Avoiding NII Tax For High Net Worth Individuals

advertisement
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
 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.
 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
 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
 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.
 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
 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 and 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
Income Tax
NII Tax ($100,000 x 3.8%)
Total Tax
With a Non-grantor CLT
$100,000
(20,000)
80,000
x 39.6%
31,680
3,800
$35,480
Royalty Income
Less: Charitable Deduction
Taxable Income
Income Tax
NII Tax
Total Tax
$100,000
(100,000)
0
x 39.6%
0
0
$0
Tax Savings of $35,480 per year.
7
 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:
1st
2nd
3rd
4th
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 selfcharged 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
Deductions
Net
$500
($100)
$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 + $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.
$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 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:
 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,
 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,
 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,
 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:
 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
35
 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.
 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
Download