By Edward Brown, Esq.
The most recent major tax act allows non-corporate taxpayers to deduct 20% of many types of income from their taxable income, at least until the year 2026. The idea was to allow non-corporate taxpayers who are otherwise subject to a 37% top income tax bracket to instead be on par with corporations that are subject to only a 21% top income tax bracket.
One problem however is that once your income exceeds a certain threshold level, some of such income is no longer available for the 20% deduction.
One strategy that Congress was quick to quash was the idea of setting up one or more of what are known as “non-grantor” trusts, each as a separate taxpayer, so that each trust has income below the threshold amount ($157,500 plus any indexing for inflation since 2018) that would otherwise disqualify the 20% deduction. Congress legislated that if any such trust is created with the principal purpose of avoiding the threshold limitation, then the IRS can simply aggregate that trust’s (or trusts’) income along with your personal income to determine whether such income tallies to over the threshold amount.
There lies the paradox. If the trust is created mainly for purposes other than dodging the 199A limitations on the Section 199A 20% deduction, you can take the Section 199A 20% deduction. This is a useful provision in that there are a number of reasons to create non-grantor trusts that are not for the 199A benefits. Non-grantor trusts serve as ideal arrangements to hold income producing properties that are not subject to the double tax regime that corporations encounter, and yet to avoid having the trust creator or beneficiaries being taxable on the trust’s income if the trustee chooses to have the trust pay the taxes. As compared to “grantor trusts,” such non-grantor trusts are also better situated to remove assets from one’s taxable estate since a non-grantor trust is less subject to scrutiny as compared to a grantor trust that routinely allows a non-adverse independent trustee to reimburse the trust’s grantor for income taxes that relate to the trust’s income (a very typical power that trustees of grantor trusts hold). Such reimbursement power can be scrutinized as a retained power by the grantor through some implied “side agreement” with the trustee; whereas in contrast, a non-grantor trust requires at least one other beneficiary of the trust to consent to any payments that would otherwise be eligible for payment to the grantor. Such beneficiary is not as prone to scrutiny because there will be less trust corpus remaining for the beneficiary if he or she consents to any payment to the grantor.
Finally, the “tax reimbursement” grantor trust design can be less effective for spendthrift protections with regard to the creator of the trust. To bolster the spendthrift effect of such trusts, the situs of the trust can be created using the laws of South Dakota, Nevada, Wyoming, Delaware or Alaska, which are each known for spendthrift protection law, even if the grantor is or later becomes a beneficiary of the non-grantor trust. These states have the added benefit of not imposing any state income taxes on such non-grantor trusts. This is also true for offshore trusts (and yes, offshore trusts can be created as non-grantor trusts if designed correctly). These trusts can show strong indications that the primary purpose for these vehicles is state tax avoidance and creditor protection benefits that cannot be achieved on an equivalent basis by any other means (and clearly are not devices just to achieve Section 199A benefits).
Bottom line, documenting the non-income-tax reasons for creating any non-grantor trust should allow these trusts, as an incidental benefit, to also enjoy a more expanded use of the Section 199A 20% income tax deduction allowance. In essence, you get the 199A tax benefit because that was not your intent.
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