In February, the IRS issued both final and additional proposed regulations detailing how estates, trusts and their beneficiaries can qualify for the 20% income tax deduction for qualified business income received from partnerships, S corporations and proprietorships under Section 199A of the Internal Revenue Code.
The following is a brief summary of some of the most important rules applicable to estates and trusts:
- The general rule is that an estate or trust with less than a certain threshold amount of taxable income ($160,700 for 2019) for the tax year can qualify for the 20% deduction that year without having to apply certain limitations based on shares of W-2 wages and tax basis in qualified business assets. Above that threshold amount of taxable income, the qualified business from which the income is derived must generate (and allocate to the estate or trust) a sufficient amount of W-2 wage expense (or unadjusted tax basis in qualifying business assets) in order for the otherwise eligible 20% deduction to not be subject to reduction or complete elimination. In determining whether the taxable income of an estate or trust exceeds this threshold amount, the estate or trust income distributed to beneficiaries generally reduces the estate’s or trust’s taxable income.
- If a trust has substantially separate shares which are recognized for income tax purposes under Section 663(c) of the Code, the trust’s taxable income, for purposes of determining whether the W-2 wages/asset tax basis limitation rules apply, is determined based on the total taxable income of all the separate shares of the trust aggregated together. In other words, the separate share rule does not apply for purposes of determining whether taxable income exceeds the Section 199A threshold amount.
- Multiple trusts will be aggregated for purposes of applying the Section 199A threshold if they have substantially the same grantor or grantors (including spouses) and substantially the same primary beneficiary or beneficiaries, and if the primary purpose for establishing one or more of the trusts (or adding assets to them) is the avoidance of Federal income tax. The new regulations do not elaborate on any of the key terms in this provision, referring instead to the regular income tax rules on multiple trusts under Section 643(f) of the Code and the regulations thereunder.
- For a trust taxable as a grantor trust for income tax purposes, the Section 199A deduction is available to the grantor of the trust, on the same basis and to the same extent as if the grantor owned the trust’s business interests directly and conducted the activities of the trust directly as well.
- The taxable income of an Electing Small Business Trust will be determined on an aggregate basis, including both the income of the S Corporation portion and the non-S Corporation portion of the trust.
- The regulations conclude that because Charitable Remainder Trusts are not subject to income tax, such trusts do not have or need to calculate a Section 199A deduction, and therefore the Section 199A threshold amount does not apply to such trusts.
- It was determined that no special Section 199A qualification rule is needed for non-grantor Charitable Lead Trusts, since they are taxable under the general fiduciary income tax rules applicable to non-grantor trusts.
- An individual beneficiary of an estate or trust includes any amount of small business income deemed distributed to the beneficiary by the estate or trust in calculating his or her own personal Section 199A deduction. The estate or trust distribution is generally created in the same way as though the income had been allocated to the individual beneficiary directly from the closely held business.
These details of the final and proposed regulations issued by the IRS in February must be analyzed to determine if any given estate or trust, or the beneficiaries thereof, can benefit from this new income tax deduction.