If there was one part of the Tax Cuts and Jobs Act (“TCJA”) that estate planners were especially pleased to see, it was the increase in the basic exclusion amount from $5.49 million, in 2017, to $11.18 million for gifts made, and decedents dying, in 2018.[i] However, many estate planners failed to appreciate the potential impact of an income tax provision that came late to the party and that was specifically intended to benefit the individual owners of pass-through entities (“PTEs”).
A Brief History
As it made its way through Congress, the TCJA was billed[ii] as a boon for corporate taxpayers, and indeed it was. The corporate tax rate was reduced from 35% to 21%. The corporate AMT was eliminated. The system for the taxation of foreign income was changed in a way that skews in favor of C corporations.
But what about the closely held business – the sole proprietorships, the S corps, the partnerships and LLCs that are owned primarily by individual taxpayers and that often represent the most significant asset in their estates?
These businesses are usually formed as PTEs for tax purposes, meaning that the net operating income generated by these entities is generally not subjected to an entity-level tax; rather, it flows through to the individual owners, who are taxed thereon as if they had realized it directly.
With the introduction of the TCJA, the owners of many PTEs began to wonder whether they should revoke their S corporation elections, or whether they should incorporate[iii] their sole proprietorships and partnerships.
In response to the anxiety felt by individual business owners, Congress enacted a special deduction for PTEs in the form of Sec. 199A.[iv] However, shortly after its enactment on December 22, 2017, tax advisers starting peppering the IRS with questions about the application of 199A.
The IRS eventually proposed regulations in August, for which hearings were held in mid-October.[v]
In September, House Republicans introduced plans for making Sec. 199A “permanent.” Then, during the first week of November, the Republicans lost control of the House.[vi]
Notwithstanding this state of affairs, the fact remains that 199A is the law for at least two more years,[vii] and estate planners will have to deal with it; after all, the income tax consequences arising from an individual’s transfer of an interest in a PTE in furtherance of their estate plan will either enhance or reduce the overall economic benefit generated by the transfer.
In order to better appreciate the application of 199A to such “estate planning transfers,” a quick refresher may be in order.
Sec. 199A Basics
Under Sec. 199A, a non-corporate taxpayer[viii] – meaning an individual, a trust, or an estate – who owns an interest in a PTE that is engaged in a qualified trade or business (“QTB”),[ix] may claim a deduction for a taxable year equal to 20% of their qualified business income (“QBI”)[x] for the taxable year.[xi]
This general rule, however, is subject to a limitation that, if triggered, may reduce the amount of the 199A deduction that may be claimed by the non-corporate taxpayer (the “limitation”).
What triggers the limitation? The amount of the taxpayer’s taxable income from all sources[xii] – not just the taxpayer’s share of the QTB’s taxable income. Moreover, if the taxpayer files a joint return with their spouse, the spouse’s taxable income is also taken into account.
Specifically, once the taxpayer’s taxable income exceeds a specified threshold amount, the limitation becomes applicable, though not fully; rather, it is phased in. In the case of a single individual, the limitation starts to apply at taxable income of $157,500 (the so-called “threshold amount”). The limitation is fully phased in when taxable income exceeds $207,500.[xiii]
This $157,500 threshold amount also applies to non-grantor trusts and to estates.
These thresholds are applied at the level of each non-corporate owner of the business – not at the level of the entity that actually conducts the business. Thus, some owners of a QTB who have higher taxable incomes may be subject to the limitations, while others with lower taxable incomes may not.
As stated earlier, the Sec. 199A deduction for an individual, a trust, or an estate for a particular tax year is generally equal to the 20% of the taxpayer’s QBI for the year.
However, when the above-referenced limitation becomes fully applicable, the taxpayer’s 199A deduction for the year is equal to the lesser of:
- 20% of their QBI from a QTB, and
- The greater of:
- 50% of the W-2 Wages w/r/t such QTB, or
- 25% of the W-2 Wages w/r/t such QTB plus 2.5% of the “unadjusted basis” of the “qualified property” in such QTB.
In considering the application of this limitation, the IRS recognized that there are bona fide non-tax, legal or business reasons for holding certain properties – such as real estate – separate from the operating business, and renting it to such business. For that reason, the proposed regulations allow the owners of a QTB to consider the unadjusted basis of such rental property in determining the limitations described above – even if the rental activity itself is not a QTB – provided the same taxpayers control both the QTB and the property.[xiv]
Thus, assuming the presence of at least one QTB,[xv] much of the planning for 199A will likely involve the taxpayer’s “management” of (i) their taxable income (including their wages and their share of QBI) and, thereby, their threshold amount for a particular year, (ii) the W-2 Wages paid by the business, (iii) the unadjusted basis of the qualified property[xvi] used in the business, and (iv) the aggregation of QTBs.
Of the foregoing items, the management of the unadjusted basis of qualified property may be especially fruitful in the context of estate planning, as may the management of the threshold amount.
Generally speaking, the unadjusted basis of qualified property is its original basis in the hands of the QTB as of the date it was placed into service by the business.
Where the business purchased the property, its cost basis would be its unadjusted basis – without regard to any adjustments for depreciation or expensing subsequently claimed with respect to the property – and this amount would be utilized in determining the limitation on an owner’s 199A deduction.
However, where the property was contributed to a PTE in a tax-free exchange for stock or a partnership interest, the PTE’s unadjusted basis would be the adjusted basis of the property in the hands of the contributor at the time of the contribution – i.e., it will reflect any cost recovery claimed by such person.
In the case of an individual who acquires property from a decedent before placing it into service in a QTB, the stepped-up basis becomes the unadjusted basis or purposes of 199A.
However, if the qualified property is held in a partnership, no Section 754 adjustment made at the death of a partner will be taken into account in determining the unadjusted basis for the transferee of the decedent’s interest for purposes of 199A.[xvii]
Based on the foregoing, and depending upon the business,[xviii] a taxpayer who can maximize the unadjusted basis of the QTB’s qualified property will increase the likelihood of supporting a larger 199A deduction in the face of the limitation.
Toward achieving this end, there may be circumstances in which qualified property should be owned directly by the owners of the PTE (say, as tenants-in-common[xix]), rather than by the PTE itself, and then leased by the owners to the business.
For example, if a sole proprietor is thinking about incorporating a business, or converting it into a partnership by bringing in a partner, and the business has qualified property with a relatively low unadjusted basis (say, the original cost basis), the sole proprietor may want to retain ownership of the depreciable property and lease it (rather than contribute it) to the business entity, so as (i) to preserve their original unadjusted cost basis and avoid a lower unadjusted cost basis in the hands of the entity (based on the owner’s adjusted basis for the property) to which it would otherwise have been contributed, and (ii) to afford their successors in the business and to the property an opportunity to increase their unadjusted basis in the property, assuming it has appreciated – basically, real estate – after the owner’s death.
Trusts – the Threshold Amount
A non-grantor trust is generally treated as a form of pass-through entity to the extent it distributes (or is required to distribute) its DNI (“distributable net income;” basically, taxable income with certain adjustments) to its beneficiaries, for which the trust claims a corresponding distribution deduction. In that case, the income tax liability for the income that is treated as having been distributed by the trust shifts to the beneficiaries to whom the distribution was made.
To the extent the trust retains its DNI – i.e., does not make (and is not required to make) a distribution to its beneficiaries – the trust itself is subject to income tax.
In the case of a non-grantor trust, at least in the first instance, the 199A deduction is applied at the trust level. Because the trust is generally treated as an individual for purposes of the income tax, the threshold amount for purposes of triggering the application of the limitation is set at $157,500 (with a $50,000 phase-in range).
However, if the trust has made distributions during the tax year that carry out DNI to its beneficiaries, the trust’s share of the QBI, W-2 Wages, and Unadjusted Basis of the QTB in which it owns an interest are allocated between the trust and each beneficiary-distributee.
This allocation is based on the relative proportion of the DNI of the trust that is distributed, or that is required to be distributed, to each beneficiary, or that is retained by the trust. In other words, each beneficiary’s share of the trust’s 199A-related items is determined based on the proportion of the trust’s DNI that is deemed distributed to the beneficiary.
The individual beneficiary treats these items as though they had been allocated to them directly from the PTE that is engaged in the QTB.
Following this allocation, the trust uses its own taxable income for purposes of determining its own 199A deduction, and the beneficiaries use their own taxable incomes.
Based on the foregoing, a trustee may decide to make a distribution in a particular tax year if the trust beneficiaries to whom the distribution is made are in a better position to enjoy the 199A deduction than are the trust and the other beneficiaries.[xx]
In any case, the beneficiaries to whom a distribution is not made may object to the trustee’s decision notwithstanding the tax-based rationale.
Of course, where the trustee does not consider the tax attributes of an individual beneficiary, and makes a distribution to such individual which pushes them beyond the threshold amount, or disqualifies their SSTB from a 199A deduction, the beneficiary may very well assert that the trustee did not act prudently.
Limitations Applied to Non-grantor Trusts
The 199A threshold and phase-in amounts are applied at the level of the non-grantor trust.[xxi]
Because of this, the IRS is concerned that taxpayers will try to circumvent the threshold amount by dividing assets among multiple non-grantor trusts, each with its own threshold amount.
In order to prevent this from happening, the IRS has proposed regulations that introduce certain anti-abuse rules.[xxii]
Specifically, if multiple trusts are formed with a “significant purpose” – not necessarily the primary purpose – of receiving a deduction under 199A, the proposed regulations provide that the trusts will not be “respected” for purposes of 199A.[xxiii] Unfortunately, it is not entirely clear what this means: will the trusts not qualify at all, or will they be treated as a single trust for purposes of the deduction?
In addition, two or more trusts will be aggregated by the IRS, and treated as a single trust for purposes of 199A, if:
- The trusts have substantially the same grantor(s),
- Substantially the same “primary” beneficiary(ies), and
- “A” principal purpose for establishing the trusts is the avoidance of federal income tax.
For purposes of applying this rule, spouses are treated as one person. In other words, if a spouse creates one trust and the other spouse creates a second trust, the grantors will be treated as the same for purposes of the applying this anti-abuse test, even if the trusts are created and funded independently by the two spouses.[xxiv]
If the creation of multiple trusts results in a “significant income tax benefit,” a principal purpose of avoiding tax will be presumed.
This presumption may be overcome, however, if there is a significant non-tax (or “non-income tax”) purpose that could not have been achieved without the creation of separate trusts; for example, if the dispositive terms of the trusts differ from one another.
The application of 199A to a grantor trust is much simpler because the individual grantor is treated as the owner of the trust property and income, and the trust is ignored, for purposes of the income tax.[xxv] Thus, any QTB interests held by the trust are treated as owned by the grantor for purposes of applying 199A.
In other words, the rules described above with respect to any individual owner of a QTB will apply to the grantor-owner of the trust; for example, the QBI, W-2 Wages, and Unadjusted Basis of the QTB operated by the PTE in which the trust holds an interest will pass through to the grantor.
As we know, many irrevocable trusts to which completed gifts have been made are nevertheless taxed as grantor trusts for income tax purposes. The grantor has intentionally drafted the trust so that the income tax liability attributable to the trust will be taxed to the grantor, thereby enabling the trust to grow without reduction for income taxes, while at the same time reducing the grantor’s gross estate for purposes of the estate tax.
This may prove to be an expensive proposition for some grantors, which they may remedy by renouncing the retained rights or authorizing the trustee to toggle them on or off, or by being reimbursed from the trust (which defeats the purpose of grantor trust status).
The availability of the 199A deduction may reduce the need for avoiding or turning off grantor trust status, thus preserving the transfer tax benefits described above. In particular, where the business income would otherwise be taxed at a 37% federal rate,[xxvi] the full benefit of 199A would yield a less burdensome effective federal rate of 29.6%.
In addition to more “traditional” grantor trusts – which are treated as such because the grantor has retained certain rights with respect to the property contributed to the trust – there are other trusts to which the grantor trust rules may apply and which may, thereby, lend themselves to some 199A planning.
For example, a trust that holds S corporation stock may qualify as a subchapter S trust for which the sole current beneficiary of the trust may elect under Sec. 1361(d) (a “QSST” election) to be treated as the owner of such stock under Sec. 678 of the Code.[xxvii] Or a trust with separate shares for different beneficiaries, each of which is treated as a separate trust for which a beneficiary may elect treatment as a QSST.
Another possibility may be a trust that authorizes the trustee to grant a general power of appointment to a beneficiary as to only part of the trust – for example, as to a portion of one of the PTE interests held by the trust – thereby converting that portion of the trust into a grantor trust under Sec. 678.[xxviii]
It remains to be seen what the final 199A regulations will look like.[xxix] That being said, estate planners should have enough guidance, based upon what has been published thus far, to advise taxpayers on how to avoid the anti-abuse rules for non-grantor trusts, how to take advantage of the grantor trust rules, and how to maximize the unadjusted basis for qualified property.
Hopefully, the final regulations will provide examples that illustrate the foregoing. Absent such examples, advisers will have to await the development of some Sec. 199A jurisprudence. Of course, this presupposes that 199A will survive through the 117th Congress.[xxx]
[i] The exclusion amount increases to $11.4 million in 2019. It is scheduled to return to “pre-TCJA” levels after 2025. See the recently proposed regulations at REG-106706-18.
[ii] Pun intended. P.L. 115-97.
[iii] Or “check the box” under Reg. Sec. 301.7701-3.
[iv] This provision covers tax years beginning after 12/31/2017, but it expires for tax years beginning after 12/31/2025.
[v] More recently, the IRS announced its 2018-2019 priority guidance project, which indicated that it planned to finalize some of the regulations already proposed, but that more regulations would be forthcoming; it also announced that a Revenue Procedure would be issued that would address some of the computational issues presented by the provision.
[vi] Thus, we find ourselves at the end of November 2018 with a provision that expires after December 31, 2025, for which the issued guidance is still in proposed form.
[vii] Through the next presidential election.
[viii] The deduction is not determined at the level of the PTE – it is determined at the level of each individual owner of the PTE, based upon each owner’s share of qualified business income.
[ix] In general, a QTB includes any trade or business other than a specified service trade or business (“SSTB”) and the provision of services as an employee.
If an individual taxpayer does not exceed the applicable taxable income threshold (described below), their QBI from their SSTB will be included in determining their 199A deduction. If the taxpayer exceeds the applicable threshold and phase-in amounts, none of the income and deduction items from the SSTB will be included in determining their 199A deduction.
[x] Basically, the owner’s pro rata share of the QTB’s taxable income.
[xi] This deduction amount is capped at 20% of the excess of (i) the owner’s taxable income for the year over (ii) their net capital gain for the year.
[xii] Business and investment, domestic and foreign.
[xiii] In the case of a joint return between spouses, the threshold amount is $315,000, and the limitation becomes fully applicable when taxable income exceeds $415,000.
[xiv] Consistent with this line of thinking, and recognizing that it is common for taxpayers to separate into different entities, parts of a business that are commonly thought of as a single business, the IRS will also allow individual owners – not the business entities themselves – to elect to aggregate (to treat as one business) different QTBs if they satisfy certain requirements, including, for example, that the same person or group of persons control each of the QTBs to be aggregated.
It should be noted that owners in the same PTEs do not have to aggregate in the same manner. Even minority owners are allowed to aggregate. In addition, a sole proprietor may aggregate their business with their share of a QTB being conducted through a PTE.
[xv] Whether a QTB exists or not is determined at the level of the PTE. An owner’s level of involvement in the business is irrelevant in determining their ability to claim a 199A deduction. A passive investor and an active investor are both entitled to claim the deduction, provided it is otherwise available.
[xvi] Basically, depreciable tangible property that is used in the QTB for the production of QBI, and for which the “depreciation period” has not yet expired.
[xvii] The Section 754 adjustment is not treated as a new asset that is placed into service for these purposes. Compare Reg. Sec. 1.743-1(j)(4).
[xviii] For example, is it labor- or capital-intensive?
[xix] Of course, this presents its own set of issues.
[xx] Of course, this assumes that the trustee has the relevant beneficiary information on the basis of which to make this decision, which may not be feasible.
[xxi] For purposes of determining whether the trust’s taxable income exceeds these amounts, the proposed regulations provide that the trust’s taxable income is determined before taking into account any distribution deduction. Query whether this represents a form of double counting? The distributed DNI is applied in determining the trust’s threshold, and it is applied again in determining the distributee’s.
[xxii] Under both IRC Sec. 199A and Sec. 643(f).
[xxiii] Prop. Reg. Sec. 1.199A-6(d)(3).
[xxiv] Prop. Reg. Sec. 1.643(f)-1.
[xxv] IRC Sec. 671 through 679.
[xxvi] The new maximum federal rate for individuals after the TCJA.
[xxvii] See Reg. Sec. 1.1361-1(j).
[xxviii] A so-called “Mallinckrodt trust.”
[xxix] The proposed regulations also address the treatment of ESBTs under Sec. 199A. According to the proposed regulations, an ESBT is entitled to the deduction. Specifically, the “S portion” of the ESBT takes into account its share of the QBI and other items from any S corp owned by the ESBT.
The grantor trust portion of the trust, if any, passes its share to the grantor-owner.
The non-S/non-grantor trust portion of the trust takes into account the QBI, etc., of any other PTEs owned by the trust. Does that mean that the ESBT is treated as two separate trusts for purposes of the 199A rules? It is not yet clear.
[xxx] January 2021 to January 2023.