Few will be surprised to learn that the Tax Cuts and Jobs Act has a number of implications for trusts and individual estates. After all, there aren’t many aspects of business and personal finance that have not been affected.
Most of the changes ushered in by the new law revolve around the business income deduction, state and local taxes, expenses, and charitable contributions. Here is some clarification on a few particularly worrisome provisions that could come up as you plan future tax strategies.
State and local tax deduction
The new tax law specifically references a $10,000 deduction limit on state and local income taxes, but there has been some confusion as to whether the same limit applies to trusts and estates.
In many cases, the taxable income of a trust or estate is calculated in the same manner as an individual, so the $10,000 deduction limit does apply to trusts and estates for tax years beginning in 2018.
Section 199A deduction qualifications
Trusts and estates qualify for a new 20 percent deduction under IRC Section 199A if they have business income from a sole proprietorship, partnership, or S corporation, and the thresholds that apply to non-married taxpayers also apply to trusts and estates.
The deduction is divided between the trust or estate and its beneficiaries. For trusts holding S corporation stock must make an election to be either a qualified subchapter S trust (QSST) or an electing small business trust (ESBT), with limited exceptions. Each of these has unique tax reporting requirements that impact the Section 199A deduction.
Qualified subchapter S trust
A QSST treats S corporation income as a grantor trust to the beneficiary. In other words, the beneficiary is treated as if he or she owns the S corporation stock directly, at least for tax purposes. The calculation of the Section 199A deduction is based on the beneficiary’s taxable income and reported on the beneficiary’s tax return.
If the trust also has business income from another source, such as a partnership, the calculation of the Section 199A deduction is at the trust level like any other nongrantor trust.
Electing small business trust
An ESBT calculates the tax on S corporation income separately from all other trust income using a separate schedule. Once the ESBT tax is determined, it is added to the total tax calculated for the non-S income of the trust. Since the ESBT pays tax on all of the S corporation income, regardless of whether it has been distributed to the beneficiaries, the 199A deduction for the ESBT portion of the trust will reduce the ESBT income and will not be apportioned to the beneficiaries.
Administrative expenses are still deductible
Another area that became cloudy after the tax reform law took effect is the deductibility of certain expenses incurred by a trust or estate. It is clear that any miscellaneous itemized deductions subject to the 2 percent of adjusted gross income (AGI) limitation, such as investment management fees, are no longer deductible by a trust or estate. However, it is less straightforward for other expenses.
In the past, several expenses have been fully deductible for a trust or an estate, even though they would have been limited for an individual. For example, a trust’s accounting expenses (including the cost of preparing the income tax return) and a trust’s legal expenses, have been fully deductible and not limited by the 2 percent threshold. Also, trusts and estates have been allowed to fully deduct trustee and executor fees. Under previous tax law, these deductions have been allowed to the extent that the expense “would not have been incurred if the property were not held in such trust or estate.”(IRC Section 67(e))
Opinions differ on whether the new tax law applies to these trust and estate expenses since it does not reference the previous requirements. However, there is additional support for continuing to deduct these items. IRC Section 67(g) applies to miscellaneous itemized deductions. Since these expenses are essentially above-the-line deductions for a trust or an estate, they are factored into the determination of AGI. At this time, we believe these expenses are still fully deductible.
Electing small business trusts
The Tax Cuts and Jobs Act made two additional changes that impact ESBTs:
Nonresident alien individuals are now permitted to be a potential current beneficiary. Previously, the existence of a nonresident alien beneficiary would have disqualified the trust from becoming an ESBT. This gives the trust greater latitude in who it can name as beneficiary.
The Tax Cuts and Jobs Act now provides that an ESBT will follow the same rules as individuals regarding charitable deductions. In order for a charitable contribution to be deductible under the previous law, it had to be made pursuant to the governing instrument of the trust or estate, and the contribution had to be made from the gross income of the trust. In addition, excess contributions could not be carried forward, and the AGI limitations on individuals did not apply to estates and trusts.
Under the new law, excess deductions can be carried forward and the contribution does not have to be made from the ESBT’s gross income, but is now subject to the same AGI limitations as individual taxpayers. In order for the ESBT to take the deduction, the S corporation needs to make the charitable contribution. A charitable contribution made directly by the trust would be reported on the non-ESBT portion of the tax return and could not be allocated to the ESBT portion.
New tax brackets for trusts and estates
Instead of the seven tax rates that apply to individuals, trusts and estates now have just four. The brackets — 10 percent, 24 percent, 35 percent, and 37 percent — are still extremely compressed, with the top rate applying at $12,500 of taxable income.
How we can help
Our tax professionals continue to monitor new guidance from the IRS related to estate and trust taxation issues. We’re ready to help you filter out the misconceptions so you may effectively plan your tax strategy.