By: Jacqueline Z. Fox, Esq., LL.M.
On August 8, 2018, the Internal Revenue Service (“IRS”) released proposed regulations for deductions taken under section 199A of the Internal Revenue Code (“IRC”). Taxpayers may rely on the rules provided in the proposed regulations until final regulations are published in the Federal Register.
By way of background, section 199A was created by the Tax Cuts and Jobs Act (the “new tax law”) and potentially allows (1) individuals, trusts, and estates to deduct up to 20% of qualified business income (“QBI”) received from a pass-through trade or business (such as an S-corporation, partnership, limited liability companies taxed as partnerships, and sole proprietorships) in which it has an ownership percentage; and (2) further allows deduction of up to 20% of an eligible taxpayer’s combined qualified real estate investment trust (“REIT”) dividends and qualified publicly traded partnership (“PTP”) income. The sum of these two amounts is referred to as the combined QBI amount. Generally, this deduction is the lesser of the combined QBI amount and an amount equal to 20% of the taxable income minus the taxpayer’s net capital gain.
Essentially, section 199A was created as a workaround to certain problems that pass-through businesses would have faced under the new tax law following its implementation of a lower top marginal tax rate for corporations at 21% while rates largely remained higher for individual taxpayers. That is because in a pass-through type entity, the entity itself does not pay income tax on the entity level; rather, income and expenses of the business pass through the entity and are treated as the responsibility of the individual owner(s). For this reason, the section 199A deduction is intended to create a more level playing field for owners of such pass-through entities by effectively reducing the new top 37% marginal income tax rate for business owners to approximately 29.6% (i.e., 80% of 37%).
The section 199A deduction is available for years beginning after December 31, 2017, and eligible taxpayers can claim the deduction on their 2018 federal income tax return. It should be noted, however, that the amount of QBI subject to the section 199A deduction from each qualified trade or business is subject to certain limitations and exceptions that are fully described in the proposed regulations. More specifically, if a taxpayer’s taxable income exceeds $315,000 for a married couple filing a joint return, or $157,500 for individual taxpayers, then such taxpayer’s ownership in a specified service trade or business (“SSTB”) (i.e., trade or businesses involving the performance of services such as in health, law, accounting, consulting, financial services, investing and investment management, etc.) would not constitute a qualified trade or business eligible for the section 199A deduction. In addition, performing services as an employee is also exempted from the definition of a qualified trade or business that is eligible for such a deduction.
In an explanation of provisions, the proposed regulations issued by the IRS provide that,
The purpose of [the] proposed regulations is to provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of section 199A. These proposed regulations contain six substantive sections, §§1.199A-1 through 1.199A-6, each of which provides rules relevant to the calculation of the section 199A deduction. Additionally, the proposed regulations would establish anti-abuse rules under section 643(f) to prevent taxpayers from establishing multiple non-grantor trusts or contributing additional capital to multiple existing non-grantor trusts in order to avoid Federal income tax, including abuse of section 199A.
As such, in addition to the above, the proposed regulations would also consequently establish anti-abuse rules under section 643(f) of the IRC so as to prevent taxpayers from establishing multiple non-grantor trusts or from contributing additional capital to multiple existing non-grantor trusts with the intended purpose of avoiding the payment of Federal income tax. In this regard, the proposed regulations provide that such a result “is inappropriate and inconsistent with the purpose of section 199A and general trust principles,” leading the IRS to take the position that “the rule in proposed §1.643(f)-1 generally reflects the intent of Congress regarding the arrangements involving multiple trusts that are appropriately subject to treatment under section 643(f).”
Therefore, if multiple trusts “have substantially the same grantors and beneficiaries, and a principal purpose for establishing such trusts or contributing additional cash or other property to such trusts is the avoidance of Federal income tax, then the various trusts would be generally considered one trust, including for section 199A purposes.” In determining the principal purpose for establishing the trusts, the proposed regulations state that it will be presumed to be for the avoidance of Federal income tax if establishing or funding the trust results in a significant income tax benefit “unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation” of separate trusts. This concept is fleshed out in further detail by way of two examples on pages 182 and 183 of the proposed regulations released by the IRS.
The IRS’ position on the utilization of non-grantor trusts in this context is not surprising given that some taxpayers with income greater than the thresholds outlined above and in Section 199A have been utilizing non-grantor trusts (which are each considered to be separate taxpayers) so as to ensure that each trust created receives the maximum amount of income before the phase-out threshold, thus allowing each such non-grantor trust to individually qualify for a section 199A deduction. In a nutshell, even if an individual taxpayer would not qualify for a section 199A deduction against his or her total income, each non-grantor trust created would individually qualify for the section 199A deduction. Therefore, the proposed regulations issued by the IRS have in part sought to hinder taxpayers from taking such action by instituting the anti-abuse rules under section 643(f).
Despite the limitations created by the proposed regulations under Section 199A, there are still strategies that can be imposed that include the use of non-grantor trusts. Please contact our office if you are interested in discussing how you are affected by these proposed regulations and or would like to delve further into other planning options available to you for purposes of minimizing your federal/state income taxes.
*The information in this article is provided for general informational purposes only, and may not reflect the current law in your jurisdiction. No information contained in this post should be construed as legal advice from Greenspoon Marder LLP or the individual author(s), nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this Post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.