Upload
nguyenthuy
View
219
Download
1
Embed Size (px)
Citation preview
WHO TO CONTACT DURING THE LIVE EVENT
For Additional Registrations:
-Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10)
For Assistance During the Live Program:
-On the web, use the chat box at the bottom left of the screen
If you get disconnected during the program, you can simply log in using your original instructions and PIN.
IMPORTANT INFORMATION FOR THE LIVE PROGRAM
This program is approved for 2 CPE credit hours. To earn credit you must:
• Participate in the program on your own computer connection (no sharing) – if you need to register
additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford
accepts American Express, Visa, MasterCard, Discover.
• Listen on-line via your computer speakers.
• Respond to five prompts during the program plus a single verification code. You will have to write down
only the final verification code on the attestation form, which will be emailed to registered attendees.
• To earn full credit, you must remain connected for the entire program.
Mastering NIIT for Trusts and Estates: Net Investment
Income Tax Planning Strategies to Minimize Surtax
WEDNESDAY, OCTOBER 19, 2016, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
Tips for Optimal Quality
Sound Quality
When listening via your computer speakers, please note that the quality
of your sound will vary depending on the speed and quality of your internet
connection.
If the sound quality is not satisfactory, please e-mail [email protected]
immediately so we can address the problem.
FOR LIVE PROGRAM ONLY
Oct. 19, 2016
Mastering NIIT for Trusts and Estates
Matthew E. Rappaport, Esq., LL.M.
New York
Michele Schlereth, CPA, J.D., MST, Senior Tax Manager
Baker Tilly Virchow Krause, Melville, N.Y.
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Baker Tilly refers to Baker Tilly Virchow Krause, LLP,
an independently owned and managed member of Baker Tilly International
© 2010 Baker Tilly Virchow Krause, LLP
Mastering NIIT for Trusts and
Estates
Presented by
Matthew E. Rappaport, Esq., LL.M.
Michele Schlereth, J.D., CPA, MST - Baker Tilly
October 19, 2016
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Definition and scope of IRC § 1411 impact on
trusts and estates
6
PART I
MATTHEW E. RAPPAPORT,
Esq., LL.M.
What is the Net Investment Income
(NII) Tax?
The net investment income tax, or NII tax, became
effective on January 1, 2013. The tax was part of
the Patient Protection and Affordable Care Act,
which was modified by the Health Care and
Education Reconciliation Act. These two Acts are
known colloquially to some as “Obamacare,”
President Obama’s initiative to provide quality,
affordable health care to all Americans. The NII tax
is meant to help fund the implementation and
ongoing administration of the Obamacare initiative.
8
MATTHEW E. RAPPAPORT,
Esq., LL.M.
How Does the NII Tax Work?
The NII tax applies on a rather narrow basis. The NII tax
applies to the following taxpayers: • Individuals with modified adjusted gross income (MAGI) in excess of $200,000
(or $250,000 if married filing jointly).
• Estates and trusts with adjusted gross income (AGI) greater than $12,400.
Notice that individuals become subject to the NII tax before
their income reaches the highest tax bracket, while estates
and trusts only become subject to the NII tax upon their
income reaching the highest tax bracket.
Applicability of the NII tax is measured on a year-to-year
basis, so qualification for the NII tax in one year does not
automatically subject the taxpayer to the NII tax in all
succeeding years. * Threshold stated above for estates and trusts are for 2016. Individual thresholds are not indexed for inflation.
9
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Trusts and Estates Subject to NIIT
Treas. Reg. § 1.1411-3(a)
General application.— Section 1411 and the regulations
thereunder apply 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
Internal Revenue Code, unless specifically exempted under
paragraph (b) of this section.
These include:
• Estates
• Trusts: complex, simple, ESBT, Qualified Funeral trusts (special rules),
and Bankruptcy Estates (special rules)
10
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Trusts and Estates NOT Subject to NIIT
Treas. Reg. § 1.1411-3(b)
(i) A trust or decedent's estate all of the unexpired interests in which are devoted to
one or more of the purposes described in section 170(c)(2)(B).
(ii) A trust exempt from tax under section 501.
(iii) A charitable remainder trust described in section 664. However, see paragraph (d)
of this section for special rules regarding the treatment of annuity or unitrust
distributions from such a trust to persons subject to tax under section 1411.
(iv) Any other trust, fund, or account that is statutorily exempt from taxes imposed in
subtitle A. For example, see sections 220(e)(1), 223(e)(1), 529(a), and 530(a).
(v) A trust, or a portion thereof, that is treated as a grantor trust under subpart E of
part I of subchapter J of chapter 1.
(vi) Electing Alaska Native Settlement Trusts subject to taxation under section 646.
(vii) Cemetery Perpetual Care Funds to which section 642(i) applies.
(viii) Foreign trusts (but see § 1.1411-3(e)(3)(ii) and § 1.1411-4(e)(1)(ii))
(ix) Foreign estates (but see § 1.1411-3(e)(3)(ii))
11
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Investment Income Defined
Treas. Reg. § 1.1411-4
Included
• Interest*
• Dividends*
• Annuity distributions*
• Royalties*
• Rents*
• Income derived from passive activity
• Net capital gain attributable to the disposition of property
* Only if not derived in ordinary course of business
13
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Investment Income Defined, cont.
Excluded
• Salary, wages or bonuses (Treas. Reg. § 1.1411-1(d)(4)(ii))
• Distributions from IRAs or qualified plans (IRC § 1411(c)(5))
• Self-employment income (IRC § 1411(c)(6))
• Unemployment compensation and social security benefits (Treas. Reg. § 1.1411-1(d)(4)(ii))
• Alimony (Treas. Reg. § 1.1411-1(d)(4)(ii))
• Gain on sale of an active interest in a partnership or S
corporation (IRC § 1411(c)(4))
• Income derived in ordinary course of a trade or business (Treas. Reg. § 1.1411-4(b))
14
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Expenses
Included - properly allocated deductions under
Treas. Reg. § 1.1411-4(f)
• Investment advisory and brokerage fees allocable to investment income (not
allocable to tax-exempt income, subject to 2% floor and itemized deduction phase-out)
• Investment interest expense
• State and local income taxes attributable to NII under Treas. Reg. § 1.1411-
4(g)(1) (taxes paid in current year for prior year’s taxes get allocated based on prior year’s
ratio of NII to AGI)
• Other allowable deductions under IRC § 212(3) to the extent allocable to NII
under Treas. Reg. § 1.1411-4(g)(1) (tax preparation fee, tax audit representation,
legal fees in connection with the determination, collection, or refund of any tax)
• Fiduciary expenses to the extent allocable to NII under Treas. Reg. § 1.1411-
4(g)(1)
• Deductions allocable to gross income from rents and royalties (if income is
subject to NIIT)
• NOL to the extent allocable to NII under Treas. Reg. § 1.1411-4(h)
16
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Expenses, cont.
Excluded – deductions not stated in Treas. Reg.
§ 1.1411-4(f) (unless provided for in § 1.1411-1
through § 1.1411-10)
• Deductions in excess of gross income and net gain (except
as allowed under chapter 1)
• Deductions allocable to income not subject to NIIT
(including tax-exempt income)
* Common deductions not stated in Treas. Reg. § 1.1411-4(f)
include, but are not limited to: charitable contributions, medical and
dental, real estate taxes, mortgage interest, unreimbursed employee
expenses.
17
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Differences in Deductibility of
Certain Expenses Type of
Deduction
Deductibility on
Form 1040
Deductibility on
Form 1041
Deductibility on
Form 8960, Part II
Deductibility on
Form 8960, Part
III, Line 19a
(AGI)
Tax
preparation
fees
Fully deductible Fully deductible Deductible to the
extent allocable to
investment income
Fully deductible
Legal fees Fully deductible
depending on
reason for
expense
Fully deductible
depending on
reason for
expense
Deductible to the
extent allocable to
investment income
Fully deductible
depending on
reason for
expense
Fiduciary fees N/A Deductible to the
extent allocable
to taxable
income
Deductible to the
extent allocable to
investment income
Deductible to the
extent allocable
to taxable
income
Miscellaneous
itemized
deductions
Deductible to the
extent allocable
to taxable
income (after the
2% floor)
Deductible to the
extent allocable
to taxable
income (after the
2% floor)
Deductible to the
extent allocable to
investment income
(after the 2% floor)
Not deductible
Investment
interest
expense
Fully deductible,
but limited to net
investment
income
Fully deductible,
but limited to net
investment
income
Fully deductible,
but limited to net
investment income
Not deductible
Charitable
deductions
Fully deductible Fully deductible Not deductible Not deductible
State and local
taxes
Fully deductible Fully deductible Deductible to the
extent allocable to
investment income
Not deductible
18
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Impact on Trusts and Estates
3.8% on lesser of:
• Undistributed net investment income (NII) for such
taxable year
OR
• The excess (if any) of:
• Adjusted gross income (as defined in IRC § 67(e) and as
adjusted under Treas. Reg. § 1.1411-10(e)(2), if applicable)
for such taxable year; over
• The dollar amount at which the highest tax bracket in section
1(e) begins for such taxable year. (12,400 in 2016)
19
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Tax Computation
3.8% on lesser of:
• Undistributed net investment income (NII) for such
taxable year
OR
• The excess (if any) of:
• Adjusted gross income (as defined in IRC § 67(e) and as
adjusted under Treas. Reg. § 1.1411-10(e)(2), if applicable)
for such taxable year; over
• The dollar amount at which the highest tax bracket in section
1(e) begins for such taxable year. (12,400 in 2016)
21
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Calculation of Undistributed NII
NII from Part III, Line 12
Less:
• Distributions of NII to beneficiaries
And
• Deductions under IRC § 642(c) – amounts paid or
permanently set aside for a charitable purpose
24
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Distributions of NII to Beneficiaries
The lesser of:
• Amount deductible to the estate or trust under
IRC § 651 or 661 (must allocate distribution between
NII and excluded income)
Or
• Net investment income of the estate or trust
25
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Deductions Under IRC § 642(c)
Amounts paid or permanently set aside for a
charitable purpose (must allocate distribution
between NII and excluded income)
26
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified)
Facts
Dividend income = 15,000
Interest income = 10,000
Capital gain = 5,000
IRA distribution = 75,000
Discretionary distribution = 10,000
Section 642(c) distribution = 20,000
Exemption = 100
Highest bracket for 2016 = 12,400
27
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified) - Computation, Step 1
Determine character of Distributable net income under
Treas. Reg. § 1.661(b)-1 & calculate distribution of NII
Distribution under IRC § 661 / Distributable net income X each category
of income
10,000 / 100,000 X 15,000 dividends = 1,500
10,000 / 100,000 X 10,000 interest= 1,000
10,000 / 100,000 X 75,000 IRA dist = 7,500
Distribution of NII = 2,500 (1,500 + 1,000)
28
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified) - Computation, Step 2
Determine which is the lesser of
• Amount deductible to the estate or trust under IRC § 651
or 661 (must allocate distribution between NII and excluded
income) = 2,500
Or
• Net investment income of the estate or trust = 30,000
29
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified) - Computation, Step 3
Calculate deduction for amounts paid or
permanently set aside for a charitable purpose
Distribution under IRC § 642(c) / Distributable net income X each
category of income
20,000 / 100,000 X 15,000 dividends = 3,000
20,000 / 100,000 X 10,000 interest= 2,000
20,000 / 100,000 X 75,000 IRA dist = 15,000
Deductible distribution under IRC § 642(c) = 5,000 (3,000 + 2,000)
30
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified) - Computation, Step 4
Calculate undistributed NII
NII from Part III, Line 12 = 30,000
Less:
• Distributions of NII to beneficiaries = 2,500
And
• Deductions under IRC § 642(c) – amounts paid or
permanently set aside for a charitable purpose = 5,000
Undistributed NII = 22,500
31
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Calculation of NII on trust’s adjusted gross income
& tax computation
32
PART II(b)
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Adjusted Gross Income – IRC § 67(e)
Total income (Form 1041, line 9)
Less:
• Administrative costs • fiduciary fees,
• attorney,
• Accountant or return preparer fees,
• Other deductions NOT subject to 2% floor
• Income distribution deduction
• Exemption
• Domestic production activities deduction
• Net operating loss deduction * Note: investment interest expense, taxes, charitable deductions and miscellaneous
itemized deductions subject to 2% floor are not subtracted
33
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified) - Computation, Step 5
Calculate AGI less highest bracket
Total income (Form 1041, line 9) = 105,000
Less: Income distribution deduction = (30,000)
Less: Exemption = (100)
AGI = 74,900
Less: highest bracket = (12,400)
AGI less highest bracket = 62,500
34
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified) - Computation, Step 6
Tax computation
Lesser of:
• Undistributed net investment income = 22,500
Or
• AGI less highest bracket = 62,500
NIIT = 855 (22,500 x 3.8%)
35
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example 1 from Treas. Reg. § 1.1411-3(e)(5)
(modified) - Summary
Trust Income DNI
Bene's share of
DNI (10%)
Trust's total
NII
Bene's share
of NII (10%)
Deductions under
642(c) (20%)
Deductions under
642(c) (20%)
Only NII Trust's UNII
Dividends 15,000 15,000 1,500 15,000 1,500 3,000 3,000 10,500
Interest 10,000 10,000 1,000 10,000 1,000 2,000 2,000 7,000
Capital Gain 5,000 5,000 5,000
IRA 75,000 75,000 7,500 15,000
Total 105,000 100,000 10,000 30,000 2,500 20,000 5,000 22,500
36
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Material participation and other mitigating factors to
reduce impact of NIIT
37
PART III
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Importance of Material
Participation
• Recall Treas. Reg. § 1.1411-4: income from a
passive activity will be considered NII. The
passive activity rules are found in IRC § 469.
• IRC § 469(c)(1)(B) defines a passive activity
partly by reference to whether a taxpayer
“materially participates” in the activity. Note that
rental activity is a passive activity per se unless
the real estate professional exception in IRC §
469(c)(7) applies.
38
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Individuals
• Standards for determining material participation by
individuals are set forth in IRC § 469(h) and Treas. Reg.
§ 1.469-5T. The regulations feature seven safe harbors
to satisfy the material participation requirement:
1) Single Activity 500 Hour Test
2) “Substantially All” Test
3) 100 Hour + More Than Others Test
4) Multi-Activity “Significant Participation” 500 Total Hour Test
5) 5-out-of-10 Test
6) Personal Service Activity Any-Three-Year Test
7) Facts-and-Circumstances Catchall Test
39
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Individuals, cont.
• Limited partners in a limited partnership cannot materially
participate in an activity under any circumstances.
IRC § 469(h)(2); Treas. Reg. § 1.469-5T(e). Exceptions
exist for limited partners satisfying certain requirements.
Treas. Reg. § 1.469-5T(e)(2).
• If the activity in question is rental real estate, taxpayers
can qualify the activity as active if they are real estate
professionals, as measured in § 469(c)(7). The real
estate professional test has two parts. Taxpayers must
satisfy both criteria to pass the test.
40
MATTHEW E. RAPPAPORT,
Esq., LL.M.
The Real Estate Professional Test
• Part One – The “More Than Half” Test: The taxpayer
must perform more than one-half of personal services in
real property trades or businesses in the year in question;
• Part Two – The “More Than 750 Hours” Test: The
taxpayer must spend more than 750 hours performing
services in real property trades or businesses in which
the taxpayer materially participates.
• Therefore, to qualify renting real estate as active, the
taxpayer must satisfy both the real estate professional
test and the material participation test. The former is for
individuals; the latter is for activities.
41
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Individuals
• Exceptions: For all activities, work done in an individual’s
capacity as an investor will not count toward material
participation. This essentially boils down to preparing and
reviewing financial or operational statements in a non-
managerial capacity. Treas. Reg. § 1.469-5T(f)(2)(B).
• Proof: The taxpayer may use “any reasonable means,”
but a contemporaneous log is preferred. Alternative
means include appointment books, calendars, or narrative
summaries. Treas. Reg. § 1.469-5T(f)(3).
42
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Trusts
Still unresolved in the regulations is the question of whether trusts
could materially participate in activities, specifically real estate
activities. The IRS has never issued such regulations despite being
given the authority to do so. Treas. Reg. § 1.469-5T(g).
The IRS Passive Activity Audit Technique Guide states that trusts
must satisfy the “regular, continuous, and substantial” requirement of
IRC § 469(h)(1), and while the seven safe harbors in Treas. Reg. §
1.469-5T(a) technically do not apply to trusts, the IRS will look to
those safe harbors as an “administrative proxy.”
Cathy Hughes, Attorney-Advisor on Estate and Gift Tax for the IRS
Office of Tax Policy, stated at the ABA Tax Section meeting in
Boston (September-October 2016) that regulations addressing
material participation by trusts are forthcoming.
43
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Trusts, cont.
In Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003),
a testamentary trust owned a ranch operated by the trustee and
several others employed by the trustee. The issue was whether the
trust could materially participate in its real estate activity. The IRS
position was that material participation should be determined by
reference to the trustee exclusively. The taxpayer’s position was
that such determination should include the activities of its employees
and agents.
The federal district court sided with the taxpayer and concluded that
the activities of the trust’s agents and employees were sufficient to
justify material participation under IRC § 469(h). The court did not
reference the seven safe harbors in Treas. Reg. § 1.469-5T(a).
44
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Trusts, cont.
In Frank Aragona Trust v. U.S., 142 T.C. No. 9 (2014), a complex
irrevocable trust owned real property through a Michigan LLC
ignored as a DRE for federal tax purposes. One independent
trustee and the five beneficiary children served as trustees, with one
child (Paul) serving as executive trustee and having the power to
make all major decisions. The Michigan LLC employed some of the
trustees and other unrelated individuals to conduct its real estate
enterprises. The main issue was whether the trust qualified for the
real estate professional exception in IRC § 469(c)(7). This issue
was the crux of the trust’s argument that it should be able to deduct
losses from its rental real estate activities.
45
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Trusts, cont.
The Tax Court concluded that the activities of the trustees should be
the point of reference when weighing whether the trust has passed
the two-part test in IRC § 469(c)(7). The Tax Court notably
disregarded the activities of the DRE’s employees. Even though two
of the trustees were involved in joint real estate ventures with the
trust, the Tax Court noted that the trustees’ individual interests were
minority interests. The trustees’ combined individual interests never
exceeded 50% of the total ownership interests and never exceeded
the trust’s ownership interest in any venture.
After weighing the relevant facts and circumstances, the Tax Court
determined the trust qualified for the IRC § 469(c)(7) exception and
that the trust materially participated in its real estate activities.
Therefore, the trust could deduct its rental real estate losses.
46
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Trusts, cont.
Takeaways for Trust Material Participation:
• The two cases together show that trusts can (1) materially
participate in rental real estate activities, and (2) trusts can qualify
as real estate professionals under § 469(c)(7). Trusts can likely
look to Treas. Reg. § 1.469-5T(a) while awaiting -5T(g)
regulations.
• While Mattie Carter Trust permitted examination of the activities
of the trustees’ designees, Frank Aragona Trust disregarded
activities of those employed by a trust’s wholly owned DRE. The
IRS position is that only the activities of the trustees count. See,
e.g., TAM 200733023.
• Per Frank Aragona Trust, the trustees’ activities are to be
considered collectively, which could be a downside if the trust’s
activities go beyond rental real estate.
47
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining Material
Participation: Trusts, cont.
Trusts with Deemed Owners – The Determination is Easier
• For grantor trusts, only the activities of the substantial owner under
IRC §§ 671-679 will count.
• For ESBTs, it appears that for both the S portion and non-S portion,
only the activities of the trustees will count. Treas. Reg. § 1.1411-
3(c)(1). However, if a grantor or another person is treated as
substantial owner of the ESBT assets, such status will prevail, and
only the substantial owner’s activities will count. Id.
• For QSSTs, only the activities of the beneficiary will count. IRC §
1361(d)(1)(B). However, for purposes of determining NII for
dispositions of QSST stock, it appears only the activities of the
trustees will count. Prop. Reg. § 1.1411-7(a)(4)(iii)(C); but see IRC §
1361(d)(1)(C).
48
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Determining whether trust documents permit
capital gains to be included in DNI
49
PART IV
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Treas. Reg. § 1.643(a)-3
3 situations where capital gains can be
included in DNI
1. Allocated to income (but if income under the state statute is defined as,
or consists of, a unitrust amount, a discretionary power to allocate gains
to income must also be exercised consistently and the amount so
allocated may not be greater than the excess of the unitrust amount over
the amount of distributable net income determined without regard to this
subparagraph § 1.643(a)-3(b));
2. Allocated to corpus but treated consistently by the fiduciary on the trust’s
books, records, and tax returns as part of a distribution to a beneficiary,
or
3. Allocated to corpus but actually distributed to the beneficiary or utilized
by the fiduciary in determining the amount that is distributed or required
to be distributed to a beneficiary.
50
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Treas. Reg. § 1.643(a)-3
Overriding framework
All 3 situations must be pursuant to the:
1. Terms of the governing instrument AND applicable local law, or
2. A reasonable and impartial exercise of discretion by the fiduciary
(in accordance with a power granted to the fiduciary by applicable
local law or by the governing instrument if not prohibited by
applicable local law)
*Applicable law will usually not preclude allocation of capital gains to income, it will be permissive.
51
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Order of Authority
1. If trust document provides for specific direction –
must follow document (even if contradict UPIA)
2. If trust document provides for discretionary power –
fiduciary may use that power (even if contradict UPIA)
3. If trust document is silent or doesn’t grant the
fiduciary a discretionary power, fiduciary must
administer the trust according to UPIA.
4. If both trust document and UPIA are silent, you
must allocate to principal. * Capital gains under UPIA are generally allocated to principal
52
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Steps in Determining if Capital Gains
can be Included in DNI
1. Review the trust document
2. Look to local law (state statutes – UPIA?)
53
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Steps in Determining if Capital Gains
can be Included in DNI, cont.
1. If trust document language mandates or allows for
allocation of capital gain to income AND local law
doesn’t preclude, use Treas. Reg. § 1.643(a)-3(b)(1)
2. If trust document language is not strong enough to
allocate capital gains to income, use Treas. Reg. §
1.643(a)-3(b)(2) or (3)
54
MATTHEW E. RAPPAPORT,
Esq., LL.M.
1. Allocated to Income
Sample terms in trust document that allow capital
gains to be allocated to income
• “the fiduciary has the discretion to allocate capital gains to
income”
• “the fiduciary has the discretion to allocate capital gains to either
income or principal”
Sample terms in trust document that may NOT
allow capital gains to be allocated to income
• “the fiduciary has the discretion to allocate receipts and
disbursements between income and principal”
55
MATTHEW E. RAPPAPORT,
Esq., LL.M.
1. Allocated to Income, cont.
What if governing instrument is silent?
Fiduciary must rely only on local law.
• UPIA power to adjust? May be a discretionary power “granted
to the fiduciary by applicable law.” This power is constrained by
“reasonable and impartial exercise of discretion.” Need to
consider income and remainder beneficiaries interests.
56
MATTHEW E. RAPPAPORT,
Esq., LL.M.
1. Allocated to Income, cont.
What if governing instrument is silent and local law
states capital gains are allocated to principal?
Solution: Decant to include a clause overriding local law.
"Pursuant to Section 11‐A‐1.3 of the N.Y. Ept. Law I hereby override the
state law default treatment of allocation of capital gains to trust principal as
follows: any Trustee not a beneficiary nor “related or subordinate” (as those
terms are defined in I.R.C. § 672) to any beneficiary of a trust may reallocate
capital gains taxable income from fiduciary accounting principal to fiduciary
accounting income in the sole discretion of the trustee. In doing so, the
trustee may consider the net tax effect of the allocation to the trust and the
beneficiary together, such as whether leaving capital gains as taxable to the
trust would otherwise cause Medicare surtax or short‐term capital gains rates
in excess of the net additional tax effect of a reallocation on a beneficiary’s
taxes.“ http://wealthmanagement.com/estate‐planning/avoid‐38‐percent‐medicare‐surtax
57
MATTHEW E. RAPPAPORT,
Esq., LL.M.
2. Allocated to Corpus
Treated consistently by the fiduciary on the trust’s
books, records, and tax returns as part of a distribution
to a beneficiary
• Governing instrument is silent on allocation of capital gains
between income and principal or trust language not strong
enough for allocation to income.
• Local law allocates capital gains to principal.
58
MATTHEW E. RAPPAPORT,
Esq., LL.M.
2. Allocated to Corpus, cont.
Treated consistently by the fiduciary on the trust’s
books, records, and tax returns as part of a distribution
to a beneficiary
• Need clear evidence capital gains are included in the distribution
• Document in the trust’s books and records
• Include capital gains in DNI on the tax return
• Consistent: not defined – “regular practice”, or treating or
deeming capital gains as distributed in current or future years
• Pre-existing trusts? Doubt as to if a “consistent” practice can be established.
Opportunity if trust never had capital gains in the past.
• New trusts? Establish consistency on initial return that has capital gains.
59
MATTHEW E. RAPPAPORT,
Esq., LL.M.
3. Allocated to Corpus
Actually distributed to the beneficiary or utilized by the
fiduciary in determining the amount that is distributed or
required to be distributed to a beneficiary
• Need clear evidence capital gains are included in the distribution
• Document in the trust’s books and records
• Include capital gains in DNI on the tax return
• Gains realized to effectuate distributions are in DNI
• If trust document mandates a distribution (ex. Age attainment) and an asset must
be sold to satisfy this requirement, capital gains are included in DNI. (Ex. 9 in
Treas. Reg. § 1.641(b)-3)
• If a trust is to terminate and all principal distributed, all of the capital gains are
actually being distributed so they are allocated to DNI. (Ex. 7 in Treas. Reg. §
1.641(b)-3)
• If no distribution is required, but capital gains are generated to effectuate the
distribution, capital gains are included in DNI.
60
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Gains Flowing from K-1’s
Capital gains flowing from a partnership or
S corporation K-1 to a trust or estate are
included in DNI. Crisp v. United States, 34 Fed. Cl.
112 (1995)
* Note: in a simple trust, the IRC § 661 deduction is limited to the
lesser of FAI and DNI. Therefore, not all capital gains may be
distributed.
61
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Alternative Consideration:
IRC § 643(e)
In-kind distributions
If a trust did not want to incur a gain to effectuate a
distribution, the trustee may consider making an in-kind
distribution.
• Gain or loss is not recognized on the in-kind distribution of
property to a beneficiary that is not funding a pecuniary
bequest. IRC § 643(e)
• Distribution carries out DNI (lesser of property’s basis or
FMV)
• Beneficiary takes carryover basis in property
62
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Special Computational Rules:
Treas. Reg. § 1.1411-3(c)(1)
The S portion and non-S portion are treated as
separate trusts in calculating undistributed net
investment income BUT treated as a single trust for
purposes of determining the amount subject to tax
under IRC § 1411.
Note: If a grantor is treated as the owner of a portion of the ESBT, those
items of income and deduction are included in the grantor’s calculation of NII,
not the trust’s.
64
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Computation of Tax
1a. Calculate S portion’s undistributed NII,
1b. Calculate non-S portion’s undistributed NII,
1c. Combine amounts from S portion and non-S portion to
calculate the trust’s undistributed NII.
2a. Calculate S portion’s adjusted gross income,
2b. Calculate non-S portion’s adjusted gross income,
2c. Combine AGI of S portion and non-S portion.
3a. Subtract the highest tax bracket for that year from the combined
AGI computed in 2c.
3b. Tax is 3.8% on the lesser of 1c (combined undistributed NII) or
3a (combined AGI less highest tax bracket for that year). 65
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example from Treas. Reg. § 1.1411-3(c)(3)
Facts
Non-S portion income:
Dividend income = 15,000
Interest income = 10,000
Capital loss = (5,000)
S portion income:
Net rental income = 21,000
Capital gain = 7,000
General:
Trustee fee = 1,000 (60% to non-S portion and 40% to S portion)
Distribution from income to a beneficiary = 9,000
66
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example from Treas. Reg. § 1.1411-3(c)(3),
cont.
Undistributed NII for S portion
Net rental income: 21,000
Capital gain: 7,000
Trustee annual fee: (400)
S portion undistributed NII: 27,600
Undistributed NII for non-S portion Dividend income: 15,000
Interest income: 10,000
Deductible capital loss: (3,000)
Trustee annual fee: (600)
Distributable net income deduction: (9,000)
Non-S portion undistributed NII: 12,400
67
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example from Treas. Reg. § 1.1411-3(c)(3),
cont.
Combined Undistributed NII
S portion undistributed NII: 27,600
Non-S portion undistributed NII: 12,400
Combined undistributed NII: 40,000
68
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example from Treas. Reg. § 1.1411-3(c)(3),
cont.
Adjusted Gross Income
Dividend income: 15,000
Interest income: 10,000
Deductible capital loss: (3,000)
Trustee annual fee: (600)
Distributable net income deduction: (9,000)
S potion income: 27,600
Adjusted gross income: 40,000
69
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Example from Treas. Reg. § 1.1411-3(c)(3),
cont.
Tax Computation
Lesser of:
• Combined undistributed net investment income = 40,000
Or
• Combined AGI less highest bracket = 27,600 (40,000 – 12,400)
NIIT = 1,049 (27,600 x 3.8%)
70
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Passive Activity Strategies
Actively Participate: Individuals should be
keeping contemporaneous logs of activities to
satisfy material participation and the real estate
professional test. Note that satisfying the real
estate professional test when the taxpayer has a
non-real estate “day job” is nearly impossible. On
the other hand, trustees can wear multiple hats.
The case law shows that a trustee’s activities will
only be evaluated in his capacity as trustee and not
in his capacity as an individual.
72
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Passive Activity Strategies, cont.
For trusts, first consider optimal trust status.
Grantor trust? Non-grantor trust? For S portions of
a trust: QSST? ESBT? Consider whose activities
will count for passive/active determination, then
keep logs accordingly.
Second, consider the identity of the trustees.
Trustee selection will be critical when planning for
avoidance of the NII tax. (Independent and
unrelated professionals will always be your
friend…)
73
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Passive Activity Strategies, cont.
Grouping: The regulations allow taxpayers to
“group” certain activities for passive activity
purposes if they comprise an “appropriate
economic unit.” Treas. Reg. § 1.469-4(c)(1). The
Service will use a facts-and-circumstances test to
determine if grouping is reasonable. Treas. Reg. §
1.469-4(c)(2). Note that rental real estate cannot
be grouped with any other activities. Treas. Reg. §
1.469-9(e)(3)(i).
74
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Passive Activity Strategies, cont.
The upside of grouping is that the taxpayer is
considered to be active in the entire group if the
taxpayer materially participates in the group.
Therefore, crafty use of grouping could qualify
certain activities as active when those activities
would be passive if considered individually.
There is case law on grouping, some taxpayer-
favorable and some not. Compare Lamas v.
Commissioner, T.C. Memo. 2015-59 with Williams
v. Commissioner, T.C. Memo. 2014-158.
75
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Passive Activity Strategies, cont.
Certain Rental Activities: Note that there are
several exceptions to the rule that rental activities
are per se passive activities. You can find these
exceptions in Treas. Reg. § 1.469-1T(e)(ii)(3). Two
nifty exceptions are (1) when the average period of
customer use is seven days or less, and (2) rental
of property to a non-passive activity (the self-rental
rules). Treas. Reg. § 1.469-1T(e)(ii)(3)(B)(ii)(A);
Treas. Reg. § 1.469-2(f)(6).
76
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Financial Strategies
• Conversion to Tax-Exempt Income: While this
would exclude such income from calculation for
the NII tax, variations in deductibility of expenses
may lead to interesting results. Treas. Reg. §
1.1411-1(d)(4). http://www.thetaxadviser.com/issues/2015/nov/is-
anomaly-in-form-8960-resulting-in-unintended-tax-on-tax-exempt-
income.html
• Loss Harvesting: Simple and obvious – if the
taxpayer can trigger built-in losses to offset
gains that would be considered NII, the taxpayer
should consider the merits of doing so.
77
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Financial Strategies, cont.
• Installment Sales: Depending on the taxpayer’s
AGI for the years in question, installment sales
may eliminate NII tax partially or entirely. See
generally IRC § 453. Not always easy to find a
buyer willing to pay in installments. • Related – CRTs: Installment sale treatment without the counter-
party risk. Taxpayer should be charitably inclined. When used
with a wealth replacement trust, could result in favorable tax
results overall, including for NII purposes. See Treas. Reg. §
1.1411-3(d).
78
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Financial Strategies, cont.
• Life Insurance and Annuities: Under IRC §
72(e), taxpayers can defer income taxation for
the cash value of life insurance and annuities,
thereby avoiding the imposition of NII tax. Also
keep in mind IRC § 101(a) for life insurance
policies – death benefit is not subject to any
income taxes, including the NII tax. • For the ultra-high net worth, private placement life insurance and
annuities may prove a compelling vehicle for certain tax-
inefficient assets.
79
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Distribution Planning
For complex non-grantor trusts, consider the timing
and amount of distributions to beneficiaries and
how that may affect NII tax in these situations:
• Routine distributions of yearly income from
interest, dividends, rents, royalties, etc.
• Income from the sale of interests in pass-through
entities, especially S-Corps (or the deemed sale
per Prop. Treas. Reg. § 1.1411-7)
80
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Minimizing NII Tax Owed:
Distribution Planning, cont.
• For grantor trusts, consider giving the “toggle
power” through grantor renunciations or trust
protectors. Note the several other tax issues
associated with toggling.
• For S-Corps, consider how the shares should be
owned – get creative with grantor trusts vs.
QSSTs vs. ESBTs vs. outright individual
ownership.
81
MATTHEW E. RAPPAPORT,
Esq., LL.M.
Questions?
82
Matthew E. Rappaport, Esq., LL.M.
31 East 32nd Street, 4th Floor
New York, New York 10016
212-453-9889
265 Sunrise Highway, Suite 32
Rockville Centre, New York 11570
516-558-3377
Michele Schlereth, CPA, J.D., MST
1 Penn Plaza – Ste 3000
New York, New York 10119
125 Baylis Road – Ste 300
Melville, New York 11747
631-719-3281