AVOIDING NII TAX FOR HIGH NET WORTH INDIVIDUALS

AVOIDING NII TAX FOR HIGH NET WORTH INDIVIDUALS Fort Worth CPA 2015 Tax Institute August 7, 2015 Marvin E. Blum, J. D. , C. P. A. THE BLUM FIRM, P. C. 777 Main Street, Suite 700 Fort Worth, Texas 76102 Tel. : (817) 334 -0066 www. theblumfirm. com Materials co-authored by Marvin E. Blum, John R. Hunter, and Emily K. Seawright © The Blum Firm, P. C. All Rights Reserved

Beginning with 2013, Section 1411 of the Internal Revenue Code imposes a 3. 8% tax on the net investment income (“NII”) of individuals, trusts, and estates that have income in excess of set thresholds. We’re all asked by our clients if there are strategies available to avoid paying the 3. 8% tax on net investment income. INDIVIDUALS Individuals pay the 3. 8% tax on the lesser of: – The taxpayer’s NII for the year; and – The amount by which the taxpayer’s modified adjusted gross income for the year exceeds the threshold amount. The threshold amounts are $200, 000 for a single taxpayer and $250, 000 for a married couple filing jointly and do not adjust for inflation. 1

IRC Section 1411 has its own definition of modified adjusted gross income (“MAGI”). For purposes of net investment income, MAGI is calculated by taking the individual’s adjusted gross income and adding back any foreign earned income. NII tax is 3. 8% tax on the lesser of: – the amount of NII; and – the amount of MAGI over the $200, 000/$250, 000 threshold. There are just two ways to reduce the NII tax: 1) reduce the amount of NII; or 2) Reduce the MAGI. First, we’ll look at ways to reduce the MAGI. 2

Ø MAXIMIZE CONTRIBUTIONS TO YOUR RETIREMENT PLANS Maximize deductible contributions to tax-favored retirement accounts such as 401(k) accounts, self-employment SEP accounts, and selfemployed defined benefit plans to reduce your MAGI. Ø ROTH CONVERSION PROVIDES TAX SAVINGS IN THE LONG RUN While distributions from retirement plans are not considered NII, distributions from traditional IRAs ARE included in calculating an individual's MAGI. Consider converting a traditional IRA to a Roth IRA so that future distributions from the Roth IRA will not be included in the MAGI. Of course, this may cause a big tax and a big MAGI for the one year of conversion, but MAGI will be lower in future years. To pay the tax hit, use investment assets that generate NII, if available. You’ve essentially moved the investment asset into the Roth IRA and made its income no longer subject to NII tax. 3

Ø SPREAD OUT THE GAIN If your MAGI is close to the $200, 000/$250, 000 threshold and you expect a large gain next year, consider recognizing part of the gain this year to avoid exceeding the threshold next year. For example, you plan to sell appreciated stock next year to pay for a house remodel and expect a $20, 000 capital gain. Recognize as much of the gain as possible this year while staying under the threshold. The capital gain would of course be subject to LTCG tax, but would not also be subject to NII tax. 4

Ø INSTALLMENT SALE Another way to spread out gain would be to do an installment sale. The gain could be spread out over years allowing your MAGI to stay under the threshold. Ø SECTION 1031 EXCHANGE Another way to spread out the gain—actually, postpone the gain—is to do a Section 1031 like-kind exchange. A taxpayer looking to sell an asset with a low basis could exchange it for a like-kind asset and avoid receiving the gain and having to pay NII tax on it. 5

Ø UTILIZE A CHARITABLE LEAD TRUST An individual gets no charitable deduction in computing his MAGI, but a trust does. So if you give a certain amount to charity each year and you can afford to commit a batch of assets to a trust to cover the next 10 or so years of charitable contributions, you can save NII tax and also save income tax by utilizing a Charitable Lead Trust. Furthermore, there are no Pease limitations. A Charitable Lead Trust (a “CLT”) is a trust that makes an annual payout to a charity for a fixed term of years, and, at the end of the term, the trust assets return to the donor or pass to the donor’s family. This technique is especially beneficial when you want the asset to remain in the family but do not need the income generated by it. 6

Example: Assume Husband Wife have income that is high enough so they can only deduct 20% of their itemized deductions, mineral royalty income of $100, 000 per year, and they give $100, 000 per year to their favorite charities. Without a CLT Royalty Income Less: Charitable Deduction (80% cutback) Taxable Income Tax NII Tax ($100, 000 x 3. 8%) Total Tax With a Non-grantor CLT $100, 000 Royalty Income $100, 000 Less: Charitable Deduction (100, 000) (20, 000) Taxable Income 0 80, 000 x 39. 6% Income Tax 0 31, 680 NII Tax 0 3, 800 Total Tax $0 $35, 480 Tax Savings of $35, 480 per year. 7

Ø UTILIZE A CHARITABLE REMAINDER TRUST Prior to selling an asset, consider contributing it to a Charitable Remainder Trust (“CRT”) and then having the CRT sell the asset. The CRT makes annual distributions to the creator for a term of years or for life, with the remainder passing to charity. When the CRT sells an asset, there is no income tax at that time. The gain passes out to the creator as the CRT makes distributions. Since the gain dribbles out each year, the creator prevents a spike in income and diminishes his MAGI. CRT distributions carry out income on a Worst-In-First-Out (“WIFO”) basis. The order in which the income was earned is irrelevant. If a CRT has pre-2013 ordinary investment income (39. 6% rate), post-2012 ordinary investment income (43. 4% rate), pre-2013 LTCG (20% rate), and post-2012 LTCG (23. 8% rate), the CRT carries out income to the creator on a WIFO basis in the following order: 1 st 2 nd 3 rd 4 th 43. 4% ordinary income 39. 6% ordinary income 23. 8% LTCG 20% LTCG 8

If you can’t reduce MAGI, reduce the amount of NII. What is NII? NII is broken down into 3 categories: 1) The “Forbidden Five: ” Gross income from interest, dividends, annuities, royalties, and rents, unless the income was derived in the ordinary course of an active trade or business. 2) Passive business income: Income derived from a passive trade or business. 3) Passive gain: Net gain from the disposition of property that is held in a passive trade or business. Exceptions: -Non-passive trade or business income. -Distributions from IRAs and qualified plans. -Tax-exempt income and tax-exempt annuities. -Income subject to self-employment tax. 9

Let’s go back to the definition of NII and look at that second category — passive business income. Income from a passive trade or business is considered NII. How do we get around this? If the taxpayer materially participates in the trade or business, the first exception—non-passive income—is met and the income is not subject to NII tax. Note: There is a special rule for oil and gas working interests. Oil and gas working interests are automatically non-passive only if the liability is not limited and has not been limited in the past. If liability is or has been limited, then the material participation test applies to determine if the working interests are passive or non-passive. How do we meet the material participation requirement? 10

For individuals, you must satisfy 1 of 7 tests: 1) Participate more than 500 hours per year. 2) Participation is substantially all of the activity of all individuals. 3) Participate more than 100 hours per year, and no other individual participates more. 4) Activity is a significant participation activity, and individual's aggregate participation in all significant participation activities exceeds 500 hours in a year. 5) Individual materially participated in the activity for 5 of past 10 taxable years. 6) Activity is a personal service activity, and the individual materially participated in the activity for any 3 preceding taxable years. 7) Based on all facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during the year. 11

SPECIAL RULES FOR SELF-CHARGED RENT AND SELF-CHARGED INTEREST Self-charged Rent Although self-charged rent is treated as “not derived from a passive activity” for purposes of the passive loss rules, proposed Section 1411 regulations did not specify whether or not it would therefore be deemed as “derived from the ordinary course of a trade or business” and not included in NII. If you’re not in the real estate business, you couldn’t meet the requirement that it be “derived in the ordinary course of a trade or business. ” This meant that if you segregated your real estate into a separate entity for asset protection purposes and paid rent from your operating company to your real estate entity, the concern was that the income could be considered NII. However, Treasury Regulations Section 1. 411 -4(g)(6) clarified that self -charged rent from an operating company in which you materially participate is removed from your NII. 12

IF (i) your income from your operating company is subject to selfemployment tax, (ii) your operating company pays rent to your real estate entity, and (iii) your rental income from your real estate entity is not subject to the NII tax, THEN consider increasing the rent to the high end of the range of reasonable market rent. You will reduce the operating company’s income (and thereby reduce your self-employment tax), but the corresponding increase in your real estate entity is not subject to NII tax or self-employment tax. 13

Self-charged Interest Treasury Regulations Section 1. 1411 -4(g)(5) provides that certain interest income you are indirectly paying yourself is not considered NII. If you’ve loaned money to a non-passive activity (a business in which you are an owner), your interest income on the loan is considered derived in the ordinary course of a trade or business and is excluded from your NII to the extent of your share of deductions for interest expense paid by the business. In other words, if you own 100% of the business, you exclude 100% of the interest income from your NII. If you own 75% of the business, then 75% of the interest income is excluded from your NII. 14

SPECIAL RULES FOR SIGNIFICANT PARTICIPATION ACTIVITIES A “significant participation activity” is a trade or business in which you participate for more than 100 hours in the year but less than 500 hours. The first thing you need to know about significant participation activities is that they provide an avenue for meeting the material participation requirement. Let’s look back at one of the seven material participation tests for individuals. Test #4: Activity is a significant participation activity and individual’s aggregate participation in all significant participation activities exceeds 500 hours in a year. Assume you have 3 significant participation activities—activities in which you participate 101 -500 hours a year in each. Activity 1 175 hours per year Activity 2 200 hours per year Activity 3 150 hours per year 525 Together, you meet the material participation requirement for all 3 significant participation activities. All income and losses are non-passive. 15

The second opportunity with significant participation activities involves a special rule called Recharacterization of Income. The passive loss rules include a special rule for significant participation activities which recharacterizes income from a significant participation activity as “not from a passive activity. ” This rule was aimed at limiting a taxpayer’s ability to take passive losses. However, this unfavorable rule with regard to passive losses is now a favorable rule because Treasury Regulations Section 1. 1411 -5(b) clarified that this recharacterized income is not subject to NII tax. Therefore, if you participate for 101 -500 hours a year in an activity, the income is recharacterized to non-passive (so that you cannot offset passive losses against it), but it is not subject to NII tax. 16

If you have a profitable activity and aren’t able to participate over 500 hours, strive for significant participation! 500 hours a year is (approximately) 2 hours per day, Monday through Friday. 100 hours a year is (approximately) 2 hours a week—much more feasible. Material Participation (more than 500 hours) Income is non-passive; not subject to NII tax. Losses are non-passive. Significant Participation (101 -500 hours) Income is non-passive; not subject to NII tax. Losses are passive. Neither (100 hours or less) Income is passive and subject to NII tax. Losses are passive. 17

If you have more than one significant participation activity, you must combine them together and then determine what portion of each activity’s income is recharacterized as non-passive. This essentially offsets significant participation income with significant participation losses and then recharacterizes any remaining significant participation income. It prevents income from being recharacterized as non-passive until after significant participation activity losses are offset. Example: Activity 1 Income $500 Deductions ($100) Net $400 Activity 2 Income Deductions Net $1, 000 ($600) $400 Activity 3 Income Deductions Net $200 ($500) ($300) 18

To calculate what portion of each activity’s income is recharacterized to nonpassive, you multiply each activity’s net income by a fraction. The numerator is the total gross net income for all significant participation activities. For our example, it is $400 + ($300) = $500. If this number is a loss, stop here and none of the income from the significant participation activities is recharacterized to non-passive. The denominator is the total of the gain for all significant participation activities that had net gains. Activity 1 had a net gain of $400, so we include it. Activity 2 had a net gain of $400, so we include it. Activity 3 had a net loss, so we do not include it. $400 +$400 = $800 which is our denominator. Our fraction is 500/800 or 5/8. So 5/8 of each activity’s net income is recharacterized as non-passive. 19

Activity 1 had a net gain of $400 x 5/8 = $250 so $250 is recharacterized as non-passive income. The other $150 of income remains passive. Activity 2 had a net gain of $400. $250 is recharacterized as non-passive income. The other $150 of income remains passive. Activity 3 had a net loss of ($300). The entire loss remains passive. Non-passive Income Passive Loss Activity 1 $250 $150 $0 Activity 2 $250 $150 $0 Activity 3 $0 $0 ($300) Total $500 $300 ($300) $300 passive income offsets $300 passive loss, and you’re left with $500 nonpassive income. The $500 of recharacterized non-passive income escapes NII tax. 20

TRUSTS AND ESTATES Trusts and estates pay the 3. 8% tax on the lesser of: – The “undistributed net investment income” and – The adjusted gross income in excess of the highest federal tax bracket threshold for trusts and estates. This threshold, adjusted for inflation, is $12, 300 for 2015. Undistributed net investment income is the NII reduced by distributions of NII to beneficiaries and by charitable deductions. 21

Some trusts are exempt from the tax including: – Grantor trusts. – Trusts exempt from tax under IRC Section 501(c). – Charitable remainder trusts (although the trust’s distributions may be subject to the NII tax). – Trusts in which all of the unexpired interests of the trust are devoted to charitable contributions under IRC Section 170. – Most foreign trusts. Although grantor trusts are not subject to NII tax, the income passes through to the grantor’s form 1040 as if it had been earned directly by the grantor. 22

Trusts That Own Businesses For trusts that own businesses and generate income, who do you look to for determining material participation? Grantor trusts are easy because grantor trusts are essentially disregarded for purposes of NII tax. Note: Although grantor trusts are not subject to NII tax, the income passes through to the grantor’s form 1040. To avoid having grantor trust income being considered net investment income, the grantor needs to materially or significantly participate in the activity. 23

For non-grantor trusts, the answer is not so clear. The IRS and the courts take different positions on who you look to for the material participation test. The IRS takes a harsh position while the courts have been more taxpayer-friendly. – In Private Letter Ruling 201029014, the IRS ruled that material participation of a trust is determined only by the trustee’s direct involvement in the operations of the entity’s activities on a regular, continuous and substantial basis. – However, in The Mattie K. Carter Trust v. U. S. , the Texas District Court counted work done by the trustee’s employees when determining whether material participation existed. 24

– In Technical Advice Memorandum 201317010, the IRS stated that only the trustee’s direct actions as a fiduciary and not as an employee of the business should be considered in determining whether a trust materially participates in an activity. (TAM 201317010 also stated that a “special trustee” with limited authority who is activity in the business does not satisfy the material participation test. ) – However, in Frank Aragona Trust v. Commissioner, the Tax Court counted the work done by the trustee in his capacity as employee. (Also in Aragona, the material participation test was satisfied with just 3 of the 6 trustees actually involved in the business activity. ) The bottom line for non-grantor trusts is that we know that what the trustee does matters. The cleanest case is where an individual is serving as trustee (not a corporate trustee), and the individual materially participates as a trustee and not as an employee of the business. 25

Planning Tip #1 for a trust owning a business: Ø CHANGE THE TRUSTEE TO AN INDIVIDUAL WHO IS ACTIVE IN THE BUSINESS OR ADD A CO-TRUSTEE Example: Surviving wife Jane is the trustee of a non-grantor trust but does not participate in the business. Add son Andy, who is actively involved in the business operations, as co-trustee. The trust agreement will specify how trustee changes may be made. If the trust agreement does not allow appointing a new trustee or a cotrustee, court action may be needed to accomplish this. Note: Be careful if the new trustee is also a beneficiary of the trust that you don’t inadvertently cause the trust assets to be includable in the new trustee’s gross estate. 26

Planning Tip #2 for a trust owning a business: If the trust agreement permits, Ø DISTRIBUTE, SELL OR SWAP ASSETS TO GET THE BUSINESS OUT OF THE TRUST and owned by someone who materially participates. Obtain an appraisal of the business to make sure you’re not shortchanging the trust. Note: Be careful if distributing a highly-appreciating business from a trust, especially a trust that is GST-exempt. You will save NII tax, but later may pay substantial estate tax. 27

Planning Tip #3 for a trust owning a business: When the grantor of a grantor trust does not meet the material participation test but the trustee does, Ø CONVERT THE GRANTOR TRUST INTO A NON-GRANTOR TRUST Although grantor trusts are disregarded for purposes of NII tax, that income passes to the grantor and will be subject to NII. If the trustee materially participates in the business, converting the trust into a non-grantor trust shifts the material participation test to the trustee. To convert the trust, have the grantor release or “toggle off” the “defect” that causes the trust to be a grantor trust by signing a Release of Power. 28

Planning Tip #4 for a trust owning a business: If the business is owned by a non-grantor trust where the trustee does not materially participate, but the grantor can satisfy the material participation test, Ø CONVERT THE NON-GRANTOR TRUST TO A GRANTOR TRUST This would shift the material participation test from the trustee to the grantor (because grantor trusts are essentially disregarded and the income flows to the grantor). How do you do this? There are four ways: 1) Change the trustee so that the grantor is the trustee of the trust. IRC Section 674 provides that if the grantor of a trust has the power to control or direct the trust’s income or assets, then the trust is considered a grantor trust. Note: Watch out for estate tax consequences. 29

2) Lend trust funds to the grantor without adequate interest and adequate security. IRC Section 675(3) provides that the trust will be treated as a grantor trust if the loan was without adequate interest and adequate security and has not been completely repaid before the beginning of the taxable year. 3) Decant the trust. Decanting is essentially pouring the trust assets into a new trust agreement. It is especially useful when you want to make changes to an irrevocable trust. Decanting is new to Texas; it was added to the Texas Trust Code effective September 1, 2013. The basic steps to accomplish this are to provide notice to the beneficiaries and prepare a trustee resolution authorizing the trust assets be distributed out to the new trust. 4) Judicial modification. 30

Planning Tip #5 for a trust: Ø PLAN DISTRIBUTIONS SO AS TO MINIMIZE OVERALL TAX If the non-grantor trust permits discretionary distributions to multiple beneficiaries, consider distributing the income out to beneficiaries that have MAGIs below the $200, 000/$250, 000 threshold. If a grantor trust, convert to a non-grantor trust so you can move the taxable income from the grantor to the trust and beneficiaries. 31

SAFE HARBOR FOR REAL ESTATE PROFESSIONALS Generally, a real estate rental activity is treated as a passive activity regardless of the extent of material participation, and rental income is considered passive and subject to NII tax. However, Treasury Regulations Section 1. 1411 -4(g)(7) provides a safe harbor for those whose business is rental real estate. IF (i) more than 50% of your work is in real estate trades or businesses and (ii) you perform more than 750 hours of service during the year in those real estate trades or businesses, THEN the IRS calls you a Real Estate Professional. IF (i) you are a Real Estate Professional and (ii) at least 500 of those 750 hours are in rental activities (or 500 hours for any 5 of the preceding 10 years), THEN the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business. As such, the rental income and any subsequent gain from the sale of the rental property will be excluded from NII and not subject to NII tax. 32

ENTITY STRUCTURING TO AVOID THE NII TAX: WATCH OUT FOR THE SELF-EMPLOYMENT TAX In an effort to characterize trade or business income as non-passive in order to avoid the 3. 8% NII tax, be careful that you aren’t operating in a type of entity that is automatically/statutorily subject to the self-employment tax. In that case, you’ve just traded one 3. 8% tax for another 3. 8% tax. The self-employment tax has 3 components: – 12. 4% Old Age, Survivors and Disability Insurance Tax, taxed on the first $118, 500 of self-employment income. – 2. 9% Hospital Insurance Tax, taxed on all self-employment income. – Another 0. 9% Hospital Insurance Tax, taxed on self-employment income in excess of $200, 000 for single taxpayers and $250, 000 for joint returns. Thus, for earnings over the $200, 000/$250, 000 threshold, the selfemployment tax is 3. 8% (2. 9 + 0. 9 = 3. 8). Regulations provide that if income is subject to self-employment tax, it is not subject to NII tax, and vice versa. 33

S Corp Flow through income from an S Corp is not subject to self-employment tax, as long as the owner pays himself a reasonable salary. Partnership A partner’s distributive share of trade or business income is subject to self-employment tax, but there is an exception for a limited partner. LLC Income flowing through to an LLC member who participates in management will most likely be subject to self-employment tax. The rule may be different for a manager-managed LLC if the LLC owner is not a manager, but there is no clear answer. 34

SUMMARY OF TRADE OR BUSINESS OWNERSHIP Sole Proprietorship (includes Disregarded Entity) – Subject to self-employment tax. – Therefore, is not also subject to NII tax. General Partnership Interest (interest in General Partnership or GP Interest in LP) – Subject to self-employment tax. – Therefore, is not also subject to NII tax. Limited Partner Interest Distributive Share – Not subject to self-employment tax. – Maybe subject to NII tax: Subject to NII tax if passive trade or business. S Corporation (S Corp for tax purposes, regardless of state law entity) – Not subject to self-employment tax, provided owner takes reasonable salary. – Maybe subject to NII tax: Subject to NII tax if passive trade or business. LLC Taxed as Partnership – Usually subject to self-employment tax. (Some believe members should be treated as LPs and so no self-employment tax. However, recent Tax Court rulings are that LLC members hold management powers and so ARE subject to self-employment tax. ) – Maybe subject to NII tax: If not subject to self-employment tax, then will be subject to NII tax if passive trade or business. 35

Ø FORM BUSINESS AS S CORP OR LIMITED PARTNERSHIP If forming an entity for your business and you’ll be making management decisions for the entity, structure your business as an S Corp or as a limited partnership to avoid both NII tax and selfemployment tax. Ø CONVERT LLC TO S CORP OR LIMITED PARTNERSHIP If you are already operating a business in an LLC, convert the entity to an S Corp or Limited Partnership. If you materially participate in the business, you can avoid both NII tax and self-employment tax. 36

QUESTIONS? 37