Breanna Young, Nelson Young & Braland
Introduction
The Medicare tax on net investment income is imposed under section 1411 of the Internal Revenue Code. Section 1411 was adopted on March 30, 2010 as part of the Health Care and Education Reconciliation Act of 2010. The section comprises the newly enacted Chapter 2A of the Code, entitled “Unearned Income Medicare Contribution.” For this reason, the tax is frequently called the “Medicare tax.” The tax is also referred to as the “Net Investment Income Tax” or the “NIIT.”
The Medicare tax imposes an additional 3.8% surtax on certain individuals, trusts, and estates. Although section 1411 was adopted in 2010, the Medicare tax did not become effective until 2013. The tax is to be reported on Form 8960 for tax years beginning after December 31, 2012.
The IRS and Treasury Department have issued proposed regulations for the Medicare tax, and final regulations are expected to be released by the end of 2013. The IRS has stated that taxpayers may rely on the proposed regulations until the effective date of the final regulations. Any election made in reliance on the proposed regulations will be in effect for the year of the election, and will remain in effect for subsequent taxable years.
For individuals, the 3.8% tax is imposed on the lesser of (a) net investment income, or (b) the excess of modified adjusted gross income over a certain threshold amount (in 2013, the threshold amounts are $250,000 for married filing jointly and $200,000 for single filers).
For trusts and estates, the 3.8% tax is imposed on the lesser of (a) undistributed net investment income, or (b) the excess of adjusted gross income over the top income-tax-bracket threshold (in 2013, $11,950). Consequently, the exposure is greater for trusts and estates than for individual taxpayers.
Factor 1: “Undistributed Net Investment Income.”
Undistributed net investment income, or “UNII,” is the first of two factors in calculating the Medicare tax for trusts and estates. The term “undistributed net investment income” is not defined, but presumably means net investment income, less distributions to beneficiaries.
UNII includes interest, dividends, royalties, annuities, and rents (other than rents from the ordinary course of a trade or business). Also included are trade or business income from a “passive activity” under I.R.C. §469, and net gain from disposition of property less deductible losses under I.R.C. §61(a)(3).
UNII is reduced by properly allocable deductions, including investment interest, advisory fees, and brokerage fees; expenses related to rental and royalty income; and state and local income taxes allocable to net-investment-income items.
A Note about Material Participation.
Trade or business income from a passive activity is included in net investment income, or “NII.” Conversely, income from a trade or business in which the taxpayer materially participates does not count toward NII.
I.R.C. §1411 defers to I.R.C. §469 to define a passive activity. Under section 469, an activity is not passive if the taxpayer’s involvement in the trade or business operations is regular, continuous, and substantial. Regulations promulgated under section 469 provide a seven-part test to determine whether an individual taxpayer’s actions constitute material participation. No such test exists, however, where the taxpayer is a trust or an estate.
The IRS position is that only the activities of the trustee should be considered in determining material participation. See PLR 201029014, TAM 201317010, and TAM 200733023. But the federal district court in Mattie K. Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003), determined that material participation should be determined by considering the activities of all persons acting on behalf of the trust.
A Note about Expense Allocations.
Direct expenses must be allocated to the income that generated the expenses. Some amount of indirect expense must be allocated to tax-exempt income, but the remainder may be allocated to reduce NII. If indirect expenses are allocated to income not included in NII, these deductions are wasted for purposes of the Medicare tax. Thus, the trustee may consider allocating as many indirect expenses as possible to NII.
Factor 2: “Excess of Adjusted Gross Income over Threshold Amount.”
The excess of adjusted gross income, or “AGI,” over the over the top income-tax-bracket threshold is the second of two factors in calculating the Medicare tax. In 2013, the applicable threshold amount is $11,950.
AGI is calculated under I.R.C. §§62 and 67(e). AGI includes gross income, less certain deductions, including rental and trade or business deductions. Excluded from AGI are the personal deduction, costs relating to administering the trust or estate, charitable contributions, and distributions to beneficiaries.
Typically, the excess of AGI over the threshold amount will be the lesser of the two measuring factors. As a result, in most cases the 3.8% tax will be assessed on the excess of AGI over the threshold.
Applicability to Certain Trusts and Estates.
The general rule in I.R.C. §1411 is that the Medicare tax applies 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 Code.” Accordingly, ordinary trusts, pooled-income funds, and funeral trusts all are subject to the Medicare tax. Exempt from the tax are trusts not subject to income taxes (e.g., charitable trusts); trusts in which all of the unexpired interests are devoted to one or more of the purposes described in I.R.C. §170(c)(2)(B) (e.g., religious or educational purposes); trusts classified as grantor trusts under I.R.C. §§671-679; and trusts that are not classified as “trusts” for federal-income-tax purposes (e.g., REIT’s).
Planning Considerations.
State law, fiduciary duties, and the language of the will or trust govern a fiduciary’s investment and distributions of trust or estate property. Where permitted, a fiduciary may consider taking certain actions to mitigate the impact of the Medicaid tax on the trust or estate. These actions may include:
Choosing Investments Carefully. Certain investments may reduce includable interest income (e.g., municipal bonds) and capital gains (e.g., low-turnover funds).
Allocating Expenses Wisely. Deductions may be used to reduce NII. A fiduciary should consider allocating as many indirect expenses as possible to NII.
Making Charitable Contributions. Charitable gifts can reduce AGI.
Distributing Income to Beneficiaries. Distributions to beneficiaries reduce both UNII and AGI. Each beneficiary’s modified AGI will be considered separately for determining the Medicare tax. Distributions to lower-income trust beneficiaries may eliminate the tax entirely. However, distributions to higher-income trust beneficiaries may only serve to transfer the Medicare-tax liability to the beneficiaries.
Planning Example.
A hypothetical example of how the Medicare tax can be reduced or eliminated with the use of distributions is as follows:
During the 2013 tax year, the Smith Family Trust had $100,000 of NII and $19,700 of deductible expenses. Each beneficiary is in the 28% income-tax bracket. Each beneficiary’s MAGI is below the threshold amount.
|
If Trustee Distributes $0: |
If Trustee Distributes $80,000: |
|
| Gross income |
100,000 |
100,000 |
| (Less deductible expenses) |
(19,700) |
(19,700) |
| Adjusted total income |
80,300 |
80,300 |
| (Less personal exemption) |
(300) |
(300) |
| (Less distributions to beneficiaries) |
0 |
(80,000) |
| Taxable income |
80,000 |
0 |
| Income tax at trust level |
30,407 |
0 |
| Income tax at beneficiary level |
0 |
12,000 |
| Total Income Tax |
30,407 |
12,000 |
| Medicare tax at trust level |
2,614 |
0 |
| Medicare tax at beneficiary level |
0 |
0 |
| Total Medicare Tax |
2,614 |
0 |
| Total Tax |
33,021 |
12,000 |
Tax Savings with Proper Planning: $21,021
Conclusion
Due to the relatively low threshold amount at which the Medicare tax applies, fiduciaries should be cognizant of the tax’s impact on trusts and estates. In certain cases, the impact of the tax can be reduced or eliminated with proper planning. While final regulations for the Medicare tax have not been released, fiduciaries may rely on the proposed regulations until the effective date of the final regulations.