Explained here are the provisions dealing—directly or indirectly—with charitable remainder trusts, charitable gift annuities, pooled income funds and charitable lead trusts. Warning: Rough going!
First Some Background
The 3.8 Percent Medicare Surtax for individuals. Starting in 2013, in addition to any other tax, a 3.8 percent tax is imposed on the lesser of: (A) the individual’s net investment income for the taxable year, or (B) the excess (if any) of: (i) the individual’s modified adjusted gross income (AGI) for the taxable year, over (ii) the threshold amount. The threshold amount(s) are: (1) for a taxpayer filing a joint return or as a surviving spouse, $250,000; (2) for a married taxpayer filing a separate return, $125,000; and (3) in any other case, $200,000. For most taxpayers, modified AGI istheir AGI. “Modified” applies only to taxpayers living abroad and using the foreign earned income exclusion. Note. The dollar thresholds for individuals are established by statute and aren't indexed for inflation.
What is net investment income? Simply stated (ifs, ands and buts abound), it's gross income from interest, dividends, annuities, rents and net capital gains. Excluded from net investment income are items, such as tax-exempt bond interest, excludable gain on the sale of a principal residence and qualified retirement plan distributions.
For estates or trusts. A tax (in addition to any other tax) for each taxable year, starting in 2013, is imposed equal to 3.8 percent of the lesser of: (A) the estate’s or trust’s undistributed net investment income, or (B) the excess (if any) of: (i) the estate’s or trust’s AGI for the taxable year, over (ii) the dollar amount at which the highest tax bracket in IRC Section 1(e) begins for the taxable year. Translation. That threshold amount for 2013 is $11,950, and for 2014, it's $12,150 (indexed for inflation in future years).
Now for the Regulations
CHARITABLE REMAINDER TRUSTS
Bear with me. I’ll first tell you about the proposed regulations, before telling about the final regulations. Read on and you’ll see why both are important.
The proposed regulations provided special computational rules for the classification of the income of and the distributions from charitable remainder trusts (CRTS), solely for IRC Section §1411 purposes. Proposed Reg. Section 1.1411-3(c)(2)(i) provided that distributions from a CRT to a beneficiary for a taxable year consist of net investment income in an amount equal to the lesser of the total amount of the distributions for that year or the current and accumulated net investment income of the CRT. Proposed Reg. Section 1.1411-3(c)(2)(iii) defined the term accumulated net investment income (ANII) as the total amount of net investment income received by a CRT for all taxable years beginning after Dec. 31, 2012, less the total amount of net investment income distributed for all prior taxable years beginning after Dec. 31, 2012.
The Treasury acknowledged in the preamble to the proposed regulations that the classification of income as net investment income or non-net investment income would be separate from, and in addition to, the four tiers under IRC Section 664(b), which would continue to apply. The Treasury also stated in the preamble that it considered an alternative method for determining the distributed amount of net investment income under which net investment income would be determined on a class-by-class basis within each of the Reg. Section 1.664-1(d)(1) enumerated categories. The Treasury acknowledged that, although differentiating between net investment income and non-net investment income within each class and category might be more consistent with the structure created for CRTs by IRC Section 664 and its regulations, the Treasury was concerned that the apparent record-keeping and compliance burdens on trustees would outweigh the benefits of this alternative.
Multiple commentators asked that the final regulations follow the existing rules under IRC Section 664 that create subclasses in each category of income as the tax rates on certain types of income are changed from time to time. They said that CRT trustees are already maintaining the appropriate records and are familiar with the existing rules, so compliance would be less complicated than under the new system described in the proposed regulations. Some of the commentators suggested that the final regulations allow the trustee to elect between the method described in the proposed regulations and the existing rules under IRC Section 664.
The final regulations (IRC Section 1.1411-3(d)(2)) adopt the commentators' request to categorize and distribute net investment income based on the existing IRC Section 664 category and class system.
The provisions of Reg. Section 1.1411-3(d)(2) (discussed in the preamble to the proposed regulations) will apply to CRT taxable years that begin after Dec. 31, 2012, provided, however, that, for CRTs that relied on the proposed regulations for returns filed before the publication of the final regulations in the Federal Register on Dec. 2, 2013, the CRT and its beneficiary (as applicable) don't have to amend their returns to comply with rules in the final regulations. For such a CRT, when transitioning from the method in the proposed regulations to the method in the final regulations, the CRT may use any reasonable method to allocate the remaining undistributed net investment income for that year to the categories and classes under IRC Section 664.
The final regulations retain the concept of ANII. ANII is the total amount of net investment income received by a charitable remainder trust for all taxable years beginning after Dec. 31, 2012, less the total amount of net investment income distributed for all prior taxable years beginning after Dec. 31, 2012. The final regulations apply the IRC Section 664 category and class system to ANII by providing that the federal income tax rate applicable to an item of ANII, for purposes of allocating that item of ANII to the appropriate class within a category of income, as described in Reg. Section 1.664-1(d)(1), is the sum of the income tax rate imposed on that item under chapter 1 and the rate of the tax imposed under IRC Section 1411. Thus, if a charitable remainder trust has both excluded income (such as income received by the trust prior to Jan. 1, 2013, or other income received after Dec. 31, 2012 but excluded from net investment income) and ANII in an income category, such excluded income and ANII will constitute separate classes of income for purposes of Reg. Section 1.664-1(d)(1)(i)(b).
The Treasury says that special rules are necessary to apply the IRC Section 664 category and class system contained in Reg. Section 1.664-1(d) to certain distributions made to CRTs that own interests in controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs) not making the Reg. Section 1.1411-10(g) election to account for the difference between the income inclusion for chapter 1 and for IRC Section 1411 purposes.Accordingly, the final regulations reserve paragraph Reg. Section 1.1411-3(d)(2)(ii) for special rules in this case. The companion notice of proposed rule-making (REG-130843-13) contains special rules relating to CFCs and PFICs and is proposed to be effective for tax years beginning after Dec. 31, 2013.
The final regulations reserve Reg. Section 1.1411-3(d)(3) for rules allowing a CRT to elect between the simplified method contained in the proposed regulations and the IRC Section 664 method contained in the final regulations.The companion notice of proposed rule-making (REG-130843-13) provides rules to enable a CRT to choose between the simplified method described in the proposed regulations (with the modification noted in the companion notice) and the existing rules under Section 664. The rules contained in the companion proposed regulation are proposed to be effective for taxable years beginning after Dec. 31, 2012. Prop. Reg. Section 1.1411-3(d)(3)(i).
In the case of a CRT established after Dec. 31, 2012, the CRT’s election must be made on its income tax return for the taxable year in which the CRT is established. In the case of a CRT established before Jan. 1, 2013, the CRT’s election must be made on its income tax return for its first taxable year beginning on or after Jan. 1, 2013. The CRT may make the election on an amended return for that year only if neither the taxable year for which the election is made, nor any taxable year that is affected by the election, for both the CRT and its beneficiaries, is closed by the period of limitations on assessments under IRC Section 6501.
Once made, the election is irrevocable. Prop. Reg. Section 1.1411-3(d)(3)(iii).
What you have read so far is from the preamble to the final regulations. And now, with no fanfare, here are the final regulations:
(d) Application to charitable remainder trusts (CRTs)—(1) Operational rules—(i) Treatment of annuity or unitrust distributions. If one or more items of net investment income comprise all or part of an annuity or unitrust distribution from a CRT, such items retain their character as net investment income in the hands of the recipient of that annuity or unitrust distribution.
(ii) Apportionment among multiple beneficiaries. In the case of a CRT with more than one annuity or unitrust beneficiary, the net investment income is apportioned among such beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the CRT for that taxable year.
(iii) Accumulated net investment income. The accumulated net investment income of a CRT is the total amount of net investment income received by a CRT for all taxable years that begin after December 31, 2012, less the total amount of net investment income distributed for all prior taxable years of the trust that begin after December 31, 2012.
(2) Application of Section 664—(i) General rule. The Federal income tax rate of the item of net investment income, to be used to determine the proper classification of that item within the appropriate income category as described in §1.664–1(d)(1)(i)(b), is the sum of the income tax rate applicable to that item under chapter 1 and the tax rate under section 1411. Thus, the accumulated net investment income and excluded income (as defined in §1.1411–1(d)(4)) of a CRT in the same income category constitute separate classes of income within that category as described in §1.664–1(d)(1)(i)(b).
(ii) Special rules for CRTs with income from CFCs or PFICs. [Reserved]
(iii) Examples. The following examples illustrate the provisions of this paragraph (d)(2).
Example 1. (i) In 2009, A formed CRT as a charitable remainder annuity trust. The trust document requires an annual annuity payment of $50,000 to A for 15 years. For purposes of this example, assume that CRT is a valid charitable remainder trust under section 664 and has not received any unrelated business taxable income during any taxable year.
(ii) As of January 1, 2013, CRT has the following items of undistributed income within its §1.664–1(d)(1) categories and classes:
Pursuant to §1.1411–3(d)(1)(iii), none of the $624,000 of undistributed income is accumulated net investment income (ANII) because none of it was received by CRT after December 31, 2012. Thus, the entire $624,000 of undistributed income is excluded income (as defined in §1.1411–1(d)(4)).
(iii) During 2013, CRT receives $7,000 of interest income, $9,000 of qualified dividend income, $4,000 of short-term capital gain, and $11,000 of long-term capital gain. Prior to the 2013 distribution of $50,000 to A, CRT has the following items of undistributed income within its §1.664–1(d)(1) categories and classes after the application of paragraph (d)(2) of this section:
(iv) The $50,000 distribution to A for 2013 will include the following amounts:
The amount included in A’s 2013 net investment income is $20,000. This amount is comprised of $7,000 of interest income, $9,000 of qualified dividend income, and $4,000 of short-term capital gain.
(v) As a result, as of January 1, 2014, CRT has the following items of undistributed income within its §1.664–1(d)(1) categories and classes:
Keep in mind: Charitable remainder unitrusts and charitable remainder annuity trusts aren’t subject to the 3.8 percent Medicare surtax (IRC Section 1411). However, annuity and unitrust distributions may be net investment income to non-charitable recipient beneficiaries and that tax will apply to beneficiaries who have significant income.
CHARITABLE GIFT ANNUITIES
Here’s what you need to know. Earnings of funds held by charities for their gift annuity programs aren’t taxable, unless the charity runs afoul of the rules under IRC Sections 514(c)(5) and 501(m). But, annuity payments (other than the excludable amount—the deemed return of principal) are net investment income to the annuitant. And, any capital gain triggered by the transfer of appreciated assets for the gift annuity (under the bargain sale rules) is net investment income to the donor (who may or may not be an annuitant).
For those who want to know how jazz came up the Mississippi. One commentator requested that the final regulations clarify that net investment income from charitable gift annuities established post-2012 will be spread over the annuitant's life expectancy, similar to other items of income under Section 1.1011-2(c), Example 8. The commentator also requested that the final regulations clarify that the income recognized and distributed from charitable gift annuities established prior to 2013 isn't subject to the net investment income tax. The commentator asked that the final regulation extend the benefit afforded to CRTs regarding pre-2013 gifts to pre-2013 funded charitable gift annuities as well.
Treasury’s response. Charitable gift annuities, like installment sales and other tax deferral transactions, defer the recognition of income to a future year. Charitable gift annuities share more characteristics with installment sales than with CRTs. In the case of installment sales, amounts received in taxable years beginning after Dec. 31, 2012, on installment sales made prior to the effective date of section 1411 are included in net investment income, unless an exception applies. See Section 1.1411-4(d)(4)(i)(C), Example 2. A CRT, as defined in Section 664, must provide for the distribution of a specified payment, at least annually, to one or more persons (at least one of which is a non-charitable beneficiary). On the termination of the non-charitable interest or interests, the remainder must either be held in continuing trust for charitable purposes or be paid to or for the use of one or more organizations described in Section 170(c). During its operation, a CRT is a tax-exempt entity. Unlike charitable gift annuities, the federal income tax character of the income received by a CRT's annuity or unitrust beneficiary is dependent on the federal income tax character of the income received by the CRT in the year of distribution and, in many cases, income received in year(s) prior to the distribution. In the case of charitable gift annuities, the amount and character of the income paid to the annuity recipient generally is known at the inception of the annuity. Furthermore, the amount and character of the income paid to the annuity recipient is not dependent on the charity's use (or sale) of the property exchanged for the annuity. The Section 1411 policy reason behind the exclusion of pre-2013 accumulated income within a CRT from net investment income is that the character is passed through from the CRT to the recipient, and pre-2013 income isn't net investment income. Because the character of the distribution to the recipient of a charitable gift annuity is not dependent on its character in the hands of the payor, the final regulations don't adopt the requested change.
POOLED INCOME FUNDS
Here’s what you need to know:
Income earned by pooled income funds. A pooled income fund distributes all its income to the fund’s income beneficiaries. Thus, that income doesn’t subject the fund itself to the 3.8 percent tax. High income beneficiaries may be subject to the 3.8 percent tax under the rules on an individual’s net investment income discussed earlier.
Pooled income fund’s capital gains. They are never paid to the beneficiaries. So, the beneficiaries aren’t potentially subject to the 3.8 percent tax on capital gains.
Pooled income fund’s long-term capital gains. Those capital gains aren’t taxable to a pooled income fund under the “regular” income tax rules. And, they're permanently set aside for charity so they shouldn’t be subject to any type of federal tax to any one in sight.
Pooled income fund’s short-term capital gains. These gains are taxable to the fund under the “regular” income tax rules. And, the short-term gains over $11,950 for 2013 ($12,150 for 2014, indexed for inflation) are subject to the 3.8 percent tax. Note. Short-term capital gains, as well as long-term capital gains, are added to the fund’s principal for ultimate distribution to the charitable remainder organization.
More how jazz came up the Mississippi. Commentators on the proposed regulations recommended that the final regulations provide that Section 1411 not apply to PIFs because doing so would be tantamount to taxing a charity that, ultimately, receives the property after the expiration of the income interest. Specifically, only the PIF's undistributed short-term gains are subject to tax under chapter 1, and those gains are held for ultimate distribution to charity. The commentators stated that the provisions of the Code dealing with charitable organizations, and contributions to them, should be broadly construed in favor of charitable organizations and their donors; thus, Section 1411 shouldn't apply to PIFs. Furthermore, one commentator stated that treating PIFs in a manner significantly different from CRTs is inequitable. The commentator analogized PIFs, operationally, to CRTs. However, the commentator acknowledged that, unlike CRTs, PIFs, by being taxable on undistributed short-term capital gains, don't escape all instances of federal income taxation. The commentators recommended that the final regulations either: (1) provide that a PIF's short-term capital gains be excluded from net investment income, or (2) exclude PIFs from the application of Section 1411 altogether.
The final regulations don't adopt these suggestions. The Treasury recognized that imposing tax on the PIF would reduce the amount of property the charitable remainderman will receive after the expiration of the income interest. However, Section 1411 limits its exclusion to wholly charitable trusts; this group of trusts doesn't include either CRTs or PIFs. While CRTs are excluded from Section 1411 by the express language of Section 664, there's no comparable provision excluding PIFs.
Historical note. To begin with, why are short-term capital gains of pooled income funds taxable? A long, long time ago (1969), in far-out legislative deliberations, Congress was drafting language specifying the requirements for charitable pooled income funds. Some drafters said that those arrangements smelled like mutual funds and should be taxable on all capital gains. Others argued that all capital gains on termination of life interests go to the charity; therefore, they shouldn’t be taxable. "Come on guys," said one of them, "let’s compromise." Thus, it came to pass that short-term capital gains, but not long-term capital gains, are taxable to pooled income funds.
NON-GRANTOR CHARITABLE LEAD TRUSTS
Although not specifically identified, those trusts are subject to the 3.8 percent tax on any net investment income that isn’t distributed to the charitable lead beneficiaries. And remember the low $11,950 threshold for 2013; $12,150 for 2014 (indexed for inflation).
GRANTOR CHARITABLE LEAD TRUSTS
The donor to a grantor trust is taxable on trust income and capital gains, even though paid to the charity. The charitable lead trust itself isn’t subject to the 3.8 percent tax, but a donor will be subject to that tax on any trust net investment income—together with other net investment income—that exceeds the applicable net-investment-income threshold.
ADDITIONAL 0.9 PERCENT MEDICARE TAX
Alert: An individual is liable for the new additional 0.9 percent Medicare tax if his or her wages, compensation or self-employment income exceed the threshold amount for the individual’s filing status.
Filing Status Threshold Amount
Married filing jointly $250,000
Married filing separately $125,000
Single $200,000
Head of household (with qualifying person) $200,000
Qualifying widow(er) with dependent child $200,000
Effective. Jan. 1, 2013. The dollar thresholds are established by statute and aren't indexed for inflation.
Additional Medicare tax is not due on all wages, compensation, etc., but just on the wages, compensation, etc. above the threshold for the individual’s filing status
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Wages that aren't paid in cash, such as fringe benefits, are subject to the 0.9 percent additional Medicare tax.
Reminder. The new 3.8 percent tax imposed on an individual’s net investment income (discussed earlier) isn't applicable to FICA wages or self-employment income.
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