Author: Nadia A. Havard
Originally published in October 2018
Copyright © 2018 Knox McLaughlin Gornall & Sennett, P.C.
The Tax Cuts and Jobs Act was enacted in the Tax Cuts and Jobs Act (TCJA, PL 115-97) on December 22, 2017 and amended by the Consolidated Appropriations Act, 2018 (PL 115-141) on March 23, 2018 (the “Act”). Most of the provisions are effective only for seven (7) years (from 2018 through 2025) and referred to as “temporary” in these materials, while a few are made permanent.
The basic exclusion amount under Section 2010(c)(3) is temporary increased from $5,000,000 to $10,000,000 (indexed for inflation after 2011). For 2018, the basic exclusion amount is $11,180,000 and the gift tax annual exclusion is $15,000 per donee. (Thomson Reuters project the basic exclusion amount for 2019 in the amount of $11,400,000, with the gift tax annual exclusion remaining the same at $15,000 for 2019.)
New section 2001(g)(2) of the Internal Revenue Code of 1986, as amended (hereinafter, the “Code”) requires the Treasury to promulgate regulations that will address transfer tax issues related to the difference in the basic exclusion amount at the time of the gift and at the time of the death. (A so-called “claw back” problem).
Treas. Reg. Section 20.2010(2)(c)(1) defines the deceased spouse’s unused exemption (“DSUE”) amount. Based on the current provisions of the section, the DSUE will likely continue to be based on the exclusion amount in effect at the time of the first spouse to die (the “portability”).
Most of them are temporary. Rate brackets are:
The chained CPI (i.e. the Department of Labor Chained Consumer Price Index for All Urban Consumers) will be used going forward to index for inflation. In general, chained CPI grows at a slower pace than CPI-U because it takes into account a consumer’s ability to substitute between goods in response to changes in relative prices. It was believed that CPI-U overstated increases in the cost of living. It did not take into account that consumers generally adjust their buying patterns when the prices go up. Because the way it is calculated, the updated numbers will be available only in February of the current calendar year. That creates a problem with regards to gifting to be made within first 2 months of the calendar year.
Standard deduction is increased and personal exemption is eliminated:
One of the main impacts on the trust and estate income tax liability is the temporary ban on miscellaneous expense deductions under Section 67(a) of the Code.
Excess deductions or losses at termination of the estate or trust are effectively eliminated by virtue of disallowing miscellaneous itemized deductions for individuals. As a general rule, Section 642(h)(1) of the Code provides that a net operating loss or capital loss carryover is allowed as deduction to the beneficiaries of the estate or trust succeeding to the property of the estate or trust. Because capital losses are not itemized deductions, the ban on miscellaneous itemized deductions should not prevent their deductibility by the beneficiaries. However, any deductions passing to the estate or trust beneficiaries pursuant to Section 642(h)(2) (i.e. dealing with the deductions for the last taxable year of the estate or trust in excess of gross income for the year) are eliminated because of the ban imposed by Section 67(g).
Electing Small Business Trusts (ESBT) can (i) have a nonresident alien individual as a permissible trust beneficiary, (ii) take a charitable deduction under Section 170 rather than Section 642(c), and (iii) reduce taxable income by Section 199A deduction for qualified business income. Unless other considerations warrant planning with QSST trust rather than ESBT, ESBT may be a great way to hold S corporation stock and provide for charitable donations.
(Because Section 170 does not require charitable contributions being made from the gross income pursuant to the terms of the governing instrument, ESBT with S corporation stock is more flexible in making charitable donations. However, unlike Section 642(c) charitable deduction which can be taken in the full amount, Section 170 deduction sets a cap on the amount of annual deductions based on the applicable percentage of AGI.)
The unrelated business taxable income is determined separately for each trade or business activity. New Section 512(a)(6) provides that a loss from one activity cannot offset the income from another activity. However, a loss from the activity can offset the income from the same activity in the future years. All losses generated prior to taxable years starting in 2018 are grandfathered. Also, some private colleges and universities are subject to a 1.4% of net investment income.
To simplify, a deduction of up to 20% of income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust or estate is allowed for tax years beginning after 2017 and before 2026. (26 USA 199A). Depending on whether the trade or business is a non-service or service, the amount of 199A deduction will vary. It is a temporary deduction which will expire in 2025. The following taxpayers who are the owners of a pass-through entity engaged in a trade or business, can take advantage of the deduction: individuals, estates, and trusts.
As a general rule, for each $1.00 of lost 199A deduction, the taxpayer pays tax on $1.63. (As calculated by Robert S. Keebler, CPA, PFS, MST, AEP, CGMA).
Deduction under Section 199A is not available for purposes of calculating 3.8% tax on the net investment income or SSI tax.
The threshold for calculating penalties imposed under Section 6662 related to the substantial understatement of income tax liability is reduced from 10% to 5% as related to deductions under Section 199A. (26 USA 6662(d)(1)(C)). “Special rule for taxpayers claiming section 199A deduction. In the case of any taxpayer who claims any deduction allowed under section 199A for the taxable year, subparagraph (A) shall be applied by substituting “5 percent” for “10 percent.” (Id.)
The Preamble to the Proposed Regulations to Section 199A provides that “[f]or taxpayers whose taxable income exceeds a statutorily-defined amount (threshold amount), section 199A may limit the taxpayer's section 199A deduction based on (i) the type of trade or business engaged in by the taxpayer, (ii) the amount of W-2 wages paid with respect to the trade or business (W-2 wages), and/or (iii) the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (UBIA of qualified property).”
As a general rule, if a taxpayer is engaged in a non-service trade or business, then (i) Section 199A deduction is 20% if the taxpayer’s taxable income is bellow threshold, (ii) Section 199A deduction is limited if the taxpayer’s taxable income is above the threshold but less than the cap, and (iii) Section 199A deduction is subject to wage and capital testing if the taxable income is above the cap.
As a general rule, if a taxpayer is engaged in a service trade or business, then (1) Section 199A deduction is 20% if the taxpayer’s taxable income is bellow threshold; (ii) Section 199A deduction is phased out if the taxpayer’s taxable income is above the threshold but less than the cap, and (iii) Section 199A deduction is disallowed if the taxable income is above the cap.
The Preamble to the Proposed Regulations under Section 199A provides that the definition of “service” business as defined in Sections 1202(e)(3)(A) is incorporated, with some modifications in the definition of service trade or business under Section 199A. Because Section 1202(e)(3)(A) tracts Section 448, both sections and the regulations there under are used for purposes of Section 199A. Additionally, the Preamble to the Proposed Regulations under Section 199A provides that “…proposed §1.199A-5(c)(1) provides that a trade or business (determined before the application of the aggregation rules in proposed §1.199A-4) is not a [specified service trade or business, hereinafter “SSTB”] if the trade or business has gross receipts of $25 million or less (in a taxable year) and less than 10 percent of the gross receipts of the trade or business is attributable to the performance of services in an SSTB. For trades or business with gross receipts greater than $25 million (in a taxable year), a trade or business is not an SSTB if less than 5 percent of the gross receipts of the trade or business are attributable to the performance of services in an SSTB."
The Proposed Regulations Section 1.199A-5(c)(1), “specified trade or business” means “after application of the modifications described in section 199A(d)(2)(A), the definition of an SSTB for purposes of section 199A is (1) any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, and (2) any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c) (2)), partnership interests, or commodities (as defined in section 475(e)(2)).”
On August 16, 2018, the Treasury Department released very technical proposed regulations under Section 199A.
“Section 7805(b)(1)(A) and (B) of the Code generally provide that no temporary, proposed, or final regulation relating to the internal revenue laws may apply to any taxable period ending before the earliest of (A) the date on which such regulation is filed with the Federal Register, or (B) in the case of a final regulation, the date on which a proposed or temporary regulation to which the final regulation relates was filed with the Federal Register. However, section 7805(b)(2) provides that regulations filed or issued within 18 months of the date of the enactment of the statutory provision to which they relate are not prohibited from applying to taxable periods prior to those described in section 7805(b)(1).
Furthermore, section 7805(b)(3) provides that the Secretary may provide that any regulation may take effect or apply retroactively to prevent abuse. Accordingly, proposed §§1.199A-1 through 1.199A-6 generally are proposed to apply to taxable years ending after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, taxpayers may rely on the rules set forth in proposed §§1.199A-1 through 1.199A-6, in their entirety, until the date a Treasury decision adopting these regulations as final regulations is published in the Federal Register. In addition, to prevent abuse of section 199A and the regulations thereunder, the anti-abuse rules of proposed §§1.199A-2(c)(1)(iv), 1.199A-3(c)(2)(B), 1.199A-5(c)(2), 1.199A-5(c)(3), 1.199A-5(d)(3), and 1.199A-6(d)(3)(v) are proposed to apply to taxable years ending after December 22, 2017, the date of enactment of the TCJA. Finally, the provisions of proposed §1.643-1, which prevent abuse of the Code generally through the use of trusts, are proposed to apply to taxable years ending after August 16, 2018.”
The Preamble to the Proposed Regulations under Section 199A provides that “[t]he proposed regulations also contain an anti-avoidance rule under section 643 of the Code to treat multiple trusts as a single trust in certain cases. … Section 643(f) grants the Secretary authority to treat two or more trusts as a single trust for purposes of subchapter J if (1) the trusts have substantially the same grantors and substantially the same primary beneficiaries and (2) a principal purpose of such trusts is the avoidance of the tax imposed by chapter 1 of the Code. Section 643(f) further provides that, for these purposes, spouses are treated as a single person.” As a result, Prop. Reg. 1.119A-6(d)(3)(v) provides that “trusts formed or funded with a significant purpose of receiving a deduction under Code Section 199A will not be respected for purposes of Code Sec. 199A”.
The Preamble to the Proposed Regulations under Section 199A provides that “[t]he Ii an individual has multiple trades or businesses, the individual must calculate the QBI from each trade or business and then net the amounts. Section 199A(c)(2) provides that, for purposes of section 199A, if the net QBI with respect to qualified trades or businesses of the taxpayer for any taxable year is less than zero, such amount shall be treated as a loss from a qualified trade or business in the succeeding taxable year.” Furthermore, “[t]he individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses.”
The Preamble to the Proposed Regulations under Section 199A provides that “the section 199A deduction has no effect on the adjusted basis of the partner's interest in the partnership. With respect to S corporations, the section 199A deduction has no effect on the adjusted basis of a shareholder's stock in an S corporation or the S corporation's accumulated adjustments account.”
The Preamble to the Proposed Regulations under Section 199A provides that “the deduction under section 199A does not reduce net earnings from self-employment under section 1402 or net investment income under section 1411. Therefore, both sections 1402 and 1411 are calculated as though there is no section 199A deduction.”
Based on the information available from the IRS, the most popular form of small businesses in the USA is a sole proprietorship. The next one is partnerships, then S corporations, and finally LLCs.
Because of the low interest rates over the past 5 years, a lot of business have high leverage on the real estate and leased equipment. Most of the family owned companies have real estate and the business operations owned by one entity. Some businesses are owned by either grantor trusts or non-grantor trusts (i.e. QSST trusts).
Permanent reduction in corporate income tax down to 21% may outweigh a temporary relief provided to owners of the pass-through entities by Section 199A. It is better to have a C corporation in light of low corporate income tax if (i) there is a need to build equity, and (ii) there is a need to grow company and reinvest its income.
Section 199A deduction for qualified business income presents a great opportunity to review the existing structure of the entities and, if needed, have the companies restructured to position them for a better planning. The Joint Committee on Taxation projected that Section 199A stands to cost the federal budget $414.4 billion over ten years. If that is the case, then the taxpayers need to take advantage of the savings available.
If cash flow from the company to the equity owners matters, pass-through entities are better than C corporations.
If the taxable income for a taxpayer is below a threshold (e.g. for a married couple it is $315,000), then a better form is either a partnership, and LLC or a sole proprietorship. (Because no wages will be taken into account to calculate 199A deduction thus allowing the taxpayers to maximize 199A deduction.) If the taxable income is above the threshold, then S corporations better because wages and capital limitations will leverage the 199A deduction. (The main goal is to keep the taxable income below the threshold and optimize wage and capital limitation.) The Preamble to the Proposed Regulations under Section 199A provides that “[t]he rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.”
In his article “How Much Owner Salary Should S Corp Pay to Maximize Qualified Income Deduction?” published by FORBES on December 28, 2017, Mr. Peter J. Reilly states that 28.57% of the S corporation total income will yield the maximum amount of salary that should be paid to the owner. The resulting ratio of 50% of W-2 paid and 20% of the net income before 199A deduction will give the best amount for 199A deduction.
Here is an excerpt from the article: “Thinks of an S corporation with a single owner who is the sole employee. Total income is $3,000,000. The owner takes a salary of $150,000 leaving $2,850,000 to flow through. The S corporation is saving him $82,650 in Medicare tax. Not exactly a fortune, but if it was laying on the sidewalk, he would bend over to pick it up. Now we have the 20% qualified business income deduction. The nature of the business is such that depreciable assets are negligible. So we take 20% of $2,850,000 - $570,000 -and compare it to 50% of $150,000 -$75,000. We get the lower number. Well that sucks. We need more W-2. Sure it will cost us more Medicare tax but when you compare 2.9% to 50% of 37%. Well I'll let you do the math. There is a problem, though. As we increase the W-2, the flow-through goes down lowering our result on the first test. If there is more W-2 than we need, we are wasting Medicare tax. I have often remarked that you learn all the math that you need to do tax work by fourth grade. I am now going to give you something that let's you stay with that. Try 28.57% of the $3,000,000 as your salary. That would be $857,100 which leaves you $2,142,900 of flow through. Now let's run the test. 2% of $2,142,900 equals is $428,580 and half of $857,100 is $428,550. It is not perfect because 28.57% is not the exact percentage. Try dividing $3,000,000 by 3.5, if you are a fanatic.”
If an entity has a bona fide trade or business and owns real estate then (i) the real estate used by such entity should be moved out to a separate entity (i.e. the landlord) and (ii) the landlord company should pick up real estate taxes, maintenance and insurance expenses. Such expenses (if incurred by an S corporation tenants) are not considered by the IRS as incurred in trade or business (The term “trade or business” are defined in Section 162 and the IRS follows it. The preamble to the final Treasury Regulations under section 1411 specifically states that the rental of a single piece of property is not a trade or business).
Furthermore, the Preamble to the Proposed Regulations under Section 199A provides that “[n]either the statutory text of section 199A nor the legislative history provides a definition of trade or business for purposes of section 199A. Multiple commenters stated that section 162 is the most appropriate definition for purposes of section 199A. Although the term trade or business is defined in more than one provision of the Code, the Department of the Treasury (Treasury Department) and the IRS agree with commenters that for purposes of section 199A, section 162(a) provides the most appropriate definition of a trade or business. This is based on the fact that the definition of trade or business under section 162 is derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries.
Thus, the definition of a trade or business under section 162 provides for administrable rules that are appropriate for the purposes of section 199A and which taxpayers have experience applying and therefore defining trade or business as a section 162 trade or business will reduce compliance costs, burden, and administrative complexity”.
The Preamble to the Proposed Regulations under Section 199A provides that “[t]he proposed regulations extend the definition of trade or business for purposes of section 199A beyond section 162 in one circumstance. Solely for purposes of section 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing and the other trade or business are commonly controlled under proposed §1.199A-4(b)(1)(i). It is not uncommon that for legal or other non-tax reasons taxpayers may segregate rental property from operating businesses.”
Also, the lease payments even if incurred on the commercial lease, are not payments in trade or business and thus do not qualify for 199A deduction.
Caution. The Preamble to the Proposed Regulations under Section 199A states that “[t]he Treasury Department and the IRS are aware that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the section 199A deduction. Such a strategy is inconsistent with the purpose of section 199A. Therefore, in accordance with section 199A(f)(4), in order to carry out the purposes of section 199A, proposed §1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. Additionally, if a trade or business has 50 percent or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB (meaning the income will be treated as income from an SSTB). For example, A, a dentist, owns a dental practice and also owns an office building. A rents half the building to the dental practice and half the building to unrelated persons. Under proposed §1.199A-5(c)(2), the renting of half of the building to the dental practice will be treated as an SSTB.”
The Preamble to the Proposed Regulations under Section 199A provides that “…individuals and trusts must establish that the trades or businesses meet at least two of three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business.
These factors include:
Create new basis in the real estate by contributing fully depreciated real estate to trusts. Trusts will allow to create additional threshold of taxable income for 199A deduction.
However, the Preamble to the Proposed Regulations under Section 199A provides that “[t]he Treasury Department and the IRS request comments concerning appropriate methods for accounting for non-recognition transactions, including rules to prevent the manipulation of the depreciable period of qualified property using transactions between related parties.”
The Preamble to the Proposed Regulations under Section 199A provides that: “[t]o the extent that a grantor or another person is treated as owning all or part of a trust under sections 671 through 679 (grantor trust), including qualified subchapter S trusts (QSSTs) with respect to which the beneficiary has made an election under section 1361(d), the owner will compute its QBI with respect to the owned portion of the trust as if that QBI had been received directly by the owner. In the case of a section 199A deduction claimed by a non-grantor trust or estate, section 199A(f)(1)(B) applies rules similar to the rules under former section 199(d)(1)(B)(i) for the apportionment of W-2 wages and the apportionment of UBIA of qualified property. In the case of a non-grantor trust or estate, the QBI and expenses properly allocable to the business, including the W-2 wages relevant to the computation of the wage limitation, and relevant UBIA of depreciable property must be allocated among the trust or estate and its various beneficiaries.
Specifically, proposed §1.199A-6(d)(3)(ii) provides that each beneficiary's share of the trust's or estate's W-2 wages is determined based on the proportion of the trust's or estate's DNI that is deemed to be distributed to that beneficiary for that taxable year. Similarly, the proportion of the entity's DNI that is not deemed distributed by the trust or estate will determine the entity's share of the QBI and W-2 wages. In addition, if the trust or estate has no DNI in a particular taxable year, any QBI and W-2 wages are allocated to the trust or estate, and not to any beneficiary. …This is the case regardless of how any depreciation or depletion deductions resulting from the same property may be allocated under section 643(c) among the trust or estate and its beneficiaries for purposes other than section 199A. …
Furthermore, “[c]ommenters have noted that taxpayers could circumvent the threshold amount by dividing assets among multiple trusts, each of which would claim its own threshold amount. This result is inappropriate and inconsistent with the purpose of section 199A. Therefore, proposed §1.199A-6(d)(3)(v) provides 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. …Proposed §1.643(f)-1 provides that, in the case in which two or more trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or 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 such trusts will be treated as a single trust for Federal income tax purposes. …The rule in proposed §1.643(f)-1 would apply to any arrangement involving multiple trusts entered into or modified on or after August 16, 2018. In the case of any arrangement involving multiple trusts entered into or modified before August 16, 2018, the determination of whether an arrangement involving multiple trusts is subject to treatment under section 643(f) will be made on the basis of the statute and the guidance provided regarding that provision in the legislative history of section 643(f).” (See the Preamble to the Proposed Regulations under Section 199A.)
Because of the limitations on the interest deduction by businesses and wage/capital assets test for taxpayers in non-service trade, the business should try to reduce debt on the real estate and buy instead of lease equipment.
Try to reduce the taxable income of the taxpayer below the threshold for 199A deduction by (i) making nongrantor trusts additional shareholders, (ii) 401(k) planning, (iii) tax-free income, (iv) real estate depreciation deduction among other things.
In light of the increased lifetime and death exemption, the focus should shift to getting step-up basis for the transferred property in order to eliminate or reduce capital gain tax. Options such as (i) powers of appointment, (ii) upstream gifting, (iii) long-term GRATs (up to 7 years to end in 2025), (iv) substituting assets with low basis for the assets with high basis if the trust document allows so; (v) purchasing back from the trust the assets with low basis, (vi) lifetime QTIP trusts for the spouse, (vii) income only trusts, and (viii) no and minimum discounts for valuation purposes in the estates of the decedents.
With regards to trusts and estate, a close look should be taken in how various expenses are classified. Depending whether it is Section 67(e) expenses that are unique to the trust and estate administration (such as fiduciary accounting fees, court petition costs, Form 1041 preparation fee, etc,), Section 63(b) expenses (i.e. expressly allowed by statute such as a charitable deduction under 642(c), or state and local income tax), or Section 67(e) expenses that are miscellaneous itemized expense subject to 2% AGI (e.g investment management expenses, expense to defend against creditors), the trust and estate may reduce its income tax liability.
Author: Nadia A. Havard
Originally published in October 2018
Copyright © 2018 Knox McLaughlin Gornall & Sennett, P.C.