The impact of The Net Investment Income Tax ("NIIT") on trusts and estates cannot be understated. Because trusts tend to remain in existence far longer than estates, the overall tax consequences of this surtax on trusts is likely to be even more profound, and the following discussion will focus mainly on trusts.
NIIT is a 3.8 percent surtax enacted pursuant to The Health Care and Education Reconciliation Act of 2010. Unlike the Additional Medicare Surtax that is limited to individuals, estates and many trusts are also subject to the tax. Those not subject to the tax include charitable trusts, qualified retirement plan trust, grantor trusts, real estate investment trusts and common trust funds as set forth in Code section 1141(e)(2) and Treasury Regulations section 1.1411-3(b).
In operation, the 3.8 percent NIIT surtax is imposed on trusts and estates on the lesser of:
- "undistributed net investment income"; or
- the excess of adjusted gross income over the amount of the highest regular income tax bracket in effect for such taxable year.
Compared to the thresholds for individual taxpayers that are based on adjusted gross income, the threshold for trusts and estates is based on the highest tax bracket of those entities. Though the threshold for trusts and estates is indexed for inflation (unlike the thresholds for individual taxpayers), that is of little comfort to fiduciaries and beneficiaries. The highest regular income tax bracket for trusts and estates (above which the NIIT surtax is imposed) begins at an amount that is significantly lower than the NIIT thresholds for individuals.
For tax year 2015, the highest regular income tax bracket for trusts and estates (39.6 percent) begins with taxable income in excess of $12,300. The unindexed thresholds for individual taxpayers ($250,000 for joint filers) are much higher. Moreover, by their nature, most trusts and estates are likely to have only net investment income. This means that trusts and estates with relatively small amounts of net investment income may nonetheless be in the highest income tax bracket and be subject to the 3.8 percent NIIT.
As mentioned above, The NIIIT tax base of trusts and estates is "undistributed net investment income." In simple terms, undistributed net investment income is any net investment income—as defined by Code section 1411(c)(1)(A)—that is retained by a trust or an estate. Distributions retain their characterization as net investment income when distributed to a beneficiary. If the trust has net investment income that is distributed to a beneficiary, it will be characterized as net investment income for beneficiary.
The NIIT affects both simple and complex trusts. A simple trust is required to distribute all of its current fiduciary accounting income (FAI) to its beneficiaries. FAI is income derived from principal such as interest and dividends (as opposed to capital gains derived from the sale or disposition of principal). Since a simple trust is required to distribute all of its FAI to its beneficiaries each year, its undistributed net investment income is limited to the capital gain it generates.
Under Code section 662(a), a complex trust is not required to make mandatory distributions to its beneficiaries. Instead, complex trusts generally make discretionary distributions of FAI (and sometimes principal) to beneficiaries. A complex trust is likely to have a mix of net investment income that includes dividends, interest and capital gains. This income may or may not be retained by the trust.
In order to understand how to compute the undistributed net investment income of a trust, it is necessary to comprehend the meaning of distributable net income (DNI). Essentially, the DNI of a trust is the taxable income of a trust, with certain modifications. Distributions to beneficiaries are not included in DNI, effectively shifting the obligation to pay tax on the distributed income from the trust to the beneficiaries.
Similarly, for net investment income purposes, DNI that is distributed to a beneficiary is included in the beneficiary's net investment income, and is subject to the NIIT. Conversely, undistributed investment income included in DNI—as well undistributed investment income not included in DNI—is included in the net investment income tax base of the trust. The most notable exclusion of income from the computation of DNI is capital gain.
Example
The following example from Treasury Regulations section 1.1411-3(e)(5) demonstrates how to compute net investment income for a complex trust, including calculations of DNI.
Example: Assume that in 2015 the trustee of this complex trust makes a discretionary FAI distribution of $10,000 to Beneficiary A.
| Trust Income 2015 | |
| Dividend Income | $15,000 |
| Interest Income | $10,000 |
| Capital Gain | $5,000 |
| IRA Distribution | $75,000 |
| Total Trust Income | $105,000 |
Step 1: Determine the DNI of the trust. Code section 643(a) provides that the DNI of a trust is tentative taxable income ($105,000) minus capital gain. Excluding the $5,000 of capital gain, the DNI of the trust is $100,000.
Step 2: Determine the trust's distribution deduction. According to Code section 661(a), the distribution deduction of a complex trust is equal to the amount distributed (here, $10,000).
