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Investment Income Tax Affects Planning for Estates and Trusts

The net investment income tax will affect trusts and estates by creating planning opportunities and by imposing new income-tracking rules for the benefit of beneficiaries who may receive distributions with net investment income.

The tax was created by the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152), which added new §1411 to the tax code. The IRS has announced proposed rules (REG-130507-11) governing the net investment income tax. The tax is scheduled to take effect Jan. 1, 2013, affecting the income tax returns of individuals, estates, and trusts for their first tax year beginning after that date.

Executors should pay careful attention to choice of tax year in the cases of estates for decedents who died in 2012, and should consider accelerating the recognition of net investment income for beneficiaries of charitable remainder trusts.

How the NII Tax Affects Estates and Trusts:

The 3.8% net investment income tax is applied to the lesser of two amounts for estates and trusts, just as it is in the individual context. The first amount is net investment income, but only to the extent that it is not distributed by the trust, a concept that is “obviously not relevant” when you’re dealing with an individual.

The second amount is adjusted gross income in excess of the dollar amount at which the highest income-tax bracket for trusts begins, rather than AGI in excess of a set dollar figure. The highest trust bracket begins at $11,650 for tax year 2012, and is projected to rise to $11,950 for 2013.

For trusts and estates, the AGI threshold amount is indexed for inflation by virtue of its reference to the tax brackets, which is not true of the individual threshold amounts.

As is the case for individuals, trusts and estates will have to factor the net investment income tax into their estimated tax payments for 2013.

As the net investment income tax is effective for tax years beginning after 2012, estates for decedents who died in 2012 might consider choosing a fiscal year that ends on or before Dec. 30, 2012, thereby allowing the estate to avoid net investment income tax on two years of income, because both years would begin before the effective date.

Where NII Tax Applies:

The net investment income tax generally applies to estates and trusts including non-grantor trusts, electing small business trusts, and certain foreign trusts with U.S. beneficiaries. However, grantor trusts, tax-exempt trusts, and foreign trusts without U.S. beneficiaries or not subject to the new tax.

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