Trust and estate income tax returns under the TCJA
Preparers of these so-called fiduciary returns should review changes — including new opportunities for tax savings — enacted by the law known as the Tax Cuts and Jobs Act.
By Sonja E. Pippin, CPA, Ph.D.
The rules governing income taxes assessed on trusts and estates are quite distinct from other income tax provisions because they combine fiduciary accounting rules, some of which differ across jurisdictions, with federal income tax law. For that reason, tax professionals preparing income tax returns of trusts and estates must consult a separate set of rules and ensure they know how new income tax provisions apply in this specific context. In addition, CPA tax preparers need to take a close look at the most significant income tax provisions of the tax reform law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, to determine how it affects these fiduciary returns for tax year 2018 and subsequently. This article highlights several aspects of how the TCJA alters federal income tax planning and tax return preparation of trusts and estates, focusing on how these entities may claim the new Sec. 199A deduction for qualified business income (QBI).
QBI THRESHOLDS, PHASEOUTS, AND ALLOCATIONS
For income tax purposes, trusts and estates are often treated similarly to individual taxpayers. For example, just like individuals, trusts and estates can have income from a trade or business, and Sec. 199A specifically includes them with individuals and passthrough entities eligible to claim the QBI deduction, which is available from 2018 through 2025. The basic amount of the deduction is 20% of the QBI from a qualified trade or business, but it is subject to several limitations.
The deduction is limited to the lesser of 20% of the QBI or 20% of taxable income minus capital gains. Taxpayers with income above a threshold amount are also subject to a limitation on the deduction based on W-2 wages or W-2 wages and the unadjusted basis of certain property (the W-2 wage limitation). For trusts and estates, this threshold amount is the same as for taxpayers filing as single or head of household ($160,700 in 2019). As discussed further, below, the limitation is phased in over a $50,000 range, with taxpayers with income of $210,700 or more subject to the full limitation. For taxpayers subject to the full limitation, the deduction cannot be more than 50% of the W-2 wages that are associated with the QBI or the sum of 25% of W-2 wages and 2.5% of the unadjusted basis of all acquired qualified property.
In addition, the deduction is limited for taxpayers engaging in certain specified service trades or businesses (SSTBs) who have income above the $160,700 threshold. This limitation is phased in the same way as the W-2 wage limitation, with taxpayers with income of $210,700 or more subject to the full SSTB limitation. For more on the Sec. 199A QBI deduction generally, see "Sec. 199A: Prop. Regs. Shed Light Light on QBI Deduction," JofA, Feb. 2019.
If an estate or trust does not distribute its income, the QBI deduction calculation is made much the same as for other entities and individuals, subject to the above limitations. Trusts and estates, however, often have capital gains as a major component of their taxable income.
Example 1: A trust has two equal beneficiaries, both individual taxpayers. The trust has taxable income of $100,000 for 2019 from a business that is not an SSTB. Of this amount, $20,000 is capital gains and $50,000 is QBI. The trust does not distribute any income. Since the business is not an SSTB and the trust's income is below the threshold amount for the W-2 wage limitation, the only limitation for the QBI deduction is based on taxable income minus capital gains and computed as 20% × ($100,000 − $20,000) = $16,000 limit. The full QBI deduction of $10,000 (20% of $50,000) is thus available. If the trust had QBI of $90,000, the maximum deduction would be $18,000 (20% of QBI), but it would be limited to $16,000 as a percentage of taxable income minus capital gains.
Example 2: Assume the same facts as in Example 1, except that the trust has taxable income of $180,000. This is above the threshold amount of $160,700; thus, the trust is potentially subject to the W-2 wage limitation. Also assume that paid W-2 wages related to the qualified business are $35,000. The wage limitation is 50% of $35,000, or $17,500. If QBI remains $50,000, the entire possible deduction (20% × $50,000 = $10,000) can be claimed, since it is below the wage limitation amount.
If QBI in Example 2 is instead $90,000, the phase-in of the W-2 wage limitation applies. This formula is fairly complex and depends on taxable income; the threshold amount; the difference between the full QBI deduction and 50% of W-2 wages; and the relationship between taxable income in excess of the threshold and a denominator of $50,000. In this case, the allowable QBI deduction is the smallest of three possible numbers:
First, the full QBI deduction, or 20% of $90,000 = $18,000;
Second, the income limitation, which is $32,000 (20% of taxable income minus capital gains: $180,000 — $20,000); or
Third, $17,807, which is 20% of QBI reduced by the phase-in amount.
The third number is computed by reducing the full 20%-of-QBI deduction ($18,000) by 38.6% of the difference between the full QBI deduction and 50% of W-2 wages ($500). The ratio of 38.6% is derived by dividing $19,300 (the difference between taxable income of $180,000 and the 2019 threshold amount of $160,700) by $50,000 (Sec. 199A(b)(3)(B)). Thus, in this case, the applicable limitation is W-2 wages, limiting the deduction to $17,807.
All noncorporate taxpayers, individuals, and entities with QBI may be able to use the QBI deduction. For flowthrough entities — partnerships, LLCs, or S corporations — the QBI deduction is determined at the owner (partner or shareholder) level.
For trusts and estates, the calculation of the QBI deduction may be done at the entity or the beneficiary level and depends on the allocation of overall income and QBI between the trust and the beneficiary. Each entity's, as well as the owners' or beneficiaries', share of overall income, QBI, and W-2 wages must be computed because this determines how much the taxpayer will be able to deduct. If a trust distributes its income to the beneficiaries, the QBI deduction is calculated at the beneficiary level and the trust level, depending on how much income is distributed. In general, the tax rules favor trusts that distribute income, because individuals' tax rates tend to be lower than trusts' tax rates. However, a deduction against the higher tax rates at the trust level may yield the greater tax benefit.
Example 3: In Example 1, the tax benefit of the QBI deduction at the trust level using the tax rate schedule under the TCJA for 2019 is 37% of the deduction amount, which is $3,700 for the $10,000 deduction (see below for more on the trust and estate tax rate changes under the TCJA). On the other hand, if the two beneficiaries' applicable marginal tax rates are 24% and 22%, respectively, the total benefit for both of them together would be only $2,300 (24% × $5,000 and 22% × $5,000), assuming that both taxpayers can claim the full deduction. Thus, it is advantageous in this instance for the deduction to be claimed at the trust level.
But that is not necessarily always the case. The Conference Committee report accompanying the TCJA specifically states that the W-2 wage allocation between the trust and the beneficiary must be made in a similar manner as it was determined under the now-repealed Sec. 199 and related Treasury regulations ( Joint Explanatory Statement of the Committee of Conference at 40, incorporated into Conference Report to Accompany H.R. 1, H.R. Conf. Rep't No. 115-466, 115th Cong., 1st Sess. (Dec. 15, 2017)). For grantor trusts, this means W-2 wages are apportioned based on the ownership of the trust. For nongrantor trusts, the allocation is determined based on distributable net income (DNI). Trusts that do not distribute income or distribute very little income would be allocated all or most of the W-2 wages.
To complicate matters further, it appears that the W-2 wage limitation threshold and phase-in amounts are based on the beneficiaries' tax situation and not the trust's. Following the old Sec. 199 rules, individual beneficiaries may also be able to combine incomes and W-2 wages from other sources to arrive at the overall threshold and limitation amounts. In other words, when the deduction is calculated at the trust level, the W-2 wage limit comes into play when the trust's income exceeds $160,700 (for 2019). If the income is distributed to the beneficiaries, the limit is $321,400 for individual taxpayers filing jointly, $160,700 for single individuals and heads of household, and $160,725 for married individuals filing separately. Thus, it is possible that distributing the QBI could still lead to a higher overall tax benefit.
On Aug. 16, 2018, the IRS issued proposed "reliance" regulations on Sec. 199A covering issues including the allocation of QBI and W-2 wages for trusts and estates (REG-107892-18). Under Prop. Regs. Sec. 1.199A-6(d)(3)(ii), each beneficiary's (or the trust's) share of a trust's or estate's W-2 wages is determined based on the proportion of the trust's or estate's DNI that is deemed to be distributed to that beneficiary (or retained by the trust or estate) for the tax year.
Thus, it appears that trusts and estates can take the deduction to the extent they do not distribute income. This also implies that beneficiaries will be able to claim the deduction when the trust has DNI.
Example 4: Assume that the trust's taxable income is $180,000, capital gains are $20,000, and QBI is $90,000. Further assume the W-2 wages are associated with the QBI. If the trust does not distribute income, the deduction will be limited to $11,052 (due to the phase-in of the W-2 wage limitation: 20% of $90,000, reduced by 38.6%), and the tax benefit would be $4,089 (37% × $11,052). If the income is distributed to the two beneficiaries, their marginal tax brackets in Example 3 suggest that neither would be subject to the wage limitation. They would be able to claim a $9,000 deduction each. The total combined tax benefit would be $4,140 (24% × $9,000 and 22% × $9,000).
One can imagine many other permutations based on the beneficiaries' tax characteristics. For example, one beneficiary might have a high tax rate and be subject to the W-2 wage threshold while the other is not. Such considerations can introduce a new planning element into situations where the trustee and beneficiaries determine distributions from the trust based on the beneficiaries' relative tax situations. In such situations, it may be important to consider Sec. 663(b), which allows distributions made within 65 days of the end of the tax year to be counted as part of the tax year.
OTHER TCJA PROVISIONS AFFECTING TRUSTS AND ESTATES
In addition to the Sec. 199A deduction, several other TCJA provisions affect trusts and estates. The following are the most significant issues to consider when preparing fiduciary returns and for tax planning purposes.
Tax rates and brackets
As it did for individuals, the TCJA reduced tax rates and brackets for trusts and estates from 2018 through 2025, reducing the number of brackets for trusts and estates to four (10%, 24%, 35%, and 37%) (Sec. 1(j)(2)(E)). Previously, there were five brackets: 15%, 25%, 28%, 33%, and 39.6%. Yet the brackets remain compressed and, unlike those for individuals, nearly the same as before, with the highest bracket starting at $12,500 in 2018 and $12,750 in 2019.
Further, the rules for capital gains rates have changed, with the introduction of a "maximum zero rate amount" for trusts and estates of up to $2,600 in taxable income in 2018 ($2,650 in 2019), a "maximum 15% rate amount" of up to $12,700 in taxable income in 2018 ($12,950 in 2019), and a "maximum 20% rate amount" for taxable income over $12,700 in 2018 ($12,950 in 2019). Note that the "straddle computation rule" of Sec. 15 applies in the case of trusts or estates that do not have a calendar year end. This rule implies that for any fiscal year ending before Dec. 31, an average tax rate will apply. For example, for a trust in the highest bracket with a fiscal year end of Jan. 31, 2018, the rate was 39.38%; if the fiscal year end was Nov. 30, 2018, the rate was 37.22%. For a trust in the lowest bracket, the rates were 14.58% (January year end) and 10.42% (November year end), respectively.
Interestingly, the personal and dependency exemption, which is suspended (through 2025) for individual taxpayers, was not repealed for estates and trusts. It remains at $100 or $300 for trusts and $600 for estates; further, although the House bill would have repealed the enhanced exemption for qualified disability trusts, the enacted law retained it ($4,150 in 2018 and $4,200 in 2019).
The TCJA suspended for trusts and estates as well as individuals miscellaneous itemized deductions subject to a limitation of 2% of adjusted gross income (AGI) (or modified income, in the case of trusts and estates). Not suspended are miscellaneous itemized deductions not subject to the 2%-of-AGI limitation. This means that the Supreme Court decision in Knight, 552 U.S. 181 (2008), is now even more important than before. This decision confirmed the deductibility of all investment advisory fees paid by a trust or estate (that would have not have been incurred if the taxpayer were not a trust or estate) without the 2%-of-AGI limitation. In Notice 2018-61, the IRS clarified this point as well.
Alternative minimum tax
Another item specifically addressed by the TCJA is the alternative minimum tax, which was repealed for corporations and modified for individual taxpayers. Specifically, the exemption amount for individuals was increased significantly, by almost 30%. Yet the new law did not address the amount for estates and trusts. Thus, it has a low $24,600 exemption for 2018 ($25,000 for 2019), with the phaseout of the exemption starting at $81,900 (in 2018; $83,500 in 2019).
Net investment income tax
On the other hand, despite some discussion and attempts to repeal the net investment income tax under Sec. 1411, the TCJA did not do so in the end. The tax is assessed at 3.8% of the lesser of the net investment income amount and the amount by which (modified) AGI exceeds the applicable filing status threshold amount. This is especially significant for trusts (and to a lesser extent for estates) for two reasons: First, a large portion of trust income often meets the definition of investment income under Sec. 1411(c)(1). Second, for trusts and estates, the income threshold for the net investment income tax is much lower than for other taxpayers, with the top tax bracket starting at $12,500 of taxable income in 2018 and 12,750 in 2019.
Electing small business trusts
Starting in 2018, a nonresident alien individual can be a beneficiary of an electing small business trust (ESBT). Further, charitable contribution deductions for ESBTs are now treated like those made by individual taxpayers.
While this is by no means an exhaustive treatment of all the changes brought by the TCJA to the computation of fiduciary returns of trusts and estates and their tax planning, it does illustrate the extent of those changes. Hopefully, this discussion provides several planning points for CPA tax preparers and advisers and their trust and estate clients for assessing the treatment of items going forward.