On Dec. 22, 2017, President Donald Trump signed into law P.L. 115-97, known as the Tax Cuts and Jobs Act. Its many new provisions include noteworthy changes to the income taxation of trusts and estates, most of which are effective for tax years 2018 through 2025 (unless otherwise noted).
General impact on income taxation of trusts and estates
Below is a brief overview of the main amendments to the income taxation of trusts and estates.
Rate reduction and thresholds: The law provides, for tax years 2018 through 2025, a new table under Sec. 1(j)(2)(E) of ordinary income tax rates and thresholds for trusts and estates (subject to adjustment for inflation for years after 2018) as shown in the chart below.
Ordinary income tax rates
The law retains the preferential rates for qualified dividend and long-term capital gain income under Sec. 1(j)(5) but adjusts the thresholds as illustrated in the chart below.
Capital gains and qualified dividend rates
Application of Sec. 641(b): Generally, under Sec. 641(b), the taxable income of an estate or trust is computed in the same manner as for an individual. This means that many of the amendments to the Code applicable to individuals are also relevant to calculating the adjusted total income of trusts and estates:
- Sec. 164, state and local taxes: The law amends Sec. 164(b) to limit the aggregate deduction for state and local real property taxes, state and local personal property taxes, and state and local income taxes to a maximum of $10,000 per year. This limitation does not apply to any real property taxes or personal property taxes incurred by a trust or estate in carrying on a trade or business, or an activity under Sec. 212.
- Sec. 67, miscellaneous itemized deductions: The law amends Sec. 67 by suspending all miscellaneous itemized deductions. Trusts and estates will not be permitted to deduct investment fees and expenses and unreimbursed business expenses, among others. On its face, the law does not appear to impact Sec. 67(e), which does not apply the 2% limitation to administration expenses incurred solely because the property is held in a trust or estate (i.e., trustee fees); however, this is an area where clarification will be required.
- Sec. 642(b), personal exemptions: The law amends Sec. 151 to suspend the personal exemptions for individuals; however, trusts and estates remain entitled to their personal exemptions under Sec. 642(b). The amounts of the personal exemptions for trusts and estates remain unchanged.
Alternative minimum tax (AMT) — Sec. 55: The law did not amend the AMT for trusts and estates. The exemption of $24,600 and phaseout threshold of $82,050 for trusts and estates (for 2018) were not changed. These amounts will continue to be adjusted for inflation under Sec. 55(d)(3).
Income distribution deduction (IDD) under Sec. 651: Under Sec. 651(b), simple trusts are entitled to an IDD, which is limited to the lesser of fiduciary accounting income (FAI) or distributable net income (DNI). In the past, FAI has generally been greater than DNI for simple trusts, so the IDD for simple trusts usually equals DNI. This is because all expenses were allowed in calculating DNI, while some expenses were allocated to principal when calculating FAI.
As trusts and estates lose the deductions discussed above, the adjusted total income (ATI) will increase. As ATI increases, DNI increases. FAI will remain the same, as the allocation of expenses for FAI is controlled by a trust's governing document or the applicable state's Principal and Income Act. As such, this may result in FAI becoming the more common IDD limitation, which may result in trusts and estates paying more income tax at the trust level than before the Tax Cuts and Jobs Act was enacted.
Example: A simple trust has ordinary dividends of $100,000, state taxes of $13,000, and a personal exemption amount of $300. The trust document allocates taxes entirely to income, not principal.
As depicted in the chart below, following the amendments to the law, the deduction of state taxes for DNI is limited to $10,000, and FAI is now less than DNI, resulting under Sec. 651(b) in FAI serving as the allowable IDD. Income is now trapped at the trust level, rather than passing out to the beneficiaries, as it would have prior to tax reform. With the compressed tax rate structure of trusts, this result is problematic.
Taxation of trusts and estates with business income
Sec. 199A deduction: Sec. 199A, also introduced by the Tax Cuts and Jobs Act, provides a deduction generally equal to 20% of the net "qualified business income" to any taxpayer other than a corporation, with several limitations. This deduction on passthrough income is thus made available to trusts and estates. The formula for calculating the deduction is complex, and this item does not discuss it in depth, but it is important to consider these issues related to trusts and estates:
- Impact on charitable remainder trusts (CRTs): Under Sec. 664(c)(2), CRTs pay an excise tax of 100% on any unrelated business taxable income (UBTI) that the trust receives. Regs. Sec. 1.512(a)-1(a) defines UBTI as "gross income derived from any unrelated trade or business regularly carried on, less those deductions allowed by chapter 1 of the Code which are directly connected with the carrying on of such trade or business." To be "directly connected," the item of deduction must "have a proximate and primary relationship" to the carrying on of that business. Whether the Sec. 199A deduction (which is found in Chapter 1) meets the requirements of a proximate and primary relationship will need to be clarified by Treasury. If allowed, the new Sec. 199A deduction may work to reduce the amount of the excise tax paid by CRTs with UBTI.
- Impact on electing small business trusts (ESBTs): The portion of the ESBT that is considered to own the S corporation stock may be entitled to the Sec. 199A deduction on the income from the S corporation, reducing its taxable income base. This, along with the rate reduction, may reduce the tax paid by ESBTs on S corporation income from a maximum of 39.6% in tax year 2017 to a potential effective rate of 29.6% starting in tax year 2018 (taxable income reduced to 80%, times 37% top rate). However, note that Sec. 641(c)(2) sets out the specific deductions available to ESBTs, which do not include Sec. 199A. This may prevent ESBTs from being entitled to the deduction, pending further clarification from Treasury or Congress.
Excess business loss limitation under Sec. 461(l): The law amends Sec. 461 to limit the business losses in excess of its business income in a tax year available to a trust or estate (or other noncorporate taxpayer) to $250,000 (adjusted for inflation after 2018). Under Sec. 461(l)(4)(A), the loss limitation is an aggregate figure that applies at the trust or estate level (partner or shareholder level, not the entity level) if the trust or estate is a partner in a partnership or a shareholder in an S corporation. Under Sec. 461(l)(2), any loss in excess of $250,000 will be added to the trust's or estate's net-operating-loss carryover and used in a future tax year. This will impact trusts and estates that previously used business losses to offset portfolio income.
Charitable contributions by ESBTs: The law amends Sec. 641(c)(2) to require that ESBTs compute their charitable deduction in the same manner as an individual. Under prior law, Sec. 642(c) permitted ESBTs to deduct 100% of a charitable contribution made from the gross income of the S corporation. Under the new law, ESBTs are now subject to the same adjusted gross income limitations and charitable contribution carryforwards as individuals when making charitable contributions under Sec. 170(b)(1)(G). These limitations apply only to the S portion and not to the non-S portion. As a result of the change, the S portion of an ESBT may deduct charitable contributions made by the S corporation even if those contributions are not made from the S corporation's gross income. This amendment is permanent.
While the majority of media coverage surrounding tax reform focused on the impact on individuals and corporations, the modifications discussed above impact the income taxation of trusts and estates beginning in 2018.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.