Final Regulations Make Changes to Application of 3.8% Medicare Tax on Net Investment Income to Charitable Remainder Trusts and Wholly Charitable Estates

Final Regulations Make Changes to Application of 3.8% Medicare Tax on Net Investment Income to Charitable Remainder Trusts and Wholly Charitable Estates

News story posted in Income Tax, Charitable Remainder Trust, Regulations on 9 January 2014| comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 27 April 2017
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by Richard L. Fox, Esq.

The Treasury Department issued final regulations under IRC § 1411 on November 26, 2013 (TD 9644, 78 Fed. Reg. 72394-01), which makes changes to the net investment income (NII) tax as it applies to charitable remainder trusts (CRTs) and wholly charitable estates.  The final regulations change the regime adopted by the proposed regulations that were issued on November 30, 2012.  Similar to the rule adopted by the proposed regulations that exempts wholly charitable trusts from the NII, the final regulations exclude wholly charitable estates, which were not exempt under the 2012 proposed regulations. On the CRT front, after consideration of multiple comments, the final regulations modify the 2012 proposed regulations, which, in an attempt to utilize a simplified method, provided that the classification of income as NII or non-NII (or excluded NII) would be separate from, and in addition to, the four-tier system under IRC § 664(b).   Under the final regulations, NII and excluded NII are categorized and distributed based on the existing IRC § 664 four-tier category and class system. Although the IRS was initially concerned that differentiating between NII and non-NII within each class and category would impose an undue burden, commentators emphasized that CRT trustees are already maintaining the appropriate records and are familiar with the existing rules. The final regulations apply to the tax years of CRTs that begin after December 31, 2012, but CRTs that relied on the 2012 proposed regulations for returns filed before publication of the final regulations do not have to amend their returns.

Background on the 3.8% Medicare Tax on Net Investment Income

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

Examples:  

  1. A husband and wife, who file a joint income tax return, have salaries totaling $275,000, constituting their only source of income (thus, they have no NII), and an AGI of $275,000.  Because they have no NII,  IRC § 1411 does not apply, notwithstanding that their AGI exceeds the applicable threshold amount of $250,000. 
  1. If the couple had NII of $150,000, salaries of $100,000, and an AGI of $250,000, the 3.8% tax would similarly not apply because although they have NII, their $250,000 AGI does not exceed the $250,000 threshold amount. 
  1. If the couple had NII of $150,000, salaries of $275,000, and an AGI of $425,000, the 3.8% tax under IRC § 1411 would apply to the entire $150,000 of NII, since such amount is less than $175,000, the excess of the $425,000 AGI over the $250,000 threshold amount.  If the couple had NII of $150,000, salaries of $200,000 and an AGI of $350,000, the 3.8% tax under  IRC § 1411 would apply to only $100,000 of NII, the excess of the $350,000 AGI over the $250,000 threshold amount, since that amount is less than the $150,000 in NII. 

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

Special Rules for Applying the 3.8% Medicare Tax to Estates and Trusts

Generally

In the case of an estate or trust, the 3.8% tax under IRC § 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 AGI of the estate or trust over (ii) the inflation-adjusted dollar amount at which the highest tax bracket in Section 1(e), a relatively nominal amount equal to only $11,950 for 2013 and $12,150 for 2014.  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 IRC §1411 tax to estates and trusts and to focus on possible techniques to minimize the exposure. This may include shifting 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 of the beneficiaries of the trust are affluent such 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 IRC § 1411 tax. Moreover, even if making distributions to beneficiaries results in an overall reduction of the IRC § 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.  

The AGI of an estate or trust is reduced by distributions to beneficiaries to the extent of distributable net income (“DNI”) that is deductible under IRC §§ 651 or 661, and its undistributed NII is reduced to the extent that such DNI consists of NII distributed to beneficiaries.  The respective amounts of the DNI and NII that are deducted by the estate or trust are subject to tax in the hands of the beneficiaries.  Unless capital gain income is included in DNI, which generally is not the case, it is not deductible under IRC §§ 651 or 661 and is, therefore, taxed entirely at the estate or trust level and is not passed out to the beneficiaries for tax purposes. The same concept applies to NII, so that only NII of an estate or trust that is included in DNI and deductible under IRC §§ 651 or 661 as a result of distributions to a beneficiary will be taxed at the beneficiary level.

The deductions attributable to distributions of DNI by an estate or trust to its beneficiaries, and the related income to the beneficiaries, are treated as consisting of the same proportion of each class of items of income entering into the computation of DNI as the total of each class bears to the total DNI.  For example, if a trust that has DNI of $40,000, consisting of $10,000 of taxable interest (equal to 25% of DNI) and $30,000 of royalties (equal to 75% of DNI), distributes $10,000 to a beneficiary, the trust’s deduction of $10,000 and the $10,000 of income taxable to the beneficiary, is deemed to consist of $2,500 (25% x $10,000) of interest and $7,500 (75% x $10,000) of royalties. Where DNI consists of both NII and so-called “excluded income,” a distribution of DNI to the beneficiary must similarly be allocated between the NII and the excluded income, so that a proportionate amount of the total NII of the estate or trust is deemed to be distributed to the beneficiaries. All items of NII that are considered distributed to the beneficiaries retain their character as NII for purposes of computing Section 1411 tax on the NII of the recipient beneficiaries.

Reduction of Net Investment Income Allocated to Section 642(c) Deduction for Charitable Contributions By Estates and Trusts

In lieu of the charitable income tax deduction under Section 170(a), a charitable income tax deduction is available under  IRC § 642(c) to estates and trusts for charitable contributions made from gross income.  Unlike individuals, whose charitable income tax deductions are limited to a certain percentage of their AGI under IRC § 170(b), estates and trusts are entitled to claim an unlimited charitable income against their gross income.  In computing its undistributed NII, an estate or trust is allowed a deduction for that portion of its NII that is allocated to amounts allowable as a charitable deduction under  IRC §  642(c).  As a result, an IRC § 642(c) charitable deduction will effectively shift NII from an estate or trust into the hands of a tax-exempt charitable beneficiary. Unless all of the requirements of Section 642(c) are satisfied, however, a transfer to charity by an estate or trust to charity will not be deductible.  Specifically,  IRC §  642(c)(1) allows an estate and trust an income tax deduction for “any amount of gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in IRC § 170(c).” The key to the charitable income tax deduction for an estate and trust under IRC § 642(c)(1) is that amount is paid (1) during the taxable year; (2) from gross income (not from corpus or principal), including gross income accumulated in earlier years; (3) pursuant to the terms of the governing instrument (i.e., the will or trust document); and (4) for a purpose specified in IRC § 170(c).  It is imperative for purposes of the IRC § 642(c) deduction for the contribution be paid “pursuant to the terms of the governing instrument.”  Therefore, if an executor or trustee voluntary makes a payment to charity that is not authorized under the will or trust document, no charitable income tax deduction is available under  IRC § 642(c).  The governing instrument need not “definitively direct” the charitable contribution in order to support a deduction under IRC § 642(c), as long as it specifically authorizes a payment to charity.  In addition to the available deduction under IRC § 642(c)(1), estates, as well as certain trusts created on or before October 9, 1969, are allowed a charitable income tax deduction under IRC § 642(c)(2) for amounts of gross income that are permanently set aside for charitable purposes. Specifically, under IRC § 642(c)(2), a charitable deduction is allowed in computing taxable income for “any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, permanently set aside for a purpose specified in IRC § 170(c), or is to be used exclusively for religious, charitable, scientific, literary or educational purposes” and certain other specified purposes.

Final Regulations Expand Exemption from NII to Wholly Charitable Estates

Under the 2012 proposed regulations, a trust where all the unexpired interests of which are devoted to one or more purposes described in  IRC § 170(c)(2)(B) (“wholly charitable trust”) is not subject to the NII tax under IRC § 1411.  As noted in the preamble to the final regulations, the 2012 proposed regulations did not have an exclusion to exempt an estate all of the unexpired interests in which are devoted to one or more of the purposes described in IRC § 170(c)(2)(B) (''wholly charitable estate''). Thus, unlike a wholly charitable trust, which was exempted from NII under the 2012 proposed regulations, a wholly charitable trust had to rely upon IRC § 642(c) in order to avoid the tax.  Thus, although a wholly charitable estate was not exempt from the IRC § 1411 tax, it could effectively achieve such exemption through the operation of provisions outside of IRC § 1411 by relying on the IRC § 642(c). The preamble noted the inconsistency between the treatment of wholly charitable trusts and wholly charitable estates and further noted that such inconsistency could have an inadvertent and adverse impact on both wholly charitable estate and wholly charitable trusts for income tax purposes - specifically, on their decision to make an election under IRC § 645 (a ''645 Election''). Section 645 was enacted to eliminate the differences in income tax treatment between the disposition of a decedent's property by will (through an estate) and by a revocable trust (that becomes irrevocable on the decedent's death). See H.R. Rep. No. 148, 105th Cong., 1st Sess. 618 (1997).  The preamble to the final regulations noted that one commentator stated that “[a]ssuming a wholly-charitable disposition by a decedent, a trustee of the decedent's formerly revocable trust and the executor of the related estate would normally join in a 645 Election to minimize the cost and burden of administration and to achieve consistency in the income tax treatment of the estate and trust. However, unless an estate and trust have the same exemption from section 1411, the trustees of a [wholly charitable trust] may be reluctant to join in an otherwise useful election.”

The preamble to the final regulations states that “the Treasury Department and the IRS believe it is consistent with the Congressional intent of both section 1411 and section 645 to treat both types of entities as exempt from section 1411. Accordingly, § 1.1411-3(b)(1) of the final regulations excludes from the application of section 1411 an estate in which all of the unexpired interests are devoted to one or more of the purposes described in section 170(c)(2)(B).”   So, the final regulations now exempt both a wholly charitable trust and a wholly charitable estate under Reg. § 1.1411-3(b)(1), which provides an exemption from IRC § 1411 for 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).” Note that it could be the case that a trust or estate is not initially wholly charitable because of the existence of non-charitable beneficiaries, in which case they would not be exempt from NII. However, once such non-charitable beneficiaries’ interests are terminated (because all non-charitable assets have been distributed) and all of the unexpired interests in the trust or estate are held for IRC § 170(c)(2)(B) purposes, the trust or estate would then become exempt from NII. 

CRTs Are Wholly Exempt from NII But Distributions to Non-Charitable Beneficiaries Carry Out NII

A CRT is a charitable vehicle that can be particularly useful in planning to avoid the impact of the NII.  Because it is wholly exempt from Section 1411, property having significant appreciation can be transferred to a CRT and then sold without the imposition of the 3.8% tax on NII (or the imposition of any regular income tax).   Moreover, although annuity and unitrust payments carry out NII to its noncharitable beneficiaries,  a CRT has the effect of smoothing out NII that is passed through to such beneficiaries on a year-to-year basis, and subjects the taxation of such NII to the higher AGI thresholds applicable to individuals. Depending upon the recipient beneficiaries’ respective NII and AGI, the use of a CRT may result in the  elimination, reduction, or at the very least, the deferral, of the 3.8% tax on NII realized by the CRT.   

Background on CRTs

The CRT has become a staple among estate planners and is often a recommended vehicle for individuals with substantial appreciated capital gain property, a charitable intent, and a need for a stream of income during their lifetimes.  The basic concept of a CRT involves a transfer of property to an irrevocable trust, the terms of which provide for the payment of a specified amount, at least annually, to the grantor or other designated noncharitable beneficiaries for life or another predetermined period of time up to twenty years. The amount remaining in the trust after the expiration of that period, i.e., the remainder interest, must be transferred to one or more qualified charitable organizations or continue to be held in the trust for the benefit of such organizations. Thus, unlike an outright gift to charity, a CRT blends the philanthropic intentions of a donor with his or her financial needs or the financial needs of others. There is generally no gain recognition on the transfer of appreciated property to a CRT,  and because it is exempt from income tax,  the transferred property may be sold by the CRT on a tax-free basis. While the CRT itself is exempt from income tax, the annual annuity or unitrust payments carry out income to the noncharitable beneficiary or beneficiaries based on specified ordering rules under a special four-tier system, generally treating the most highly taxed income of the trust as being distributed first.   Under these ordering rules, the annuity or unitrust payments carry out income from the CRT in the following order: (1) first, from ordinary income; (2) second, from capital gain income; (3) third, from other income, including tax-exempt income; and (4) finally, as a tax-free return of principal.   The CRT regulations provide specific rules for characterizing a distribution from a CRT to take into account differences in the federal income tax rates applicable to classes of income that are assigned to the same category, basically considering the highest taxed classes of income within the same category to be distributed first.   Thus, within the ordinary income and capital gains categories, income is treated as distributed from the classes of income in that category beginning with the class subject to the highest federal income tax rate and ending with the class subject to the lowest federal income tax rate.  The idea of annuity or unitrust distributions carrying out the highest taxed income first under the special four-tier system doesn’t always work because certain capital gain may be taxed at a higher tax rate than certain ordinary income.  For example, the tax-rate of short-term capital gain (taxed at a maximum of 39.6%) and long-term capital gain on collectibles (28%) exceeds the maximum 20% tax rate on qualified dividend income.  Yet, because qualified dividend income is income in the “ordinary income” category, the lower-taxed qualified dividend income is deemed to pass out first under the ordering rules prescribed by the CRT regulations. These regulations also provide that the tax rates applicable to a distribution from a CRT to a noncharitable beneficiary are the tax rates applicable to the classes of income from which the distribution is derived in the year of the distribution and not the tax rates applicable to the income in the year it is realized by the CRT.

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 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 § 1411 tax imposed on the NII earned by the CRT. Thus, in addition to its other benefits, including an upfront 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.

Example.  A, a single taxpayer, has a salary of $150,000 and no other income.   If A were to sell long-term capital gain 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. If instead of A selling the property, 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 gain, then A would be considered to realize long-term capital gain 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 IRC § 1411.

Method of Determining NII Considered to Be Distributed Under 2012 Proposed Regulations

The 2012 proposed regulations provided that 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 (ii) the current and accumulated NII of the CRT.  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, current and accumulated NII of a CRT were deemed to be distributed before amounts that were not items of NII for purposes of IRC § 1411, irrespective of the four-tier ordering rule that is otherwise applicable under the  IRC § 664 tax regime for determining the character of income attributable to annuity or unitrust payments.  Thus, the proposed regulations, in an attempt to provide a simplified method, provided that the classification of income as NII or non-NII (or excluded NII) would be separate from, and in addition to, the four tiers under IRC § 664(b).   Under the 2012 proposed regulations, depending upon the character of the income realized by the CRT, the difference in the ordering rules may have resulted 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 individual retirement account (IRA) and long-term capital gain, an annuity or unitrust payment could carry out only  IRA income (which is not NII) for IRC § 664 purposes and only long-term capital gain (which is NII) for  IRC § 1441 purposes.  Recognizing that the ordering rule applicable to distributions of NII under the IRC § 1411 proposed regulations are not consistent with the four-tier ordering rule under IRC § 664, the preamble to the proposed regulations stated 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-tier categories under the Section 664 tax regime. This alternative method would have created a sub-class system of NII and non-NII within each class and category of the four-tier Section 664 framework. The preamble further stated, 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 recordkeeping 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 upon the noncharitable beneficiaries of the CRT.  

Final Regulations Change Method of Determining NII Considered to Be Distributed

After consideration of multiple comments, the final regulations modify the 2012 proposed regulations’ special computational rules for classifying income and distributions from CRTs for IRC § 1411 purposes. Under the final regulations, NII is categorized and distributed based on the existing IRC § 664 “category and class” system.  Although the IRS was initially concerned that differentiating between NII and non-NII within each class and category would impose an undue burden, commentators emphasized that CRT trustees are already maintaining the appropriate records and are familiar with the existing rules.   

The final regulations retain the concept in the 2012 proposed regulations “accumulated NII,” discussed above, and apply the IRC § 664 category and class system to accumulated NII by providing that the federal income tax rate applicable to an item of accumulated NII, for purposes of allocating that item of accumulated NII to the appropriate class within a category of income, is the sum of the (1) income tax rate imposed on that item under chapter 1 (for regular income tax purposes) and (2) tax imposed under IRC § 1411 (the 3.8% tax).  Therefore, if a CRT has both excluded income (such as income received by the trust prior to January 1, 2013, or other income received after December 31, 2012, but excluded from NII) and accumulated NII within the same income category, such excluded income and accumulated NII will constitute separate classes of income within the same income category, with the higher taxed income deemed to pass out first.  For example, income from an IRA and interest income are both in the ordinary income category, but because interest income constitutes NII and income from an IRA is excluded from NII, the federal income tax rate applicable to the interest income (which is NII) is 43.4% (39.6% plus 3.8%) and for the IRA income (which is excluded from NII) is 39.6%.  Thus, the interest income, being taxed at a higher tax rate than the IRA income, would be deemed to be passed out first under the IRC § 664 category and class system used to determine the nature of the distributions from CRTs to non-charitable income beneficiaries.

The final regulations apply to taxable years of CRTs that begin after December 31, 2012.  However, for CRTs that relied on the 2012 proposed regulations for returns filed before the publication of the final regulations in the Federal Register, the CRT and its beneficiary (as applicable) do not have to amend their returns to comply with rules set forth in the final regulations.  For such a CRT, when transitioning from the method in the proposed regulations to the method in the final regulations, the CRT may use any reasonable method to allocate the remaining undistributed NII for that year to the categories and classes under IRC § 664. See Reg. § 1.1411-1(f)(2). 

Example:

In 2009, A formed CRT as a charitable remainder annuity trust. The trust document requires an annual annuity payment of $50,000 to A for 15 years and the trust qualifies as a valid CRT under IRC § 664.

  1. As of January 1, 2013, CRT has the items of undistributed income within its IRC § 664 categories and classes of income as set forth below. 

Category

Class

Tax Rate

Amount

Ordinary Income

Interest

39.6%

$4,000

Net Rental Income

39.6%

$8,000

Non-Qualified Dividend Income

39.6%

$2,000

Qualified Dividend Income

20.0%

$10,000

Capital Gain

Short-Term

39.6%

$39,000

Unrecaptured Section 1250 Gain

25.0%

$1,000

Long-Term

20.0%

$560,000

Other Income

None

Total undistributed income as of January 1, 2013 $624,000
=======

Pursuant to Reg. § 1.1411–3(d)(1)(iii), none of the $624,000 of undistributed income is accumulated NII because none of it was received by CRT after December 31, 2012. Thus, the entire $624,000 of undistributed income is excluded from NII (excluded income).

  1. During 2013, CRT receives $7,000 of interest income, $9,000 of qualified dividend income, $4,000 of short-term capital gain, and $11,000 of long-term capital gain, all of which (totaling $31,000) constitutes NII. For purposes of allocating the items of the accumulated NII to the appropriate class within a category of income, the $7,000 of interest income (within the ordinary income category) has a tax rate of 43.4% (39.6% regular tax and 3.8% NII tax); the $9,000 of qualified dividend income (within the ordinary income category) has a tax rate of 23.8% (20% regular tax and 3.8% NII tax); the $4,000 short-term capital gain (within the capital gain category) has a tax rate of 43.4% (39.6% regular tax and 3.8% NII tax); and the $11,000 long-term capital gain (within the capital gain category) has a tax rate of 23.8% (20% regular tax and 3.8% NII tax).  Prior to the 2013 distribution of $50,000 to A, the CRT has the following items of undistributed income within its IRC § 664 categories and classes of income:  
     

Category

Class

NII or Excluded From NII

Tax Rate

Amount

Ordinary Income

Interest

NII

43.4%

$7,000

Interest

Excluded

39.6%

$4,000

Net Rental Income

Excluded

39.6%

$8,000

Non-Qualified Dividend Income

Excluded

39.6%

$2,000


Qualified Dividend Income


NII


23.8%


$9,000

Qualified Dividend Income

Excluded

20.0%

$10,000

Capital Gain

Short-Term

NII

43.4%

$4,000

Short-Term

Excluded

39.6%

$39,000

Unrecaptured Section 1250 Gain

Excluded

25.0%

$1,000

Long-Term

NII

23.8%

$11,000

Long-Term

Excluded

20.0%

$560,000

Other Income

None

Total $655,000
=======
  1. As reflected below, the $50,000 annuity distribution in 2013 carries out $50,000 of income to A for 2013, starting with ordinary income category (from highest taxed to lowest taxed ordinary income) and then capital gain category (from highest taxed to lowest taxed capital gain), of which $20,000 is NII:

Category

Class

NII or Excluded From NII

Tax Rate

Amount

Ordinary Income

Interest

NII

43.4%

$7,000

Interest

Excluded

39.6%

$4,000

Net Rental Income

Excluded

39.6%

$8,000

Non-Qualified Dividend Income

Excluded

39.6%

$2,000

Qualified Dividend Income

NII

23.8%

$9,000

Qualified Dividend Income

Excluded

20.0%

$10,000

Capital Gain

Short-Term

NII

43.4%

$4,000

Short-Term

Excluded

39.6%

$6,000

Unrecaptured Section 1250 Gain

Excluded

25.0%

None

Long-Term

NII

23.8%

None

Long-Term

Excluded

20.0%

None

Other Income

None

Total $50,000
=======

As indicated above, the $20,000 amount included in A’s 2013 NII is comprised of $7,000 of interest income, $9,000 of qualified dividend income, and $4,000 of short-term capital gain.

  1. As of January 1, 2014, the CRT has the following items of undistributed income within its Reg. § 1.664–1(d)(1) categories and classes:

Category

Class

NII or Excluded From NII

Tax Rate

Amount

Ordinary Income

Interest

None

Net Rental Income

None

Non-Qualified Dividend Income

None

Qualified Dividend Income

None

Capital Gain

Short-Term

Excluded

39.6%

$33,000

Unrecaptured  Section 1250 Gain

Excluded

25.0%

$1,000

Long-Term

NII

23.8%

$11,000

Long-Term

Excluded

20.0%

$560,000

Other Income

None

Total undistributed income as of January 1, 2014 $605,000
=======
   
Total accumulated NII $11,000
======

The $605,000 total undistributed income of the CRT as of January 1, 2014 can be reconciled as follows:

Undistributed income as of January 1, 2013 $624,000
Plus:  Income of CRT During 2013 $31,000
Less: Income Distributed During 2013 ($50,000)
  $605,000
=======

The $11,000 total accumulated NII of the CRT as of January 1, 2014 can be reconciled as follows:

Accumulated NII as of January 1, 2013 $          0
Plus:  NII of CRT During 2013 $31,000
Less: NII Distributed During 2013 ($20,000)
   $11,000
=======

Copyright © Richard L. Fox 2014.


About the Author

Richard L. Fox, Esq. is a partner in the Philadelphia-based law firm of Buchanan Ingersoll & Rooney. He concentrates his practice in the areas of charitable giving, private foundations, tax-exempt organizations, estate planning, trusts and estates, and family planning. Mr. Fox is the author of the treatise, Charitable Giving; Taxation, Planning and Strategies, a Warren, Gorham and Lamont publication, writes a national bulletin charitable giving, and writes and speaks frequently on issues pertaining to nonprofit organizations, estate planning and philanthropy. See More

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