ELITE ADVISOR BEST PRACTICES

Using CRTs to Avoid the 3.8 Percent Medicare Tax on Net Investment Income - Part One

What advisors need to know about charitable remainder trusts (first in a series)

By Richard Fox

Key Takeaways:

  • New Section 1411 subjects individuals, estates and trusts to a 3.8 percent Medicare tax on net investment income.
  • Property having significant appreciation may often be transferred to a CRT and then sold without the imposition of the 3.8 percent tax on NII.
  • Although annuity and unitrust payments carry out NII to its noncharitable beneficiaries, a CRT has the effect of smoothing out NII that is passed through to such beneficiaries on a year-to-year basis.


As has been widely publicized, new Section 1411 subjects individuals, estates and trusts to a 3.8 percent Medicare tax on net investment income (NII), effective for tax years beginning on or after January 1, 2013. The threshold for the imposition of the tax on individuals is an adjusted gross income (AGI) of $250,000 for married couples filing joint returns and $200,000 for single filers. By contrast, the threshold for an estate or trust is AGI equal to the relatively nominal amount at which the highest income tax bracket begins under Section 1(e), a mere $11,950 for the tax year 2013.

With the increase in the top income tax rates under the American Taxpayer Relief Act of 2012 to 39.6 percent on ordinary income and 20 percent on long-term capital gains income and the imposition of the new 3.8 percent tax under Section 1411, individuals, estates and trusts now face a substantial tax of up to 43.4 percent on ordinary investment income and 23.8 percent on long-term capital gains income. Unlike in the context of the income tax, a charitable contribution deduction cannot reduce the tax imposed on individuals under Section 1411. Thus, a charitable contribution by an individual that is deductible under Section 170 will have no effect on a taxpayer’s liability under Section 1411, no matter how large the contribution.

Nonetheless, certain charitable planning vehicles can be utilized to minimize the tax imposed under Section 1411. A CRT is a charitable vehicle that can be particularly useful in planning to avoid the impact of the NII.

Because it is wholly exempt from Section 1411, property having significant appreciation can be transferred to a CRT and then sold without the imposition of the 3.8 percent tax on NII (or the imposition of any regular income tax). Moreover, although annuity and unitrust payments carry out NII to its noncharitable beneficiaries, a CRT has the effect of smoothing out NII that is passed through to such beneficiaries on a year-to-year basis and subjects the taxation of such NII to the higher AGI thresholds applicable to individuals.

Depending on the recipient beneficiaries’ respective NII and AGI, the use of a CRT may result in the elimination, reduction or, at the very least, deferral of the 3.8 percent tax on NII realized by the CRT. Because it can also result in favorable income, estate and gift tax consequences, a CRT can provide excellent tax planning opportunities to reduce the overall tax burden of a taxpayer. Of course, the use of a CRT is premised on the taxpayer having a desire to advance his or her philanthropy, an ever-growing goal among individuals in the United States. The proposed regulations that have now been issued under Section 1411 are particularly helpful, as they clarify the application of the Section 1411 tax in the context of a CRT.

Background on the 3.8 percent medicare tax on net investment income

Section 1411 imposes a 3.8 percent tax on individuals, estates and trusts on NII provided that the taxpayer’s adjusted gross income exceeds certain applicable thresholds. In the case of an individual, the 3.8 percent tax is imposed for each taxable year on an amount equal to the lesser of (A) the individual’s NII for such taxable year or (B) the excess, if any, of (i) the individual’s AGI for such taxable year over (ii) the “threshold amount.” The threshold amount is $250,000 in the case of taxpayers filing a joint return, $125,000 in the case of a married taxpayer filing a separate return, and $200,000 for single filers. Section 1411 tax liability will only result, therefore, when a taxpayer has NII and the taxpayer’s AGI exceeds the applicable threshold amount.

Real-world example

A husband and wife, who file a joint income tax return, have salaries totaling $275,000, constituting their only source of income (thus, they have no NII), and an AGI of $275,000. Because they have no NII, Section 1411 does not apply, notwithstanding that their AGI exceeds the applicable threshold amount of $250,000. If the couple had NII of $150,000, salaries of $100,000, and an AGI of $250,000, the 3.8 percent tax would similarly not apply.

Why? Although they have NII, their $250,000 AGI does not exceed the $250,000 threshold amount. If the couple had NII of $150,000, salaries of $275,000, and an AGI of $425,000, the 3.8 percent tax under Section 1411 would apply to the entire $150,000 of NII, since such amount is less than $175,000, the excess of the $425,000 AGI over the $250,000 threshold amount. If the couple had NII of $150,000, salaries of $200,000 and an AGI of $350,000, the 3.8 percent tax under Section 1411 would apply to only $100,000 of NII, the excess of the $350,000 AGI over the $250,000 threshold amount, since that amount is less than the $150,000 in NII.

NII generally means the excess, if any, of (A) the sum of (i) interest, dividends, annuities, royalties and rents; (ii) gross income derived from a passive activity or a trade or business of trading in financial instruments or commodities; and (iii) net gain attributable to the disposition of property derived from a passive activity or a trade or business of trading in financial instruments or commodities over (B) deductions that are allocable to such gross income or net gain. Income that does not fall within the definition of NII is generally referred to as “excluded income” for the purposes of the Section 1411 tax regime.

Conclusion

CRTs can be very useful for avoiding the impact of the NII. Because it is wholly exempt from Section 1411, property having significant appreciation can be transferred to a CRT and then sold without the imposition of the 3.8 percent tax on NII (or the imposition of any regular income tax). In the next installment, we’ll explore special rules for applying the 3.8 percent Medicare tax to estates and trusts.


About the Author

Richard L. Fox is an attorney and partner in the Philadelphia office of the law firm of Dilworth Paxson LLP (www.dilworthlaw.com) where he heads the Philanthropic and Nonprofit practice. Mr. Fox is the author of the treatise “Charitable Giving: Taxation, Planning and Strategies,” a Thomson Reuters/Warren, Gorham and Lamont publication. He is also a member of the editorial board of Estate Planning and a member of the Board of Advisors of the American College Chartered Advisor in Philanthropy program (www.theamericancollege.edu).