David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. This week, checking back in with estate planning and section 199A. Regular listeners to this podcast have probably heard me end many episodes by telling my guests that we'll have to bring them back again to talk about it when we know more. Well, this week, we're actually doing that. Tax Notes Today reporter Jonathan Curry is here to follow up on the things we've learned since he was last here in April to talk about estate planning and the Tax Cuts and Jobs Act. Jonathan, welcome back.
Jonathan Curry: Thanks, Dave. Great to be back in the studio.
David Stewart: I guess we should start with what changed about the estate tax, and what's happening now?
Jonathan Curry: Yeah, that makes sense. Well, this year, I've been covering the wonderful world of the estate tax. The Tax Cuts and Jobs Act didn't change much in the tax code itself in this area. But the one change that it did make was a big one. It doubled the estate and gift tax exemption from $5 million per person to $10 million, and that's adjusted for inflation so that for a married couple, it's as high as $22.4 million this year, and that's a lot. Now, if you look at the actual legislation itself, it didn't take up a lot of space in the bill. But in reality, it's created a huge wave in the estate planning profession. For most estate planners, the bulk of their clients are not wealthy enough to have to worry about owing estate taxes anymore with this huge new exemption in effect, even though technically it's scheduled to expire and revert back in 2026.
David Stewart: Now, that 2026 date is subject to change, because as I understand it, congressional Republicans are hoping to make this change permanent?
Jonathan Curry: Right, and we'll see how that plays out, especially with the results of the midterms in, and how they manage to do that with a divided Congress. But in the meantime, instead of planning to avoid estate taxes, clients want to get their tax savings elsewhere, so they're looking at income tax planning with trusts. Now, a big part of income tax planning right now is basis planning, where they're trying to figure out how to get a step-up in basis on highly appreciated assets so that if or when they're sold, they'll owe less, and sometimes a lot less, capital gains taxes on the appreciated value. But that is a topic for another day. The other main way estate planners are thinking of to try to help clients avoid income taxes involves using trusts, sometimes lots of them. Now, when people hear the word trust, they might think of special trust funds that subsidize rich kids' crazy antics. But there is a lot more to it than that.
David Stewart: So what kind of trusts are we talking about here?
Jonathan Curry: Well, broadly speaking, there are two main types of trusts that come up in tax planning discussions. There's grantor trusts and non-grantor trusts. And there's a lot more nuance than this, but in general, a grantor trust is one where the grantor, who's the person that established the trust, they retain certain powers over the trust and pay the income taxes on the assets in the trust. So, for tax purposes, the trust is an extension of the grantor himself. A non-grantor trust is one where the grantor essentially gives up control over the trust. Because they have little control over it, the trust is treated like its its own unique taxpayer. And that means it has to pay its own taxes. But on the flip side, it also gets to claim its own deductions. Now both types of trusts are useful for their own reasons, but a big focus of this new planning these days is on using non-grantor trusts to squeeze every last dollar of tax savings they can get from the 199A deduction.
David Stewart: The 199A deduction, we've talked about it here. Actually, listeners interested in an in-depth discussion of the regulations on that should go back to the August 17th episode of this podcast. It provides a 20 percent deduction for passthrough income. And there are limitations once you reach a certain income threshold based on the business type. How does that factor into this planning?
Jonathan Curry: Right, so the section 199A deduction is the hottest thing in tax news these days. The corporate tax rate cut was huge, from 35 percent to 21 percent, but it's just an adjustment to the existing tax structure. On the other hand, the 199A deduction is a brand new chunk of tax code that millions of people get to take advantage of. And one of the ways they get to do that is through trusts. Now the 199A deduction isn't for everybody, as you said. There are quite a few limitations, including phaseout thresholds, etc., that apply. The first big exception is that there are what's called specified service trades or businesses, or what we commonly call SSTBs. These are categories of businesses that aren't eligible to claim the deduction. We're talking things like lawyers, or Wall Street traders, accountants, athletes, consultants, etc. It's a pretty lengthy list.
David Stewart: So, if you're earning money through one of these SSTBs, you're just out of luck.
Jonathan Curry: Well, maybe, or maybe not. The SSTB limitation only kicks in above certain income thresholds. So, if you earn less than $157,500 as an individual or a trust, or $315,000 as a couple, in qualified business income, the SSTB limitation does not kick in. And if you make more than that, the deduction gradually phases out to nothing with higher incomes. So, what's the owner of, say, a small family run business to do? Well, maybe he can spread that income around a little bit. Let's say the owner of a relatively small successful family business that earned $600,000 a year is an SSTB that isn't ordinarily excluded from claiming the 199A deduction. Perhaps that owner can gift 25 percent interest in the business to, say, three different non-grantor trusts. That might use up some of his estate and gift tax exemption, but remember, with these higher exemptions in effect, most people aren't worried about that right now. So now the income from the business is split up across three trusts and himself so that each one of those entities reports $150,000 in income.
David Stewart: And that would get them below the threshold.
Jonathan Curry: Yeah, exactly. So without all this planning, this business owner wouldn't have gotten any deduction for his business income. Now he's getting four separate deductions on the same income. And doing some back of the envelope math here, if he's in the top tax bracket, he's saving the business about $55,000 in taxes.
David Stewart: This sounds a little too easy.
Jonathan Curry: Yeah, yeah it does, and it looks like the IRS and Treasury thought so, too. The proposed section 199A regulations they issued back in August took a rather dim view of this strategy, because they included not one, but two antiabuse rules about using trusts to gain the 199A deduction.
David Stewart: So, sort of a belt and suspenders approach to stopping abuse in this area.
Jonathan Curry: Yeah, pretty much. Interestingly, one rule was actually issued under section 643(f), which deals with multiple trust arrangements in general. And the other one is specific to the section 199A deduction. Now these two rules are similar, but there are same notable distinctions.
David Stewart: Let's start with the 643(f) rule. Walk us through that.
Jonathan Curry: Sure. This one says that two or more trusts will be aggregated and treated for tax purposes as a single trust, if they have substantially the same grantor and same beneficiaries, and if a principal purpose of creating the trust or contributing assets to it is income tax avoidance. And notably, in the preamble to the regulations, the IRS specifically says it included this rule to stop taxpayers from circumventing the 199A deduction income thresholds, calling it “inappropriate and inconsistent with the purpose of section 199A and general trust principles.” So after months of practitioners talking about ways they can get this 199A deduction using a couple different trusts, it looks like the IRS was eavesdropping and figured out that they wanted to do something about this. And then as a double whammy, they added a second rule regarding multiple trust arrangements, which says that trusts formed or funded with a significant purpose of receiving a deduction under section 199A will not be respected for purposes of section 199A.
David Stewart: It doesn't sound like they left a lot of room for planners to work around these rules.
Jonathan Curry: No, they didn't, but lawyers gonna law, you know what I mean?
David Stewart: I don't know if I should take that personally or not.
Jonathan Curry: I mean, no disrespect intended, but anyway, they quickly started asking questions like, what exactly does it mean to disrespect the deduction? Or what constitutes a significant purpose of tax avoidance? Since both of these rules refer to multiple trust arrangements, does this mean taxpayers can get away with setting up just one trust that gets the deduction and not worry about getting caught up in these rules? For example, what if a trust is created for other legitimate purposes, like creditor protection? But it also now happens to qualify for the 199A deduction? Or what if a business owner wants to pass his business on to his kids? And so he splits the business up among a couple different trusts, names one kid as a beneficiary of each trust? That's not a terribly unusual scenario, and since each trust has a different beneficiary, it wouldn't run afoul of the 643(f) rule, because there's different kids in each trust. But it could still arguably trip the 199A-specific rule depending on how hard the IRS chooses to enforce this.
David Stewart: When will tax planners get answers on this?
Jonathan Curry: Well, so far, it looks like for the most part, they're going to have to wait until final regulations are issued. And even then, I'm sure there's going to be a couple questions, but we have had some hints. For example, during an American Bar Association webinar back in September, a Treasury attorney said that they intended the 199A antiabuse rule to apply even in cases where there's just one trust that's been created. She also said that to disrespect the deduction means you don't get it at all. But that that determination will depend a lot on the facts and circumstances of each situation, which would leave the IRS with a lot of leeway. Now technically, the Treasury official was speaking informally, so it wasn't official guidance. But you can bet that any tax lawyer's going to listen carefully to what she said.
David Stewart: How are tax planners reacting to the antiabuse rules?
Jonathan Curry: Well, so far, there's been some concerns that the IRS might be overreaching a bit with these antiabuse rules. Based on the language of the proposed regs, it looks like they say if a trust is initially formed for the sneaky purpose of trying to get the 199A deduction, then it forever loses the ability to claim that deduction. But what if, in later years the business qualifies for the 199A deduction without the use of a trust? In other words, tax avoidance is no longer a principal purpose of that trust. Should it still be denied the deduction? And there's also been some consternation among the tax planning community that the proposed regs impose some fuzzy math requirements for trusts in calculating the deduction.
David Stewart: How so?
Jonathan Curry: Well, when trusts and estates pay out income to their beneficiaries, that's called distributable net income, or DNI. But the proposed regs say that for purposes of the 199A deduction, trusts and estates don't get to subtract DNI from their total income when calculating it, if they fall below the SSTB income threshold. So let's say there's a trust that has $300,000 of business income that comes from an SSTB. If it distributes half of it to the beneficiary, the trust income falls below the income threshold, so it can now qualify for that 199A deduction. But in reality, the trust and the beneficiary each only have $150,000 in income each. But the IRS treats the trust as if it still has $300,000 and the beneficiary as having $150,000. So now, on paper, it looks like there's $450,000 in qualified business income floating around. The idea here is that the IRS doesn't want trusts just distributing income out in order to get themselves below those income thresholds where it doesn't matter if your income comes from an SSTB, which makes sense from a tax administration perspective. But in a way, they're also conjuring up an extra $150,000 in income that isn't there. And I've been told that, arguably, that approach runs counter to the intent of the statute itself, which is supposed to mirror the original 199.
David Stewart: It sounds like there's still a lot to figure out here. It's almost as if you're setting us up for another sequel to this podcast.
Jonathan Curry: Yep, guess I'll have to be back in the studio for that one.
David Stewart: Jonathan, where can listeners find you online?
Jonathan Curry: Well, as usual, you can find me online on Twitter @jtcurry005.
David Stewart: Thank you for being here.
Jonathan Curry: Of course. My pleasure.
David Stewart: And now, Coming Attractions. Each week we preview commentary that will be appearing in the next issue of the Tax Notes magazines. We're joined by executive editor for commentary, Jasper Smith. Jasper, who will you have for us?
Jasper Smith: In Tax Notes, Patrick McCormick examines how U.S. tax law treats holdings in international business entities and trusts, and John Godfrey explains why public-private partnerships aren't better at improving industries than public or private efforts.
In State Tax Notes, Timothy Noonan and Elizabeth Pascal discuss Connecticut's new passthrough entity tax, and David Cassidy launches his new column by discussing a Louisiana case on non-enumerated services.
And in Tax Notes International, Tom O'Shea looks at the Code of Conduct Group and harmful tax competition by members of the EU, while Bill Parks argues the U.K. should adopt a destination-based corporate tax system and set an example for other countries.
David Stewart: That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And hey, if you like what we're doing here, please leave us a rating or review. We'll be back next week with another episode of Tax Notes Talk.
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