On Jan. 18, the Internal Revenue Service and Treasury issued final regulations under Internal Revenue Code Section 199A. IRC Section 199A was enacted in December 2017 as part of the Tax Cuts and Jobs Act, creating a tremendous number of jobs for CPAs and other tax professionals.
The statute itself made no mention of trusts, other than to generally provide that trusts that are taxed as separate entities (complex trusts) would qualify for the 20 percent IRC Section 199A deduction, even if they received income from specified trades or businesses (SSTB) or trades or businesses that didn’t have wages or qualified property.
The trust and estates industry was therefore ready, willing and able to design and implement an army of complex trusts that would own portions of trades and businesses to qualify for the Section 199A deduction under circumstances in which the grantors of these trusts wouldn’t otherwise have qualified.
The deduction applies to single taxpayers, trusts and estates whose taxable income falls below $160,700 in 2019 and to married taxpayers filing separately whose taxable income falls below $321,400.
Proposed Regs
The proposed regs issued in August provided that a complex trust established with a principal purpose of avoiding income tax under Section 199A would be “disrespected” under Section 199A.
To our knowledge, the word “disrespected” has never appeared in an IRC Section provision or regulation and is in fact a pejorative term that hasn’t been accepted since the case of Brown v. The Board of Education was decided in 1954.
In addition, the drafters of the proposed regs sought to wake up a sleeping monster known as IRC Section 643(f), which was enacted in 1984 (no relation to George Orwell). Section 643(f) provides that the Treasury has the authority to issue regulations that would cause multiple complex trusts to be aggregated to prevent taxpayers from taking advantage of having a separate tax bracket for each trust. Complex trusts currently reach the highest tax bracket at $12,750 of income, which means that each trust would only save approximately $1,000 of federal income tax and perhaps $370 of Medicare tax. Thus, this strategy does not have a lot of value, other than with respect to discussions at tax conferences and in related literature.
Final Regs
The final regs impose the Section 643(f) rule on taxpayers who have income that would otherwise qualify under Section 199A based on the $160,700 per complex trust threshold. Assuming that high-income parents established two separate trusts for their two children that received $160,700 each of K-1 income from an entity that didn’t pay wages or have qualified property or that was an SSTB, the Treasury Department would apply Section 643(f) to only allow one $160,700 bracket for both trusts.
The statutory authority to enact regulations probably enables the Treasury Department to apply the multiple trust aggregation rule to prevent multiple trusts from using a single $160,700 bracket, although this isn’t absolutely clear and may be challenged in court.
Many commentators believe that Section 643(f) was self-executing and didn’t need regulations, although we aren’t aware of any audit, court case challenges or deliberations that have occurred.
Opportunities for Clients
It’s possible to put these final regs into practice immediately to save significant tax money for clients.
For example, trusts that were formed and funded before Section 199A was enacted weren’t formed or funded with a principal purpose to take advantage of the Section 199A deduction, and there’s nothing in the regulations or commentary to the regulations that would indicate that a complex trust can’t buy into an SSTB or other business entity.
Complex trusts can also pay up to $10,000 a year on property taxes on residential vacation real estate, providing the ability to use income from an SSTB, or other business, to pay property taxes and benefit from the $10,000 income tax deduction.
The final regs replicate the proposed regs exactly with respect to trusts that are disregarded for income tax purposes and therefore considered as owned by their grantor, or another person under Sections 671 through 679 of the IRC.
Trusts that are considered as owned by their grantors are known as “defective grantor trusts” and don’t have any utility that we’re aware of for Section 199A planning purposes.
On the other hand, we’ve been using IRC Section 678 trusts for many years to allow all of the income of a trust that can be held for several individuals, or even charities, to be taxed to one individual beneficiary as if the assets and income of the trust belonged to that beneficiary.
This is typically done by allowing the beneficiary to have a one-time withdrawal right over all trust assets or by providing that the beneficiary has the right to withdraw all income. A downside of giving a beneficiary a withdrawal right like this in a non-asset protection trust statute state is that it would allow the creditors of that beneficiary to reach into the trust if the beneficiary is also a discretionary beneficiary. To mitigate this risk, a beneficiary or third party can be given the right to appoint the trust assets to other beneficiaries so that a creditor would receive nothing because all trust assets were transferred to one or more of the other beneficiaries before the creditor has a judgment.
Such a trust can use its earnings to purchase a home that can be the primary residence of the beneficiary and qualify for the IRC Section 121 $250,000 exclusion from capital gains when the home is eventually sold.
Many SSTBs must be owned only by licensed professionals; therefore, they can’t be owned in whole or in part by children, grandchildren or irrevocable trusts. Nevertheless, almost every state has permitted management companies to derive significant income from SSTBs. Even though the Section 199A final regs require that common related ownership can cause a management company, factoring company or other related party company to be considered to be an SSTB in proportion to such entity’s net income from financial interaction with the SSTB, children, grandchildren, Section 678 trusts and other entities can have ownership interest in such management companies and take the Section 199A deduction if they’re below the income thresholds mentioned above. It’s common in the management services industry to have the owner professionals sign long-term employment agreements with non-competition covenants to in effect transfer goodwill from the licensed professional to the management company, which would be considered to be a gift for federal gift tax purposes. Therefore, the management company can be used not only to save income tax, but also to avoid federal estate tax by having a significant amount of the profits of a professional practice flow to a defective grantor trust, a grantor retained annuity trust or otherwise.