow Krause, LLP,

an independently owned and managed member of Baker Tilly International

© 2010 Baker Tilly Virchow Krause, LLP

Mastering NIIT for Trusts and

Estates

Presented by


Michele Schlereth, J.D., CPA, MST - Baker Tilly

October 19, 2016


Esq., LL.M.

Definition and scope of IRC § 1411 impact on

trusts and estates

6

PART I


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Form 8960

7


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What is the Net Investment Income

(NII) Tax?

The net investment income tax, or NII tax, became

effective on January 1, 2013. The tax was part of

the Patient Protection and Affordable Care Act,

which was modified by the Health Care and

Education Reconciliation Act. These two Acts are

known colloquially to some as “Obamacare,”

President Obama’s initiative to provide quality,

affordable health care to all Americans. The NII tax

is meant to help fund the implementation and

ongoing administration of the Obamacare initiative.

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How Does the NII Tax Work?

The NII tax applies on a rather narrow basis. The NII tax

applies to the following taxpayers: • Individuals with modified adjusted gross income (MAGI) in excess of $200,000

(or $250,000 if married filing jointly).

• Estates and trusts with adjusted gross income (AGI) greater than $12,400.

Notice that individuals become subject to the NII tax before

their income reaches the highest tax bracket, while estates

and trusts only become subject to the NII tax upon their

income reaching the highest tax bracket.

Applicability of the NII tax is measured on a year-to-year

basis, so qualification for the NII tax in one year does not

automatically subject the taxpayer to the NII tax in all

succeeding years. * Threshold stated above for estates and trusts are for 2016. Individual thresholds are not indexed for inflation.

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Trusts and Estates Subject to NIIT

Treas. Reg. § 1.1411-3(a)

General application.— Section 1411 and the regulations

thereunder apply to all estates and trusts that are subject to the

provisions of part I of subchapter J of chapter 1 of subtitle A of the

Internal Revenue Code, unless specifically exempted under

paragraph (b) of this section.

These include:

• Estates

• Trusts: complex, simple, ESBT, Qualified Funeral trusts (special rules),

and Bankruptcy Estates (special rules)

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Trusts and Estates NOT Subject to NIIT

Treas. Reg. § 1.1411-3(b)

(i) A trust or decedent's estate all of the unexpired interests in which are devoted to

one or more of the purposes described in section 170(c)(2)(B).

(ii) A trust exempt from tax under section 501.

(iii) A charitable remainder trust described in section 664. However, see paragraph (d)

of this section for special rules regarding the treatment of annuity or unitrust

distributions from such a trust to persons subject to tax under section 1411.

(iv) Any other trust, fund, or account that is statutorily exempt from taxes imposed in

subtitle A. For example, see sections 220(e)(1), 223(e)(1), 529(a), and 530(a).

(v) A trust, or a portion thereof, that is treated as a grantor trust under subpart E of

part I of subchapter J of chapter 1.

(vi) Electing Alaska Native Settlement Trusts subject to taxation under section 646.

(vii) Cemetery Perpetual Care Funds to which section 642(i) applies.

(viii) Foreign trusts (but see § 1.1411-3(e)(3)(ii) and § 1.1411-4(e)(1)(ii))

(ix) Foreign estates (but see § 1.1411-3(e)(3)(ii))

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Form 8960, Part I, Investment Income

12


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Investment Income Defined

Treas. Reg. § 1.1411-4

Included

• Interest*

• Dividends*

• Annuity distributions*

• Royalties*

• Rents*

• Income derived from passive activity

• Net capital gain attributable to the disposition of property

* Only if not derived in ordinary course of business

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Investment Income Defined, cont.

Excluded

• Salary, wages or bonuses (Treas. Reg. § 1.1411-1(d)(4)(ii))

• Distributions from IRAs or qualified plans (IRC § 1411(c)(5))

• Self-employment income (IRC § 1411(c)(6))

• Unemployment compensation and social security benefits (Treas. Reg. § 1.1411-1(d)(4)(ii))

• Alimony (Treas. Reg. § 1.1411-1(d)(4)(ii))

• Gain on sale of an active interest in a partnership or S

corporation (IRC § 1411(c)(4))

• Income derived in ordinary course of a trade or business (Treas. Reg. § 1.1411-4(b))

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Form 8960, Part II, Investment Expenses

15


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Expenses

Included - properly allocated deductions under

Treas. Reg. § 1.1411-4(f)

• Investment advisory and brokerage fees allocable to investment income (not

allocable to tax-exempt income, subject to 2% floor and itemized deduction phase-out)

• Investment interest expense

• State and local income taxes attributable to NII under Treas. Reg. § 1.1411-

4(g)(1) (taxes paid in current year for prior year’s taxes get allocated based on prior year’s

ratio of NII to AGI)

• Other allowable deductions under IRC § 212(3) to the extent allocable to NII

under Treas. Reg. § 1.1411-4(g)(1) (tax preparation fee, tax audit representation,

legal fees in connection with the determination, collection, or refund of any tax)

• Fiduciary expenses to the extent allocable to NII under Treas. Reg. § 1.1411-

4(g)(1)

• Deductions allocable to gross income from rents and royalties (if income is

subject to NIIT)

• NOL to the extent allocable to NII under Treas. Reg. § 1.1411-4(h)

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Expenses, cont.

Excluded – deductions not stated in Treas. Reg.

§ 1.1411-4(f) (unless provided for in § 1.1411-1

through § 1.1411-10)

• Deductions in excess of gross income and net gain (except

as allowed under chapter 1)

• Deductions allocable to income not subject to NIIT

(including tax-exempt income)

* Common deductions not stated in Treas. Reg. § 1.1411-4(f)

include, but are not limited to: charitable contributions, medical and

dental, real estate taxes, mortgage interest, unreimbursed employee

expenses.

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Differences in Deductibility of

Certain Expenses Type of

Deduction

Deductibility on

Form 1040

Deductibility on

Form 1041

Deductibility on

Form 8960, Part II

Deductibility on

Form 8960, Part

III, Line 19a

(AGI)

Tax

preparation

fees

Fully deductible Fully deductible Deductible to the

extent allocable to

investment income

Fully deductible

Legal fees Fully deductible

depending on

reason for

expense

Fully deductible

depending on

reason for

expense

Deductible to the

extent allocable to

investment income

Fully deductible

depending on

reason for

expense

Fiduciary fees N/A Deductible to the

extent allocable

to taxable

income

Deductible to the

extent allocable to

investment income

Deductible to the

extent allocable

to taxable

income

Miscellaneous

itemized

deductions

Deductible to the

extent allocable

to taxable

income (after the

2% floor)

Deductible to the

extent allocable

to taxable

income (after the

2% floor)

Deductible to the

extent allocable to

investment income

(after the 2% floor)

Not deductible

Investment

interest

expense

Fully deductible,

but limited to net

investment

income

Fully deductible,

but limited to net

investment

income

Fully deductible,

but limited to net

investment income

Not deductible

Charitable

deductions

Fully deductible Fully deductible Not deductible Not deductible

State and local

taxes

Fully deductible Fully deductible Deductible to the

extent allocable to

investment income

Not deductible

18


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Impact on Trusts and Estates

3.8% on lesser of:

• Undistributed net investment income (NII) for such

taxable year

OR

• The excess (if any) of:

• Adjusted gross income (as defined in IRC § 67(e) and as

adjusted under Treas. Reg. § 1.1411-10(e)(2), if applicable)

for such taxable year; over

• The dollar amount at which the highest tax bracket in section

1(e) begins for such taxable year. (12,400 in 2016)

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Esq., LL.M.

Tax computation for Estates and Trusts

20

PART II


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Tax Computation

3.8% on lesser of:

• Undistributed net investment income (NII) for such

taxable year

OR

• The excess (if any) of:

• Adjusted gross income (as defined in IRC § 67(e) and as

adjusted under Treas. Reg. § 1.1411-10(e)(2), if applicable)

for such taxable year; over

• The dollar amount at which the highest tax bracket in section

1(e) begins for such taxable year. (12,400 in 2016)

21


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Form 8960, Part III, Tax Computation

22


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Calculation of NII on trust undistributed income

23

PART II(a)


Esq., LL.M.

Calculation of Undistributed NII

NII from Part III, Line 12

Less:

• Distributions of NII to beneficiaries

And

• Deductions under IRC § 642(c) – amounts paid or

permanently set aside for a charitable purpose

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Distributions of NII to Beneficiaries

The lesser of:

• Amount deductible to the estate or trust under

IRC § 651 or 661 (must allocate distribution between

NII and excluded income)

Or

• Net investment income of the estate or trust

25


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Deductions Under IRC § 642(c)

Amounts paid or permanently set aside for a

charitable purpose (must allocate distribution

between NII and excluded income)

26


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Example 1 from Treas. Reg. § 1.1411-3(e)(5)

(modified)

Facts

Dividend income = 15,000

Interest income = 10,000

Capital gain = 5,000

IRA distribution = 75,000

Discretionary distribution = 10,000

Section 642(c) distribution = 20,000

Exemption = 100

Highest bracket for 2016 = 12,400

27


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(modified) - Computation, Step 1

Determine character of Distributable net income under

Treas. Reg. § 1.661(b)-1 & calculate distribution of NII

Distribution under IRC § 661 / Distributable net income X each category

of income

10,000 / 100,000 X 15,000 dividends = 1,500

10,000 / 100,000 X 10,000 interest= 1,000

10,000 / 100,000 X 75,000 IRA dist = 7,500

Distribution of NII = 2,500 (1,500 + 1,000)

28


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Determine which is the lesser of

• Amount deductible to the estate or trust under IRC § 651

or 661 (must allocate distribution between NII and excluded

income) = 2,500

Or

• Net investment income of the estate or trust = 30,000

29


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Calculate deduction for amounts paid or

permanently set aside for a charitable purpose

Distribution under IRC § 642(c) / Distributable net income X each

category of income

20,000 / 100,000 X 15,000 dividends = 3,000

20,000 / 100,000 X 10,000 interest= 2,000

20,000 / 100,000 X 75,000 IRA dist = 15,000

Deductible distribution under IRC § 642(c) = 5,000 (3,000 + 2,000)

30


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Calculate undistributed NII

NII from Part III, Line 12 = 30,000

Less:

• Distributions of NII to beneficiaries = 2,500

And

• Deductions under IRC § 642(c) – amounts paid or

permanently set aside for a charitable purpose = 5,000

Undistributed NII = 22,500

31


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Calculation of NII on trust’s adjusted gross income

& tax computation

32

PART II(b)


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Adjusted Gross Income – IRC § 67(e)

Total income (Form 1041, line 9)

Less:

• Administrative costs • fiduciary fees,

• attorney,

• Accountant or return preparer fees,

• Other deductions NOT subject to 2% floor

• Income distribution deduction

• Exemption

• Domestic production activities deduction

• Net operating loss deduction * Note: investment interest expense, taxes, charitable deductions and miscellaneous

itemized deductions subject to 2% floor are not subtracted

33


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Calculate AGI less highest bracket

Total income (Form 1041, line 9) = 105,000

Less: Income distribution deduction = (30,000)

Less: Exemption = (100)

AGI = 74,900

Less: highest bracket = (12,400)

AGI less highest bracket = 62,500

34


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Tax computation

Lesser of:

• Undistributed net investment income = 22,500

Or

• AGI less highest bracket = 62,500

NIIT = 855 (22,500 x 3.8%)

35


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(modified) - Summary

Trust Income DNI

Bene's share of

DNI (10%)

Trust's total

NII

Bene's share

of NII (10%)

Deductions under

642(c) (20%)

Deductions under

642(c) (20%)

Only NII Trust's UNII

Dividends 15,000 15,000 1,500 15,000 1,500 3,000 3,000 10,500

Interest 10,000 10,000 1,000 10,000 1,000 2,000 2,000 7,000

Capital Gain 5,000 5,000 5,000

IRA 75,000 75,000 7,500 15,000

Total 105,000 100,000 10,000 30,000 2,500 20,000 5,000 22,500

36


Esq., LL.M.

Material participation and other mitigating factors to

reduce impact of NIIT

37

PART III


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Importance of Material

Participation

• Recall Treas. Reg. § 1.1411-4: income from a

passive activity will be considered NII. The

passive activity rules are found in IRC § 469.

• IRC § 469(c)(1)(B) defines a passive activity

partly by reference to whether a taxpayer

“materially participates” in the activity. Note that

rental activity is a passive activity per se unless

the real estate professional exception in IRC §

469(c)(7) applies.

38


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Determining Material

Participation: Individuals

• Standards for determining material participation by

individuals are set forth in IRC § 469(h) and Treas. Reg.

§ 1.469-5T. The regulations feature seven safe harbors

to satisfy the material participation requirement:

1) Single Activity 500 Hour Test

2) “Substantially All” Test

3) 100 Hour + More Than Others Test

4) Multi-Activity “Significant Participation” 500 Total Hour Test

5) 5-out-of-10 Test

6) Personal Service Activity Any-Three-Year Test

7) Facts-and-Circumstances Catchall Test

39


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Participation: Individuals, cont.

• Limited partners in a limited partnership cannot materially

participate in an activity under any circumstances.

IRC § 469(h)(2); Treas. Reg. § 1.469-5T(e). Exceptions

exist for limited partners satisfying certain requirements.

Treas. Reg. § 1.469-5T(e)(2).

• If the activity in question is rental real estate, taxpayers

can qualify the activity as active if they are real estate

professionals, as measured in § 469(c)(7). The real

estate professional test has two parts. Taxpayers must

satisfy both criteria to pass the test.

40


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The Real Estate Professional Test

• Part One – The “More Than Half” Test: The taxpayer

must perform more than one-half of personal services in

real property trades or businesses in the year in question;

• Part Two – The “More Than 750 Hours” Test: The

taxpayer must spend more than 750 hours performing

services in real property trades or businesses in which

the taxpayer materially participates.

• Therefore, to qualify renting real estate as active, the

taxpayer must satisfy both the real estate professional

test and the material participation test. The former is for

individuals; the latter is for activities.

41


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Participation: Individuals

• Exceptions: For all activities, work done in an individual’s

capacity as an investor will not count toward material

participation. This essentially boils down to preparing and

reviewing financial or operational statements in a non-

managerial capacity. Treas. Reg. § 1.469-5T(f)(2)(B).

• Proof: The taxpayer may use “any reasonable means,”

but a contemporaneous log is preferred. Alternative

means include appointment books, calendars, or narrative

summaries. Treas. Reg. § 1.469-5T(f)(3).

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Participation: Trusts

Still unresolved in the regulations is the question of whether trusts

could materially participate in activities, specifically real estate

activities. The IRS has never issued such regulations despite being

given the authority to do so. Treas. Reg. § 1.469-5T(g).

The IRS Passive Activity Audit Technique Guide states that trusts

must satisfy the “regular, continuous, and substantial” requirement of

IRC § 469(h)(1), and while the seven safe harbors in Treas. Reg. §

1.469-5T(a) technically do not apply to trusts, the IRS will look to

those safe harbors as an “administrative proxy.”

Cathy Hughes, Attorney-Advisor on Estate and Gift Tax for the IRS

Office of Tax Policy, stated at the ABA Tax Section meeting in

Boston (September-October 2016) that regulations addressing

material participation by trusts are forthcoming.

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Participation: Trusts, cont.

In Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003),

a testamentary trust owned a ranch operated by the trustee and

several others employed by the trustee. The issue was whether the

trust could materially participate in its real estate activity. The IRS

position was that material participation should be determined by

reference to the trustee exclusively. The taxpayer’s position was

that such determination should include the activities of its employees

and agents.

The federal district court sided with the taxpayer and concluded that

the activities of the trust’s agents and employees were sufficient to

justify material participation under IRC § 469(h). The court did not

reference the seven safe harbors in Treas. Reg. § 1.469-5T(a).

44


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In Frank Aragona Trust v. U.S., 142 T.C. No. 9 (2014), a complex

irrevocable trust owned real property through a Michigan LLC

ignored as a DRE for federal tax purposes. One independent

trustee and the five beneficiary children served as trustees, with one

child (Paul) serving as executive trustee and having the power to

make all major decisions. The Michigan LLC employed some of the

trustees and other unrelated individuals to conduct its real estate

enterprises. The main issue was whether the trust qualified for the

real estate professional exception in IRC § 469(c)(7). This issue

was the crux of the trust’s argument that it should be able to deduct

losses from its rental real estate activities.

45


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The Tax Court concluded that the activities of the trustees should be

the point of reference when weighing whether the trust has passed

the two-part test in IRC § 469(c)(7). The Tax Court notably

disregarded the activities of the DRE’s employees. Even though two

of the trustees were involved in joint real estate ventures with the

trust, the Tax Court noted that the trustees’ individual interests were

minority interests. The trustees’ combined individual interests never

exceeded 50% of the total ownership interests and never exceeded

the trust’s ownership interest in any venture.

After weighing the relevant facts and circumstances, the Tax Court

determined the trust qualified for the IRC § 469(c)(7) exception and

that the trust materially participated in its real estate activities.

Therefore, the trust could deduct its rental real estate losses.

46


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Takeaways for Trust Material Participation:

• The two cases together show that trusts can (1) materially

participate in rental real estate activities, and (2) trusts can qualify

as real estate professionals under § 469(c)(7). Trusts can likely

look to Treas. Reg. § 1.469-5T(a) while awaiting -5T(g)

regulations.

• While Mattie Carter Trust permitted examination of the activities

of the trustees’ designees, Frank Aragona Trust disregarded

activities of those employed by a trust’s wholly owned DRE. The

IRS position is that only the activities of the trustees count. See,

e.g., TAM 200733023.

• Per Frank Aragona Trust, the trustees’ activities are to be

considered collectively, which could be a downside if the trust’s

activities go beyond rental real estate.

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Trusts with Deemed Owners – The Determination is Easier

• For grantor trusts, only the activities of the substantial owner under

IRC §§ 671-679 will count.

• For ESBTs, it appears that for both the S portion and non-S portion,

only the activities of the trustees will count. Treas. Reg. § 1.1411-

3(c)(1). However, if a grantor or another person is treated as

substantial owner of the ESBT assets, such status will prevail, and

only the substantial owner’s activities will count. Id.

• For QSSTs, only the activities of the beneficiary will count. IRC §

1361(d)(1)(B). However, for purposes of determining NII for

dispositions of QSST stock, it appears only the activities of the

trustees will count. Prop. Reg. § 1.1411-7(a)(4)(iii)(C); but see IRC §

1361(d)(1)(C).

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Determining whether trust documents permit

capital gains to be included in DNI

49

PART IV


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Treas. Reg. § 1.643(a)-3

3 situations where capital gains can be

included in DNI

1. 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 distributable net income determined without regard to this

subparagraph § 1.643(a)-3(b));

2. 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

3. 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.

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Treas. Reg. § 1.643(a)-3

Overriding framework

All 3 situations must be pursuant to the:

1. Terms of the governing instrument AND applicable local law, or

2. 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)

*Applicable law will usually not preclude allocation of capital gains to income, it will be permissive.

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Order of Authority

1. If trust document provides for specific direction –

must follow document (even if contradict UPIA)

2. If trust document provides for discretionary power –

fiduciary may use that power (even if contradict UPIA)

3. If trust document is silent or doesn’t grant the

fiduciary a discretionary power, fiduciary must

administer the trust according to UPIA.

4. If both trust document and UPIA are silent, you

must allocate to principal. * Capital gains under UPIA are generally allocated to principal

52


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Steps in Determining if Capital Gains

can be Included in DNI

1. Review the trust document

2. Look to local law (state statutes – UPIA?)

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Steps in Determining if Capital Gains

can be Included in DNI, cont.

1. If trust document language mandates or allows for

allocation of capital gain to income AND local law

doesn’t preclude, use Treas. Reg. § 1.643(a)-3(b)(1)

2. If trust document language is not strong enough to

allocate capital gains to income, use Treas. Reg. §

1.643(a)-3(b)(2) or (3)

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1. Allocated to Income

Sample terms in trust document that allow capital

gains to be allocated to income

• “the fiduciary has the discretion to allocate capital gains to

income”

• “the fiduciary has the discretion to allocate capital gains to either

income or principal”

Sample terms in trust document that may NOT

allow capital gains to be allocated to income

• “the fiduciary has the discretion to allocate receipts and

disbursements between income and principal”

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1. Allocated to Income, cont.

What if governing instrument is silent?

Fiduciary must rely only on local law.

• UPIA power to adjust? May be a discretionary power “granted

to the fiduciary by applicable law.” This power is constrained by

“reasonable and impartial exercise of discretion.” Need to

consider income and remainder beneficiaries interests.

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1. Allocated to Income, cont.

What if governing instrument is silent and local law

states capital gains are allocated to principal?

Solution: Decant to include a clause overriding local law.

"Pursuant to Section 11‐A‐1.3 of the N.Y. Ept. Law I hereby override the

state law default treatment of allocation of capital gains to trust principal as

follows: any Trustee not a beneficiary nor “related or subordinate” (as those

terms are defined in I.R.C. § 672) to any beneficiary of a trust may reallocate

capital gains taxable income from fiduciary accounting principal to fiduciary

accounting income in the sole discretion of the trustee. In doing so, the

trustee may consider the net tax effect of the allocation to the trust and the

beneficiary together, such as whether leaving capital gains as taxable to the

trust would otherwise cause Medicare surtax or short‐term capital gains rates

in excess of the net additional tax effect of a reallocation on a beneficiary’s

taxes.“ http://wealthmanagement.com/estate‐planning/avoid‐38‐percent‐medicare‐surtax

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2. Allocated to Corpus

Treated consistently by the fiduciary on the trust’s

books, records, and tax returns as part of a distribution

to a beneficiary

• Governing instrument is silent on allocation of capital gains

between income and principal or trust language not strong

enough for allocation to income.

• Local law allocates capital gains to principal.

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2. Allocated to Corpus, cont.

Treated consistently by the fiduciary on the trust’s

books, records, and tax returns as part of a distribution

to a beneficiary

• Need clear evidence capital gains are included in the distribution

• Document in the trust’s books and records

• Include capital gains in DNI on the tax return

• Consistent: not defined – “regular practice”, or treating or

deeming capital gains as distributed in current or future years

• Pre-existing trusts? Doubt as to if a “consistent” practice can be established.

Opportunity if trust never had capital gains in the past.

• New trusts? Establish consistency on initial return that has capital gains.

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3. Allocated to Corpus

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

• Need clear evidence capital gains are included in the distribution

• Document in the trust’s books and records

• Include capital gains in DNI on the tax return

• Gains realized to effectuate distributions are in DNI

• If trust document mandates a distribution (ex. Age attainment) and an asset must

be sold to satisfy this requirement, capital gains are included in DNI. (Ex. 9 in

Treas. Reg. § 1.641(b)-3)

• If a trust is to terminate and all principal distributed, all of the capital gains are

actually being distributed so they are allocated to DNI. (Ex. 7 in Treas. Reg. §

1.641(b)-3)

• If no distribution is required, but capital gains are generated to effectuate the

distribution, capital gains are included in DNI.

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Gains Flowing from K-1’s

Capital gains flowing from a partnership or

S corporation K-1 to a trust or estate are

included in DNI. Crisp v. United States, 34 Fed. Cl.

112 (1995)

* Note: in a simple trust, the IRC § 661 deduction is limited to the

lesser of FAI and DNI. Therefore, not all capital gains may be

distributed.

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Alternative Consideration:

IRC § 643(e)

In-kind distributions

If a trust did not want to incur a gain to effectuate a

distribution, the trustee may consider making an in-kind

distribution.

• Gain or loss is not recognized on the in-kind distribution of

property to a beneficiary that is not funding a pecuniary

bequest. IRC § 643(e)

• Distribution carries out DNI (lesser of property’s basis or

FMV)

• Beneficiary takes carryover basis in property

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Electing small business trusts and NIIT

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PART V


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Special Computational Rules:

Treas. Reg. § 1.1411-3(c)(1)

The S portion and non-S portion are treated as

separate trusts in calculating undistributed net

investment income BUT treated as a single trust for

purposes of determining the amount subject to tax

under IRC § 1411.

Note: If a grantor is treated as the owner of a portion of the ESBT, those

items of income and deduction are included in the grantor’s calculation of NII,

not the trust’s.

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Computation of Tax

1a. Calculate S portion’s undistributed NII,

1b. Calculate non-S portion’s undistributed NII,

1c. Combine amounts from S portion and non-S portion to

calculate the trust’s undistributed NII.

2a. Calculate S portion’s adjusted gross income,

2b. Calculate non-S portion’s adjusted gross income,

2c. Combine AGI of S portion and non-S portion.

3a. Subtract the highest tax bracket for that year from the combined

AGI computed in 2c.

3b. Tax is 3.8% on the lesser of 1c (combined undistributed NII) or

3a (combined AGI less highest tax bracket for that year). 65


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Example from Treas. Reg. § 1.1411-3(c)(3)

Facts

Non-S portion income:

Dividend income = 15,000

Interest income = 10,000

Capital loss = (5,000)

S portion income:

Net rental income = 21,000

Capital gain = 7,000

General:

Trustee fee = 1,000 (60% to non-S portion and 40% to S portion)

Distribution from income to a beneficiary = 9,000

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Example from Treas. Reg. § 1.1411-3(c)(3),

cont.

Undistributed NII for S portion

Net rental income: 21,000

Capital gain: 7,000

Trustee annual fee: (400)

S portion undistributed NII: 27,600

Undistributed NII for non-S portion Dividend income: 15,000

Interest income: 10,000

Deductible capital loss: (3,000)


Distributable net income deduction: (9,000)

Non-S portion undistributed NII: 12,400

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cont.

Combined Undistributed NII

S portion undistributed NII: 27,600

Non-S portion undistributed NII: 12,400

Combined undistributed NII: 40,000

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cont.

Adjusted Gross Income

Dividend income: 15,000

Interest income: 10,000

Deductible capital loss: (3,000)


Distributable net income deduction: (9,000)

S potion income: 27,600

Adjusted gross income: 40,000

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cont.

Tax Computation

Lesser of:

• Combined undistributed net investment income = 40,000

Or

• Combined AGI less highest bracket = 27,600 (40,000 – 12,400)

NIIT = 1,049 (27,600 x 3.8%)

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Planning strategies

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PART VI


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Minimizing NII Tax Owed:

Passive Activity Strategies

Actively Participate: Individuals should be

keeping contemporaneous logs of activities to

satisfy material participation and the real estate

professional test. Note that satisfying the real

estate professional test when the taxpayer has a

non-real estate “day job” is nearly impossible. On

the other hand, trustees can wear multiple hats.

The case law shows that a trustee’s activities will

only be evaluated in his capacity as trustee and not

in his capacity as an individual.

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Passive Activity Strategies, cont.

For trusts, first consider optimal trust status.

Grantor trust? Non-grantor trust? For S portions of

a trust: QSST? ESBT? Consider whose activities

will count for passive/active determination, then

keep logs accordingly.

Second, consider the identity of the trustees.

Trustee selection will be critical when planning for

avoidance of the NII tax. (Independent and

unrelated professionals will always be your

friend…)

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Grouping: The regulations allow taxpayers to

“group” certain activities for passive activity

purposes if they comprise an “appropriate

economic unit.” Treas. Reg. § 1.469-4(c)(1). The

Service will use a facts-and-circumstances test to

determine if grouping is reasonable. Treas. Reg. §

1.469-4(c)(2). Note that rental real estate cannot

be grouped with any other activities. Treas. Reg. §

1.469-9(e)(3)(i).

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The upside of grouping is that the taxpayer is

considered to be active in the entire group if the

taxpayer materially participates in the group.

Therefore, crafty use of grouping could qualify

certain activities as active when those activities

would be passive if considered individually.

There is case law on grouping, some taxpayer-

favorable and some not. Compare Lamas v.

Commissioner, T.C. Memo. 2015-59 with Williams

v. Commissioner, T.C. Memo. 2014-158.

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Certain Rental Activities: Note that there are

several exceptions to the rule that rental activities

are per se passive activities. You can find these

exceptions in Treas. Reg. § 1.469-1T(e)(ii)(3). Two

nifty exceptions are (1) when the average period of

customer use is seven days or less, and (2) rental

of property to a non-passive activity (the self-rental

rules). Treas. Reg. § 1.469-1T(e)(ii)(3)(B)(ii)(A);

Treas. Reg. § 1.469-2(f)(6).

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Financial Strategies

• Conversion to Tax-Exempt Income: While this

would exclude such income from calculation for

the NII tax, variations in deductibility of expenses

may lead to interesting results. Treas. Reg. §

1.1411-1(d)(4). http://www.thetaxadviser.com/issues/2015/nov/is-

anomaly-in-form-8960-resulting-in-unintended-tax-on-tax-exempt-

income.html

• Loss Harvesting: Simple and obvious – if the

taxpayer can trigger built-in losses to offset

gains that would be considered NII, the taxpayer

should consider the merits of doing so.

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Financial Strategies, cont.

• Installment Sales: Depending on the taxpayer’s

AGI for the years in question, installment sales

may eliminate NII tax partially or entirely. See

generally IRC § 453. Not always easy to find a

buyer willing to pay in installments. • Related – CRTs: Installment sale treatment without the counter-

party risk. Taxpayer should be charitably inclined. When used

with a wealth replacement trust, could result in favorable tax

results overall, including for NII purposes. See Treas. Reg. §

1.1411-3(d).

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Financial Strategies, cont.

• Life Insurance and Annuities: Under IRC §

72(e), taxpayers can defer income taxation for

the cash value of life insurance and annuities,

thereby avoiding the imposition of NII tax. Also

keep in mind IRC § 101(a) for life insurance

policies – death benefit is not subject to any

income taxes, including the NII tax. • For the ultra-high net worth, private placement life insurance and

annuities may prove a compelling vehicle for certain tax-

inefficient assets.

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Distribution Planning

For complex non-grantor trusts, consider the timing

and amount of distributions to beneficiaries and

how that may affect NII tax in these situations:

• Routine distributions of yearly income from

interest, dividends, rents, royalties, etc.

• Income from the sale of interests in pass-through

entities, especially S-Corps (or the deemed sale

per Prop. Treas. Reg. § 1.1411-7)

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Distribution Planning, cont.

• For grantor trusts, consider giving the “toggle

power” through grantor renunciations or trust

protectors. Note the several other tax issues

associated with toggling.

• For S-Corps, consider how the shares should be

owned – get creative with grantor trusts vs.

QSSTs vs. ESBTs vs. outright individual

ownership.

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Questions?

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31 East 32nd Street, 4th Floor

New York, New York 10016

212-453-9889

265 Sunrise Highway, Suite 32

Rockville Centre, New York 11570

516-558-3377

[email protected]

Michele Schlereth, CPA, J.D., MST

1 Penn Plaza – Ste 3000

New York, New York 10119

125 Baylis Road – Ste 300

Melville, New York 11747

631-719-3281

[email protected]

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