How the §1411 Final Regulations Impact Trusts and Estates

As many are familiar with by now, §1411 is the net investment income (NII) tax of 3.8% imposed on individuals, trusts, and estates with a certain threshold of income for tax years beginning in 2013. Nearly a year following the proposed regulations (REG-130507-11), the IRS issued the much-anticipated final regulations (T.D. 9644), providing guidance on the general application and computation of the NII tax. While there are several other components to the regulations, this discussion focuses only on the effect for trusts and estates.

Section1411(a)(2) imposes an additional tax of 3.8% on trusts and estates on the lesser of (1) the undistributed NII; or (2) the excess of the adjusted gross income over the highest tax bracket in §1(e). The §1(e) threshold amount is $11,950 for 2013 and $12,150 for 2014. Final Regs. §1.1411-3 provides guidance on the computation of the net investment income tax for trusts and estates. 

The proposed regulations provided that §1411would apply to ordinary trusts defined in Regs. §301.7701-4(a), including pooled income funds, cemetery perpetual care funds, qualified funeral trusts, and certain Alaska Native Settlement Trusts. However, the IRS received many comments requesting exceptions, and made some adjustments under final Regs. §1.1411-3(b)(1). An exception is created for cemetery trusts and Alaska Native Settlement Trusts. The IRS did not make exceptions for pooled income funds, nor qualified funeral trusts (but Regs. §1.1411-3(b)(2)(i) was added to confirm the method to calculate the tax, providing that each beneficiary's interest in a beneficiary's contract be treated as a separate trust). Section 1411(e)(2) provides that the NII tax does not apply to a trust, all of the unexpired interests in which are devoted to one or more of the charitable purposes described in §170(c)(2)(B). Final Regs. §1.1411-3(b)(1)(i) expands this exclusion to include estates. 

The final regulations retain the calculation of the undistributed NII and modified adjusted gross income of electing small business trusts (ESBTs), the provision which was relocated to Regs. §1.1411-3(c). The S portion and the non-S portion of a trust are treated as separate trusts for computing the undistributed NII, but are treated as a single trust for determining the amount subject to the NII tax. 

As to charitable remainder trusts (CRTs), the proposed regulations provided special NII computational rules for the classification of income and distributions of CRTs. The final regulations adopt commentators’ requests to categorize and distribute NII based on the existing §664 category and class system. These new rules apply to tax years beginning after December 31, 2012, but an exception is made for CRTs that relied on the 2012 proposed regulations for returns filed before the publication of these final regulations. Treasury and the IRS provide that these CRTs, when transitioning methods, may use any reasonable method to allocate the remaining undistributed NII for that year to the §664 categories and classes. The final regulations retain the concept of accumulated NII, and apply the §664 category and class system to it. Additionally, some regulations are reserved: (1) for special rules necessary to apply the §664 category and class system to certain distributions made to CRTs that own interests in controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs); and (2) for rules allowing CRTs to elect between the simplified method in the 2012 proposed regulations and the §664 method contained in the final regulations. New proposed regulations were issued simultaneously in REG-130843-13 addressing these additional issues.  

Section 1411does not specifically address the treatment of foreign estates and foreign nongrantor trusts. The proposed regulations provided that as a general rule, foreign trusts and estates would not be subject to NII tax. Treasury and the IRS continue to believe that §1411should not apply to foreign estates, as finalized in Regs. §1.1411-3(b)(1)(ix). However, U.S. beneficiaries receiving distributions from foreign estates are not exempt. Similarly, Treasury and the IRS agree that §1411 should not apply to foreign trusts, but that it should apply to U.S. beneficiaries that receive distributions of accumulated net investment income from a foreign trust. Until guidance on this subject is issued, no NII tax is imposed on such accumulated income. Treasury and the IRS request additional comments concerning this issue. 

“Undistributed net investment income” is a §1411term used solely for trusts and estates, yet is not defined in §1411. The final regulations retain the approach used in the proposed regulations for calculating the undistributed NII of a trust or estate in final Regs. §1.1411-3(e). Examples are provided in Regs. §1.1411-3(f)  (but note that computational errors from the proposed regulations are corrected).   

Finally, several commentators noted that §1411 creates the need to determine how a trust or estate “materially participates” in an activity, and requested guidance. Treasury and the IRS believe this guidance would be addressed more appropriately in the §469 regulations in separate guidance at a later date. Treasury and the IRS welcome any comments and recommendations on this issue.