Tax-exempt trusts: New guidance on Sec. 199A deduction

By Nanaz Benyamini, CPA, Los Angeles

Editor: Mark G. Cook, CPA, CGMA

It is often overlooked that a tax-exempt trust may be eligible for a qualified business income (QBI) deduction. On April 26, 2019, the IRS posted informal guidance on its website to explain how trusts that file Form 990-T, Exempt Organization Business Income Tax Return, and have unrelated business income (UBI) can claim the deduction (IRS, "Trust — Qualified Business Income Deduction Under Section 199A," available at www.irs.gov).

For tax years beginning in 2018 and through 2025, the law known as the Tax Cuts and Jobs Act, P.L. 115-97, allows eligible taxpayers to claim a new business deduction computed as follows: the lesser of 20% of QBI plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, or 20% of taxable income minus net capital gains. However, there are certain limitations set by taxable income thresholds. By now, it is widely understood that the deduction is available to individuals with ownership or beneficial interests in relevant passthrough entities (RPEs) such as sole proprietorships, partnerships, S corporations, trusts, and estates. However, nongrantor tax-exempt trusts may be eligible as well, so long as they report UBI on a Form 990-T. The deduction could be used to offset the UBI, thereby reducing the trust's income tax liability. A nongrantor trust must calculate its QBI and related Sec. 199A deduction at the entity level (Regs. Sec. 1.199A-6(d)(3)(i)).

The QBI deduction has two components:

  • The QBI component: A deduction equal to 20% of QBI generated from a domestic trade or business operated as a sole proprietorship or through a passthrough entity (i.e., a partnership, S corporation, trust, or estate). If the taxpayer's income exceeds a certain threshold level, this component of the deduction is subject to limitations based on whether the trade or business producing the QBI is a specified service trade or business (SSTB), the amount of W-2 wages paid by the trade or business, and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business.
  • The REIT/PTP component: A deduction equaling 20% of qualified REIT dividends and qualified PTP income. Unlike the QBI component, this component is not limited by W-2 wages or UBIA of qualified property. However, if the taxpayer's taxable income exceeds a threshold amount, the amount of PTP income that qualifies for the deduction may be limited if the PTP's trade or business is an SSTB.

Real estate investments can only qualify for the deduction if the rental real estate enterprise is a trade or business as defined in Sec. 199A(d). Rental real estate held as a passive activity is unlikely to suffice. Note that many tax-exempt trusts have Form 990-T filing requirements due to income from rental activity that is debt-financed. To add clarification and help reduce uncertainty, the IRS issued Notice 2019-7 to provide a "safe harbor" assuring rental real estate enterprises they will be considered a "trade or business" for purposes of Sec. 199A if they fulfill certain prerequisites. According to the notice, even if an enterprise fails to satisfy the requirements for the safe harbor, it may still be treated as a Sec. 199A trade or business so long as it otherwise meets the definition of a trade or business set forth in Regs. Sec. 1.199A-1(b)(14).

If a tax-exempt trust that is otherwise eligible for the QBI deduction has taxable income (before the QBI deduction) above the threshold amount, the deduction may be limited based on whether the trade or business is an SSTB (the SSTB limitation) or the W-2 wages paid by the trade or business and the UBIA of qualified property used by the business (the W-2 wages and qualified property limitation). If a tax-exempt trust's taxable income from unrelated business activities is less than $160,700 in 2019, then the full QBI deduction is available for QBI from an unrelated business activity even if the activity is an SSTB and no W-2 wages are paid. If the trust's income is $160,700 or greater, a partial SSTB limitation or W-2 wages and qualified property limitation will apply in calculating the deduction, and if the trust's income is $210,700 or greater, the full SSTB limitation or W-2 and qualified property limitation will apply.

Per the IRS website's guidance, the taxable income used for calculating the QBI deduction is the amount reported on Form 990-T, line 36, "Total of Unrelated Business Taxable Income Before Specific Deduction," less the specific deduction permitted by Sec. 512(b)(12).

Aside from the considerations given above for a tax-exempt trust to qualify for Sec. 199A, taxpayers must also abide by the new rules set forth in the TCJA affecting tax-exempt organizations. That is, for tax years beginning after Dec. 31, 2017, Sec. 512(a)(6) states that a tax-exempt organization must determine its UBI separately for each unrelated trade or business when the organization has multiple UBI activities, and the income for any individual unrelated trade or business cannot be less than zero. In other words, a loss from one unrelated business activity cannot be used to offset income from another unrelated business activity.

Accordingly, when a tax-exempt trust is calculating its QBI, it must exclude items of income, gain, deduction, and loss from any unrelated trade or business that generated a loss for the tax year. Such a loss will be carried forward to future years when the trust has income from the same UBI activity so that the loss may be used in calculating the UBI in those future years. Similarly, for tax-exempt trusts with taxable income amounts over the $160,700 taxable income threshold, W-2 wages and UBIA of qualified property from an unrelated trade or business that operated at a loss during the current tax year will be excluded in calculating the current-year limitation on QBI, thereby reducing the potential deduction allowed to be taken in the current tax year.

For 2018 tax returns, the calculation of the QBI deduction is computed on a separate worksheet that is retained by the taxpayer (and not filed with the IRS). The resulting QBI deduction amount is added to any specific deduction already permitted, and the total of these two amounts is reported on Form 990-T, line 37, "Specific Deduction." The tax-exempt trust will need to attach a statement to its Form 990-T identifying the amount of the QBI deduction claimed on line 37.

Starting with the 2019 tax return, there is a new Form 8995, Qualified Business Income Deduction Simplified Computation, to be used for reporting the computation of the Sec. 199A deduction, and attached to the Form 990-T filed with the IRS.

EditorNotes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

All contributors are members of SingerLewak LLP.

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