The Impact of the Net Investment Income Tax on Estates and Trusts

EXECUTIVE SUMMARY

Photo by MerveKarahan/iStock In addition to applying to individuals, the net investment income tax applies to estates and trusts; however, the threshold for applicability of the Sec. 1411 tax to trusts and estates is much lower ($12,150 for 2014) than the threshold for individual taxpayers. Net investment income for an estate or trust is determined in the same way that it is for an individual. Whether income is net investment income depends on whether the income is derived from a trade or business and, if so, if the trade or business is a passive activity or trading in financial instruments or commodities. Trusts and estates determine their undistributed net investment income similar to the way they determine distributable net income (DNI) and the income distribution deduction for income tax purposes. Foreign estates are not subject to the tax, although U.S. beneficiaries generally are subject to it on distributions from foreign trusts. However, whether the net investment income tax applies to distributions of accumulated income from foreign trusts under the “throwback” rules remains an open question. The IRS has not issued regulations that explain how an estate or trust meets the material participation requirement for purposes of the passive activity rules. The IRS continues to take the position that only the activities of a fiduciary of a trust are taken into account in the material participation determination; however, a district court has held that the activities of agents or employees of a trust should also be taken into account in the determination.

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The enactment of Sec. 14111 has attracted widespread attention and planning with respect to its impact on individuals but surprisingly little comment regarding its consequences on estates and trusts. This article describes the calculation of the Sec. 1411 net investment income tax on estates and trusts, demonstrating that the additional complexity and burden of the tax may give tax professionals pause in advising that a trust is a viable means for accumulating and preserving wealth from one generation to the next.2 At the very least, the tax adds to the responsibility of fiduciaries to distribute sums to income beneficiaries in a way that reduces the immediate tax burden of the trust, but potentially at the expense of having less to distribute to remainder beneficiaries at the trust’s termination.

This article also points out that the passive activity rules of Sec. 469, upon which Sec. 1411 relies to derive the tax base of net investment income, leave unanswered questions of when an estate or trust is materially participating in an activity and offers suggestions for defining material participation by such entities. Finally, the article suggests how and when accumulation distributions from foreign trusts under the “throwback” rules of Secs. 665−668 should be taxed under Sec. 1411.

Statutory Overview

In the case of an individual, Sec. 1411(a)(1) imposes a 3.8% tax (in addition to any other income tax)3 on the lesser of:

• The individual’s net investment income (defined below) for the tax year; or
• The excess (if any) of the individual’s modified adjusted gross income4 (MAGI) for the year over a threshold amount, i.e., $250,000 for married taxpayers filing a joint return; $200,000 for taxpayers filing single or head of household; and $125,000 for married individuals filing separately.5
  Example 1: X and Y, married filing jointly, have income of $500,000, all of which is salary. The surtax does not apply because they have no net investment income.
  
  Example 2: X and Y, married filing jointly, have $500,000 of salary and $50,000 of net investment income. The surtax applies to the $50,000 of net investment income because it is less than the excess of MAGI over the threshold (i.e., $550,000 − $250,000 = $300,000).
  
  Example 3: X, a single filer, has $275,000 of net investment income and no other income. The surtax applies only to the $75,000 that exceeds the $200,000 threshold for single filers.
  
  Example 4: X and Y, married filing jointly, have $225,000 of salary income and $125,000 of net investment income. The surtax applies to $100,000, the difference between their threshold ($250,000) and MAGI ($350,000), which is less than their net investment income of $125,000.

For an estate or trust, Sec. 1411(a)(2) imposes the tax on the lesser of:

• The entity’s undistributed net investment income, or
• The excess (if any) of its adjusted gross income (AGI) over the dollar amount threshold of the highest tax bracket to which estates and trusts are subject, i.e., $12,150 for 2014.6

The AGI of an estate or trust is computed in the same manner as for an individual, except deductions are permitted only for (1) costs in connection with the administration of the estate or trust that would not have been incurred if the property were not held by an estate or trust; (2) the personal exemption under Sec. 642(b) of $600 for an estate, $300 for a simple trust, and $100 for a complex trust; and (3) distributions of income to beneficiaries not in excess of distributable net income (DNI).7

Therefore, almost every estate or trust must for each tax year determine its net investment income and the portion, if any, of net investment income that is not distributed to beneficiaries.8

Example 5: A trust may pay income and principal as needed to its beneficiary, a single individual who has no other income. In 2014, the trust has dividend and interest income of $150,000 and net capital gain of $300,000. The trust makes no distributions and has AGI of $450,000. Because the highest tax bracket for a trust is $12,150 in 2014, the trust’s net investment income is $437,850 ($450,000 − $12,150).

Example 6: If, in the preceding example, the $150,000 of dividend and interest income is distributed to the trust’s beneficiary, the trust’s net investment income is $287,850 ($450,000 − $150,000 − $12,150). Because the surtax threshold for a single individual is $200,000, the beneficiary is not subject to the tax on the $150,000 distributed.

In the above examples, the trust or estate with net investment income is subject to estimated tax payment requirements and penalties for underpaying estimated tax.9

Net Investment Income

As the above examples illustrate, the starting point for calculating the tax is the derivation of net investment income. The net investment income of an estate or trust is determined in the same way as for an individual10 and consists of the following three categories of taxable income, less deductions properly allocable to such income:11

• Interest, dividends, annuities, royalties, and rents that are not derived from a trade or business that is not a passive activity under Sec. 469 or a trade or business of trading in financial instruments or commodities;12
• Other income derived from a trade or business that constitutes a passive activity to the taxpayer under Sec. 469 or a trade or business of trading in financial instruments or commodities;13 and
• Net gain attributable to the disposition of property that is not held in a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities.14

Net investment income also includes income attributable to an investment in working capital15 but excludes income subject to self-employment tax16 and distributions from qualified plans under Sec. 401(a), 403(a), 403(b), 408, 408A, or 457(b).17

Because estates and trusts often consist of a portfolio of stocks, bonds, and other securities or hold real estate on which rent is collected, their income will frequently fall within the definition of net investment income. However, as discussed below, determining whether a trust or estate materially participates in a trade or business allows fiduciaries substantial flexibility in determining whether income from a trade or business received by an estate or trust is subject to the surtax.

Interest, dividends, rent, etc., that might otherwise be net investment income are not taken into account if such income is derived in the ordinary course of a trade or business that is not a passive activity or trading in financial instruments or commodities.18 Although the final regulations to Sec. 1411 define a trade or business for this purpose only by reference to Sec. 162,19 their preamble refers to the Supreme Court case of Higgins,20 which held that whether a taxpayer is engaged in a trade or business is determined on a case-by-case basis.21

But the Supreme Court in Groetzinger22 also made clear that for an activity to be a trade or business, it must be conducted regularly and continuously. Similarly, in Moller23 the Federal Circuit stated:

In determining whether a taxpayer who manages his own investments is a trader, and thus engaged in a trade or business, relevant considerations are the taxpayer’s investment intent, the nature of the income to be derived from the activity, and the frequency, extent, and regularity of the taxpayer’s securities transactions.24

And in Liang25 the Tax Court held that investors hold financial instruments for appreciation in value and income, while traders buy and sell “with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis.”26

For individuals, estates, and trusts (and disregarded entities owned by the taxpayer), whether an activity is conducted with sufficient regularity and continuity to be a trade or business is determined at the owner level. In contrast, if the activity is conducted through a partnership or S corporation, whether the activity and, consequently, its income are derived from a trade or business is determined at the entity level.27

Temp. Regs. Secs. 1.469-2T(c)(3)(ii)(A) through (G) describe the following cases where interest, dividends, royalties, and annuities are treated as derived from a trade or business:

• Interest income on loans and investments made in the ordinary course of a trade or business of lending money;
• Interest on accounts receivable arising from the performance of services or the sale of property in the ordinary course of a trade or business of performing such services or selling such property, but only if credit is customarily offered to customers of the business;
• Income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies;
• Income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business;
• Royalties derived by the taxpayer in the ordinary course of a trade or business of licensing intangible property, where the taxpayer created the intangible or performed substantial services or incurred substantial costs in developing or marketing the property;28
• Amounts included in the gross income of a patron of a cooperative by reason of any payment or allocation to the patron based on patronage occurring with respect to a trade or business of the patron; and
• Other income identified by the IRS as derived by the taxpayer in the ordinary course of a trade or business.
  Example 7: A trust owns stock of an S corporation engaged in a trade or business. If the trust materially participates in the business, any interest income derived in the corporation’s trade or business and attributed to the trust is not net investment income. 29
  
  Example 8: A trust rents a building. Because the rental of a single building is not a trade or business and constitutes a passive activity under Sec. 469, the rent is net investment income. 30

As Example 8 demonstrates, the conduct of a rental activity is per se passive, and therefore the taxpayer’s material participation is irrelevant. For this purpose, rent includes amounts paid principally for the use of (or right to use) tangible property.31 But Temp. Regs. Sec. 1.469-1T(e)(3)(ii) provides that activities involving the use of tangible property are not rentals if, in a tax year:

• The average period of customer use for such property is seven days or less;
• The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers;
• Extraordinary personal services are provided by or on behalf of the owner in connection with making the property available for use by customers (without regard to the average period of customer use);
• The rental of such property is treated as incidental to a nonrental activity of the taxpayer;
• The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers; or
• The provision of the property is for use in a nonrental activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest.
  Example 9: A trust leases equipment where the average period of customer use is seven days or less, so the activity is not necessarily passive under Sec. 469. Therefore, if the trust materially participates in the activity that constitutes a trade or business under Sec. 162, the rent is not net investment income. 32

Thus, the above exceptions to passive status for rentals under Sec. 469 also serve to avoid the Sec. 1411 tax. An exception is available in the final regulations for real estate professionals.33 If a real estate professional participates for more than 500 hours in a rental activity in a tax year, the rent will be deemed to be derived in the ordinary course of a trade or business. Alternatively, if the taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last 10 tax years (one or more of which may be prior to the effective date of Sec. 1411), then the rental income will be deemed to be derived in the ordinary course of a trade or business. If the taxpayer cannot satisfy this safe harbor, the taxpayer is not precluded from establishing that gross rental income and gain or loss from disposition is not included in net investment income by establishing both material participation and Sec. 162 trade or business status for the rental activity.

Other exceptions also are available for self-charged rent for use in a trade or business of the taxpayer34 and grouping a rental activity with a trade or business to render it nonpassive.35 While the exceptions for self-charged rent and grouping of activities appear to be available to estates and trusts, the regulations under neither Sec. 469 nor Sec. 1411 offer guidance on how an estate or trust would meet the hour thresholds of participation in the safe harbor for real estate professionals.

Finally, the nature of the income as net investment income or income derived from a trade or business does not change as it passes through a series of entities to the taxpayer.

Example 10: Trust X owns an interest in upper-tier partnership UTP, which in turn owns an interest in lower-tier partnership LTP. UTP is engaged in a trade or business, and LTP is not. LTP receives interest that passes through to UTP and ultimately to X. The character of the interest to X as net investment income does not change as a result of its passing through UTP, even if X materially participates in UTP’s trade or business.36

Therefore, partnerships and S corporations need to provide information to owners so they can determine how to classify interest, dividends, rents, and royalties for net investment income purposes.

Undistributed Net Investment Income

As previously discussed, estates and trusts are subject only to the tax on their net investment income that is not distributed to beneficiaries and exceeds a threshold ($12,150 for 2014). Therefore, all estates and trusts will have to determine their undistributed net investment income in a manner similar to the way an estate or trust measures DNI and the income distribution deduction.37 Thus, distributions to beneficiaries up to the income distribution deduction under Sec. 651 or 661 are taken into account in arriving at undistributed net investment income.38

Where the net investment income and DNI of the estate or trust are the same because its income is solely net investment income, the computation of the deduction for distributions to beneficiaries for purposes of Sec. 1411 is the same as for the income tax.

Example 11: A trust has DNI of $20,000 consisting of $10,000 of interest and $10,000 of dividends. If $10,000 is distributed to a beneficiary, one-half of the distribution will be interest, one-half will be a dividend, and the total will constitute net investment income to the beneficiary.39

Example 12: Assume the same facts as in Example 11, except the DNI consists of $10,000 of dividends and $10,000 of tax-exempt income. The $10,000 distribution will consist of only $5,000 of taxable income and net investment income to the beneficiary.

If otherwise taxable income distributed to beneficiaries is only partly attributable to net investment income, then the deductibility of the distribution to determine undistributed net investment income must be allocated between the net investment income and other income received by the estate or trust. In this event, the Sec. 1411 regulations adopt the general rule of Sec. 661 that treats distributions as consisting of the same proportion of each class of items entering into the computation of DNI as the total of each class bears to the total DNI.40

The Sec. 661 regulations ratably allocate the character of a distribution based on the proportion that each class of income bears to the total income of the estate or trust for the year.41 Although the Sec. 661 regulations state that this pro rata allocation method may be overridden by specific provisions in a trust’s governing instrument, the regulations to Sec. 1411 make clear that the character of an item of income received by a trust or estate as net investment income cannot be changed when that item is part of a distribution to a beneficiary.42 Therefore, special allocations of net investment income to beneficiaries whose AGI might be below the threshold for application of the surtax are not possible.

Example 13: In the current tax year, a trust distributes $10,000 to a beneficiary when its DNI of $100,000 consists of $15,000 of dividends, $10,000 of interest, and $75,000 of non−Sec. 1411 income. It also has $5,000 of capital gain that is allocated to principal for trust accounting purposes and that does not enter into DNI. Therefore, of the $10,000 distribution, $1,500 (15% of the dividends) and $1,000 (10% of the interest) is net investment income to the beneficiary.43

Generally, the determination of undistributed net investment income and the character of distributions to a beneficiary as net investment income follow the same rules when there is a contribution to charity by the trust at the same time as distributions to other beneficiaries. However, if a trust is required to make distributions to a beneficiary and makes charitable contributions in the same year, the character of the mandatory distribution is determined prior to taking into account the charitable contribution.44

Example 14: Assume the same facts as in Example 13, except the trust is required to distribute $30,000 to a beneficiary, contributes $10,000 to a charity, and makes an additional $20,000 discretionary distribution to a second beneficiary. The trust’s net investment income is $30,000 ($15,000 of dividends, $10,000 of interest, and $5,000 of capital gain). Because the required distribution of $30,000 is 30% of DNI ($100,000), that percentage of each class of income constituting DNI is treated as distributed, so that net investment income to that beneficiary consists of $4,500 of dividend income (30% × $15,000) and $3,000 of interest (30% × $10,000). The $10,000 charitable contribution then is allocated to the remaining undistributed net investment income based upon its percentage of DNI of $100,000, or 10%. Net investment income is then reduced by $2,500 ($1,500 allocated to dividends and $1,000 to interest). Because the $20,000 discretionary distribution is 20% of DNI, $3,000 of that distribution is a dividend (20% × $15,000) and $2,000 is interest (20% × $10,000). This leaves the trust with $15,000 of undistributed net investment income consisting of $6,000 of dividends, $4,000 of interest, and $5,000 of capital gain.45

Calculations determining undistributed net investment income and the character of items distributed are required for all trusts and estates for tax years beginning after 2013.46 However, while a trust must have a calendar tax year,47 an estate with a fiscal year was not subject to Sec. 1411 for a fiscal year that ended in 2013.48

Foreign Estates and Trusts

While the final regulations to Sec. 1411 generally provide comprehensive guidance for the application of the net investment income tax to estates and trusts, several unanswered questions remain in the area of foreign trusts. While the regulations provide that the surtax does not apply to foreign estates, effectively treating them as nonresident aliens, who are specifically exempt from the surtax under Sec. 1411(e)(1),49 they make clear that items distributed by a foreign estate to a U.S. beneficiary retain their character as net investment income to the recipient, following the general rules described above.50

An unresolved question, however, is the application of the surtax to distributions of accumulated income from foreign trusts51 subject to the “throwback” rules of Secs. 665−668 for income tax purposes.52 The final regulations specifically reserve a paragraph for future rules pertaining to the application of Sec. 1411 to foreign trusts and distributions of accumulated income from such trusts to U.S. beneficiaries.53 The preamble to the final regulations states that Sec. 1411 should apply to U.S. beneficiaries receiving distributions of accumulated net investment income of a foreign trust, but until guidance is issued, Sec. 1411 will not apply to U.S. beneficiaries receiving accumulation distributions from foreign trusts.54 Furthermore, when such guidance is issued, it will adopt the general rule previously discussed, that the character of an item of net investment income received by a foreign trust will constitute net investment income when distributed to a U.S. beneficiary.55

Such guidance, when issued, should provide that accumulation distributions of undistributed net investment income from prior years be treated under Sec. 1411 in the same manner as such distributions are treated for purposes of the throwback rules. Thus, for income tax purposes, where a foreign trust does not distribute all of its DNI for a year, the trustee must record the undistributed net income (UNI), and when a distribution in a subsequent year exceeds that year’s DNI, the excess is “thrown back” to the earliest year in which the trust has UNI.56 Because the final regulations already require a calculation of UNI for income tax purposes, this same approach can be adopted under Sec. 1411 to account for distributions of undistributed net investment income attributable to prior years.

Example 15: A foreign trust has the amounts of UNI and undistributed net investment income for prior years, as shown in the exhibit below. In 2016, the trust’s DNI is $20,000, its net investment income is $10,000, and the trust distributes $35,000 to a U.S. beneficiary. Consequently, for income tax purposes, $5,000 and $10,000 of the distribution are thrown back to 2014 and 2015, respectively. Similarly, for surtax purposes, $3,000 and $7,000 would be thrown back to 2014 and 2015, respectively.

However, to minimize complexity, there should be no throwback of distributions for purposes of Sec. 1411 when there is no accumulation distribution triggering a throwback of an excess distribution for income tax purposes.

Example 16: A foreign trust has $30,000 of UNI, $10,000 of which is attributable to 2014 and $20,000 to 2015. The trust also has undistributed net investment income of $4,000 in 2014 and $16,000 in 2015. In 2016, the trust distributes all of its DNI and has no net investment income. Even though a distribution is made in 2016 that exceeds net investment income for that year, because there is no throwback for purposes of the income tax, there should be no throwback for purposes of Sec. 1411.

In addition, following the general approach of the regulations, that income attributable to tax years before 2013 should not be subject to Sec. 1411, any distribution in excess of net investment income for a tax year should not be thrown back to any year with undistributed net investment income prior to 2013.

Material Participation

As previously mentioned, while net investment income includes income from a trade or business that is a passive activity under Sec. 469, the IRS has issued no guidance regarding how an estate or trust materially participates in an activity, to determine whether its income is passive.57 The preamble to the final regulations of Sec. 1411 stated that defining “material participation” for an estate or trust is more appropriate for regulations under Sec. 469, and because of the complexity of the issue, addressing material participation at that time would have significantly delayed the finalization of the Sec. 1411 rules.58 However, no such guidance has been issued in almost 30 years, and with the creation of the net investment income tax, the need for additional guidance is more essential now than when Sec. 469 was enacted in 1986.

In Mattie K. Carter Trust,59 a district court held that a trust was sufficiently similar to a closely held corporation to find that the material participation of a trust in certain ranching activities should be determined by reference to individuals who conducted the business on behalf of the trust. While the IRS argued that only the participation of the trustee be taken into account, the court found that the acts of other agents or employees of the trust must also be considered in measuring the material participation of the trust in an activity. The court noted that the Senate Finance Committee report60 and a footnote in the Joint Committee on Taxation’s explanation61 of the legislation that enacted Sec. 469 referred to the issue. However, the court found it unnecessary to resort to the legislative history because it determined that the statute was not ambiguous on this point.

In a footnote, the court stated that the trust’s analogy of a trust to a closely held C corporation was potentially appropriate in determining whether a trust’s activities constituted material participation. If the court’s analogy of a corporation’s agents to a trust’s agents is appropriate for measuring material participation, then the IRS should seriously consider the rules governing material participation for a corporation when ultimately prescribing such rules for a trust or estate.

Under Sec. 469(h)(4), a closely held C corporation62 is treated as materially participating in an activity only if:

• One or more shareholders holding stock representing more than 50% (by value) of the outstanding stock of the corporation materially participate in the activity,63 or
• During the entire 12-month period ending on the last day of the tax year, the corporation:64
  • Had at least one full-time employee substantially all of whose services were in the active management of the business;65
  • Had at least three full-time nonowner employees substantially all of whose services were directly related to the business;66 and
  • Had deductions under Sec. 162 or Sec. 404 attributable to such business that exceeded 15% of its gross income.67

These codified standards of material participation for closely held corporations could easily be modified to apply to trusts and estates in measuring their material participation in an activity.

Despite the holding in Mattie Carter, the IRS continues to look only to the activities of the trustee to determine whether a trust materially participates in an activity.68 Thus, in a 2007 technical advice memorandum69 the IRS concluded that a trust materially participates in an activity only if one or more of the trust’s fiduciaries participate in the trust’s activities on a regular, continuous, and substantial basis.70 In fact, in its audit guidelines, the IRS directs its revenue agents not to raise the issue of a trust’s material participation in an activity if the trustee works in operations on a regular, continuous, and substantial basis and meets any of the material participation tests in Temp. Regs. Sec. 1.469-5T(a).71 Under these regulations, a taxpayer materially participates in an activity if and only if the taxpayer meets at least one of the following seven tests:72

1. The taxpayer works 500 hours or more during the year in the activity.73
2. The taxpayer does substantially all the work in the activity.74
3. The taxpayer works more than 100 hours in the activity during the year, and no one else works in it more than the taxpayer.75
4. The activity is a “significant participation activity” (a trade or business activity in which the taxpayer participates more than 100 hours during the year), and the taxpayer works more than 500 hours in all such activities for the year.76
5. The taxpayer materially participated in the activity in any five of the prior 10 years.77
6. The activity is a personal service activity in which the taxpayer materially participated in any three prior years.78
7. Based on all the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year.79 However, to meet this test, the taxpayer must participate in the activity for more than 100 hours. In addition, the taxpayer’s services performed in the management of an activity will not be taken into account under this test unless no one works more hours in connection with the management of the activity than the taxpayer or no one who performs services in connection with the management of the activity receives compensation for doing so.80

For tiered entities (e.g., the trust holds an interest in a partnership that conducts an activity), material participation is measured at the lowest tier.81 Thus, if the trust fails to materially participate in a partnership, the partnership income attributable to the trust and distributed to the trust’s beneficiaries will be passive and constitute net investment income.

In Technical Advice Memorandum 201317010, two trusts owned interests in an S corporation that owned a qualified subchapter S subsidiary (QSub). A special trustee was appointed under the trust agreements of both trusts who had the power to vote and sell the stock of the S corporation. The person appointed as the special trustee was also the owner of the remaining interests in the S corporation not owned by the trust and was the president of the QSub. Focusing only upon the fact that the special trustee’s powers were listed and his role as president was not connected with being a trustee, the IRS found that the special trustee’s activities as a fiduciary did not result in the trusts’ materially participating in the S corporation’s activities.82

Because a trust sometimes pays tax on its income, sometimes passes all its income to beneficiaries, and sometimes does both, considerable flexibility in applying the material participation rules is appropriate. Therefore, when the Treasury Department and the IRS issue guidance on measuring the participation of a trust or estate in an activity, the regulation should find material participation if:

• The fiduciary materially participates under any of the tests of the existing regulations under Sec. 469, including the facts-and-circumstances test;83 or
• The fiduciary’s employees or contractors participate directly in the activity on a regular, continuous, and substantial basis.84

The first of the proposed standards for the material participation of estates and trusts would simply formalize the current ruling policy of the IRS. The second would allow certain trusts to be treated in a manner similar to closely held C corporations and would be consistent with the district court’s opinion in Mattie Carter.

Conclusion

Trusts and estates need to take into account the complexity of Sec. 1411 in calculating the surtax, including keeping track of undistributed net investment income if an estate or trust chooses to accumulate rather than distribute its income to beneficiaries. Furthermore, the unresolved issues regarding the application of the tax to foreign trusts and the renewed importance of what constitutes material participation by an estate or trust make for uncertainty that calls for yet more guidance from the IRS under Sec. 1411. Because additional guidance does not appear to be coming anytime soon, this uncertainty that Sec. 1411 brings to estates and trusts may continue for years to come.

Footnotes

¹ Section 1402 of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, adding Sec. 1411 as a new chapter 2A of subtitle A of the Code, effective for tax years beginning after 2012.

² A grantor trust under Sec. 671 et seq. is not subject to Sec. 1411 (Regs. Sec. 1.1411-3(b)(1)(v)). In addition, certain charitable trusts are also exempt from the tax (Sec. 1411(e)(2) and Regs. Sec. 1.1411-3(b)).

³ No credits in chapter 1 of the Code, e.g., the foreign tax credit, may be claimed against the Sec. 1411 tax unless specifically provided in the Code (Regs. Sec. 1.1411-1(e)).

⁴ Sec. 1411(d) defines MAGI as adjusted gross income increased by the foreign earned income exclusion of Sec. 911(a)(1), less any deductions disallowed under Sec. 911(d)(6) with respect to the excluded income.

⁵ Sec. 1411(b).

⁶ For an estate or trust with a tax year of less than 12 months, e.g., its first or final tax year, the dollar threshold for the imposition of the surtax is not reduced. However, the threshold is prorated where the short year arises from a change of annual accounting period other than from a change due to an individual’s death (Regs. Sec. 1.1411-3(a)(2)).

⁷ Sec. 67(e).

⁸ Certain trusts all of whose interests are devoted to charitable, religious, literary, educational, or other purposes specified under Sec. 170(c)(2)(B) are not subject to the surtax (Sec. 1411(e)(2)).

⁹ Sec. 6654(a). However, for any tax year ending before the date two years after the date of the decedent’s death, neither the estate nor any trust treated as a grantor trust prior to the decedent’s death and to which the residue of the decedent’s estate passes will be subject to underestimated tax penalties (Sec. 6654(l)(2)).

¹⁰ Regs. Sec. 1.1411-3(e). Thus, for example, rules and elections dealing with the inclusion or exclusion of subpart F income of controlled foreign corporations or income attributable to passive foreign investment companies for which a qualifying electing fund election is in effect apply to estates and trusts holding interests in such foreign corporations. See Regs. Secs. 1.1411-10(c), (e)(2), and (f).

¹¹ In determining the proper allocation of deductions under Sec. 1411(c)(1)(B) to net investment income, the regulations generally permit any reasonable method, including the ratio of net investment income to AGI (Regs. Sec. 1.1411-4(g)(1)). Thus, administrative expenses paid by the fiduciary of an estate or trust must be allocated to net investment income using such a method (Regs. Sec. 1.1411-4(f)(3)(viii)). In addition, special rules provide for deducting investment expenses under Sec. 163(d)(4)(C) and estate tax attributable to net investment income that constitutes income in respect to a decedent under Sec. 691(c). See Regs. Secs. 1.1411-4(f)(3)(i), (ii), and (v).

¹² Sec. 1411(c)(1)(A)(i).

¹³ Sec. 1411(c)(1)(A)(ii).

¹⁴ Sec.1411(c)(1)(A)(iii). For a more complete discussion of the three “baskets” that constitute net investment income, see Williamson, “Planning for the ‘Parallel Universe’ of the Net Investment Income Tax,” 44 The Tax Adviser 534 (August 2013).

¹⁵ Sec. 1411(c)(3), cross-referencing Sec. 469(e)(1)(B). Although undefined in either Sec. 1411 or Sec. 469, “working capital” generally refers to amounts set aside for use in and future needs of a trade or business. See Regs. Sec. 1.1411-6, noting that the principles of Temp. Regs. Sec. 1.469-2T(c)(3)(ii) apply in determining whether an item of gross income is attributable to working capital.

¹⁶ Sec. 1411(c)(6) and Regs. Sec. 1.1411-9. Because under Sec. 1401(a), the self-employment tax applies only to individuals, this exclusion from net investment income is inapplicable to estates and trusts.

¹⁷ Sec. 1411(c)(5) and Regs. Sec. 1.1411-8.

¹⁸ Sec. 1411(c).

¹⁹ Regs. Sec. 1.1411-1(d)(12).

²⁰ Higgins, 312 U.S. 212 (1941).

²¹ T.D. 9644.

²² Groetzinger, 480 U.S. 23 (1987).

²³ Moller, 721 F.2d 810 (Fed. Cir. 1983).

²⁴ Id. at 813.

²⁵ Liang, 23 T.C. 1040 (1955).

²⁶ Id. at 1043.

²⁷ See S. Rep’t No. 313, 99th Cong., 2d Sess. 237 (1986); see also, generally, Temp. Regs. Sec. 1.469-2T(e)(1).

²⁸ See Temp. Regs. Sec. 1.469-2T(c)(3)(iii)(B).

²⁹ Regs. Sec. 1.1411-4(b)(3), Example (4).

³⁰ Regs. Sec. 1411-5(b)(3), Example (1), referring to Sec. 469(c)(2), which provides that all rental activities are generally passive activities, except those of certain real estate professionals described in Sec. 469(c)(7) for whom Regs. Sec. 1.1411-4(g)(7) provides a safe harbor for exempting such rental income from net investment income.

³¹ Regs. Sec. 1.1411-1(d)(10).

³² Regs. Sec. 1.1411-5(b)(3), Example (3), referring to the exception in Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A) for certain rental activity not necessarily being passive under Sec. 469(c)(2).

³³ Sec. 469(c)(7) and Regs. Sec. 1.1411-4(g)(7).

³⁴ Regs. Secs. 1.469-2(f)(6) and 1.1411-4(g)(6).

³⁵ Regs. Sec. 1.469-4(d)(1).

³⁶ See Regs. Sec. 1.1411-4(b)(3), Examples (1) and (2).

³⁷ The instructions to Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts, on which the tax is calculated, do not attempt to detail the steps to derive undistributed net investment income, referring simply to the rules in Secs. 651−663 that measure the income distribution deduction for determining the taxable income of an estate or trust.

³⁸ See Form 8960, Line 18b, “Deductions for distributions of net investment income and deductions under section 642(c)” (2013).

³⁹ See Regs. Sec. 1.661(b)-1.

⁴⁰ Regs. Sec. 1.1411-3(e)(3), cross-referencing Regs. Sec. 1.661(b)-1.

⁴¹ Regs. Sec. 1.661(b)-1.

⁴² Regs. Sec. 1.1411-3(e)(3)(ii).

⁴³ Regs. Sec. 1.1411-3(e)(5), Example (1).

⁴⁴ Regs. Sec. 1.1411-3(e)(4).

⁴⁵ Regs. Sec. 1.1411-3(e)(5), Example (2).

⁴⁶ Regs. Sec. 1.1411-3(f). Note that charitable remainder trusts must apply these rules to tax years that begin after Dec. 31, 2012, and other taxpayers may apply the rules to tax years beginning after Dec. 31, 2012.

⁴⁷ Sec. 644(a).

⁴⁸ Regs. Sec. 1.1411-3(e)(5), Example (3)(ii).

⁴⁹ Regs. Sec. 1.1411-3(b)(1)(ix). For all purposes of the Code, the term “foreign estate” means an estate whose foreign-source income that is not effectively connected with the conduct of a U.S. trade or business is not includible in its gross income. Sec. 7701(a)(31)(A).

⁵⁰ Regs. Secs. 1.1411-3(e)(3)(ii) and 1.1411-4(e)(1)(ii).

⁵¹ For all purposes of the Code, the term “foreign trust” means a trust over whose administration no court within the United States can exercise primary jurisdiction and for which no U.S. persons have authority to control substantial decisions (Secs. 7701(a)(31)(B) and (a)(30)(E)).

⁵² The rules of subpart D of part I, subchapter J, governing the treatment of excess distributions by trusts with accumulated income apply only to foreign trusts and certain trusts created before March 1, 1984 (Sec. 665(c)).

⁵³ Regs. Sec. 1.1411-4(e)(1)(ii). Specifically, the preamble to the final regulations requests comments on how to identify and exclude from Sec. 1411 accumulation distributions from years prior to 2013 and where a default rule similar to that of Notice 97-34 for income tax purposes may be a viable approach for Sec. 1411 purposes (T.D. 9644).

⁵⁴ T.D. 9644 and Regs. Sec. 1.1411-3(b)(1)(viii).

⁵⁵ T.D. 9644 and Regs. Sec. 1.1411-3(e)(3)(ii).

⁵⁶ Regs. Sec. 1.665(a)-1A.

⁵⁷ See Temp. Regs. Sec. 1.469-5T(g) and Regs. Sec. 1.469-8, reserving the application of Sec. 469 to estates, trusts, and beneficiaries.

⁵⁸ T.D. 9644.

⁵⁹ Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003).

⁶⁰ The Senate Finance Committee stated, “An estate or trust is treated as materially participating in an activity (or as actively participating in a rental real estate activity) if an executor or fiduciary, in his capacity as such, is so participating” (S. Rep’t No. 313, 99th Cong., 2d Sess. 735 (1986)).

⁶¹ A trust may be treated as an association taxable as a corporation, for tax purposes, if it is a joint enterprise for the conduct of business for profit (Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87), at 242, n. 33 (May 4, 1987)).

⁶² Sec. 469(j)(1) defines “closely held corporation” by reference to Sec. 465(a)(1)(B), which is any C corporation meeting the stock ownership requirements of Sec. 542(a)(2) where at any time during the last half of the tax year, more than 50% in value of the corporation’s stock is owned, directly or indirectly, by five or fewer individuals.

⁶³ Sec. 469(h)(4)(A).

⁶⁴ Sec. 469(h)(4)(B), cross-referencing Sec. 465(c)(7)(C).

⁶⁵ Sec. 465(c)(7)(C)(i).

⁶⁶ Sec. 465(c)(7)(C)(ii).

⁶⁷ Sec. 465(c)(7)(C)(iii).

⁶⁸ In the case of a grantor trust, under Sec. 671 et seq., the trust is not recognized as a separate taxable entity, and only the participation of the grantor is taken into account to determine the material participation of the trust in an activity.

⁶⁹ Technical Advice Memorandum 200733023.

⁷⁰ See also IRS Letter Ruling 201029014.

⁷¹ IRS Audit Technique Guide for Passive Activity Loss, at 6−7.

⁷² Temp. Regs. Sec. 1.469-5T(a).

⁷³ Temp. Regs. Sec. 1.469-5T(a)(1).

⁷⁴ Temp. Regs. Sec. 1.469-5T(a)(2).

⁷⁵ Temp. Regs. Sec. 1.469-5T(a)(3).

⁷⁶ Temp. Regs. Sec. 1.469-5T(a)(4).

⁷⁷ Temp. Regs. Sec. 1.469-5T(a)(5).

⁷⁸ Temp. Regs. Sec. 1.469-5T(a)(6).

⁷⁹ Temp. Regs. Sec. 1.469-5T(a)(7).

⁸⁰ Temp. Regs. Secs. 1.469-5T(b)(2)(ii) and (iii).

⁸¹ Regs. Sec. 1.1411-4(b)(2)(i).

⁸² In the context of whether a trust can be a real estate professional under Sec. 469(c)(7), the Tax Court in Frank Aragona Trust, 142 T.C. No. 9 (2014), recently held that the services of trustees may qualify a trust as a real estate professional.

⁸³ Temp. Regs. Secs. 1.469-5T(a)(1)−(7).

⁸⁴ See Temp. Regs. Secs. 1.469-1T(g)(1)−(3) for rules governing the material participation of closely held C corporations under Sec. 469(a)(2)(B) that treat the corporation as materially participating in any activity where any shareholder or shareholders owning more than 50% of the value of the corporation materially participate in the activity or the activity is conducted by employees as described in Sec. 465(c)(7)(C).

	Contributors
	Donald Williamson is a professor of taxation, the Howard S. Dvorkin Faculty Fellow, and executive director of the Kogod Tax Center at the Kogod School of Business at American University in Washington, D.C. For more information about this article, please contact Prof. Williamson at dwillia@american.edu.