Generally, for income tax purposes, the character of income that is distributed to the beneficiary of a charitable remainder trust (CRT) as an annuity or unitrust payment is preserved. However, this may not be the case for certain distributions for purposes of the new 3.8% tax on net investment income.

    Although the CRT itself is not subject to the Internal Revenue Code §1411 net investment income tax, annuity and unitrust distributions may be net investment income to the noncharitable beneficiaries. Pursuant to the 2012 proposed regulations under §1411 (REG–130507–11), the net investment income of a CRT beneficiary attributable to his or her annuity or unitrust distribution includes an amount equal to the lesser of (1) the total amount of the distributions for the tax year, or (2) the current and accumulated net investment income of the trust. Because this definition treats any net investment income in a CRT as being carried out when distributions to beneficiaries are made, a CRT beneficiary’s annuity or unitrust payment may be subject to the 3.8% tax, even though the income is otherwise treated as ordinary income for income tax purposes.

     For example, assume that a CRT holds an IRA and receives a distribution therefrom. If the CRT distributes that amount to a beneficiary, the amount is taxable to the beneficiary as ordinary income. However, if the CRT also has income from royalties attributable to a passive trade/business (or other items of net investment income), then the distribution is treated as carrying out the net investment income as well, even if the CRT only distributed the amount attributable to the IRA. The end result is that an item of income that is not typically net investment income (i.e., the IRA distribution) winds up being subject to the additional 3.8% tax.

     Several prominent practitioners, including a senior manager in KPMG’s Washington National Tax Practice, Irene Estrada, are hopeful that the final regulations under §1411 remedy this anomaly. 

     This issue, along with a discussion of 2013 draft Form 8960, is highlighted in an August 8, 2013, article in Bloomberg BNA Daily Tax Report by Diane Freda.