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March 24, 2016 The Tax Lawyer

Does 3.8% Change Anything? The Intersection of the Net Investment Income Tax and Fiduciary Income Tax

Volume 69, No. 2 - Winter 2016

Christopher Floss


    The Net Investment Income Tax continues to impact taxpayers who fall within its income parameters. Due to the compressed structure of the fiduciary-income tax brackets, taxpaying trusts are more likely to experience the effect of this tax at a higher rate. Furthermore, trusts that are subject to income tax typically generate the types of revenue that are defined as Net Investment Income in the recently enacted section 1411 of the Code. As a result, estate planners and tax professionals have implemented various planning techniques to anticipate the impact of this new tax upon trusts and estates. This Article discusses two major areas in fiduciary tax planning that have been subject to further scrutiny since the onset of the Net Investment Income Tax: (1) the treatment of capital gains as income, and (2) the application of the passive activity rules to trusts that engage in business activities. In 2010, Congress enacted a new tax entitled the Unearned Income Medicare Contribution. While this new tax is part of the Health Care and Education Reconciliation Act of 2010, it has become known as the Net Investment Income Tax (NIIT). One commentator noted that rumors of this tax began to surface in late 2009 as Congress was considering increases to overall income tax rates. Other than initial rumors, there is no meaningful legislative history that describes Congress’ specific intent in enacting this new tax.

    In 2012, the Treasury issued Proposed Regulations defining statutory terms and key concepts under the new tax. The first set of Regulations was finalized in late 2013; however, upon release of the Final Regulations, Treasury released an additional set of Proposed Regulations to address specific issues that surfaced in discussions related to the Final Regulations. Since its enactment, the NIIT quickly became the topic of many articles and presentations among legal scholars and tax professionals.

    This Article discusses the application of the NIIT in the fiduciary context, specifically relating to irrevocable trusts commonly used in the estate planning process. Analysis is restricted to the following topics: (1) an overview of section 1411 and its Regulations as applied to irrevocable trusts; (2) the implications of the NIIT to capital gains and passive activity income and loss in this context; and (3) the application of the material participation standard rules to irrevocable trusts. While the analysis focuses on the NIIT, other income tax-related concepts will be explained in connection with each subtopic.

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