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Tax Law Update: October 2018

David A. Handler and Alison E. Lothes highlight the most important tax law developments of the past month.

• Proposed regulations under Internal Revenue Code Section 199A reduce income tax planning strategy—Under IRC Section 199A (enacted in 2017), a deduction for up to 20 percent of certain qualified business income (income from a domestic business operated as a sole proprietorship, partnership or S corporation) is available for years 2018-2025. The deduction may be claimed by individuals, non-grantor trusts and estates. However, the deduction is limited when income exceeds certain thresholds. To circumvent this limitation, some taxpayers have established multiple non-grantor trusts and then conveyed interests in the pass-through businesses to those trusts. By partitioning ownership (and therefore income) among multiple non-grantor trusts, each trust’s share of income may be below the threshold, thereby allowing the deductions. However, on Aug. 8, 2018, the U.S. Treasury approved proposed regulations (proposed regs) under Sections 199A and 643 and published related Notice 2018-64.  

Prop. Regs. Section 1.643(f)-1 deals with this very scenario, in which multiple non-grantor trusts with the same grantor or grantors and primary beneficiary or beneficiaries are established to avoid federal income tax. Those trusts will be treated as a single trust for federal income tax purposes. 

The proposed regs are lengthy and provide definitions, computational and anti-avoidance rules and other clarifications on the application of Section 199A. 

• Marital trust with charitable remainder beneficiary not a split-interest trust subject to private foundation (PF) rules—In Private Letter Ruling 201831009 (May 2, 2018), an irrevocable marital trust was created under a revocable trust for the benefit of the grantor’s spouse. On the spouse’s death, the remaining trust property will be paid to a PF.

The trustees of the trust requested a ruling that the marital trust during the spouse’s life wouldn’t be subject to IRC Sections 4941, 4943, 4944 and 4945, which are applicable to PFs. In addition, the trustees requested assurance that the trust wouldn’t be subject to those rules after the spouse’s death.

The Internal Revenue Service ruled that the marital trust wasn’t subject to the PF rules of Sections 4941, 4943, 4944 and 4945 during the spouse’s life. Usually, PFs are tax-exempt organizations under IRC Section 501(c)(3).
However, IRC Sections 4947(a)(1) and (a)(2) subject two types of non-exempt trusts (charitable trusts and split-interest trusts, respectively) to many of the PF rules. To meet either test under Section 4947(a)(1) or (a)(2), the trust in question must already have had a charitable deduction allowed (for example, income, gift or estate tax). Here, no charitable deduction was allowable or taken with respect to any asset transferred to the marital trust on the grantor’s death.  

On the spouse’s later death, all the assets of the trust will be includible in the spouse’s gross estate under IRC Section 2044. Then, the estate tax charitable deduction will be allowable because the marital trust property will be paid to the PF. However, the regulations under Section 4947 provide that the trust won’t be considered a charitable trust (and thus subject to the PF rules) during the time reasonably required for the trustee to perform the ordinary duties of administration to settle the trust (collecting assets, paying debts, taxes and expenses, determination of the rights of the beneficiaries, arranging for distributions, etc.).  After that reasonable period, the trust will be considered a charitable trust.

However, the IRS declined to rule on whether, during the spouse’s life, the trust would be a disqualified person or on the treatment or consequences of any transaction between the trust and PF. The IRS also noted that certain transactions with the PF during the settlement period after the spouse’s death could result in indirect self-dealing (unless the requirements of another section of the regulations were met).

• Disclaimer by appointee of limited power of appointment (POA) by beneficiary under pre-1977 trust upheld—In PLR 201831003 (April 23, 2018), an individual established a trust prior to 1977 that gave the trustee broad discretion to make distributions for the benefit of a certain family member and her descendants during her life. The beneficiary also had a testamentary POA under which she could appoint the trust property to any of the descendants of her great-grandfather and great-grandmother. The beneficiary exercised her POA in her will by appointing all of the remaining property to those descendants, per stirpes. The taxpayer was one of those descendants who was entitled to a share of the trust property as a result of the exercise of her POA, but wasn’t otherwise a remainderman.

The taxpayer wasn’t actually aware of this trust during the beneficiary’s life and only learned of it after her death. He didn’t receive any benefits of the trust property. He proposed to disclaim his entire interest in the trust in a manner that met the requirements under state law. He requested a ruling that his disclaimer wouldn’t be considered a taxable gift.

The IRS agreed that the taxpayer’s disclaimer wouldn’t constitute a gift. Under Treasury Regulations Section 25.2511-1(c)(2), relating to pre-1977 trusts, refusing a property interest isn’t a gift if made within a reasonable time after learning of the existence of the property transfer. The IRS held that the transfer occurred when the trust was created, before 1977. However, the disclaimer would be timely if made within a reasonable time after the disclaimant obtained knowledge of the transfer. In this case, the IRS held if the taxpayer makes the disclaimer within nine months of learning of his interest in the trust, it would be timely. Therefore, assuming the taxpayer doesn’t accept any of the trust property and makes the disclaimer within nine months of the date when he learned of the existence of the trust in a manner that conformed with state law requirements, the disclaimer won’t be a taxable gift.

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