Final IRC 199A Regulations Part II – Multiple Trust Aggregation

Take-Away: One planning strategy that came to light after IRC 199A appeared in the Tax Code was to use multiple non-grantor trusts so that each trust owned a part of a business that generated qualified business income. As a result, each irrevocable trust (or its beneficiaries who received trust distributions) could claim its own IRC 199A income tax deduction. That opportunity still exists under the Final Regulations published for IRC 199A, but the challenge will be to overcome the presumption that each of the multiple trusts were created with the principal purpose to avoid income taxes, or that the trusts were created in order to use more than one threshold amount for the purpose of calculating the IRC 199A income tax deduction.  Electing small business trusts (EBSTs) will also be more restricted under the Final Regulations than what was originally thought to be the case.

Background: Some trusts cannot be used to divert income that would not be deductible by professionals or high-income individuals. Irrevocable, non-grantor, trusts are separately taxed. Assets held in these non-grantor trusts are often used to support family members. After IRC 199A was passed one planning technique which quickly came to mind was to create multiple non-grantor, or complex, trusts that would own interests in businesses that produced qualified business income, including special services trades or businesses, and management services organizations (MSOs) owned by high-income individuals, so that each separate trust could accumulate $157,500 of income and/or spray/distribute out an amount of income sufficient so that each trust or beneficiary would have reportable income of up to $157,000. In a vague way, the proposed IRC 199A Regulations threatened to disregard these separate irrevocable non-grantor trusts that were formed to take advantage of the IRC 199A income tax deduction. The Final Regulations continue with the concept of disregarding multiple non-grantor trusts.

Earnings Thresholds for 2019: The qualified business income thresholds for individuals are adjusted for cost of living for 2019. For married couples filing jointly, the threshold amount increases from $315,000 to $321,400. For a single taxpayer, or a trust or estate, the threshold increases from $157,500 to $160,700.

Final Regulations-  The Final Regulations pretty much continue the Proposed Regulations of August, 2018. But there were some important changes or clarifications that are summarized below.

Single Trust Treatment: The Final Regulations provide that a separately taxed trust that is formed or funded with a principal purposes of avoiding, or of using more than one threshold amount for purposes of calculating the deduction under Section 199A, will be considered as aggregated with its contributor for IRC 199A purposes. Thus, a complex trust (which can accumulate income) that is formed or funded for the primary purpose of avoiding income tax under IRC 199A will be disrespected. This means that the $157,500 or $315,000 income thresholds for the IRC 199A income tax deduction will be aggregated with the trust settlor’s income to determine his/her eligibility to claim the IRC 199A tax deduction.

IRC 643(f): The Final Regulations also continue with the multiple trust disallowance of multiple tax brackets under IRC 643(f). Unfortunately, the Regulations dropped some examples that were helpful to better understand when IRC 642(f) actually applied. Note that this ‘aggregation’ concept not only applies to a trust’s eligibility to claim the IRC 199A income tax deduction, it also applies to aggregating or ‘bunching’ income from several trusts into one trust and thus exposing that combined income to the highest marginal federal income tax rate (37%) after accumulated income of $12,750.

Depreciation: The Proposed Regulation that had allocated depreciation deductions between the trust and its beneficiaries was highly criticized. With the Final Regulations there are revised examples that clarify the allocation of qualified business income and depreciation between the non-grantor trust and its beneficiaries. The Final Regulations continue to require that a trust (or an estate) allocate its qualified business income, including any negative losses, among the trust and its beneficiaries based on the relative portion of distributable net income (DNI) that is either distributed to the beneficiaries or retained in the trust.

EBST Trust: An electing small business trust (EBST) that holds S stock will only have one $157,500 income threshold amount for both the S corporation stock and its resulting income and the non-S corporation stock portions held in that trust. It was originally hoped that an EBST would have two separate IRC 199A income tax deductions available to it, one for the S distributions and one for the non-S income generated by other trust assets as the currently Regulations require. [Treas. Reg. 1.641(c)-1.] That is not to be the case under the Final Regulations; the S portion and the non-S portion will be treated as a single trust for the purpose of determining the applicable threshold income amount.

Single Trusts Covered:  The language was changed in the Final Regulations, going from referencing “Trusts formed or funded…” in the Proposed Regulations, to “A trust formed or funded…” in the Final Regulations. The Preamble clearly states that the Regulations not only apply to the creation of multiple trusts for tax avoidance purposes, but also to the creation of a single trust.

Tax Avoidance Presumption: The Proposed Regulations had created a presumption that a principal purpose for establishing or funding a non-grantor trust would be presumed to be tax avoidance if it resulted in a significant income tax benefit. The Final Regulations removed this presumption arising merely because income tax savings had resulted from the use of a trust. But the Service also dropped its helpful examples of when two or more trusts would not be aggregated leaving us to guess as when two trusts will be combined under IRC 643(f).

Anti-Abuse Presumption: The Final Regulations make it abundantly clear that the anti-abuse rule is alive and well. “The final regulations clarify that the anti-abuse rule is designed to thwart the creation of even one single trust with a principal purpose of avoiding, or using more than one, threshold amount. If such trust creation violates the rule, the trust will be aggregated with the grantor or other trusts from which it was funded for purposes of determining the threshold amount for calculation the deduction under IRC 199A.” Note: Arguably an irrevocable trust that was in existence prior to the 2017 Tax Act was not created for this tax avoidance purpose, and consequently it should not be subject to this anti-abuse rule. Accordingly, a preexisting trust might be able to purchase an interest in a trade or business that has qualified business income and be entitled to claim the IRC 199A income tax deduction. Less clear is if a pre-existing grantor trust could be converted to a regular complex trust, e.g. the settlor releases his/her right to exchange assets of equivalent value, in order to position that pre-existing trust to take advantage of the IRC 199A income tax deduction- will the conversion of a grantor trust to a non-grantor trust be treated as an addition to a ‘new’ trust?

DNI Deduction: One important change in the Final Regulations is that distributable net income (DNI) will now be taken into account to determine if the non-grantor trust qualifies for the IRC 199A income tax deduction. The proposed Regulations provided that income distributed from the trust to a trust beneficiary would be considered to have ‘remained in the trust’ for the purpose of determining if the non-grantor trust qualified for the deduction due to its income level. The Final Regulations for IRC 199A now allow for the taxable income of the ‘tax avoidance trust’ to be determined only after taking into account the distributable net income (DNI) deduction for income that is transferred from a separately taxed trust to a trust beneficiary. In short, the income distributed to the beneficiary will be treated as having been received by the beneficiary and not subject to aggregation with the trust’s accumulated income under the anti-abuse provisions of the Final Regulations.

• Example: A non-grantor trust has $300,000 accumulated qualified business income for 2018. Thus, it does not qualify for the IRC 199A income tax deduction because its income exceeds $157,000 or the phase-out income limitation amount. Now, because DNI can be subtracted from that income amount, the trustee can distribute $150,000 to the beneficiaries of the trust and thus reduce the accumulated income in the trust to $150,000.  Now the trust will qualify for the IRC 199A income tax deduction, since its income is less than $157,500. This is where the 65-day ‘throw-back’ rule comes into play if the trustee wants to take advantage of the IRC 199A deduction for 2018. Following the example, the trustee has until March 4, 2019 to make the distributions to the trust beneficiaries that carry out DNI (treated as having been distributed in 2018) in order to qualify the trust for the IRC 199A income tax deduction for 2018.

Grantor Trust Exception: The Final Regulations do not impose any limitation on the use of a trust that is classified under IRC 678 as a grantor trust. That is an irrevocable trust that is considered to be owned by its beneficiary or beneficiaries and thus the beneficiaries are taxed on the trust’s income whether distributed or not. Thus, an irrevocable trust that is established under the grantor trust rules [IRC 671 to 678] will not be subject to the trust ‘aggregation’ rule under the Final Regulations.

• Example: Herb and Wilma transfer some of their stock in their S corporation to an irrevocable trust for the benefit of their son, Steve. The trust instrument contains a provision that gives to Steve the right to withdraw the S corporation stock that is transferred by Herb and Wilma to the trust within 30 days of the transfer of the S stock to the trust. After 30 days Steve’s right to withdraw the S stock lapses.  This is classified as a grantor trust under IRC 678 of which Steve is the deemed grantor. The K-1 income that Herb and Wilma’s S corporation issues will be reported on Steve’s personal 1040 income tax return, even though the trust is the technical owner of the S stock. That K-1 will qualify for the IRC 199A income tax deduction, assuming that Steve’s reported income is below the threshold level [$160,700 for 2019 if he is single, $321,400 if Steve is married.] Note: If Herb and Wilma own a specified services trade or business, the S corporation could be an MSO which entered into a management contract with Herb and Wilma’s specified services trade or business.

Conclusion: You will recall that under the Proposed Regulations, and now also under the Final Regulations, that multiple trusts will be disregarded if: (i) they have the same settlor; and (ii) they have the same beneficiaries; and (iii) they were formed for the principal purpose of tax avoidance or using multiple threshold amounts used to calculate the IRC 199A income tax deduction. The easiest way to avoid the trust being disregarded is for the trust beneficiaries to be different for each trust that is created. All three conditions must exist before a trust to be disregarded. If the trust beneficiaries are not the same, then the Service cannot treat the multiple trusts as one. It would also be wise to document the non-tax reason for creating the trust, such as using the trust creditor protection for the trust beneficiary, or the creation of several trusts to exploit the temporarily enlarged federal gift tax applicable exemption amount.