Estate and income tax planning changed dramatically under the Tax Cuts and Jobs Act of 2017 (TCJA). For estate and gift tax, TCJA doubled the federal exemption to over $11 million ($22 million per couple). For income tax, TCJA added a 20% deduction on certain pass-through income – but only for qualifying trades or businesses and low-income taxpayers (also known as the 199A deduction). TCJA also limited the deduction for property and state income tax to $10,000 and then eliminated miscellaneous itemized deductions. With the combined estate and income tax changes, this means that most taxpayers have less reason to do estate planning and more reason to do income tax planning.
The good news is there are ways to use non-grantor trusts to mitigate some of the harsh results from these rules. Substantial tax benefits for using non-grantor trusts include:
- Obtaining the 20% business deduction which otherwise would not qualify;
- Getting an additional $10,000 of income tax or property tax deductions
- Deducting tax preparation fees and other non-miscellaneous itemized deductions.
Non-Grantor Trust Defined
Before you consider using a non-grantor trust, you need to understand how a non-grantor trust is taxed. A non-grantor trust is a separate legal entity and is taxed as a separate taxpayer. It does get a deduction for distributions paid to beneficiaries but pays its own tax on undistributed income.
Using a non-grantor trust, however, is not without its disadvantages. First, due to compressed income tax rates, trusts are subject to the highest tax bracket, 37%, at $12,500 of income. So planning with non-grantor trusts may only work if you are already in the highest tax bracket. Second, to be a non-grantor trust, the grantor (or his or her spouse) generally cannot have access to trust assets. Finally, like grantor trusts, gifts to non-grantor trusts are not eligible for the step-up in basis upon death which may be advantageous down the line.
The key to tax planning with a non-grantor trust is that it pays its own tax and gets to use its own fresh set of limitations under TCJA.
Section 199A Tax Benefits
One of most favorable tax benefits of TCJA is the ability to deduct up to 20% of the net business income from certain flow-through entities including partnerships, LLCs, Subchapter S corporations and sole proprietorships, including real estate trades or businesses. For someone in the highest marginal rate of 37%, the 20% deduction equates to a 29.6% federal marginal tax rate.
The IRS has not fully clarified its position with respect to real estate constituting a trade or business. Most practitioners believe an actively managed real estate investment generally would qualify but a rental that is triple-net leased might not. Even if the business is a qualified trade or business, there are still two further limitations on the 20% deduction that apply. The 20% deduction is limited to (1) 50% of wages paid by the business, or (2) 25% of wages paid, plus 2.5% of the unadjusted basis of tangible depreciable assets (which includes buildings and equipment but not land). If your real estate business pays little or no wages or has low basis in the property and you cannot otherwise aggregate this business with another, then the deduction may be limited. Furthermore, if the business is not a qualified business, i.e., it is a triple-net lease or you have another type of business that is a “specified service business,” then no deduction is allowed at all. If either is the case, then you should think about transferring at least a partial interest in this business to a non-grantor trust to maximize the deduction.
This works because in both cases there is an exception for low-income taxpayers. If the taxable income of the taxpayer is below a threshold amount, the 20% deduction is allowed in its entirety. This same taxable income threshold that applies to individuals ($315,000 for joint filers, $157,500 for single filers) also applies to trusts (which use the $157,500 threshold). So if you are above the income threshold and your 20% deduction is not allowed or is limited, you could shift $157,500 of business income (qualifying or not) to a non-grantor trust. If the trust’s taxable income is below $157,500, the trust can then use the 20% deduction without limitation. Even if the trust income exceeds the $157,500 threshold, there is a phase-out up to $207,500, at which point the low-income exception disappears.
Mary has a real estate trade or business but pays no wages and has low unadjusted basis in the property. Furthermore, her taxable income is over $700,000 so she can realize little, if any, of the tax benefit. The business generates $500,000 income per year. Mary can set up three different non-grantor trusts, one for each child and then gift 30% of the business to each trust. Each trust recognizes $150,000 of income which is under each trust’s $157,500 taxable income threshold for 199A planning purposes. Each trust qualifies for a 20% 199A deduction.
Please note that the IRS issued proposed regulations in an effort to curb this planning. These regulations say that two or more trusts are to be treated as one trust if such trusts have substantially the same grantors and beneficiaries AND the principal purpose of such trusts is to avoid tax. Whether separate trusts for separate beneficiaries qualify is a grey area especially if you don’t have a good business purpose, so please consult with your tax advisor before setting one up. In any case, you should make sure you document the business purpose for setting up the trust (estate or income tax planning is not a business purpose).
State Income Tax or Property Tax Benefits
As discussed, under TCJA the deduction for state income tax and property tax is limited to $10,000. You can use a non-grantor trust as a way to multiply the property or income tax deductions. For example, you could transfer your residence or vacation home to one or more non-grantor trusts. Each trust qualifies for a separate $10,000 property tax deduction. However, there needs to be enough income in the trust to offset the property tax deduction. Be aware that if you plan on selling the house, a transfer to a non-grantor trust could result in the loss of Sec. 121 home sale exclusion without planning well in advance of the sale.
This same strategy applies for trusts that pay state income taxes. Using a non-grantor trust is a way to obtain an additional $10,000 state income tax deduction. Again, the trust must have enough income to offset the deduction.
Tax Preparation Fees and Other Itemized Deductions
There are, of course, costs to set up the trust and annual tax preparation fees. The good news is that while tax preparation fees and miscellaneous itemized deductions are no longer deductible by individuals, trusts can continue to deduct tax preparation fees in full. In addition, trusts are allowed to deduct expenses “not commonly incurred by individuals.” This includes trustee fees and other costs to administer the trust. As is the case with individuals, investment advisory fees for trusts are not deductible. Therefore, if you have a trustee that also provides investment advisory services, ask him or her to “unbundle” these fees. If the trustee can do so in a “reasonable method,” there may be some extra deductions for the taking.
Setting up a non-grantor trust is certainly not without a cost. The biggest costs are the inability to access the trust, the loss in step up in basis and the compressed tax brackets. When doing tax planning, you should consider long-term goals and non-tax consequences and this may involve using both grantor and non-grantor trusts.