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A Rude Awakening

A Rude Awakening

Planning in 2014 is needed to avoid the significant impact the net investment income rules will have on clients’ pockets

For the first time in 12 years, the uncertainty of estate, gift and income tax legislation is behind us.  Certainty, however, doesn’t always equate to positive change, at least in the eyes of the wealthy.  Although tax reform changes over the last decade can be analogized to the proverbial rollercoaster, the downward part of the income tax ride may be less exhilarating than the long awaited permanent changes to the estate and gift tax exemptions that the wealthy will now have at their disposal.


The Net Investment Income Tax

Although, to date, focus has primarily been on estate and income tax rates, many wealthy clients are in for a rude awakening at tax time as a result of the application of the net investment income (NII) tax enacted as part of the Health Care and Education Reconciliation Act of 2010.1 For tax years beginning after Dec. 31, 2012, certain income of estates, trusts and individuals is subject to a 3.8 percent surtax (sometimes called the “unearned income Medicare contribution tax” or simply the “Medicare Tax”).2 Individual taxpayers will be subject to the surtax if they have NII and modified adjusted gross income (AGI): (1) over $125,000 for married taxpayers filing separately; (2i) over $250,000 for married taxpayers filing jointly and qualified widowers; and (3) over $200,000 for single taxpayers and those filing as head-of-household.3

Wealthy taxpayers who’ve done estate planning by transferring assets to trusts for the benefit of their descendants will feel additional pain when they see a greater reduction in trust value because of the application of the NII surtax to such trusts.  This is because the NII surtax applies to income and capital gains generated by passive investment activities such as dividends, interest income, capital gains, rental and royalty payments, non-qualified annuities, income from businesses that trade financial instruments and commodities, which are considered passive activities.4 This additional 3.8 percent increase to the already higher trust income tax rates (highest rate applies at trust level to AGI beginning at $12,150 in 2014) will apply to the lesser of (1) the estate’s or trust’s undistributed NII and or (2) the excess of AGI at which the highest income tax bracket applicable to a trust begins ($11,950 in 2013 and $12,150 in 2014).5 These same rules apply to estates of decedents filing tax returns for 2013 forward.6 Certain trusts, such as charitable trusts and business trusts, are subject to special rules.7

Clients will also experience a more direct hit by the NII surtax if they’ve established a grantor trust, as the trust’s income (along with deductions and credits) will pass through to the client’s individual income tax return and be included in calculating the client’s individual NII.8

Planning for 2013 is behind us and 2014 is already upon us.  Missed opportunities to reduce the effects of the NII surtax in 2013 will be forgiven, but planning in 2014 is required to avoid the significant impact that the NII surtax regulations will have on the clients’ pockets. 


Planning Opportunities

Clients should consider the following planning opportunities:

  1. Estimate potential NII for all grantor trusts and determine whether any of those items of income wouldn’t be considered NII in the hands of the grantor, such as a business in which the grantor is actively involved.  If so, consider whether to trigger the grantor trust power of substitution (if the trust so provides) to transfer these assets tax-free to the grantor.
  2. Trustees should consider shifting income to beneficiaries whose AGI are below the threshold amount at which the NII surtax applies.9
  3. Match gains with losses and determine how to best structure deductions.10
  4. Determine whether clients’ participation in a trade or business is sufficient to be considered active or whether it’s possible for clients to regroup their passive activities in a way that will establish material participation in a trade or business.11
  5. Consider swapping or buying back low basis assets from grantor trusts to preserve step-up in basis at death.12
  6. Consider investing in tax-exempt or tax-deferred investments, such as municipal bonds or life insurance and retirement and annuity vehicles.13
  7. Consider the use of Internal Revenue Code Section 2503(c) trusts and Crummy trusts for beneficiaries under age 14, as they will be considered separate taxpayers for calculation of NII surtax purposes and aren’t subject to the “kiddie tax.”14



The American Taxpayer Relief Act of 2012 (the Act) made permanent the concept of portability of a deceased spouse’s federal estate (but not generation-skipping transfer (GST)) tax exemption for the surviving spouse to utilize such exemption at his death.15  Although portability applies to those estates when the first spouse to die has insufficient assets to fund his federal estate tax exemption, portability also provides a planning opportunity for funded estates with significant built-in capital gains.  This translates into planning opportunities based on a comparison of estate tax savings resulting from funding at the first death versus capital gains tax savings utilizing portability because of the then available step-up in basis at the second death.  Any analysis of the benefits of portability must consider the unavailability of the GST exemption, as the deceased spouse’s GST exemption doesn’t carry forward to the surviving spouse.16


Pease Limitation

High income taxpayers will also be subject to new limitations on deductions against income tax.  The Pease Limitation will cause deductions for mortgage interest, property taxes, state and local taxes and charitable contributions to be reduced by the lesser of 3 percent of the excess of AGI over a threshold amount (indexed for inflation) or 80 percent of the client’s itemized deductions.17 The PEP Limitation will impact those same taxpayers by reducing personal and dependency exemptions by 2 percent for each time AGI exceeds the threshold by $2,500.18


State Income Tax

Finally, it should be noted that wealthy taxpayers living in states with a state income tax such as Connecticut, Delaware, Illinois, New Jersey, New York and Pennsylvania, will feel an even greater chill at tax time than that caused by the recent cold spell up north and may wish to change their state of domicile to an income tax-free state.



1. Pub.L. 111-152.

2. Ibid., Internal Revenue Code Section 1411.  The Internal Revenue Service issued Final Regulations under Section 1411 on Nov. 26, 2013.  TD 9645.

3. Ibid.

4. Ibid.

5. Ibid.

6. Ibid.; Treasury Regulations Section 1411-3.

7. Ibid.

8. Treas. Regs. Section 1.1411-3.

9. See David M, Allen, Allen M. Berry and Victor H. Bezman, “2013 Year-End Estate Planning Advisory,” National Law Review (Nov. 28, 2013) (

10. See Charles Fox, IV, Ronald D. Aucutt, Dennis I. Belcher, W. Birch Douglass, III and Michael Barker, “United States: The 3.8 Percent Net Investment Income Tax Final Regulations,” Mondaq Business Briefing (Dec. 9, 2013) (

11. See Mark Nash, Allison Shippley and Denise Dockrey, “Help Reduce Your Client’s Net Investment Income Tax Liability,” Trusts & Estates (Dec. 13, 2013) (

12. See Allen, Berry and Bezman, “2013 Year-End Estate Planning Advisory,” n. 12.

13. See  Edwin Morrow III, “Avoid the 3.8 Percent Medicare Surtax,” Trusts & Estates (Dec. 7, 2012) (  Other recommended strategies include “[u]sing traditional techniques to defer recognition/timing of gains, like tax-free exchanges, installment sales or charitable remainder trusts,” “[i]nvesting in assets with tax depreciation features, such as traditional real estate or oil and gas investments” and “[pa]ying more sensitive attention to tax recognition by using low turnover mutual funds, exchange-traded funds or even better, managing individual stocks and bonds.”  Ibid.

14. See Allen, Berry and Bezman, “2013 Year-End Estate Planning Advisory,” n. 12.

15. Pub.L. 112–240.

16. Internal Revenue Code Section 2010(c)(4) (allowing a surviving spouse to use the “deceased spousal unused exclusion amount” but not allowing a surviving spouse to use the unused generation-skipping transfer exemption of a predeceased spouse); Joint Comm Staff, Tech Expln of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (JCX-55-10), Dec. 10. 2010, p. 52.

17. IRC Section 68.

18. IRC Section 151(d)(3).










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