The 3.8% Surtax for Trusts & Estates

3.8-percent-surtax-trust-and-estates-robert-keeblerBy Robert S. Keebler, CPA/PFS, MST, AEP (Distinguished), CGMA

Executive Summary

The Health Care and Education Reconciliation Act of 2010 created a 3.8 percent surtax on certain net investment income effective for tax years beginning on and after January 1, 2013. The tax applies to estates and certain trusts as well as to individuals. Given the low income threshold at which the tax begins to apply, the tax will have broad application to trusts and estates. This article summarizes application of the 3.8% surtax to trusts and estates and offers some initial planning ideas

What Trusts are Subject to the Surtax?

Under the general rule, the surtax applies to all estates and trusts described in Subtitle A, Chapter J, Part 1 (IRC §§ 641 – 685). However, the following trusts are specifically excluded from its application:

  • A trust all the unexpired interests of which are devoted to one or more of the charitable purposes described in IRC § 170(c)(2)(B);
  • A grantor trust or §678 trust;
  • A trust exempt from tax under IRC § 501(c);
  • A charitable remainder trust;
  • Most foreign trusts;
  • Business trusts;
  • Common trust funds; and
  • Pooled income funds.

Application to Specific Trusts

Proposed regulations issued at the end of 2012 and the preamble to the proposed regulations clarify how the surtax applies to certain kinds of trusts.

Grantor Trusts and §678 Trusts. The surtax does not apply to a trust treated as owned by a grantor under IRC §§ 672-677 or to a trust treated as owned by a person other than the grantor under IRC § 678 because all the trust’s income is reported on the owner’s Form 1040. Thus, the trust income is simply added to the owner’s other income for purposes of calculating the surtax.

Charitable Remainder Trusts.  Although a CRT itself is tax-exempt and not subject to the surtax, the annuity or unitrust distributions may be NII to the non-charitable lead beneficiaries. The character of the distributions in the hands of the beneficiaries is determined under the tier rules of IRC section 664, which treat distributions as coming first from ordinary income, then from capital gains, then from other income (e.g., tax-exempt income) and finally as a tax-free return of trust corpus. The proposed regulations create a fifth category for NII which is treated as distributed first, before ordinary income. The surtax only applies to NII received by a CRT after December 31, 2012, however, so NII received by a CRT before that is not subject to the surtax regardless of when it is distributed to beneficiaries.

Charitable Lead Trusts. Recall that there are two kinds of CLTs, grantor CLTs and non-grantor CLTs. Like any other grantor trust, grantor CLTs are not subject to the surtax because all trust income is reported by the grantor under the grantor trust rules. Non-grantor CLTs are taxable entities but they receive a charitable deduction under IRC § 642(c) when they make annuity or unitrust payments to the charitable lead beneficiary. The NII of the CLT is reduced by the share of NII allocated to the IRC § 642(c) deduction of the trust in accordance with the Reg. § 1.642(c)-2(b) and the allocation and ordering rules under Reg. § 1.662(b)-2.

Foreign Estates and Non-Grantor Trusts.  Foreign estates and non-grantor trusts are generally not subject to the 3.8% surtax. The preamble to the proposed regulations indicates, however, that the Treasury Department believes the NII of a foreign estate or foreign trust should be subject to the surtax to the extent such income is earned or accumulated for the benefit of, or distributed to, United States beneficiaries. Proposed Reg. §§ 1.1411-3(d)(2)(ii) and 1.1411-3(c)(3) are reserved for guidance on the application of the surtax to foreign estates and trusts with United States beneficiaries.

Managing Distributions

The surtax applies only to the undistributed net investment income of a trust or estate. Income that is distributed is ordinarily deductible by the trust or estate and taxable to the beneficiary. Thus, a fiduciary may be able to manage or eliminate the surtax by planning distributions of income to the beneficiaries.

Example 1. The trustee of the ABC Trust has discretion to make distributions of principal and income to Harold, a single 30 year-old taxpayer with $40,000 of salary income. The Trust has dividend and interest income of $120,000. The trustee makes no distributions to Harold in 2014. The highest trust income tax bracket for trusts begins at $12,150 in 2014, so $107,850 is subject to the surtax ($120,000 – $12,150) and the surtax payable by the trust is $4,098.30 (.038 x $107,850).

Example 2. Assume the same facts as in Example 1, except that the trustee makes a distribution of $107,850 to Harold. Harold pays no surtax because his total income of $147,850 ($40,000 salary + $107,850) does not exceed the threshold amount of $200,000 for single taxpayers. The trust doesn’t pay any surtax either because its undistributed income does not exceed its $12,150 threshold amount.

Before making additional distributions, however, fiduciaries must make sure that the distributions are appropriate, taking into account both tax and non-tax factors. Such distributions should be made only if they produce an overall benefit rather than just surtax savings.

Managing Investments

Fiduciaries may wish to manage investments to reduce net investment income and MAGI, perhaps investing more in tax-exempt or tax-deferred assets. The bottom line should be after-tax return, however, and not just the amount of surtax saved.

Using Trusts to Reduce the Surtax Payable by Individuals

Trusts can also be used to reduce the surtax payable by individuals. Before providing examples of how charitable remainder trusts and charitable lead trusts can be used for this purpose, it may be helpful to provide a brief overview of how the surtax applies to individuals.

The amount subject to the tax for individuals is the lesser of:

(1) Net investment income (NII), or
(2) The excess of the taxpayer’s adjusted gross income (MAGI) over an applicable threshold amount (ATA).

NII is generally defined the same way for individuals as for trusts and estates.

MAGI is generally the number appearing on the last line of page 1 on Form 1040.

The ATAs are as follows:

  • Married taxpayers filing jointly $250,000
  • Married taxpayers filing separately $125,000
  • All other individual taxpayers $200,000

Charitable Remainder Trusts. Smoothing income from year-to-year to avoid high tax brackets has long been a popular strategy for many taxpayers. The increased tax rates and progressivity created by the 3.8% surtax and the American Taxpayer Relief Act (ATRA) should make these strategies more popular than ever.

Income smoothing can be particularly helpful when a taxpayer has a large capital gain in a tax year. An effective way to accomplish this smoothing is with a charitable remainder trust (CRAT or CRUT).

Example 3. Ellen, a single taxpayer, has a salary of $100,000 and no other income. She plans to work for 12 more years and then retire. In 2014 Ellen sells Blackacre, vacant land inherited from her parents, and recognizes a capital gain of $600,000. This gives her total income (MAGI) of $700,000 for 2014, so Ellen is subject to the surtax on the lesser of NII ($600,000) or MAGI – ATA ($500,000). Thus, she pays surtax of $19,000 in 2014 (.038 x $500,000).

Example 4. Now assume that instead of selling Blackacre, Ellen contributes it to a CRAT that pays her an annuity of $100,000/year for 12 years. The CRAT sells Blackacre and realizes a gain of $500,000 but no gain is recognized because the CRAT is tax-exempt. Assume further that the CRAT has no ordinary income.

The annuity payments will carry out $100,000 of capital gain to Ellen in each of the first five years of the trust. This will increase her income to $200,000 per year. Although the distributions are treated as NII to Ellen she will not be subject to the surtax because her MAGI does not exceed her ATA. A potential downside of the strategy is that the present value of the charitable remainder interest must be at least 10 percent of the value of the property contributed to the CRAT.

Charitable Lead Trusts. Charitable contributions don’t ordinarily reduce the amount of income subject to the surtax in the hands of an individual. While above-the-line deductions can be used to reduce MAGI, charitable deductions are claimed below-the-line on Schedule A. Certain charitable lead trusts can be used, however, to offset MAGI.

Grantor CLATs are not useful for surtax planning because, like any other grantor trust, their income is taxed to the grantor who receives a below-the-line deduction. Non-grantor CLATs can be used to reduce surtax, however, because they create a charitable deduction under IRC § 642(c) rather than IRC § 170. When a CLAT makes its annual annuity or unitrust payments to the charitable lead beneficiary, the NII of the CLAT is reduced by the share of the 642(c) deduction allocable to NII distributed to the charity. Because the deduction leaves more in the trust to pass to the non-charitable remaindermen, it indirectly gives the donor a charitable deduction against the surtax.


Tax planning for Trusts and estates is now a four dimensional game; not only do practitioners need to understand the traditional income tax and AMT provisions but they need to wrap their mind around the new 3.8% surtax and the 39.6% tax rate.

In the short-term, planning for new estates in 2012 will be critical and in the long-term trustees and their advisors will need to develop deferral and conversion strategies to address these new taxes.


Do you know how to properly fill out Form 8960, the IRS Form for computing the 3.8% Net Investment Income Tax?  If not, then be sure to join us for this special 2-part presentation entitled, “Properly Preparing the Form 8960 (NIIT)” with speaker, Robert S. Keebler, CPA/PFS, MST, AEP (Distinguished), CGMA.  For more information, click here.


Below are a number of charts and checklists (or handouts) that you can use with your clients to better understand the 3.8% Net Investment Income Tax.


robert-keebler-authorRobert S. Keebler, CPA/PFS, MST, AEP (Distinguished), CGMA is a partner with Keebler & Associates, LLP and is a 2007 recipient of the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels. He has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States and one of the Top 40 Tax Advisors to Know During a Recession. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and in estate, gift and income tax examinations and appeals.

In the past 20 years, he has received over 150 favorable private letter rulings including several key rulings of “first impression.” Mr. Keebler is nationally recognized as an expert in estate and retirement planning and works collaboratively with other experts on academic reviews and papers, and client matters. Mr. Keebler is the author of over 75 articles and columns and editor, author, or co-author of many books and treatises on wealth transfer and taxation, including the Warren, Gorham & Lamont of RIA treatise Esperti, Peterson and Keebler/Irrevocable Trusts: Analysis with Forms.

He is a frequent speaker for legal, accounting, insurance and financial planning groups throughout the United States at seminars and conferences on advanced IRA distribution strategies, estate planning and trust administration topics including the AICPA’s Advanced Estate Planning, Personal Financial Planning Conference and Tax Strategies for the High Income Individual Conference.

To contact Mr. Keebler, call his office at 920-593-1701 or by e-mail at robert.


Image courtesy of Arvind Balaraman /

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