Back to Missives
George F. Bearup, J.D. Senior Legal Trust Advisor

6-Jul-20

Final IRC 199A Regulations – The Separate Share Rule

Take-Away: The IRS published its Final Regulations with regard to IRC 199A, the 20% qualified business income deduction for individuals. These Regulations go into effect on August 24, 2020. The IRS did not, however, alter its prior position that it will not apply the separate share rule to beneficiaries of a trust or an estate with regard to this deduction.

Background: IRC 199A was enacted as part of the 2017 Tax Act. It provides an income tax deduction of up to 20% of qualified business income (QBI) from a U.S. trade or business operated as a sole proprietorship, or through a partnership, S corporation, trust or estate. This tax deduction can be taken by individuals and some trusts and estates. IRC199A provides individuals and some trusts and estates a tax deduction of up to 20% of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, subject to complex income phase-out limits and also limits based on the nature of the individual’s business.

Special Rules for Trusts and Estates: IRC 199A also applies to qualified business income (QBI), W-2 wages, and unadjusted basis immediately after acquisition (UBIA) of qualified property, qualified REIT dividends, and qualified PTP income of a trust or estate, which are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust’s or estate’s distributable net income (DNI) for the taxable year that is distributed or required to be distributed to the beneficiary or which is retained by the trust or the estate. [1.199A-6(d)(3)(ii).]

Proposed Regulations-Single Trust: The proposed Regulations had provided guidance that trusts and estates might need to compute the IRC 199A deduction of the entity to each of its beneficiaries, so they could compute their IRC 199A deduction. [Treasury Regulation 1.199A-6(d).] However, a Trust described in IRC 663(c) with substantially separate and independent shares for multiple beneficiaries will be treated as a single trust for purposes of determining whether taxable income of the Trust exceeds threshold income amounts to become ineligible to declare the IRC 199A deduction. [1.199A-6(d)(3)(iii).] If separate shares under the Trust are ignored and the aggregate qualified business income is determined at the Trust level (and not its separate shares) there is a good chance the Trust will be denied the IRC 199A deduction because its qualified business income is too high. After the Temporary Regulations that implement IRC 199A were published in February, 2019, a concern arose about applying IRC 199A to a Trust with separate shares.

Separate Share Rule: If a single trust (or an estate) has more than one beneficiary, and if different beneficiaries have substantially separate and independent shares, their shares are treated as separate trusts (or estates) for the sole purpose of determining the amount of distributable net income (DNI) allocable to the respective beneficiaries of the trusts. [Treasury Regulation 1.663(c)-1.]

  • The separate share rule can exist if a Trust instrument provides that upon the death of the current beneficiary of the share, the share will be added to the shares of the other beneficiaries of the Trust.
  • A share created under the Trust instrument may be considered separate even though more than one beneficiary has an interest in it. [Treasury Regulation, 1.663(c)-3.]
  • The primary purpose of the separate share rule is to prevent one separate share of a Trust (or an estate) from being required to pay the income tax accumulated for another separate share.
  • The separate share rule does not permit the treatment of separate shares as separate Trusts (or estates) for any purpose other than the application of DNI. For example, the separate share rule does not permit the treatment of separate shares as separate Trusts (or estates) for purposes of: (i) filing tax returns and the payment of tax; (ii) the deduction of the personal exemption; (iii) the allowance to beneficiaries succeeding to the trust property of excess deductions and unused net operating loss and capital loss carryovers on termination of the trust. [Treasury Regulation 1.663(c)-1(b).]
  • Separate share treatment for a Trust or an estate is not elective under IRC 663(c).

Temporary Regulation Comments: The IRS received several comments on the impact of IRC 199A on the separate share rule.

  • The commenters noted differences in the allocation of overall DNI to beneficiaries of a Trust (or an estate) under IRC 643(a) and 663(c) and they expressed concerns about allocations of these items in circumstances involving tax-exempt income and charitable deductions, as well as situations in which no DNI is allocated to any beneficiary.
  • The commentators claimed that under proposed Regulation 1.663(c)-2(b)(5) deductions, including the IRC 199A deduction, attributable solely to one share are not available to any other separate share of the Trust (or the estate.)
  • The commentators recommended that the allocation of QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income of a Trust or estate should be based on the portion of such items that are attributable to the income of each separate share and not the whole Trust.

Final Regulation IRS Response: The IRS confirmed the separate share rule in its Final Regulations to provide that in the case of a trust or estate described in IRC 663(c) with substantially separate and independent shares for multiple beneficiaries, the trust or estate will be treated as a single Trust  (or estate) not only for purposes of determining whether the taxable income of the Trust or estate exceeds the threshold income amount to become eligible to claim the IRC 199A deduction, but also in the determination of taxable income, net capital gain, net QBI, W-2 wages and UBIA of qualified property, qualified REIT dividends, and qualified PTP for each trade or business of the trust or estate, and computing W-2 wages, UBIA of qualified property limitations.

While saying ‘no’ to the proposed application of IRC 199A to each separate share under a Trust raised in the comments, the IRS promised to continue to study the issues raised by the commentators. It is unclear why the IRS promised to continue to look at the interplay between IRC 199A and the separate share rule. Is it unsure of its analysis? Is it ‘giving the commentators a bone’ with the promise to keep studying the issue when it has already made its decision? I guess the point is that I would not hold my breath awaiting a change in IRS position anytime soon.

Conclusion: This is admittedly very confusing topic. The key point is that an IRC 199A deduction is not available if the taxpayer earns too much money, which is why the deduction is phased out at higher earned income levels, ultimately being unavailable if the taxpayer earns too much. The commentators wanted to fractionalize the qualified business income earned by the Trust by claiming the non-elective separate share rule applied to that qualified business income, so that each trust share might separately qualify for the IRC 199A deduction since each trust share’s portion of the Trust’s earned qualified business income was small enough to thus become eligible. The IRS refused to interpret IRC 199A so generously so as to permit multiple trust shares to each claim the 20% tax deduction. The upshot is that it may be more difficult for a Trust or an estate to be able to claim the IRC 199A qualified business income tax deduction.

Postscript: Apparently the IRS received no comments on its other proposed Regulation [Treasury Regulation 1.199A-6(d)(3)(v)] that deals with charitable remainder trusts. That proposed rule, now final,  is that the taxable recipient of a unitrust or annuity distribution amount from a charitable remainder trust established under IRC 664 can take into account QBI, qualified REIT dividends, or qualified PTP income for purposes of determining the recipient’s IRC 199A deduction.