The Impact of the Tax Cuts and Jobs Act on Trusts and EstatesBy Laura E. LaForgia | May 29, 2019
Among the many provisions in the Tax Cuts and Jobs Act of 2017 (TCJA) were some significant changes to the taxation of trusts and estates. High-net-worth individuals and their advisors should be aware of both the temporary and permanent effects on their trust and estate tax planning strategies.
Prior to the TCJA, taxpayers were able to give away roughly $5 million from their estates free from estate tax. The 2017 tax act more than doubled this lifetime exclusion amount and adjusted it for inflation. Currently, this allows an individual to transfer $11.4 million and a married couple to transfer $22.8 million. While this is not a permanent change, it will remain in place through 2025 (barring Congressional action), at which point the $5 million basic exclusion amount will return, indexed for inflation.
But what happens if a taxpayer takes advantage of the full exclusion amount and it reverts to $5 million in 2026? Would a “claw back” trigger future gift or estate tax recoupment? The Internal Revenue Service (IRS) addressed these worries in proposed regulations (REG 106706-18), the conclusion of which was that a donor who takes advantage of the current lifetime gift amount will not be penalized for gift and estate tax purposes later.
The TCJA had several tax law changes that affect either directly or indirectly the income taxation of trusts and estates. The new law limited or repealed the deduction of certain expenses of trusts and estates through 2025. For example, state and local income taxes and property taxes are maxed out for trusts and estates at $10,000, similar to individuals.
TCJA also suspended the deduction of miscellaneous itemized deductions related to Internal Revenue Code Section 67(a). For an individual, these “miscellaneous 2% deductions” generally needed to exceed 2% of a taxpayer’s adjusted gross income to receive the deduction. From a trust perspective, it is not clear from the language of TCJA alone what is or is not deductible. IRS indicated in IRS Notice 2018-61 that future regulation guidance will indicate that costs of trust or estate administration are deductible as they are unique to these entities. In other words, expenses paid by a trust or estate that could have been incurred by an individual are considered miscellaneous itemized deductions and not deductible. Examples of costs allowed include tax preparation fees for trust and estate services, probate costs, appraisal fees, and certain fiduciary fees. Not allowed: regular costs of ownership of property such as insurance and maintenance costs, tax preparation fees for final Form 1040 or Form 709 gift tax, or other fees that are not unique to trusts or estates.
Investment advisory fees and management fees charged under the normal course of asset management are miscellaneous itemized deductions covered under Section 67. Hence, they are no longer deductible. Often, clients pay one bundled fee where multiple fees are billed together. Tracing must be done to carve out any deductible amounts from the bundle or else allocate using a reasonable method as provided by IRS regulations.
Although TCJA nixed an individual’s personal and dependency exemptions for the time being, it retained the exemption for trusts of $100/$300 and $600 for estates. This is a small consolation given that the tax brackets for trusts and estates are still very com- pressed as compared to individual rate brackets. Trusts and estates reach the top tax rate of 37% (down from 39%) once taxable income exceeds $12,500.
IMPLICATIONS OF SECTION 199A ON TRUSTS & ESTATES
The biggest and most complicated change of TCJA is what is called the “Section 199A deduction.” What exactly is this? As everyone has probably heard, the corporate tax rate was reduced from 35% to 21%. This was a tremendous selling point for doing business as a corporation as opposed to other forms of business. Enter Section 199A, which was written to give pass-through entities and sole practitioners who have qualified business income (QBI) a tax boost. The effective federal marginal tax rate on QBI is brought down from 37% to 29.6% after incorporating the Section 199A deduction.
Section 199A grants a deduction equal to 20% of QBI to noncorporate entities that own a pass-through that is engaged in a qualified trade or business (QTB). However, the computation is not as straightforward as it may read because it is subject to a taxable income limitation that may require complex computations and analysis. For non-grantor trusts and estates, the limitation in 2018 starts to apply at taxable income of $157,500 and gets fully phased in when taxable income exceeds $207,500. (Note: for grantor trusts, Sec 199A has no impact at the trust level as the individual is treated as the owner of the assets and all calculations are done at the individual level.)
After the limitation kicks in, the deduction for the year is equal to the lessor of:
1. 20% of QBI from a QTB, and
2. The greater of:
• 50% of the W-2 wages of the QTB, or
• 25% of the W-2 wages of the QTB plus 2.5% of the “unadjusted basis” of the qualified property in such QTB.
Trusts and estates that distribute income determine the QBI limitation at the level of either the trust or estate or the beneficiary, depending on the allocation of overall income and QBI between the trust or estate and the beneficiaries. Therefore, there is interplay between the QBI calculation and taxable income of both the individual and the trust/estate. There are planning opportunities to determine whether there would be savings to distribute a portion or all of income to a beneficiary (and hence the QBI) in exchange for the less compressed tax brackets.
Trusts and estates must compute QBI, W-2 wages, and unadjusted basis of qualified property for each trade or business. Information regarding the above mentioned must be provided to the beneficiaries so that they are able to compute their deduction.
Qualified REIT dividends received by eligible taxpayers generally are eligible for a 20% deduction under Section 199A. Form 1099-Div reports this number in box 5. A Schedule K-1 shows this information in box 20. In addition, qualified publicly traded partnership (PTP) income are eligible for a 20% deduction as well. In cases where an investor has both types of investments, both buckets are netted first before the calculation of the 20% QBI deduction.
Because of the complexities of this code section, please consult your Marks Paneth tax advisor regarding how this might affect your trust or estate.
NEW YORK UPDATE
On April 12, 2019, Governor Andrew Cuomo signed into law the New York Fiscal Year 2020 Budget. A late addition to the budget deal is a provision that decouples from the federal treatment of itemized deductions of an estate, trust or beneficiary. This change, retroactive to December 31, 2017, allows deductions under Section 67 that are not allowed at the federal level. This corrects the discrepancy between trusts & estates and individuals.
The budget also requires trusts and estates to addback as an adjustment to income the federal deduction under Section 199A. If you filed your Form 1041 early in the season, you may want to consult with your tax preparer on whether or not an amendment is advisable.
About Laura E. LaForgia
Laura E. LaForgia, CPA, MST, AEP®, is a Partner at Marks Paneth LLP and a member of the firm's Private Client Services Group. Specializing in complex tax issues for high-net worth individuals and their families, Ms. LaForgia helps her clients manage, preserve and transfer their wealth through strategic income tax planning and compliance, trusts and estate planning, business management solutions and financial planning. Ms. LaForgia also provides guidance on matters related to gift tax, multi-state... READ MORE +