On Aug. 8, the IRS issued proposed regulations for Section 199A (see REG-107892-18). The proposed regulations confirm that electing small business trusts (ESBTs) qualify for the section 199A deduction. However, they also confirm that the anti-abuse provisions of section 643(f) apply to section 199A.
For a more detailed discussion on the proposed regulations for section 199A, see our Alert: A closer look at the new pass-through deduction proposed regulations.
Electing small business trusts
While many practitioners assumed that it was legislative intent to allow section 199A for ESBTs, it is still welcome relief to advisors, trustees and beneficiaries whose fate was uncertain due to the language in sections 641 and 1366.
Taxation of ESBTs is provided by section 641, which states that the only items of income, loss, deduction, or credit to be taken into account are the following:
- items required under section 1366,
- gain or loss from the disposition of stock,
- income taxes and administrative expenses related to the S corporation income and
- interest expense related to acquisition of the S corporation stock.
As a result, we need to look to section 1366 to determine whether the 20 percent deduction is allowed for an ESBT. Section 1366 defines items that are passed through to S corporation shareholders. Since the new section 199A deduction is calculated at the taxpayer level, and not the pass-through entity level, there was uncertainty whether the 20 percent pass-through deduction would be allowed.
Consistent with how all other items of income, loss and credit are reported, under the new proposed regulation, the deduction is calculated independently for the S portion, non-S portion and grantor portion.
Use of multiple trusts
The section 199A deduction can be limited or completely phased out as a result of the various limitations placed on “specified service” businesses and business without sufficient wages or tangible assets. These limitations do not apply if the business income is earned by or allocated to a taxpayer with taxable income below the threshold amount in section 199A(e)(2), which is currently $157,500.
For example, if $100,000 of income from a “specified service” business was earned by or allocated to a taxpayer with overall taxable income of $210,000, no section 199A deduction would be allowed. However, that same $100,000 of income earned by a taxpayer with $150,000 of taxable income would be eligible for the full 20 percent ($20,000) deduction.
Treasury is concerned that some taxpayers could circumvent the various section 199A limitations by dividing assets among multiple trusts, each of which would have taxable income below the threshold. Believing that this form of planning can be inappropriate and inconsistent with the purpose of section 199A and general trust principles, Treasury and the IRS will not, at least for purposes of section 199A, respect trusts formed or funded with a significant purpose of receiving a deduction under section 199A.
According to proposed section 1.643(f)-1, a problematic fact pattern would involve a 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 the trusts or contributing additional cash or other property to the trusts is the avoidance of Federal income tax. In such a case, the trusts will be treated as a single trust for Federal income tax purposes. For purposes of applying this rule, spouses are treated as only one person and, accordingly, multiple trusts established for a principal purpose of avoiding Federal income tax may be treated as a single trust even in cases where separate trusts are established or funded independently by each spouse. A principal purpose for establishing or funding a trust will be presumed if it results in a significant income tax benefit unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation of these separate trusts. In other words, absent a goal of finding a “work-around” the section 199A thresholds, the taxpayer would not have created or funded the trusts. However, as shown in another example, there can be cases where multiple trusts will be respected and will not be aggregated because there are significant non-tax differences between the substantive terms of the trusts, so tax avoidance will not be presumed to be a principal purpose for the establishment or funding of the separate trusts.
Proposed section 1.643(f)-1 provides examples to illustrate specific situations in which multiple trusts will or will not be treated as a single trust. In what might be considered a shot across the bow of other uses of non-grantor trusts to qualify for a deduction otherwise limited by the new tax law, namely the deduction for state and local taxes, Treasury notes that the application of proposed section 1.643(f)-1 is not limited to avoidance of the limitations under section 199A.
The rule in proposed section 1.643(f)-1 would apply to any arrangement involving multiple trusts entered into or modified on or after the date the regulations are published in the Federal Register – which has yet to happen. In the case of any arrangement, involving multiple trusts entered into or modified before the date the regulations are published in the Federal Register 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). Pending the publication of final regulations, the position of the Treasury Department and the IRS is that the rule in proposed section 1.643(f)-1 generally reflects the intent of Congress regarding the arrangements involving multiple trusts that are appropriately subject to treatment under section 643(f).
Currently, the proposed regulations have been submitted to the Office of Federal Register (OFR) for publication, and are currently awaiting publication in the Federal Register. Thus, while the proposed regulations have been made available, the proposed regulations ultimately published in the Federal Register will be the official document.