Multiple Trusts and the Section 199A 20% Deduction

Section 199A Background

The Tax Cuts and Jobs Act of 2017 created a 20% deduction for noncorporate taxpayers against their qualified business income. For taxpayers in the highest bracket, this would reduce their tax on such income from 37% to 29.6%.

There are limits on the use of the deduction for higher income taxpayers. One set of limits is the exclusion of service income (subject to some exceptions) from the deduction, and another requires significant wages or depreciable business property to benefit from the deduction. Therefore, higher income taxpayers are incentivized to reduce their taxable income to avoid these limitations.

The deduction is available to trusts and estates and their beneficiaries.

Using Trusts to Reduce Income

Since trusts can take the deduction, it has been suggested that income from qualified businesses be split among numerous nongrantor trusts. By splitting the income among numerous trusts, the trust can stay below the limitation thresholds and take full advantage of the deduction.

Code §643(f) provides that under regulations, the Service can treat two or more trusts as 1 trust if (1) the trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose of such trusts is the avoidance of federal income tax. If applicable, it would defeat the above planning by combining multiple trusts into one trust – thus, the income would be combined and would then likely push the income of that trust up above the Code §199A income thresholds.

Proposed Regulations Weigh In

Treasury seeks to implement the authority under Code §643(f) and has issued Proposed Regulation §1.643(f)-1. The proposed regulation starts by parroting the above language of Code §643(f). It then indicates a “principal purpose” of avoidance will be presumed as to the establishment or funding of multiple trusts if it 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 the separate trusts. It gives an example (Example 1) of a “principal purpose” problem where interests of a business are split among nongrantor trusts for the purpose of qualifying for the Code §199A deduction when an owner reads about the idea in an article. Spouses are treated as one person (as to being a grantor or beneficiary).

As to the question of substantially same beneficiaries, that Example 1 holds that the following trusts with substantially the same terms and established by the same grantor will be aggregated as one trust:

Trust 1 – Beneficiaries B, C, D

Trust 2 – Beneficiaries E, C, D

Trust 3 – Beneficiary E.

Example 2 has one grantor and these beneficiaries:

Trust 1 – G as to mandatory income, with H as remainder beneficiary

Trust 2 – H is discretionary income beneficiary for health, support and maintenance, and G is discretionary income beneficiary for medical expenses. He is the remainder beneficiary upon G’s death.

The example concludes that the trusts will not be aggregated due to the significant non-tax differences between the terms of the two trusts.

Conclusions

One conclusion is that multiple nongrantor trusts are viable for Code §199A planning purposes, if there is sufficient differentiation as to beneficiaries and trust terms. It is not viable without that differentiation.

Another conclusion is that the examples do not provide a clear demarcation or explanation of when trusts will be aggregated when there is some level of overlap in beneficiaries and terms. So taxpayers using trusts with some level of overlap will need to proceed at their own risk.

The preamble to the regulations notes that the proposed regulations are not limited to Code §199A avoidance.

The new rules are proposed to apply to taxable years ending after August 16, 2018. The preamble indicates they will apply to trusts entered into or modified after that date, but trusts existing or modified prior to that date will be governed under Code §643(f) on the bases of the statute and legislative history guidance.