ELITE ADVISOR BEST PRACTICES

Special Rules for Applying the 3.8 Percent Medicare Tax to Estates and Trusts - Part Two

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

By Richard Fox

Key Takeaways:

  • 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.
  • Because CRTs can result in favorable income, estate and gift tax consequences, they can provide excellent tax planning opportunities.
  • 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.


As discussed in my previous article, property having significant appreciation may often be transferred to a charitable remainder trust (CRT) and then sold without the imposition of the 3.8 percent tax on net investment income (NII).

In the case of an estate or trust, the 3.8 percent tax under Section 1411 is imposed for each taxable year on an amount equal to the lesser of (A) the undistributed NII of the estate or trust or (B) the excess, if any, of (i) the adjusted gross income (AGI) of the estate or trust over (ii) the inflation-adjusted dollar amount of the highest tax bracket in Section 1(e), a relatively nominal amount equal to only $11,950 for 2013. Similar to an individual, if an estate or trust has no undistributed NII or its AGI does not exceed the applicable threshold amount for the year, no tax will be imposed under Section 1411.

Because the threshold applicable to estates and trusts is at such a low level relative to the thresholds applicable to the individual beneficiaries, it is particularly important to appreciate the application of the Section 1411 tax to estates and trusts and to focus on possible techniques to minimize the exposure. This may include shifting the NII of an estate or trust into the hands of individual beneficiaries by making additional distributions to such beneficiaries, who may be subject to a lesser tax or no tax at all on their NII because of the higher Section 1411 thresholds applicable to individuals. By combining the effects of the higher AGI thresholds applicable to individual beneficiaries and spreading out the NII of the trust among many beneficiaries, it may be possible for a trustee to eliminate or substantially reduce the tax on the NII of the trust.

Of course, if all the beneficiaries of the trust are affluent to the extent that the excess of their respective AGIs over their applicable thresholds equals or exceeds their NII, shifting NII from a trust to its beneficiaries will not reduce the Section 1411 tax. Moreover, even if making distributions to beneficiaries results in an overall reduction of the Section 1411 tax, trustees should consider other tax and non-tax factors, such as the potential estate tax savings and asset protection benefits of keeping the assets in trust.

Section 1411 and the CRT

A CRT can be particularly useful in planning to avoid the impact of the tax on NII under Section 1411 assuming, of course, that the taxpayer is willing to give the remainder of the interest in the trust to charity, which could include the taxpayer’s own private foundation, a donor-advised fund sponsored by a public charity, or a public charity. CRTs are not subject to the NII tax under Section 1411. Therefore, similar to the income tax context, a taxpayer can transfer substantially appreciated property to a CRT that can then be sold by the CRT free of any Section 1411 tax.

While a CRT is exempt from the Section 1411 tax, annuity and unitrust distributions by a CRT carry out NII to the individual noncharitable beneficiaries. A CRT, however, has the favorable effect of smoothing out the NII that is carried out to its beneficiaries on a year-to-year basis and subjects the taxation of such NII to the higher thresholds applicable to individuals. Thus, by using a CRT, NII of the CRT trust is harbored in a tax-exempt environment within the CRT, while at the same time leveling out the NII of the CRT in the hands of the individual noncharitable beneficiaries over a substantial period of time so as to minimize (or at least defer) the IRC Section 1411 tax imposed on the NII earned by the CRT. Thus, in addition to its other benefits, including an up-front income tax deduction, its exemption from income tax and its ability to avoid the imposition of tax upon the sale of substantially appreciated property, CRTs now offer the benefit of avoiding, minimizing or deferring the tax on NII imposed under Section 1411.

Real-world example

A, a single taxpayer, has a salary of $150,000 and no other income. If A were to sell long-term capital gains property at a gain of $350,000, her NII and AGI would be equal to $350,000 and $500,000, respectively. A’s NII subject to tax would be equal to $300,000, the lesser of (1) the NII of $350,000 and (2) $300,000, the excess of the $500,000 of AGI over the $200,000 threshold amount. Instead of selling the property, if A contributed the property to a CRT which then sold the property, the $350,000 gain would not be subject to the Section 1411 tax or the regular income tax. If the annual annuity or unitrust payment were equal to $50,000 for a particular year, and assuming that such payment consisted only of long-term capital gains, then A would be considered to realize long-term capital gains income from the CRT of $50,000. In such a case, A’s NII and AGI would be equal to $50,000 and $200,000, respectively. Because A’s AGI would not exceed the $200,000 threshold, A would not be subject to any tax under Section 1411.

The actual determination of the NII that is deemed to be distributed each year to individual noncharitable beneficiaries through an annuity or unitrust payment from a CRT is governed by the proposed regulations promulgated under Section 1411, rather than under Section 664 or its regulations, which otherwise govern the taxation of a CRT and its distribution of annuity or unitrust payments to its beneficiaries.

According to Prop. Reg. 1.1411-3(c)(2)(i), distributions from a CRT to a beneficiary for a taxable year consist of NII in an amount equal to the lesser of (1) the total amount of the distributions for that year or (2) the current and accumulated NII of the CRT. For CRTs with multiple annuity or unitrust beneficiaries, the NII is apportioned among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the trust for that taxable year. The term “accumulated NII” is defined as the total amount of NII received by a CRT for all taxable years beginning after December 31, 2012, reduced by the total amount of NII distributed for all prior taxable years beginning after December 31, 2012. Thus, under the proposed regulations, the current and accumulated NII of a CRT is deemed to be distributed before amounts that are not items of NII for purposes of Section 1411, irrespective of the four-tier ordering rule that is otherwise applicable under the Section 664 tax regime for determining the character of income attributable to annuity or unitrust payments.

Depending on the character of the income realized by the CRT, the difference in the ordering rules may result in the worst of both tax worlds for a beneficiary of a CRT. For example, if a CRT’s income consists of taxable income from an IRA and long-term capital gains, an annuity or unitrust payment could carry out only IRA income (which is not NII) for Section 664 purposes and only long-term capital gains (which is NII) for Section 1411 purposes.

Recognizing that the ordering rule applicable to distributions of NII under the Section 1411 proposed regulations are not consistent with the four-tier ordering rule under Section 664, the preamble to the proposed regulations under Section 1411 states that the Treasury Department and the IRS considered an alternative method for determining the distributed amount of NII, in which NII would be determined on a class-by-class basis within each of four tiers under the Section 664 tax regime. This alternative method would have created a subclass system of NII and non-NII within each class and category of the four-tier Section 664 framework. The preamble states, however, that “[a]lthough differentiating between net investment income and non-net investment income within each class and category might be considered more consistent with the structure created for charitable remainder trusts by section 664 and the corresponding regulations, the Treasury Department and the IRS believe that the record-keeping and compliance burden that would be imposed on trustees by this alternative would outweigh the benefits.” The benefits, of course, would be potentially lower taxes imposed on the noncharitable beneficiaries of the CRT.

Conclusion

A CRT 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). 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.


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).