Important changes in the TCJA for tax-exempts structured as trusts

There are a number of important changes included in the Tax Cuts and Jobs Act (TCJA) to make note of as it relates to tax-exempt organizations structured as trusts for tax purposes:

• The top tax rate for trusts is lowered
• The deduction for qualified business income from taxable income
• The limitation on losses for taxpayers other than corporations

Top tax rate for trusts is lowered

A tax-exempt organization may be structured for tax purposes in a number of ways:

1. As a corporation
2. As a limited liability company taxable as a corporation
3. As an unincorporated association, or
4. As a trust

The highlight of the legislative process focused on lowering tax rates for all taxpayers. With the new rate structures put into place, the top rates were reduced. But, did the top rate reductions result in lowering tax liabilities for all taxpayers? The answer to this question is no. For example, for corporations, the new tax rate is a flat 21 percent (down from a top rate of 35 percent), applied against all unrelated business taxable income and replacing a graduated rate structure, where the tax rate on unrelated business taxable income of less than $50,000 was taxed at only a 15 percent rate. This change represents an automatic tax increase of 6 percent for tax-exempt organizations with lower amounts of unrelated business taxable income.

Tax-exempt organizations that may be structured as trusts for tax purposes include pension trusts, charitable exempts (e.g., certain private foundations), individual retirement accounts (IRAs) or Roth IRAs, to name a few.

The following rate structure was used by exempt organizations operating as trusts to pay the unrelated business income tax for tax years 2017:

If taxable income is –

• Not over $2,550, 15% of the taxable income
• Over $2,550 but not over $6,000, $382.50 plus 25 percent of the excess over $2,550
• Over $6,000 but not over $9,150, $1,245 plus 28 percent of the excess over $6,000 
• Over $9,150 but not over $12,500, $2,127 plus 33 percent of the excess over $9,150        
• Over $12,500, $3,232.50 plus 39.6 percent of the excess over $12,500

The new law lowered the top tax rate applicable to trusts for tax years beginning in 2018:

If taxable income -

• Not over $2,550, 10 percent of the taxable income
• Over $2,550 but not over $9,150, $255 plus 24 percent of the excess over $2,550        
• Over $9,150 but not over $12,500, $1,839 plus 35 percent of the excess over $9,150        
• Over $12,500, $3,011.50 plus 37 percent of the excess over $12,500

It is important to note, this lower top rate is not permanent and will not apply to taxable years beginning after Dec. 31, 2025.

The deduction for qualified business income

This is the deduction for certain pass-through businesses that received a lot of press during the legislative process. The new law provides that trusts and estates are eligible for a 20 percent of qualified business income deduction. The deduction is claimed against taxable income. Rules similar to the rules under former section 199 (as in effect on Dec. 1, 2017, and which was repealed in tax reform) are to apply for apportioning between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property under the limitation based on W-2 wages and capital, if applicable. The effective date of this new deduction is for taxable years beginning after Dec. 31, 2017.

The deduction is applicable to certain types of business activities that are not defined as a specified business. This is important in that specified businesses may not claim the deduction for qualified business income unless its income is less than a threshold amount.

Under a safe harbor rule, called the threshold amount, the 20 percent deduction is allowable to all pass-through entities including tax-exempt organizations formed as trusts, notwithstanding what kind of business activity is generating the taxable income, including specified businesses.

A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, 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, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. This excludes engineering and architecture services.

The threshold is the amount above which both the limitation on specified service businesses and the wage limit are phased in to limit or negate the deduction for qualified business income. The deduction is dependent on wages or on wages plus a capital element as we will see later. The easiest application of the new law would be where the trust has qualified business income below the threshold limit:

Example: There is a trust with $50,000 of taxable income and qualified business income (QBI) of $40,000, the deduction is 20 percent of QBI or $8,000.

It is that easy if the activity produces income under the thresholds provided. There is no need to consider the nature of the business activity as the deduction is automatic. The calculation does become a bit more involved if the unrelated business generates income which is over the threshold amounts.

If the unrelated trade or business generates qualified business income over the threshold amounts:

1. No deduction will be allowed because the activity is a specified business and as such, it does not qualify to claim the deduction, or
2. If the above does not apply, then generally, the deduction limitation is calculated as the greater of:

a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or
b)  The sum of 25 of percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property

For purposes of the above equation, qualified property means tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the taxable year, and which is used in the production of qualified business income, and for which the depreciable period has not ended before the close of the taxable year. A qualified business does not necessarily have to have paid wages in order for a deduction to apply.

For example, a taxpayer (who is subject to the limit) does business as a trust conducting a widget-making business. The business buys a widget-making machine for $100,000 and places it in service in 2020. The business has no employees in 2020. The limitation in 2020 is the greater of:

a)     50 percent of W-2 wages, or $0, or
b)     The sum of 25 percent of W-2 wages ($0), plus 2.5 percent of the unadjusted basis of the machine immediately after its acquisition: $100,000 x .025 = $2,500.

The amount of the limitation on the taxpayer’s deduction is $2,500.

Unanswered questions still exist surrounding a few of the mechanics in applying this provision, we will keep you apprised as developments occur.

Excess business losses for taxpayers other than corporations

For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, excess business losses of a taxpayer other than a corporation are not allowed for the taxable year. Such losses are carried forward and treated as part of the taxpayer’s net operating loss (NOL) carryforward in subsequent taxable years.

An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount.

The threshold amount for a taxable year is $250,000 in 2018. The threshold amount is indexed for inflation. The provision applies after the application of the passive loss rules and the provision is effective for taxable years beginning after Dec. 31, 2017.

There are a few outstanding questions that may apply to this provision specifically:

1. For tax-exempt organizations operating as trusts, if the organization only has one trade or business activity the application of the limitations appear clear, the carryover amount is limited to the threshold amount and also the operative rules related to offsetting only 80 percent of taxable income with losses which arise in tax years beginning after Dec. 31, 2017, appear to apply.
2. For tax-exempt organizations operating as trusts with more than one trade or business, it appears that by operation of new section 512(a)(6) which requires separation of trade or businesses and losses from one may not offset losses from another, the question outstanding is: will the $250,000 limitation apply to a carryforward suspended loss into a future year? For example, in 2018 the exempt organization has trade or business A that has income of $100,000 and trade or business B that has a loss of $300,000. By operation of section 512(a)(6), the loss from trade or business B is suspended and carried into 2019 in full. For 2019, trade or business A has income of $100,000 but trade or business B has $300,000 of income. Since the suspend loss from trade or business B from the 2018 tax year of $300,000 may be used to offset income from trade or business B in future periods, the loss is in excess of the $250,000 limitation, so may only $250,000 of the suspended loss of $300,000 be allowed to be used in 2019 under this provision (we are disregarding the potential application of the section 172 new rule for only an 80 percent of taxable income offset for the purposes of this example and only are looking to the operative rules in section 512(a)(6)).

Conclusion

In addition to the new laws under the TCJA that apply to unrelated business income tax, tax-exempt organizations also have a few additional provisions to deal with if they are formed as trusts for tax purposes. RSM will keep you apprised of future developments that may occur related to any of the three provisions highlighted in this article.