T H E 3. 8 P E R C E N T T A X O N N E T I N V E S T M E N T I N C O M E

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1 Insights on... WEALTH PLANNING T H E 3. 8 P E R C E N T T A X O N N E T I N V E S T M E N T I N C O M E Final Regulations and Continuing Developments Suzanne Shier, Wealth Planning Practice Executive and Chief Tax Strategist June 2014 The 3.8 percent tax on net investment income tax ( NII Tax ) on the so-called unearned income of certain individuals, trusts, and estates that was new in 2013 is now a fact of life here to stay and be dealt with accordingly. The tax is a result of the addition of Chapter 2A, section 1411 (Unearned Income Medicare Contribution Imposition of Tax) to the Internal Revenue Code ( Code ). In late 2012, the Internal Revenue Service ( Service ) issued proposed regulations that provided interim guidance regarding the implementation of the tax until final regulations were promulgated. Final regulations were published in the Federal Register on December 2, The final regulations provided further refinements, reflecting comments received on the proposed regulations. Notably, the final regulations repealed the proposed rules regarding treatment of the disposition of interests in certain partnerships and S corporations and simultaneously proposed new regulations on this issue. The NII Tax has a widespread impact although its full impact has not yet been determined and the regulatory and other guidance is still evolving. TO WHOM THE TAX APPLIES For individuals, the NII Tax applies to the lesser of (i) net investment income ( NII ) and (ii) the excess of modified adjusted gross income over a threshold amount equal to (a) $250,000 for married taxpayers filing jointly or surviving spouses, (b) $125,000 for a married taxpayer filing a separate return, or (c) $200,000 for all other individuals. i These thresholds are not expected to be adjusted periodically for inflation. As a result, the tax is expected to apply to a broader class of taxpayers over time. For estates and trusts, the NII Tax applies to the lesser of (i) undistributed NII and (ii) the excess of adjusted gross income over a threshold amount equal to the dollar amount at which the highest tax bracket begins ($12,150 in 2014). Although this threshold for estates and trusts is substantially lower than the thresholds for individuals, it is indexed for inflation. NII which is distributed by an estate or trust, and therefore is taxed at the beneficiary level, is potentially subject to the NII Tax at the beneficiary level. NET INVESTMENT INCOME The computation of NII is the same for individuals, estates, and trusts. NII includes the following items of income, reduced by allowable deductions properly allocable to such income: (1) gross income from interest, dividends, annuities, royalties, and rents, but excluding any such income which is derived in the ordinary course of any trade or business (other than those described immediately below in item (3)); and (2) net gain (to the extent taken into consideration in computing taxable income) attributable to the disposition of property, but excluding dispositions of property held in any trade or business (other than those described immediately below in item (3)); and northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 1 of 10

2 (3) gross income from any trade or business which is a passive activity with respect to the taxpayer or which involves trading in financial instruments or commodities. Wages, self-employment income, alimony, unemployment compensation, distributions from qualified retirement plans and income otherwise excluded from taxable income, such as taxexempt interest, are not included in NII and therefore not subject to the NII Tax. In addition, certain gains not recognized under the Code generally will not be taken into account including, for example, like-kind exchanges under Code section TRUSTS The NII Tax applies to most trusts as well as their beneficiaries. The tax generally will be paid by the trust for undistributed NII and by its beneficiaries for distributed NII, similar to the typical income tax treatment of accumulated and distributed net income between a trust and its beneficiary. The NII Tax does not apply to trusts that are exempt from income tax, even if they may be subject to the special tax on unrelated business income under Code section 511 (Imposition of Tax on Unrelated Business Income of Charitable, Etc., Organizations). Examples are Code section 529 accounts (Qualified Tuition Programs) and charitable remainder trusts (although special tax accounting discussed below will be required for distributions from charitable remainder trusts). Thus, although certain income from otherwise tax-exempt trusts may be subject to federal income tax, aside from distributions from charitable remainder trusts, taxexempt trusts generally will not be subject to the NII Tax. Calculating the Tax for Estates and Trusts Calculating the tax liability for estates and trusts requires computation of NII and undistributed NII, taking into account both the allocation of NII between an estate or trust and its beneficiaries and the character of the income. To maintain consistency, the regulations allocate NII between an estate or trust and its beneficiaries, and also categorize types of income for purposes of the NII in a manner based on that used for purposes of income taxation generally. It is important to remember that in the case of U.S. domestic estates and nongrantor trusts, to appropriately allocate income tax between an estate or trust and its beneficiaries, the Code provides for a deduction for distributions to beneficiaries in computing taxable income at the estate or trust level. The amount deducted in computing the taxable income of the estate or trust is included in the computation of the taxable income of the beneficiaries. The character of the income earned at the estate or trust level is preserved at the beneficiary level for beneficiaries of domestic trusts. Undistributed NII taxed to the trust is defined as NII reduced by (1) the share of NII included in the beneficiary distribution deduction of the estate or trust and (2) the charitable deduction for amounts paid or permanently set aside for charitable purposes. In effect, as is the case for purposes of the computation of the taxable income of an estate or trust for income tax purposes generally, an estate or trust is treated as a conduit of NII to the beneficiary. It is only that portion of NII that remains at the estate or trust level that is treated as undistributed NII and taxed to the estate or trust. This general definition of NII, as further clarified in the regulations, provides for included income and excluded income for purposes of the NII Tax. When applied to estates and trusts, northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 2 of 10

3 the regulations adopt the class system of categorizing income used in the computation of distributable net income for income tax purposes to arrive at a trust's NII reduction where a beneficiary distribution is comprised of both included and excluded items of income. Thus, as discussed in greater detail below, in addition to keeping records of trust accounting income and distributable net income, trustees must keep records of NII accumulated by a trust and NII distributed to a beneficiary, taking the character of the income into account. This record keeping is best demonstrated by example: Calculation of undistributed NII (with no deduction under section 642(c)) ii In Year 1, Trust has dividend income of $15,000, interest income of $10,000, capital gain of $5,000, and $75,000 of taxable income relating to a distribution from an individual retirement account (as defined under Code section 408). Trust has no expenses. Trust distributes $10,000 of its current year trust accounting income to A, a beneficiary of Trust. Trust s distributable net income is $100,000 ($15,000 in dividends plus $10,000 in interest plus $75,000 of taxable income from an individual retirement account), from which the $10,000 distribution to A is paid. Trust s deduction under Code section 661 is $10,000. Under Treas. Reg (b) 1, the deduction reduces each class of income comprising distributable net income on a proportional basis. The $10,000 distribution equals 10 percent of distributable net income ($10,000 divided by $100,000). Therefore, the distribution consists of dividend income of $1,500, interest income of $1,000, and ordinary income attributable to the individual retirement account of $7,500. Because the $5,000 of capital gain allocated to principal for trust accounting purposes did not enter into distributable net income, no portion of that amount is included in the $10,000 distribution, nor does it qualify for the deduction under Code section 661. Trust s NII is $30,000 ($15,000 in dividends plus $10,000 in interest plus $5,000 in capital gain). Trust s $75,000 of taxable income attributable to the individual retirement account is excluded income. Trust s undistributed NII is $27,500, which is Trust s NII ($30,000) less the amount of dividend income ($1,500) and interest income ($1,000) distributed to A. The $27,500 of undistributed NII is comprised of the capital gain allocated to principal ($5,000), the remaining undistributed dividend income ($13,500), and the remaining undistributed interest income ($9,000). A s NII includes dividend income of $1,500 and interest income of $1,000, but does not include the $7,500 of ordinary income attributable to the individual retirement account because it is excluded from NII. (see following page) northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 3 of 10

4 Trust Receipts Trust s DNI A s Distribution and Trust s Distribution Deduction Trust s NII Trust s UNII Dividends $15,000 $15,000 $1,500 $15,000 $13,500 $1,500 Interest Income $10,000 $10,000 $1,000 $10,000 $9,000 $1,000 Capital Gain $5,000 $5,000 $5,000 IRA $75,000 $75,000 $7,500 Distribution TOTAL $105,000 $100,000 $10,000 $30,000 $27,500 $2,500 A s NII Change of Annual Accounting Period In general, the threshold above which the tax applies in the case of an estate or trust will not be prorated or reduced in the event of a short tax year. However, a short tax year resulting from a change of the annual accounting period will reduce the excess of the estate s or trust's adjusted gross income over the threshold. The reduction will bear the same ratio to that dollar amount as the number of months in the short tax year bears to twelve. The reduction will not apply to changes in accounting periods resulting from the death of an individual. APPLICATION TO SPECIFIC TRUSTS The NII Tax applies to all estates and trusts subject to the provisions of Subchapter J unless otherwise specifically exempted. The regulations seek to supply further guidance on the interplay between specific trusts and the tax. These specific trusts include grantor trusts, charitable remainder trusts, pooled income funds, cemetery perpetual care funds, qualified funeral trusts, Alaska Native settlement trusts, electing small business trusts, and certain state law trusts. The proposed regulations specifically requested comments regarding whether or not, from an administrative perspective, the following should be excluded from Section 1411: pooled income funds, cemetery perpetual care funds, qualified funeral trusts, and Alaska Native settlement trusts. The final regulations made some changes to the proposed regulations. Grantor Trusts In the case of a grantor trust treated as owned by the grantor or another person under subpart E of part I of Subchapter J, the NII Tax will not apply to the trust itself. Rather, the income of the trust will be treated as being the income of the grantor or other owner for purposes of the NII Tax. The regulations clarify that, in the case of the grantor treated as owner of the trust, any items of income, deduction, or credit included in computing the taxable income of the grantor or other person under Code section 671 "is treated as if it had been received by, or paid directly to, the grantor or other person for purposes of calculating such person's [NII]." iii Charitable Remainder Trusts Although a charitable remainder trust is not subject to the NII Tax at the trust level, the regulations provide computational rules to track annuity and unitrust distributions that constitute NII to the non-charitable beneficiary during the annuity or unitrust term. northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 4 of 10

5 Annuity and unitrust distributions from a charitable remainder trust to non-charitable beneficiaries are ordered for income tax purposes based on what is commonly referred to as a four-tier system (ordinary income, capital gains, tax-exempt income, and principal). Although the proposed regulations, in the interest of administrative convenience, chose not to apply the ordering rules for purposes of the NII Tax, the final regulations parallel the Code section 664 (Charitable Remainder Trusts) classifications. Under the final regulations, accumulated NII is the total amount of NII received by a charitable remainder trust for all tax years after 2012, less the total amount of NII distributed for all prior tax years that begin after Although a charitable remainder trust itself will not be subject to the NII Tax, additional recordkeeping will be required by the trustee for purposes of the tax reporting required with respect to the distributions to beneficiaries. If a trust has multiple annuity or unitrust beneficiaries, the NII will be apportioned among the beneficiaries based on the respective shares of the total annuity or unitrust they are paid by the trust during the tax year. Other Trusts The final regulations address the inclusion or exclusion of certain other types of trusts. For example, pooled income funds are not excluded from the NII Tax. Cemetery perpetual care trusts are excluded from the tax because they are similar to business trusts, which are also excluded. Alaska Native Settlement Trusts subject to the lower individual tax rate pursuant to Code section 646 (Treatment of Electing Alaska Native Settlement Trusts) are excluded. The final regulations do not exclude qualified funeral trusts from the NII Tax. However, each beneficiary s interest in a qualified funeral trust is treated as a separate trust. Due to the thresholds, this may have a significant impact on the extent to which the tax applies to an individual's interest. Electing Small Business Trusts The regulations give further guidance when determining what portion, if any, of an electing small business trust (ESBT) is subject to the NII Tax. The regulations explain that, to calculate undistributed NII, the S corporation and non-s corporation portion of an electing small business trust are treated separately. For purposes of determining the amount subject to the tax, however, the trust is treated as a single trust. Material participation is determined at the trustee level for an ESBT, both for recurring income and net gain at disposition. For example: iv In Year 1, the non-s portion of Trust, an ESBT, has dividend income of $15,000, interest income of $10,000, and capital loss of $5,000. Trust s S portion has net rental income of $21,000 and a capital gain of $7,000. The Trustee s annual fee of $1,000 is allocated 60 percent to the non-s portion and 40 percent to the S portion. Trust makes a distribution from income to a single beneficiary of $9,000. (see following page) northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 5 of 10

6 Step One: Trust must compute the undistributed NII for the S portion and non-s portion, then combine the amounts to calculate the ESBT s undistributed NII. The undistributed NII for the S portion is $27,600 and is determined as follows: Net Rental Income $21,000 Capital Gain $7,000 Trustee Annual Fee ($400) Total S portion undistributed NII = $27,600 The undistributed NII for the non-s portion is $12,400 and is determined as follows: Dividend Income = $15,000 Interest Income = $10,000 Deductible Capital Loss = ($3,000) Trustee Annual Fee = ($600) Distributable net income distribution ($9,000) Total non-s portion undistributed NII = $12,400 Step Two: The ESBT will calculate its adjusted gross income. The ESBT s adjusted gross income is the non-s portion s adjusted gross income increased or decreased by the net income or net loss of the S portion. Trust will combine the undistributed net investment income of the S and Non-S portions to arrives at Trust s combined undistributed net investment income. S portion s undistributed net investment income = $27,600 Non-S portion s undistributed net investment income = $12,400 Combined undistributed net investment income = $40,000 The adjusted gross income for the ESBT is $40,000 and is determined as follows: Dividend income = $15,000 Interest Income = $10,000 Deductible Capital Loss = ($3,000) Trustee Annual Fee = ($600) Distributable net income distribution ($9,000) S Portion Income = $27,600 Adjusted gross income = $40,000 The S portion s single item of ordinary income used in the ESBT s adjusted gross income calculation is $27,600. This item of income is determined by starting with net rental income of $21,000 and capital gain of $7,000 and reducing it by the S portion s $400 share of the annual trustee fee. Step Three: Determining the tax. Trust pays tax on the lesser of The combined undistributed NII ($40,000); or the excess of adjusted gross income ($40,000) over the dollar amount at which the highest tax bracket applicable to the trust begins for the taxable year ($12,150 in 2014). Trust pays tax on $27,850. IMPACT ON BUSINESS ENTITIES Businesses may be formed as sole proprietorships, partnerships (general and limited), limited liability companies and corporations. An eligible entity may elect to be classified as a northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 6 of 10

7 corporation, a partnership or an entity disregarded as separate from its owner for federal tax purposes. Certain corporation s may elect to be taxed as S corporations. If a business is organized as a corporation and taxed as a C corporation, the dividends paid to the shareholders are included in the NII of the shareholders. For S corporations and partnerships, determination for the NII Tax treatment requires the close examination of additional factors. As mentioned, the final regulations did not adopt the originally proposed rules regarding the sale of an interest in a partnership or an S corporation. However, new proposed rules were issued alongside the final regulations. Active Business Exception In general, the NII Tax does not apply to income from an active trade or business, meaning income derived in the ordinary course of business as generally defined for Code section 162 (Trade or Business Expenses) purposes. For purposes of calculating NII, a business is active unless it is a passive activity with respect to the taxpayer within the meaning of Code section 469 (Passive Activity Losses and Credit Limitations). However, the tax applies to a trade or business of trading in financial instruments or commodities as defined in Code section 475(e)(2), regardless of whether or not the taxpayer actively participates. The fact that a business is an active trade or business that is not related to trading in financial instruments is only step one of the analysis. The next step is to determine whether the income in question arises in the ordinary course of that business. The tax will apply to income not derived in the ordinary course of a trade or business unless otherwise excluded from the NII Tax. Notably, income on the investment of working capital is not treated as derived in the ordinary course of a trade or business and, therefore, is subject to the tax. WHAT THIS MEANS FOR BUSINESS AND BUSINESS ACTIVITIES Business owners must consider the nature of their activities in order to determine if the NII Tax will apply. Mainly, are their activities passive? For purposes of determining NII, passive activity is defined in the same way as it is under Code section 469 for the passive activity loss rules. A passive activity is an activity involving a trade or business in which the taxpayer does not materially participate in so far as her involvement in the operations of the activity is regular, continuous, and substantial. In order to determine material participation, certain activities may be aggregated and treated as a single activity if they constitute an economic unit. The Material Participation Determination For purposes of the NII Tax, based on the Code section 469 guidance, an individual is treated as materially participating in an activity for the taxable year if and only if: The individual participates in the activity for more than 500 hours during the year; The individual's participation in the activity for the taxable year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the year; The individual participates in the activity for more than 100 hours during the taxable year, and the individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year; The activity is a significant participation activity for the taxable year, and the northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 7 of 10

8 individual's aggregate participation in all significant participation activities during the year exceeds 500 hours; The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year. Trusts and Estates Material Participation The determination of material participation for estates and trusts is complex and the authoritative guidance is limited. The regulations for the NII Tax reserve aspects of this issue for future guidance. The question, simply stated, is whether a trust is capable of materially participating in a business activity such that income from that business activity can qualify for the active business exception to the NII Tax. More broadly, little definitive guidance is available to assist the taxpayer in determining whether or not a trust materially participates in an activity. Until very recently, the primary existing authority has been the case of Mattie K. Carter Trust v. United States, v from the Northern District of Texas in In Mattie K. Carter, the court ruled that when determining whether a trust materially participates in the activities of a business for purposes of the passive activity rules under Code section 469, it is not just the activities of the trustee which must be considered, but also the activities of other fiduciaries, agents, and employees of the trust. The Service had taken the position that the relevant inquiry is that questions of material participation are determined by the activities of the fiduciaries, in their capacities as fiduciaries, in the operations of the business. The Service recently addressed the question of material participation of a trust for purposes of the Code section 469 passive activity rules and certain credits under the alternative minimum tax. In Technical Advice Memorandum (TAM) , released in April 2013, the Service addressed the issue of material participation for purposes of the deduction of research and experimentation expenses in computation of the alternative minimum tax. Although the memorandum is not binding authority for any taxpayer other than the one addressed, it provides insight into the Service s view. The Chief Counsel, in concluding that the trusts did not materially participate in either company owned by the trusts, reiterated that, under the passive activities rules of Code section 469(h), material participation is regular, continuous, and substantial. However, the TAM states that the Service believes that the sole means for [the trusts] to establish material participation in the relevant activities of [the companies] is if the fiduciaries, in their capacities as fiduciaries, are involved in the operations of the relevant activities of [the companies] on a regular, continuous, and substantial basis. The memorandum concluded that the trustee did not participate in the daily activities of the trusts. Therefore, the trusts could not deduct research and experimental expenses. Rather, the expenses had to be amortized over a ten year period. northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 8 of 10

9 Frank Aragona Trust v. Commissioner On March 27, 2014, the Tax Court issued its decision in Frank Aragona Trust v. Commissioner. vi Although the case does not directly deal with material participation of a trustee in the context of Code section 1411, the fully reviewed decision is important in so far as the Tax Court held that a trust can qualify for the Code section 469(c)(7) exception to the per se rental real estate passive activity rule under Code section 469(c)(2). This exception is applicable if more than one-half of the personal services performed in trades or businesses by the taxpayer are performed in real property trades or businesses in which the taxpayer materially participates and if the taxpayer performs more than 750 hours of services during that year in real property trades or businesses in which the taxpayer materially participates. The court held that services performed by individual trustees on behalf of the trust may be considered personal services performed by the trust; therefore the trust is capable of performing personal services, thereby qualifying for the Code section 469(c)(7) exception. The Frank Aragona Trust was formed in Michigan in 1979, with Frank Aragona acting as trustee and his five children as beneficiaries. Upon the death of Frank Aragona in 1981, he was succeeded as trustee by six trustees, one an independent trustee and the other five trustees were his children. Each of the trustees received annual trustee fees. Holiday Enterprises, LLC is a wholly owned Michigan limited liability company owned by the trust and a disregarded entity for federal income tax purposes. Holiday managed most of the trust s rental real estate properties. Of the five descendant trustees, three were full-time employees of Holiday Enterprises, LLC and the remaining two were not active in the business. The Court held that, if the trustees are individuals, and they work in a trade or business as part of their trustee duties, their work may be considered work performed by an individual in connection with a trade or business. As such, the Court ruled that the trust can perform personal services and, therefore, qualify for the Code section 469(c)(7) exception. The case does not resolve numerous other issues and questions remain, but the decision is significant in so far as it provides additional clarity regarding material participation of employee-trustees. In particular, for a business which generates losses, the material participation of a trustee may allow losses from other non-passive activities of the trust to offset trust income. For purposes of the NII Tax, a trust s liability may be significantly reduced due to the non-passive nature of the activities. Other Considerations The present lack of definitive, clear or consistent authoritative guidance with respect to entity structures, trusts and the NII Tax presents challenges for business owners and their advisors. When structuring entities and trusts, consideration of who will participate in what roles is necessary: What type of entity will be used? If a limited liability company is used, will it be manager managed or member managed? If a manager managed limited liability company, who will be the manager? If the interests are held in trust, who will be the trustee or trustees? What powers will they have? Will the trust be a directed trust? Who will hold the power of direction? If the entity is taxed as an S corporation, will the trusts be taxed as QSSTs or ESBTs? northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 9 of 10

10 In order to avoid the imposition of the NII Tax, it will be necessary to design any combined entity and trust structures to satisfy the yet to be clearly stated requirements of material participation by the taxpayer. CONCLUSION Although the final regulations and other recent developments provide additional guidance regarding the new NII Taxation, the Service is still finalizing discreet areas of the regulations, including rules application to dispositions of interests in partnerships and S corporations. Additional developments are expected as the full impact of the NII Tax manifest. FOR MORE INFORMATION Wealth Planning Advisory Services at Northern Trust includes financial planning, family education and governance, philanthropic advisory services, business owner consulting, tax strategy and wealth transfer services. If you d like to learn more, contact a Northern Trust professional at a location near you or visit us at northerntrust.com. Special thanks to Amanda C. Andrews for her contributions to this piece. (c) 2014, Northern Trust Corporation. All rights reserved. Legal, Investment and Tax Notice: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. i Code ii Treas. Reg (e)(5) Example 1. iii Treas. Reg (b)(v). iv Treas. Reg (c)(3). v Mattie K. Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Texas 2003). vi Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (2014). See also, H.R. Rept. No , at 614 (1993), C.B. 167, 190. northerntrust.com I n s i g h t s o n W e a l t h P l a n n i n g 10 of 10