The Heath Care and Education Reconciliation Act of 2010 added Section 1411 to the Code, effective December 31, 2012.  Section 1411 imposes a non-deductible 3.8% tax on net investment income of individuals, estates and trusts that have income above specified thresholds as follows:
  • Married filing jointly  $250,000
  • Married filing separately  $125,000
  • Single  $200,000
  • Estates and Trusts  $12,300

Net investment income includes:

  • Interest
  • Dividends
  • Annuities
  • Royalties and rents (other than income from active trade or business)
  • Gain on disposition of property (other than property held in active trade or business)
  • Income from passive activity
Material participation rules are the key in determining whether an activity is active or passive and as such subject to the Net Investment Income Tax.  The IRS has yet to formally address the issue of material participation by a trust.
In order to understand how this might affect an individual who sets up a trust to pass on an estate to specific heirs, it helps to understand revocable and irrevocable trusts. In a revocable trust, the trust grantor, the person or entity setting up the trust, pays the taxes on the income transferred via the trust, so the compressed trust brackets do not affect the taxation of a revocable trust.
The Net Investment Income Tax is just one layer of tax imposed on undistributed trust and estate income.  Federal income tax is imposed on trusts and estates at the rate of 39.6% on trusts and estate taxable income over $12,300.  Many times the beneficiary of the trust or estate is in a lower tax bracket individually than the estate or trust tax bracket.  It is important to refer to the trust or will documents to determine the timing of distributions to potentially avoid paying a tax at a higher rate.
The TD&T Trust and Estate team is available to assist you with estate and trust planning as well as estate and trust tax return preparation.