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

27-Aug-18

IRC 199A: Trusts Under the Proposed Regulations – Part III

Take-Away: As noted previously, the IRS has provided guidance under IRC 643(f) with new proposed Regulations, declaring that it will aggregate several trusts for the purpose of identifying the reported taxable income from multiple trusts. This ‘aggregation’ approach is intended to have the effect of disqualifying  trusts with common beneficiaries that hold a trade or business interest from claiming an IRC 199A income tax deduction. This is accomplished by the IRS ‘disrespecting,’ aka ignoring,  separately taxed non-grantor trusts that receive qualified business income simply by treating all of the trusts as a single irrevocable trust.

Background: The 2017 Tax Act creates some opportunities for families to reduce income tax liability though the use of non-grantor or complex trusts. A complex trust can offer great flexibility because the income of the trust can be retained and taxed at the trust’s level, or alternatively it can be distributed in whole or in part to beneficiaries, including charities, in order to carry out income so that it can be taxed at lower marginal income tax brackets, depending upon the beneficiaries and their financial circumstances. Accordingly, such complex trusts can be: (i) in lower income tax brackets; (ii)  exempt from the 3.8% Medicare surtax on the first $12,500 of retained income; and  (iii)  deduct up to $10,000 of real estate or other state or local taxes that a related individuals cannot deduct. In addition, such trusts may also qualify for the 20% IRC 199A deduction for which related high income individuals would not qualify. However,  many hurdles have to be cleared in order for the complex trust to claim the IRC 199A  income tax deduction. For purposes of this summary, recall that a complex trust includes a qualified subchapter S trust (QSST) or an electing small business trust (EBST) which are permitted to hold S corporate stock.

Example: A married taxpayer who owns an LLC, which is a specified service trade or business under IRC 199A, pays no wages and owns no qualified property. Taxpayer earns $1.0 million of income from all sources. As a result, taxpayer and his spouse are ineligible to claim any IRC 199A deduction because their taxable income exceeds $415,000 for the calendar year. Suppose the taxpayer creates three separate complex trusts for each of his three children. Taxpayer transfer a portion of his LLC to each of the three complex trusts. In addition, a management company that provides services to the LLC on arms-length terms could also be established to reduce the LLC’s income that passes through to the taxpayer. If each of the complex trusts created for each child earns less than $157,500 of K-1 qualified business income, each trust is entitled to a separate 20% IRC 199A income tax deduction. Each trust can further reduce its taxable income for the year by paying up to $10,000 per year in state and local property taxes, or by making distributions to charities that are also named as potential beneficiaries of the trust along with the taxpayer’s child. In sum, the taxpayer who has income above the income limitation level where the IRC 199A deduction does not apply to a specified service trade or business, can intentionally decrease his income by having his LLC (or S corporation or partnership) owned in part by complex trusts in order to qualify for the IRC 199A income tax deduction.

Proposed Regulations: The proposed Regulations released earlier this month, aim to limit, or eliminate, the multi-trust planning strategy described in the example. They do so in either by aggregation of the complex trusts or by ‘disregarding’ the complex  trust (with the trust’s income treated as received by the trust’s settlor.)

  • Distribution Deductions Ignored: For trusts and trust beneficiaries, the $157,500 income threshold is measured at the trust level without taking into account any distribution deduction for distributable net income (DNI) that is actually distributed to the trust beneficiaries. The proposed Regulations state: For purposes of determining whether a trust or estate has taxable income that exceeds the threshold amount, the taxable income of a trust or estate is determined before taking into account any distribution deduction under sections 651 of 661. [Proposed Reg. 1-199A-6(d)(3)(iii) and (v).] Example: Businessman wants to establish a non-grantor trust to own a portion of his S corporation, the trust being for the benefit of his child. That trust can accept $157,500 of taxable income without being subject to the limitations of IRC 199A. If the trustee makes a distribution from the trust to the child of $50,000, and retained $157,500 of income for the taxable year, the trust will be considered to have $207,500 in taxable income for the year and would thus be subject to the wage/qualified property limitation of IRC 199A. Restated, the trustee in the above example cannot distribute amounts in excess of $157,500 to one or more trust beneficiaries and still take a distribution deduction to remain under the $157,500 threshold used by IRC 199A.
  • Pro Rata Allocation: If the trust exceeds the $157,500 income threshold, then the trust and the trust beneficiaries must each satisfy the wage/qualified property ‘test.’ Wages and qualified property must be allocated among the trustee and the trust beneficiaries in proportion to the distributable net income (DNI) distributed to the trust beneficiaries or retained by the trustee. Example: The trust has $257,500 of income. The trustee distributes $100,000 of income to the trust beneficiary. As a result the trust exceeds the $157,500 income threshold. Wages and qualified property used by the business held in the trust will be allocated 61% ($157,500/ $257,500) to the trust, and 39% ($100,000/$257,500) to the trust beneficiary.
  • Trusts Ignored: We know that many clients establish trusts for children and grandchildren that are separately taxed for a variety of purposes. Many of these non-grantor trusts are intended to hold S corporate stock, LLC membership interests,  and partnership interests. Normally these trusts will qualify for the IRC 199A deduction under situations where the parents would not qualify for the IRC 199A deduction because of the parents’ high income above the threshold levels. The proposed Regulations expressly state 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.” It is not real clear what is meant by ‘not be respected.’ Does it mean the trust will be completely ignored? Will the trusts be aggregated for all purposes or just for income tax reporting purposes? Will the IRS substitute the beneficiaries or the settlor as the taxpayer in lieu of the trust itself? Hopefully we will be provided some direction what not be respected actually means. Of relatively little help is the proposed Regulations use of a but for test: “But for the enactment of Section 199A and A [the taxpayer’s] desire to avoid the W-2 wage limitation of that provision, A [the taxpayer] would not have created or funded such trusts.”
  • Enter IRC 643: This Tax Code section gives authority to the IRS to aggregate or consolidate multiple trusts if there are not significant non-tax differences between the trusts and the trusts have substantially the same settlors and beneficiaries. [IRC 643(f)] Spouses are treated as one taxpayer under this section. This Code section was adopted in 1989. It allows the IRS to treat two or more trusts as a single trust if they (i) were formed by substantially the same settlor; (ii) had substantially the same primary beneficiaries; and (iii) were formed for the principal purpose of avoiding income taxes. Unfortunately, Treasury Regulations were never issued by the IRS on IRC 643(f)- until now that is. While the current proposed IRC 199A Regulations attempt to rely on IRC 643(f) the proposed Regulations appear to ignore the requirement of IRC 643(f) that all three (i-ii-iii) conditions must be met before the several trusts can either be aggregated into a single trust or simply ignored. This consolidation rule of IRC 643(f) can be relatively easily avoided if the trust has only one child as its current primary beneficiary, i.e. if principal cannot be invaded for another child. [This was the result of an earlier PLR 201709020.]However, the creation of separate trusts established to make health, education, and support payments for the same trust beneficiaries will probably be aggregated if the multi-trust arrangement results in the avoidance of substantial income taxes.
  • Regulatory Presumption: Perhaps more troubling is that the proposed IRC 199A Regulations state that a principal purpose of the trust will be presumed to be to avoid income taxes if it results in a significant income tax benefit, unless there are other significant non-tax purposes identified that could not have been achieved without the creation of the separate trusts. [Proposed Regulation 1.199A-6(d)(3)(v).] But no examples were provided by the IRS to guide advisors in the interpretation of this ‘new’ presumption of intended income tax avoidance, or what constitutes a significant non-tax purpose for a trust that might be asserted to overcome the presumption created by these proposed
  • Fiscal Years: S corporations, trusts, estates, and partnerships that are not on a calendar year basis for 2017 and 2018 will be considered to have all items of income and deduction occur for IRC 199A calculation purposes for the period ending in 2018. Unanswered is what happens when a trust has a fiscal year that begins in 2018 and ends in 2019 with regard to its income and deductions.

S Corporate Stock:

  • Electing Small Business Trusts: Despite the failure of Congress to conform the electing small business trust (EBST) Code section at the time the 2017 Tax Act was enacted, the proposed Regulations confirm that an EBST which is eligible to hold S corporation stock can qualify for the IRC 199A income tax deduction on its reported S corporation income.
  • Carry-Over Basis: But S stock is not treated so well from another perspective. The proposed Regulations provide that qualified property that is contributed tax-free by a shareholder to an S corporation will have its basis for the 2.5% qualified property calculation/’test’ based upon the depreciated basis of the property on the date of its transfer by the shareholder to the S corporation, instead of its original cost basis which is usually the case when ‘new’ capital assets are contributed by a shareholder to an S corporation. This approach that uses a carry-over basis will definitely hurt an individual who wants to convert his/her proprietorship or partnership into an S corporation with the transfer of business assets as capital to the ‘new’ S corporation.

Planning Considerations: Due to the proposed IRC 199A and IRC 643(f)Regulations tax planning with complex trusts need to be carefully approached. In order to ‘work-around’ these proposed Regulations, consider the following:

  • Decanting: If a large complex trust already exists for family members, consider decanting that existing trust into several smaller complex trusts. This ‘division’ might be accomplished by a non-judicial settlement agreement depending upon the terms of the trust instrument.
  • No Common Lifetime Beneficiaries: If multiple irrevocable trusts are to be considered as an individual taxpayer for IRC 199A purposes, those trusts should not have common lifetime beneficiaries, except upon very restricted and differing standards. Thus, one trust should be created for each child, with no ability to invade that trust’s principal for the benefit of the settlor’s other children, which  will probably avoid the aggregation of the several trusts under IRC 673(f). It would probably help, too, if these multiple trusts each had different distribution provisions or rights conferred on their respective trust beneficiary.
  • Non-Tax Savings Purpose: It is clear that a complex trust that is created for the sole purpose of taking advantage of IRC 199A will be ‘disrespected.’ As such, the ‘material purpose’ clause of each trust should clearly identify its ‘significant non-tax purposes.’ A clear material purpose clause in the trust may be given more evidentiary weight than the vague presumption of tax avoidance purposes that is the primary effect of the proposed
  • Increase Trust Flexibility: Since the proposed Regulations tell us that complex trusts created and taxed under IRC 678 will not be aggregated, or ‘disrespected, ’ it would make sense to add a trust protector to each trust with powers to modify the terms of the trust so that it could be converted to an IRC 678 trust, and to make any other alterations to the trust to adapt to the final IRC 199A Regulations. IRC 678 provides that a trust beneficiary who has the power to withdraw income or principal from the trust, or who has previously released or modified such a power and retains any power under the trust what would cause the trust to be considered as a disregarded grantor trust as to him [the trust beneficiary] under IRC 671 to 677, will be treated as the owner of the trust for income tax purposes, informally called in estate planning literature a beneficiary deemed-owned trust, or BDOT. In short, IRC 678 trusts will not be aggregated or ‘disregarded.’
  • ‘Divide and Conquer? Exploit IRC 678 Exception: As noted, apparently IRC 678 trusts are exempt from the proposed aggregation rule of the IRC 199A Regulations. Consider a non-grantor trust, taxed as a complex trust for federal income tax purposes, which also provides the primary beneficiary with the power to withdraw taxable income above the income phase-out level of $157,500 which will cause such portion of the trust to be considered a BDOT as to that beneficiary. The effect is to cause the trust to be divided into two separate portions for federal income tax purposes, one portion being a non-grantor complex trust and the other portion (the one above the $157,500 amount) being considered a BDOT as to the beneficiary.

Conclusion: While the threat of aggregating multiple trusts is very real, it may be fairly easy to avoid that threatened trust consolidation by making those several trusts as dissimilar as possible. Thus, there will be a premium on making those trusts as flexible as possible to respond to the  IRC 199A and IRC 673(f) Regulations whenever they become final.