Planning for the Net Investment Income Tax for Non-Grantor Trusts

Journal of Financial Planning: July 2016


Julie A. Welch, CPA, PFP, CFP®, is the director of tax services and a shareholder with Meara Welch Browne P.C. in Leawood, Kansas.

Cara Smith, CPA, CFP®, is a senior tax manager with Meara Welch Browne P.C. in Leawood, Kansas.

The Net Investment Income Tax (NIIT) under section 1411 of the Internal Revenue Code was enacted under the 2010 health care legislation in order to fund health care reform. It became effective starting in tax year 2013. The NIIT is a 3.8 percent tax imposed on net investment income.

The amount of net investment income subject to the tax is the lesser of: (1) net investment income; or (2) adjusted gross income (with some adjustments) in excess of a threshold amount.

The threshold amount for a married couple filing a joint return is $250,000, while the threshold for non-grantor type trusts corresponds with the dollar amount at which the highest tax bracket begins for the year ($12,400 for 2016). These amounts are not indexed for inflation.

Net investment income includes:

Investment income such as dividends, interest, annuities (except annuities from IRAs and qualified plans), royalties, and rents not derived in the ordinary course of business.

Passive income from entities in which the taxpayer does not “materially participate” in the operations.

Financial trading income such as capital gains on the sale of stocks, equity and debt instruments, options, derivatives, commodities, etc.

Gains derived from the disposition of non-trade or non-business property. Gains from assets held in an active business are not considered investment income unless the taxpayer did not materially participate in that business.

Net investment income does not include self-employment income, salary, wages, unemployment compensation, Social Security benefits, or alimony. Also excluded is income derived from active trade or businesses and gains on the sale of active interests in partnerships or S Corporations. Distributions from IRAs and other qualified retirement plans are also excluded from the definition of net investment income.

Deductions against Gross Investment Income

The 3.8 percent NIIT is computed on net investment income after reduction for certain allocable deductions. Allowable deductions include:

  • Investment interest and carryovers;
  • State, local, and foreign income tax (excluding foreign taxes used to compute the foreign tax credit);
  • Miscellaneous investment expenses such as investment advisory fees that are deductible in computing regular tax after the limitations under Code Section 67 (2 percent of adjusted gross income limitation) and Code Section 68 (Pease limitation); and
  • Other modifications, such as penalties for early withdrawal of savings and excess deductions allocated to a beneficiary upon the termination of an estate or trust.

Although the alternative minimum tax (AMT) often eliminates the benefit of miscellaneous itemized deductions for income tax purposes, the imposition of AMT has no impact on the deductions allocable in determining the net investment income subject to the 3.8 percent surcharge. Additionally, capital losses up to $3,000 per year are allowed as a reduction in determining net investment income.

The NIIT applies to trusts and estates as well as to individuals. And with thresholds for applicability much lower for estates and trusts than for individuals, trusts are operating at a clear disadvantage. Many trusts have only unearned-type income, and therefore even the more modest-sized trusts and estates are likely to be subject to the 3.8 percent NIIT if any income or capital gains are accumulated inside the trust.

The NIIT affects both simple and complex trusts. Simple trusts are required to make income distributions to beneficiaries, whereas complex trusts can generally make discretionary distributions of income and sometimes principal, or they can accumulate income, adding it to corpus.

It is necessary to understand distributable net income, or DNI, in order to understand the implication of the 3.8 percent NIIT on trust income. The concept of DNI is used to allocate the trust’s or estate’s taxable income between beneficiaries and the trust itself in order to determine who pays tax on the trust’s income. A trust or estate that makes beneficiary distributions is allowed a distribution deduction against its income for the taxable portion of the income distributed to the beneficiary in order to ensure that the total income of the trust is only taxed once—either to the beneficiary or to the fiduciary, but not to both.

Defining Undistributed Net Investment Income and DNI

Capital gains. Often, capital gains on the sale of investments are allocated to the principal of a trust rather than to income that can be distributed to beneficiaries. Therefore, even simple trusts required to distribute all income to beneficiaries will be subjected to the NIIT on the capital gains that create net investment income over the threshold amounts.

Historically, gains from the sale of capital assets have been excluded from the computation of DNI as they are considered related to corpus. However, final regulations Sec. 1.643(a)-3(b) provide the following guidance: capital gains can be included in DNI if, in accordance with the governing document and applicable local law, they are:

  • Allocated to income;
  • Allocated to corpus, but consistently treated as part of the distribution to the beneficiary on the trust’s books, records, and tax returns; or
  • Allocated to corpus but actually distributed to the beneficiary or used to determine the amount required to be distributed to the beneficiary.

In the above situations, capital gains can be properly used to determine DNI, and therefore, distributed to beneficiaries. This effectively reduces the taxable income to the fiduciary and the net investment income and related tax.

Passive activities. The NIIT does not apply to income from active businesses in which the owner materially participates. Under Code Section 469(h)(1), material participation is established if the taxpayer is involved in the business activity on a regular, continuous, and substantial basis. In the context of an estate or trust, written advice from the IRS indicates a trust/estate can be active in a business activity if the trustee or executor materially participates in the business activity. IRS guidance (TAM 200733023 and PLR 201029014) holds that the involvement of employees of the trust/estate rather than the activity of the trustee has proven to not be sufficient in determining material participation. Also, according to the IRS, the involvement of an employee or officer of the business activity, who is also a trustee, is not sufficient to deem the trust/estate as active in the business.

Strategies for a Trust to Minimize NIIT

Distribute income to beneficiaries who are not subject to NIIT. Although often not completely successful in eliminating the NIIT surcharge liability to a trust/estate, if the trust/estate has income that has not been distributed by year-end, a complex trust can make discretionary income distributions to reduce its net investment income. This strategy can effectively reduce the amount of income subject to NIIT as an individual’s threshold for applicability of the NIIT is much higher than a trust’s ($200,000 for single individuals and $250,000 for married couples filing jointly, compared to a $12,400 threshold for trusts/estates in 2016). A fiduciary should be careful in planning for distributions in amounts that that would not cause the beneficiary to exceed the threshold for the NIIT.

Consideration should be given to the discretionary distribution powers in the trust document. Discretionary distributions limited to the ascertainable standard (health, education, maintenance, and support) may not be sufficient to allow for distributions designed to reduce the NIIT liability of the trust/estate.
 Beneficiaries subject to the “kiddie tax” (children under 24, if full-time students with unearned income of more than $2,100 in 2016) will be taxed on certain investment income at their parents’ marginal rates. However, income allocated to beneficiaries who are subject to the kiddie tax may avoid the 3.8 percent surcharge if their income is less than the $200,000 threshold.

Distribution planning can expand to 65 days after the end of the trust’s year pursuant to Code Section 663(b). This allows the fiduciary additional time after the end of the year to make distributions of income, which could reduce the NIIT within the trust.

Invest in tax-exempt income. Income exempt from regular federal taxation also avoids the NIIT computation. Examples of tax-exempt income include investments in state and local bonds or mutual funds that invest in such obligations, the build-up of value inside a life insurance policy, or deferral of capital gain income from the sale of eligible property with the use of a like-kind exchange when there are passive activities subject to the NIIT.

Allocation of indirect expenses to undistributed income retained by the trust/estate. Reg. §1.652(b)-3 provides that indirect deductions such as fiduciary, legal fees, and accounting fees can be allocated to any item of income as long as a portion is allocated to tax-exempt income. The allocation can be made in any manner, including allocating against capital gain income taxable to the fiduciary. If, for example, all indirect deductions were allocated to capital gain income rather than to income distributed to beneficiaries, the trust could reduce the 3.8 percent NIIT within the trust. If the beneficiaries were under the applicable threshold limit, they too would avoid any NIIT on the trust’s investment income.

If assets include holdings of interests of operating businesses, choose a fiduciary active in the business. Business income in which the trust/estate is actively involved is not net investment income and therefore not subject to the 3.8 percent tax. Guidance involving material participation in business activities has provided a fairly narrow set of circumstances in which a trust can be considered active in business activities. If a large portion of a trust or estate’s income is from business entities, choosing a trustee who is active in that trade or business can help reduce the NIIT to the trust.


The NIIT has increased the effective tax rate on trusts significantly since its onset in 2013, although, there are some techniques to help combat the increased tax. Non-tax factors should also be considered when employing any of the techniques discussed here, especially with distribution planning. The funds were put into trust for a reason, such as the financial maturity of the beneficiary, future inclusion in a taxable estate, creditor protection, and protection from potential loss due to a beneficiary’s divorce. Taxation on the trust forces the trust to operate at a disadvantage, so careful consideration should be given to the tax and non-tax planning for trusts and for the funding of assets into trusts. 

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