The Tax Cuts and Jobs Act of 2017 (the Tax Act) made significant changes to the United States Tax Code, with implications on virtually all areas of taxation, including some that affect fiduciaries. This article provides a broad overview of some tax implications that may be of importance to trust and estate professionals. The primary areas of focus are related to the 199A deduction, Opportunity Zones, section 1202, and minimizing state income taxes with the use of non-grantor trusts.
The 199A deduction
The 199A deduction is available to some trusts and estates and allows non-corporate taxpayers to deduct up to 20% of their qualified business income (QBI). Under section 199A(c), QBI is the net amount of qualified items of income, gain, deduction, and loss effectively connected with the conduct of a qualified trade or business. This does not include short- or long-term capital gain or loss, dividend income, or interest income not related to a trade or business (§§ 199A(c)(1)-199A(c)(3)(B)). The 199A deduction is based on the taxpayer’s share of unadjusted basis immediately after acquisition (UBIA) and W-2 wages. For trusts and estates, the taxpayer’s share of W-2 wages and UBIA are to be allocated between the trust and the beneficiary under § 199A(f).
The 199A tax deduction is available for grantor and non-grantor trusts, with the following notable differences. For grantor trusts, the person treated as the owner of the pass-through business owned by the trust computes the deduction as if he or she conducted the activity of the trust directly, in proportion to the ownership (Reg. § 1.199A-5(d), §1.199A-6(d)(2)). There is no need to split the allocation between the trust and the beneficiary, because the grantor is treated as the owner of the pass-through entity interest that is owned by the trust. Reg. §199A-6 states that for non-grantor trusts, W-2 wages relevant to the computation of the wage limitation and relevant UBIA of the depreciable property must be allocated among the trust and the trust beneficiaries. For the purposes of determining whether the taxable income of the trust exceeds the threshold amount, the final regulations state the taxable income is determined after taking into account any distribution deduction under §651 and §661. A planning opportunity may be to gift a portion of the business interest into multiple non-grantor trusts to have the benefit of multiple 199A deductions. However, be aware that under § 643(f), two or more trusts may be treated as a single trust if the trusts have substantially the same grantors and beneficiaries and a principal purpose of the trusts is tax avoidance.
Planning with Opportunity Zones
The Opportunity Zone provisions are another possible planning option available for fiduciaries. These provisions were created to encourage a new source of capital for distressed communities. If certain Opportunity Zone provisions are met, taxpayers with capital gains may defer, reduce, or exclude the payment of tax. Taxpayers may elect to temporarily defer certain gains from inclusion of gross income from the sale or exchange of an asset to the extent of the aggregate amount invested in a qualified opportunity fund (QOF), within 180 days from the date of the sale or exchange (§ 1400Z-2(a)(1)(A)). Such deferral will last until the earlier of the sale or exchange and December 31, 2026 (§ 1400Z-2(b)(1)(B)).
The amount of time the investment is held will determine the amount of capital gains deferred and the overall taxes paid. If the investment is held for five years, the taxpayer may receive a permanent reduction of the deferred gain originally realized equal to 10%. If the investment is held for at least seven years, there is a 15% reduction of deferred gain through a partial step-up in basis (§ 1400Z-2(b)(2)(B)). The deferred gain will be included on the earlier of the sale or exchange or December 31, 2026. If the investment is held for 10 years, a permanent exclusion of the appreciation may be received through a full step-up in basis to the fair market value of the QOF investment on the date of the sale or exchange. The sale or exchange must occur before 2048 (§ 1400Z-2(b)(2)(B)). There are tax advantages if the investments are held for an appropriate amount of time, however, there are situations that would cause an inclusion event for federal income tax purposes, prior to the conclusion of the holding period.
The following situations would cause the deferred capital gains to be included in the taxpayer’s income at the earlier of the date the qualifying investment is sold or exchanged, or December 31, 2026: If a transfer of a qualifying investment in a transaction reduces the taxpayer’s equity interest (Prop. Reg. § 1400Z2(b)-1(c)); and if the taxpayer receives property that is treated as a distribution for federal income tax purposes, even if the taxpayer’s equity interest is not reduced. A transfer of an investment in a QOF, by gift, either outright or in trust, regardless of whether the transfer is a completed gift or has tax exempt status, would be considered an inclusion event (Prop. Reg. § 1400Z2(b)-1(c)(3)). Similarly, a sale, exchange, or disposition by a deceased owner’s estate or trust is an inclusion event. However, a distribution of a QOF investment from a deceased owner’s trust or estate by reason of death is not considered an inclusion event. In this situation, the deferred gains continue to the beneficiary by taking the decedent’s holding period. The beneficiary would then be responsible for any deferred tax on December 26, 2026 (Prop. Reg. § 1400Z2(b)-1(d)(1)(iv)). Further, if death is not a taxable event, the deferred gains carry over to the successor and the estate does not receive a step-up in basis, to the extent of the income with respect to the decedent (Prop. Reg. § 1400Z2(b)-1(e)). Another example of a non-inclusion event would be a transfer to a grantor trust, if the owner of the QOF is deemed the owner of the trust (Prop. Reg. § 1400Z2(b)-1(c)(5)).
Although there are benefits to investing in Opportunity Zones, it may not be the best option for your client. For instance, the additional return needed from a typical stock portfolio to have a higher ending net investment value than the QOF may not be that much. The benefits of investing in a QOF may not outweigh the need for flexibility and the amount of income that may be produced from other investments. Another necessary consideration is whether the taxpayer will have any liquidity issues when he or she is required to recognize the original gain that was invested into the QOF in 2026, which could occur prior to the 10-year holding date.
Section 1202 incentives for small businesses
Section 1202 may provide another planning opportunity for your clients. The provisions of section 1202 offer incentives to invest in small businesses. To be eligible for the capital gain exclusion, some requirements must be met. Section 1202(a) allows a taxpayer to exclude 100% of the eligible gain realized from the sale or exchange of qualified small business stock (QSBS) issued after September 27, 2010. The QSBS must be issued by a qualified business. Under section 1202(d), a qualified business is defined as a C-corporation that does not exceed $50MM in assets before and after issuance. The QSBS must be acquired by the taxpayer at the original issuance and be held for five years. Another requirement is that the C-corporation must satisfy the active business test by using at least 80% of its assets in the active conduct of a qualified trade or business. The exclusion of gain is limited to the greater of $10MM or ten times the adjusted basis on the QSBS.
Fiduciaries may consider contributing the QSBS to a non-grantor trust. Under section 1202(h), the recipient of either a gift or bequest of QSBS will be allowed to tack the holding period and the QSBS eligibility. If the transfer is made during life, the transferee will receive the transferor’s basis. If the transfer is made at death, the transferee will receive a step-up in basis. Careful consideration should be made as to which is more beneficial, the step-up in basis or the exclusion amount available to the transferor or the transferee. Another planning opportunity to maximize the QSBS gain exclusion is to make gifts to multiple non-grantor trusts. Each trust could be able to claim its own $10MM exclusion.
Eliminating state income taxes through non-grantor trusts
The Tax Act amended section 164(b) to limit individual state and local tax (SALT) deductions to a maximum of $10,000. This deduction for state and local income, sales, and property taxes has been limited for individual taxpayers, estates of decedents, and non-grantor trusts through year 2025. Under section 641 and the regulations, a decedent’s estate and non-grantor trusts are taxed similar to an individual and are allowed similar deductions. A non-grantor trust will be able to deduct $10,000 because it is considered a separate taxpayer from the grantor. In order to take full advantage of the SALT deduction, a taxpayer could consider funding multiple incomplete non-grantor trusts (INGs) with additional income producing assets that would generate at least $10,000 in income. An ING trust is not considered a grantor trust, and as such is a separate taxpayer from the grantor. A gift to an ING would not be a completed gift, as the grantor would retain ownership of the assets. ING trusts are also beneficial as they provide asset protection from future claims of creditors and protect assets for future generations. Although there are notable benefits to this planning opportunity, the expense to create or manage separate non-grantor trusts may outweigh the $10,000 income tax deduction.
The Tax Act created many changes that fiduciaries should be aware of when offering planning opportunities to clients. As always, the benefits available with these planning opportunities should be considered in light of your individual client’s goals and needs.
For further information and citations please see outline provided to The American Law Institute titled “Tax Reform Implications for Fiduciaries: Lessons Learned So Far,” from July 2019.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. Wilmington Trust does not provide tax, legal or accounting advice. The information in this article has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates and projections constitute the judgment of Wilmington Trust and are subject to change without notice. There is no assurance that any investment, financial, or estate planning strategy will be successful. These strategies require consideration for suitability of the individual, business, or investor.
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