Even though there were some excellent presentations on Day 2 related to such topics as Qualified Small Business Stock, Tax consequences of marriage and divorce under the new tax act, and making your charitable estate plan great again, we have chosen to focus this discuss on IRC Section 199A since it may affect many of our trust and estate clients.
GETTING THE 411 ON IRC 199A: JUST THE FACT MA’AM Melissa J. Willms Davis & Willms, PLLC
From time to time, a new law comes along that can dramatically affect estate and business planning, and cause accountants to lose many nights of sleep. The 2017 Tax Act brought us IRC Section 199A and the qualified business income deduction.
Code Section 199A applies to nongrantor trusts and estates as well as to their beneficiaries. The section can apply such that either the trust or estate may be treated as an individual and qualify for the Section 199A deduction, or the trust or estate may be treated as an RPE (Relevant Pass Through Entity) , passing the various elements of the deduction through to its beneficiaries who then, as individuals, may qualify for the Section 199A deduction.
Because of the nature of grantor trusts, Section 199A would not apply. The Code provides a set of rules that override the general trust taxation rules and cause the income of certain trusts to be taxed to the grantor (or someone treated as the grantor) to the extent that he or she has retained prohibited enjoyment or control of trust income and/or principal. The grantor trust rules generally treat the grantor as the owner of any portion of the trust property over which a grantor trust power applies. As a result, all items of income, deduction, expenses, and credits associated with that portion of the trust are reported directly by the grantor on his or her income tax return. The grantor calculates the Section 199A deduction as if he or she conducted the portion of the activities attributed to the trust.
Broadly speaking, income earned by a nongrantor trust or an estate in any year is taxed to the trust or estate to the extent that the income is retained, but is taxed to the beneficiaries to the extent that it is distributed to the beneficiaries with the trust or estate receiving a distribution deduction in the latter case. Subject to several exceptions, the general rule is that any distribution from a trust or an estate will carry with it a portion of the trust or estate’s DNI. Trust and estate distributions are generally treated as coming first from current income, with tax-free distributions of “corpus” arising only if distributions exceed DNI. If distributions are made to multiple beneficiaries, DNI is generally allocated to them pro rata. Once the trust or estate’s taxable income is determined, we then know whether the trust or estate falls in Stratum I, II, or III. Because the threshold limits for single filers applies to trusts and estates, for 2018, the threshold amount is $157,000, and is $160,700 for 2019.
As it currently stands, in determining a trust or an estate’s taxable income for Section 199A purposes, proposed § 1.199A-6(d)(3)(iii) provides that the trust or estate’s taxable income is calculated before taking any distribution deduction. This means that for purposes of determining the threshold amount and whether a trust or an estate falls within Stratum I, II, or III, the entity must consider all of its taxable income, even if all of its taxable income is distributed to its beneficiaries. The proposed regulations argue that because taxable income can be shifted between trusts and estates and their beneficiaries, QBI could be shared among multiple individuals, entitling each of them to their own threshold amount and that would be a bad thing.
Because Section 199A requires each nongrantor trust and estate to calculate its respective QBI, W2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income based on those items that are allocated to it, the trustee or executor will need to establish a system to track these items in its books and records. When a nongrantor trust and estate is allocated QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income, calculations of items related to Section 199A are first made at the trust or estate level, and then, if appropriate, are further allocated to the trust or estate’s beneficiaries. If those items are further allocated to a beneficiary, the trust or estate becomes an RPE to the extent of its allocation. Prop. Treas. Reg. § 1.199A-6(d)(1). If a trust or an estate allocates a portion of these items to a beneficiary and retains a portion of these items, for Section 199A purposes, the trust or estate will be treated partially as an RPE and partially as an individual.
The proposed Treasury regulations adopt DNI as the method to allocate Section 199A items between a nongrantor trust or estate and its beneficiaries, and similar to the notion that DNI carries out to beneficiaries only to the extent of taxable income, Section 199A items are allocated to beneficiaries to the extent DNI is distributed (or deemed distributed) to the beneficiaries. Once Section 199A items are allocated to a beneficiary, the beneficiary uses the allocated amounts to calculate the beneficiary’s Section 199A deduction. Likewise, the trust or estate uses its retained Section 199A items to compute its Section 199A deduction. If no DNI is distributed or deemed distributed to the beneficiaries or if the trust or estate has no DNI in any year, all Section 199A items will be allocated to the trust or estate, which will then calculate its Section 199A deduction.
In issuing the proposed Treasury regulations related to Code Section 199A, Treasury and the IRS took the opportunity to also issue new proposed Treasury regulations related to Code section 643(f) which deals with multiple trust rules. As set forth in the statute, in order for multiple trusts to be treated as one trust, Code Section 643(f) requires four elements: (1) there must be two or more trusts, (2) with substantially the same grantor(s), (3) with substantially the same primary beneficiary(ies), and (4) a principal purpose of the trusts is the avoidance of income tax. The proposed Treasury regulations take the elements of the statute a step further, providing that two or more trusts will be treated as a single trust not only if such trusts have substantially the same grantor(s) and primary beneficiary(ies), as long as the principal purpose for establishing the trusts or for contributing additional cash or other property to the trusts is the avoidance of federal income tax. The proposed Treasury regulations set forth a presumption for determining whether a principal purpose for establishing or funding a trust is to avoid federal income tax. Specifically, if establishing or funding a trust results in a “significant income tax benefit,” it is presumed the principal purpose is to avoid federal income tax, unless it is shown that there is a significant non-tax or non-income tax purpose that could not have been achieved without the creation of the separate trusts. Although proposed § 1.643(f)-1 was issued as an anti-avoidance rule to apply to all trusts, an additional proposed regulation was issued to apply to trusts, but only for Section 199A purposes. Specifically, proposed § 1.199A-6(d)(3)(v) provides that “trusts formed or funded with a significant purpose of receiving a deduction under section 199A will not be respected for purposes of section 199A.”
Proposed § 1.199A-6(d)(3)(iv) confirms that electing small business trusts (ESBTs) are entitled to a Section 199A deduction. In addition, the proposed regulation clarifies that QBI and other Section 199A items are to be accounted for separately for each of the S portion, non-S portion, and any grantor portion from any S corporation owned by the ESBT.
No specific provisions were made in Section 199A or the proposed regulations regarding charitable remainder trusts (CRTs) and whether a Section 199A deduction would be available to recipients of any taxable portion of such trusts that could result in a deduction. The suggestion made by the tax professionals is that for any Section 199A items that may be allocated to a CRT, the CRT will be treated as an RPE, like a non-charitable trust that allocates such items in accordance with the DNI rules, with those items being reported to the beneficiary on a Schedule K-1.
Section 199A and its related proposed Treasury regulations add a new income tax wrinkle, when planning involves businesses and their owners. Proposed § 1.643(f)-1 adds a new wrinkle, and uncertainty, in trust planning. Regardless, estate planners must be aware of and have working knowledge regarding the income tax issues that are important to their clients. As planners, we anxiously await the final Treasury regulations with the hope that we will have more certainty!