It is becoming increasingly common for trusts to be owners of either operating businesses or rental real estate activities that are structured as partnerships or S corporations. In this context, tax practitioners need to be aware of two special rules that apply to a nongrantor trust or estate that owns the passthrough entity. First, estates and trusts are ineligible to claim Sec. 179 deductions, so the business itself needs to make special basis adjustments to avoid wasting the deduction or a portion of it. Second, depreciation and depletion should be "separately stated items" on the partnership or S corporation Schedule K-1, Partner's [or Shareholder's] Share of Income, Deductions, Credits, etc., if a trust or estate is an owner.
Sec. 179 Deduction
Often, when a business claims a current deduction under Sec. 179 for depreciable assets placed in service, it passes the deduction through to the partners or shareholders (on line 12 of the partnership Schedule K-1 or line 11 of the S corporation Schedule K-1). However, Sec. 179(d)(4) denies this deduction for estates and trusts (other than grantor trusts). Nevertheless, a business with an estate or trust as a partner or shareholder typically still will choose to take the Sec. 179 deduction to benefit its other owners.
Normally, a business reduces the depreciable basis of the assets by the full amount of the Sec. 179 deduction taken. However, because the deduction allocated to the estate or trust otherwise would provide no tax benefit, Regs. Sec. 1.179-1(f)(3) provides that the business does not reduce the basis of the asset by the portion of the Sec. 179 deduction allocated to the trust or estate.
Example 1: A partnership with a nongrantor trust as a 25% partner acquires an asset for $1,000 that qualifies as Sec. 179 property and places it into service. The partnership elects to apply Sec. 179, and thus $250 of its Sec. 179 deduction is allocable to the trust.
In this situation, the partnership would reduce the basis in the asset by only $750, rather than $1,000, leaving it a $250 basis in the asset. Thus, if the partnership immediately disposed of the asset for $100, it would have a $150 loss allocable to all partners instead of a $100 gain allocable to all partners.
The increased basis at the time of disposal benefits all shareholders and is not allocated solely to the trust. In the end, the partnership gets a total deduction of $1,000 (the $750 deduction and $250 of basis), but the timing is spread out. Likewise, Regs. Sec. 1.179-1(f)(3) provides that the partnership can claim a depreciation deduction under Sec. 168 for the basis that remains because the Sec. 179 deduction was not allowed for the trust. In Example 1, the $250 that would have otherwise been allocated to the trust as a Sec. 179 deduction can instead be depreciated by the partnership over the depreciable life of the asset, starting in the year the asset is placed in service. However, just like the $150 loss mentioned earlier, the depreciation deduction is allocated to all owners and not just to the trust. In essence, the $250 tax benefit (which the trust would have obtained if the Sec. 179 deduction had been allowed) instead is allocated among all the owners, either in the form of additional depreciation deductions or a higher basis upon disposal of the asset.
But can the trust or estate obtain overall tax benefits comparable to those of the other owners who do qualify for the Sec. 179 deduction? S corporations have no way to rectify this problem, since Sec. 1377(a)(1) requires S corporations to allocate all income and expenses on a pro rata basis. However, partnerships can, under Sec. 704(a), allocate most items of income and expense based on the partnership agreement. Therefore, individuals drafting partnership agreements should keep in mind the possibility of trusts or estates being owners.
Drafters could include a provision in the partnership agreement that allocates Sec. 179 deductions to nontrust partners and additional other expenses to trust owners. This would prevent the trust from being allocated a Sec. 179 deduction that it is not allowed to use. This type of provision bears some risk, however, since the IRS conceivably could argue that the deduction does not have substantial economic effect (as described in Regs. Sec. 1.704-1(b)(2)) and thus is invalid. A safer approach might be for the partnership agreement to dictate that the trust or estate (as a partner) should specifically be allocated any gain or loss or Sec. 168 depreciation deduction related to the additional basis caused by the estate's or trust's inability to claim Sec. 179 deductions. This allocation could be viewed as a way to correct discrepancies between a partner's inside and outside basis rather than constituting an allocation without substantial economic effect.
Depreciation as a Separately Stated Item
In addition to the issues surrounding Sec. 179, businesses that have trusts or estates as owners need to be mindful of how depreciation expense is presented on a Schedule K-1 that is reported to the estate or trust as an owner.
When partnerships and S corporations report taxable income on Schedule K-1 to the owners, most income and deductions are netted and passed through as a single ordinary business income (or loss) figure. However, a rule for both S corporations (Sec. 1366(a)(1)(A)) and partnerships (Regs. Sec. 1.702-1(a)(8)(ii)) provides that any item of income, loss, deduction, or credit should be separately reported if the separate treatment could affect the partner's or the shareholder's income tax liability. For most partners or shareholders, depreciation expense does not need to be separately stated. However, if the partner or the shareholder is a trust or estate, the treatment of depreciation can affect the tax liability not only of the trust or estate but also of its beneficiaries. Thus, Rev. Rul. 74-71 requires depreciation to be separately stated when an entity has a trust or estate as an owner.
Depreciation can affect the tax liabilities of a trust or estate because of the rules peculiar to calculating an estate's or trust's taxable income. Specifically, a trust or estate claims a deduction for amounts distributed to a beneficiary, and the beneficiary then reports an amount of taxable income equal to the deduction claimed by the trust or estate (per Secs. 651 and 661). As part of this process, however, any depreciation or depletion deduction allowed to the estate or trust is likewise shifted to the beneficiary and is reported separately by the trust to the beneficiary (Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credits, etc., line 9, code A or B). Unlike the majority of other items of income and expense, which are shifted from the fiduciary to the beneficiary based on a proportion and measured as a distribution to the beneficiary as a percentage of the distributable net income, depreciation is allocated based on the ratio of the distribution compared with the trust's or estate's trust accounting income (TAI) (Regs. Sec. 1.167(h)-1(b)).
Example 2: A trust has only one beneficiary who can receive distributions from it, but the trust is not required to make distributions. The trust earns $1,100 of rental income, incurs trustee fees of $200 and depreciation expense of $300, and pays the beneficiary a distribution of $400.
A practitioner who is unaware of the unique rules for depreciation might conclude that the trust has net income of $600 ($1,100, less $200 and $300) while the beneficiary receives a distribution of $400. If so, he or she would issue a Schedule K-1 to the beneficiary for $400 of net rental income, leaving $200 taxable to the trust. The correct method would be to separately state the depreciation and independently allocate it between the fiduciary and the beneficiary, based on the proportion of the distribution ($400) to the TAI ($1,000).
TAI is calculated differently than taxable income and is computed in Example 2 as rental income ($1,100) less one-half of the $200 trustee fee (or $100). Therefore, the $300 of depreciation expense would be allocated 40% (or $120) to the beneficiary, while the trust itself would be allowed to claim a deduction for the remaining $180 of depreciation. Ultimately, the beneficiary would receive a Schedule K-1 showing $400 of taxable income (because of the $400 distribution) and a depreciation deduction of $120. Thus, the net taxable income to the beneficiary would be $280, rather than the $400 in Example 2. Meanwhile, the trust itself would have net taxable income of $320 (computed as $1,100 of interest, less $200 of trustee fees, less a $400 distribution deduction and $180 of depreciation). Overall, a total of $600 is taxable in both calculations, but instead of the improper allocation of $400 to the beneficiary and $200 to the trust, the proper treatment is $280 to the beneficiary and $320 to the trust.
It is clear, based on Example 2, that separately stating deprecation can significantly affect the taxation of both a trust and its beneficiary, and that it would be incorrect for a partnership or S corporation that has an estate or trust as an owner to include depreciation in the calculation of a single net number for ordinary business income. Although this difference in taxation occurs only if the trust or estate makes a distribution to the beneficiary, tax practitioners who are preparing tax returns for businesses that have estates and trusts as owners should err on the side of caution and always separately state the depreciation or depletion expense for an estate or trust. While this technique might not significantly affect the overall taxation in some scenarios, it is nearly impossible for the practitioner preparing the business return to know whether it will have an impact. Trusts are ever-changing entities, and what is true for a trust one year might not be true the next year.
When trusts own entities that hold depreciable assets, tax practitioners should proceed with caution. With distinct and tricky tax nuances at play, anyone preparing trust tax returns or business tax returns needs to think critically about otherwise simple depreciation. A partnership or S corporation tax return might need to be prepared differently simply because the entity has a trust or estate as an owner.
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.