On Dec. 2, the Treasury Department issued final regulations addressing the 3.8% net investment income tax under Sec. 1411 (T.D. 9644). Regs. Sec. 1.1411-3 addresses estates and trusts, including charitable remainder trusts (CRTs). The final regulations include an additional accounting method to tax CRT distributions.
Distributions of income from a CRT to beneficiaries are generally
taxable to the beneficiaries. The character of distributions from a
CRT to beneficiaries is determined under Sec. 664(b), which classifies
CRT income into four tiers. Tier 1 represents ordinary income, while
tier 2 represents capital gains. (To make matters more complex, tiers
1 and 2 actually have subclasses, but that is beyond the scope of this
discussion). The new method builds on the regular distribution method
of Sec. 664 by adding an intermediate layer to each class of income:
income to which the net investment income tax applies. Retained net
investment income is called accumulated net investment
The immediate planning opportunity for CRTs is to harvest short-term and long-term capital losses. Here is how it works and what changed from earlier years. In the past, harvesting long-term capital losses was a nullity; the losses reduced tier 2 gains and rarely had any impact on the Sec. 664 (Schedule K-1) distribution to the beneficiary. However, everything changed with the advent of the net investment income tax. Under current law, the distribution of 2013 and later capital gains will carry out accumulated net investment income, while the distributions of pre-2013 gains will not carry out accumulated net investment income. Hence, the key is to somehow reduce 2013 gains, thereby shrinking the 2013 net investment income portion of tier 2 gains and allowing distributions to flow from the pre-2013 accumulated gains. By harvesting losses in 2013, taxpayers can reduce accumulated net investment income.
Example: R’s CRT was created in 2000 and has no tier 1 accumulation and a $2,500,000 pre-2013 tier 2 long-term capital gain accumulation. In 2013, the trust earns $20,000 of interest (i.e., tier 1 income) and $250,000 of long-term capital gains (i.e., tier 2 gains). In 2013, R’s CRT distribution is $300,000. Assume R is already over the net investment income tax threshold for his filing status.
Under the net investment income tax regulations, $20,000 of tier 1 income and $280,000 of tier 2 gains will be reported to R on a Schedule K-1. Of this amount, $270,000 (i.e., $20,000 interest plus $250,000 of 2013 long-term capital gain) will be subject to the net investment income tax, resulting in a net investment income tax of $10,260 ($270,000 × 3.8%).
In the alternative, if the trustee were able to harvest long-term capital losses in 2013, those realized losses would reduce the $250,000 of accumulated net investment income from the 2013 gain realized. Now, for each dollar of 2013 long-term capital loss harvested, a dollar of the tier 2 distributions will be distributed from pre-2013 capital gains and not subject to the net investment income tax.
— Robert Keebler, CPA, MST, AEP, email@example.com ) is a partner with Keebler & Associates LLP in Green Bay, Wis. Ted Batson, CPA, MBA, CFP, ( firstname.lastname@example.org ) is an executive vice president with Renaissance in Indianapolis.