Trusts, Estates, and the Net Investment Income Tax

Posting by Geoffrey D. Brown, CPA, Principal

When the Patient Protection and Affordable Care Act (healthcare reform) was passed in 2010, it included a tax increase that went into effect for this tax year: a 3.8% tax on net investment income.  This increase will affect individuals, estates and trusts on the lesser of the taxpayer’s net investment income for the year or the excess of his/her modified adjusted gross income (AGI) at the following thresholds:

Individuals

  • Over $250,000 AGI for taxpayers filing a joint return;
  • $125,000 AGI for married taxpayers filing separate returns;
  • $200,000 AGI for all other taxpayers.

Estates and Trusts

  • The excess of AGI over $11,950.

What is considered Net Investment Income?
For clarity’s sake, let’s break this down further. Net investment income is generally considered the sum of interest income, dividends, certain annuities, royalties, rents, and income not derived from an active trade or business. It also includes net capital gains from the disposition of property. It does not include self-employment income or operating income from a nonpassive business – so if your family business is an LLC which you own, you will not be subject to this tax on the income from the LLC, as it is considered active trade or business income. Bear in mind, there are specific rules for active participation for Trust and Estate ownership of business interest. In general and for purposes of this entry, all income earned by a Trust or an Estate is considered net investment income.

Which Trusts and Estates are Affected?
This tax generally applies to most trusts and estates, with the exception of trusts that are treated as business entities, certain state-law trusts – such as common trust funds or designated settlement funds, tax-exempt trusts, charitable remainder trusts, and foreign trusts and estates. Grantor trusts are also exempt from this new tax; if the grantor has retained an interest in the trust, trust income is taxable to the grantor or power holder. Note that this tax will apply to pooled income funds and qualified funeral trusts. Under the finalized regulations (PDF), cemetery trusts are excluded from this tax.

Planning for 2013 Taxes
You will notice that the threshold for this tax is much lower for estates and trusts than it is for individuals, and thereby many trusts will be affected. There is a silver lining. Net investment income tax is only computed on undistributed net income. So, income or capital gains retained by your trust or the Estate may be taxed at a higher rate than if it is distributed to beneficiaries. It may be advantageous for you to distribute this income to beneficiaries, if possible under the terms of the governing document: since the threshold is much higher for individuals, the distributions may not be subject to the tax, whereas the income most likely will be taxable if it remains in the trust.

The application of these regulations can be nuanced for certain types of trusts. Consult with your legal and financial advisors regarding your unique situation and the best strategy for your family. For additional details regarding this tax, visit the IRS FAQ site.

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