The Tax Cuts and Jobs Act of 2017 (TCJA) represents a broad-based change to the U.S. tax code, touching on virtually every area of taxation, including of course fiduciary income tax. While some aspects of the new tax law impact trusts directly, the effect of the TCJA on individuals may have even greater implications for trust planning. This article will provide an overview of the more meaningful provisions affecting trust taxation as well as the practical considerations and opportunities these changes present for federal and state fiduciary income tax planning.

While the TCJA does not alter the basic pass-through structure of fiduciary income taxation with respect to distributable net income (DNI) and the income distribution deduction (IDD) as provided under IRC Subchapter J, how one arrives at these amounts has changed. Section 641(b) states, “[t]he taxable income of an estate or trust shall be computed in the same manner as an individual, except as otherwise provided in this part.” Therefore, by reference to this section much of the new tax law impacting individuals also impacts trusts. Some of the provisions that will change how trust income is calculated are as follows:

• Miscellaneous itemized deductions: The TCJA also amends § 67 by suspending all miscellaneous itemized deductions. Such deductions include investment fees and expenses (but not investment interest expense under § 163) and unreimbursed business expenses. While these expenses were often already limited for individuals and trusts alike due to the Alternative Minimum Tax and 2% limitation, this new provision, while in effect, eliminates these itemized deductions. However, as confirmed in Notice 2018-61, the amendment does not impact trust and estate expenses “incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate” as provided by § 67(e). Such expenses typically include legal, accounting, and trustee fees.

   

• State and local taxes (SALT):  The TCJA amends § 164 to limit the deduction for state and local real property taxes, state and local personal property taxes, and state and local income taxes paid to $10,000 in total per year. This limitation does not however apply to foreign income taxes, nor does it apply to any real or personal property taxes incurred in carrying on a trade or business, or an activity entered into for the production of income under § 212.

   

• Limitations on business losses: Section 461(l) was introduced to limit business losses to the extent they are greater than net business income and expenses, plus, in the case of trusts, $250,000. This limitation is applied at the trust level. Disallowed losses are then treated as a net operating loss (NOL) and carried over to the following tax year as provided under § 172 (which itself was amended to limit utilization of NOLs to the lessor of the NOL or 80% of total taxable income computed without regard to such NOL). To the extent a trust has active business losses in excess of the limitation, this provision will limit that trust’s ability to offset other non-business income.

   

• Qualified business income: New § 199A was added by the TCJA and provides for a 20% deduction on “qualified business income” for any non-corporate taxpayer, including trusts and estates. This deduction is subject to several complicated limitations, most of which are beyond the scope of this article. However, one such limitation to consider here is the “specified service trade or business” limitation as provided by §199A(d)(2). Under this provision, no deduction is allowed on income from a specified service trade, which includes investment businesses and many service-based businesses, such as legal or accounting. The provision also states that there is an exception to this limitation if a taxpayer’s income is less than a certain threshold amount. For trusts and estates, this threshold is $157,500 (the deduction is then phased out for income amounts over this amount). Therefore, it is possible for a trust or estate to get the full benefit of this new deduction even if holding a specified service business as long as its income does not exceed the above threshold amount.

Many of the new limitations and benefits of the TCJA are based on specific income amounts per taxpayer. As a result, there are possible planning opportunities for trusts as separate taxpayers.

For example, assume a trust holds an interest in an individual grantor’s investment fund management company. Although the company produces ordinary income, because it is an investment business, it would be considered a specified service company and therefore generally not eligible for the §199A deduction. However, if that trust’s income was $157,500 or less, the full deduction would be available. Depending on the trust provisions, it is possible to ensure that trust income does not exceed this amount by making trust distributions to beneficiaries. This ability to “tailor” trust income is further aided by the §663(b) “65-day rule” which allows a trustee to make a distribution within 65 days following the close of a tax year and treat it as made in that tax year. This provision allows time for the trustee to get a clearer sense of taxable income for the tax year. This example highlights just one potential benefit to having multiple taxpayers under the new tax rules.   

It should however be noted that before considering any income tax planning ideas with respects to trusts, IRC §643(f) and related regulations must be taken into account. An anti-abuse provision, §643(f) states that in the case of multiple trusts, if the grantor and beneficiaries are substantially the same, and the primary purposes of those trusts is income tax avoidance, such trusts can be aggregated into one. As a result, any tax benefits derived from having multiple trust taxpayers could be invalidated.  

One of the TCJA provisions referenced above receiving significant attention, particularly in high-income tax states, is the SALT deduction limitation. This SALT limitation has created a renewed focus on using trusts to limit state income tax. Depending on specific state law, it is often possible to structure a trust such that it is not subject to state tax in the state of which the trust’s grantor (and therefore typically the trust) is a resident. Independent of the TCJA, there is also a growing legal trend under which courts are ruling that, depending on specific circumstances, states may lack sufficient nexus or connection to subject certain resident trusts to state taxation. For example, in recent years taxpayers in Illinois and Pennsylvania successfully argued that, given these specific circumstances, those states could not validly tax resident trusts due to insufficient nexus. Although not a new concept, one result of these increasingly favorable state laws combined with the federal deduction limitation is that many taxpayers are reconsidering the use of grantor trusts in tax planning.

As provided for in §§ 671-677, it is possible to structure a trust so that the grantor retains ownership of trust assets for income tax purposes. In other words, all trust income (and expense) is imputed directly to the grantor and the trust itself pays no tax. As a result, instead of diluting trust assets by any federal and state income tax, the grantor’s estate is diluted by that amount. These tax payments made by the grantor are in effect an indirect gift to the trust which IRS does not treat as a gift. From a transfer tax standpoint, this indirect gift can be very powerful. However, because in many states it is possible for resident trusts to avoid state income tax due to nexus considerations, in the post TCJA world some taxpayers are more willing to forego this transfer tax benefit and are turning off grantor trust status (and therefore creating separate taxpaying trusts) so that trust assets may avoid state income tax.    

In addition, the SALT limitation may also create new interest in incomplete, non-grantor (ING) trusts.  Without going into detail, ING trusts are structured such that transfers to it are incomplete gifts for transfer tax purposes, but the trust is also a separate (non-grantor) taxpaying entity. Therefore, without gift tax constraints, significant assets can be transferred to these trusts. Depending on the resident state, ING trusts can also be used to limit state income tax.

Taxpayers and practitioners have just begun to see and feel the impact of the TCJA’s sweeping changes.   

As this law develops, there will also be a greater understanding of its impact and potential planning opportunities. These changes, along with a changing landscape with respect to state taxation of trusts, will likely continue to foster a renewed emphasis on fiduciary income tax planning.