Why You Must Understand the New Planning Benefits of Non-Grantor Trusts
The 2017 Tax Act dramatically changed tax planning. In the new tax environment, there are a number of significant income tax saving you can advise clients on how to realize. But for many of these planning ideas you need to understand and use non-grantor trusts. This article will provide background on non-grantor trusts, some of the new complexities and issues introduced by the new 199A Proposed Regulations, and more. You need to understand many of these concepts or your clients could lose out on substantial tax benefits, including:
• 199A benefits by splitting qualified business income (QBI) to avoid the taxable income limitation and the impact of the phase-outs (yes, even with the new Proposed Regs).
• Charitable contribution benefits with a dollar for dollar benefit without regard to the new doubled standard deduction.
• Property tax deduction up to at least another $10,000 despite the tough state and local tax (SALT) limitations imposed by the 2017 Tax Act.
• State income tax savings which are more valuable and important to planning given the tough new restrictions on SALT deductions.
While there are other potential benefits (e.g. net investment income tax savings) this article will focus on just the primary ones above. If you are able to identify further savings using non-grantor trusts for your, all the better.
What is a Non-Grantor Trust
A non-grantor trust is a trust that is treated as a separate taxpayer and which pays its own income tax. Although a non-grantor trust pays its own income tax it has a deduction for distributions made to beneficiaries thereby shifting the income tax burden on income distributed, in simple terms, to the recipient beneficiary. Thus, it is not merely enough to know for planning purposes whether a trust is a non-grantor trust, but also the amount of distributions it makes and other factors. After the 2017 Tax Act the use of non-grantor trusts has been greatly enhanced because of the possibility of such trusts enhancing the income tax benefits above in comparison to the income tax results that would be realized if the taxpayer himself or herself instead reported the tax item directly on his or her own personal return.
How Non-Grantor Trusts can Provide Charitable Deductions Taxpayers Otherwise Could Not Realize
Creative uses of non-grantor trust planning can salvage a charitable contribution deduction for moderate wealth clients who have no particularly need for estate planning in its traditional sense. Practitioners should be alert to educate clients that “estate planning” can be valuable even for those who do not view themselves as wealthy.
Example: Taxpayer is married and makes a $10,000 charitable contribution for the year. Because her standard deduction is $24,000 she realizes no tax benefit from the deduction. Instead she creates a simple non-grantor trust in her state naming her sister as trustee. The trust lists charities and descendants as beneficiaries. The taxpayer gifts $200,000 to the trust which hears 5% or $10,000 which her sister the Trustee donates to charity. The trust realizes $10,000 of income and $10,000 of contribution deduction since as a non-grantor trust it is treated as a separate taxpayer. Trusts do not receive a standard deduction so the full donation is deductible. The taxpayer still benefits from her entire $24,000 standard deduction.
Compare Non-Grantor to Grantor Trusts
It is also important to understand the different between a non-grantor trust and a grantor trust. This is crucial for practitioners not only because of the different tax compliance implications, but because of several important tax and other ramifications. Grantor trusts can have in the trust document a swap or substitution power. In fact, that is the mechanism many grantor trusts use to characterize the trust as a grantor trust. This power enables the settlor who created the trust to swap appreciated assets from the back into his or her name to achieve a basis step-up on death. That is a potentially valuable benefit that may be lost with the use of a non-grantor trust that practitioners should weigh. But that loss is not assured as it may be possible to modify even an irrevocable trust in the future and add to it a swap power, thereby changing its status from non-grantor to grantor. But this is just one of the factors that must be weighed in helping clients assess the potential benefits of using non-grantor trusts.
Grantor trusts also can permit the tax-free sale of assets.
Example: Taxpayer owns a valuable closely held business she started a decade ago in her garage. She sells a minority interest in the business to a trust for a note. One goal is to lock in valuation discounts and another is to freeze future appreciation outside her estate. If that sale were made to a non-grantor trust income tax would be triggered. If made to a grantor trust it would not be.
Grantor trusts can own stock in S corporations. However, if a non-grantor trust holds stock in an S corporation that trust will have to qualify as either an Electing Small Business Trust (ESBT) or Qualified Subchapter S Trust (QSST). The latter present compliance and other complications practitioners should be aware of. If the trust involved does not have the appropriate ESBT or QSST provisions the trust will have to be modified (which will itself present costs and complexities) in order to hold S corporation stock.
Life insurance generally may only be held in a grantor trust. This is because if a trust can use trust income to pay insurance premiums on policies insuring the settlor’s life the trust will be characterized as a grantor trust for income tax purposes.
Non-Grantor Trusts May Permit Saving Property Tax Deductions
This is another potentially valuable planning idea that, just like the charitable planning idea above, can benefit moderate wealth clients. Again, that is a critical point for all practitioners to understand as too often clients and practitioners alike dismiss the importance of “estate” planning without first understanding the valuable income tax benefits the process can provide to clients who are not “wealthy.” To understand how non-grantor trusts might save clients property tax deductions, the limitations of the 2017 Tax Act must first be understood.
The 2017 Tax Act severely restricted the Code Section 164 tax deduction for non-business state and local income, sales and property taxes to $10,000 annually. Both individual and married couples filing jointly get the same $10,000 limit. Married couples filing separately are limited to only $5,000 a year. Also, this $10,000 cap is not indexed for inflation. The bottom line is that many clients will lose most of their property tax deduction. Can practitioners help? In many instances yes. The answer is in the creative application of non-grantor trust planning.
Although some might express concern about the impact of the multiple trust rule in the new 199A Proposed Regulations (discussed below) neither those Proposed Regulations or any other law in any way prevents the use of one non-grantor trust for this purpose. For many clients, salvaging an additional $10,000 of property tax deduction per year will alone justify the planning.
If a portion of the taxpayer’s house is transferred to a non-grantor trust, that trust should be treated as a separate taxpayer and will be permitted to deduct up to $10,000 annually for state and local taxes, e.g. property tax on the home it pays. For this deduction to be realized the trust must earn income at least equal to the property taxes it pays. The trust realizes the property deduction. The individual taxpayer will still have their own $10,000 state and local tax (SALT) benefit and will qualify for his or her full standard deduction. Thus, just as illustrated for the charitable contribution deduction above, this planning idea can provide an additional $10,000 tax benefit each year. If combined with the charitable contribution deduction planning illustrated above, a single non-grantor trust can provide valuable benefits many clients will have lost under the new law.
But just as with so many creative planning ideas there are wrinkles practitioners will need to address. For example, no home sale exclusion under Code Section 121 is available. This might be mitigated by selling the house to the non-grantor trust at inception and obtaining a tax-free step up in basis up to the amount of the exclusion. Alternatively, the trust could in a future year, at least two years before sale, be converted to a grantor trust so that the gain will be included in the taxpayer’s return.
How A Non-Grantor Can Increase 199A Benefits
Practitioners are no doubt by now well familiar with the general concepts contained in Code Section 199A. This new tax benefit enacted as part of the 2017 Tax Act can provide a deduction of up to 20% of income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. The income must be qualified business income (QBI). The activity must be a trade or business as defined under Code Section 162. If that business is a Specified Service Trade or Business (SSTB) further restrictions apply. One of the key limitations on the new 199A deduction is the taxable income threshold. If married taxpayers have taxable income above $315,000 for a non-SSTB then a wage or wage and tangible property limitation may apply to reduce the amount of QBI that can qualify for the 20% deduction. If the business involved is tainted as an SSTB then the 20% deduction is phased out ratably from $315,000 to $415,000 at which point no deduction is available.
After enactment of the law, many commentators speculated that the taxable income threshold could be circumvented in some instances by transferring equity in the business to non-grantor trusts. The basis for this planning idea, which in part or whole still is viable, is that a non-grantor trust is its own taxpayer and as an independent taxpayer would be subject to its own taxable income threshold of $157,500 as if a single taxpayer.
Example: Taxpayer has an SSTB that might qualify for the 199A 20% deduction but her taxable income is over $500,000 so she cannot realize any benefit. The SSTB generates $400,000/year in income. She gifts 30% of the SSTB to three different non-grantor trusts, one for the benefit of each of her children. Each non-grantor trust realizes 30% x $400,000 = $120,000 of income which is under each trust’s $157,500 taxable income threshold for 199A phase out purposes. Each trust might qualify for a full 20% 199A deduction.
The IRS, aware of the planning ideas practitioners were considering, endeavored to attack the above planning with non-grantor trusts in the Proposed Regulations.
How the New Proposed Regs May Inhibit Non-Grantor Trust 199A Planning
On first blush the Proposed Regulations appear to eliminate this planning with non-grantor trusts by promulgating anti-abuse rules attacking the use of multiple trusts. Before examining those rules consider:
• Nothing in the Proposed Regulations suggests that use of a single non-grantor trust is problematic. However, practitioners will have to consider the aggregation and control tests that apply to SSTBs which may restrict splintering an SSTB into SSTB and non-SSTB components, and perhaps gifting part to a non-grantor trust. Thus, the above planning seems to be viable if only one non-grantor trust is created. That could be beneficial to a client. Also, in evaluating the benefits versus costs of such planning consider how many different uses a particular non-grantor trust might provide a particular client (home property tax, charitable contribution, 199A, etc.).
• The Proposed Regulations are merely proposed at the present time and may well change before finalized.
• Many commentators have attacked the Proposed Regulations as exceeding the authority granted to Treasury and also, especially with respect to the multiple trust rules they contain, contradicting the specific provisions of Code Section 643(f) for which they are providing rules.
• Depending on the reading of the Proposed Regulations by some commentators, the planning in the above example, if done properly, may still be viable.
Again, each practitioner should help each client weigh the pros and cons of this planning with each individual client and also caution clients about the potential for an audit, which certainly cannot be quantified.
The preamble to the Proposed Regulations provides: “Section 643(f) grants the Secretary authority to treat two or more trusts as a single trust for purposes of subchapter J if (1) the trusts have substantially the same grantors and substantially the same primary beneficiaries and (2) a principal purpose of such trusts is the avoidance of the tax imposed by chapter 1 of the Code [highlights added].” That language comports with the statute which has a conjunctive three prong test requiring substantially the same grantors and primary beneficiaries and a principal purpose of tax avoidance. Note that as for the tax avoidance being a “principal purpose” if the trust also provides estate tax benefits by using an exemption that is scheduled to sunset, provides important asset protection benefits, etc. will the income tax avoidance be a “principal purpose?”
The last example in the Proposed Regulations deals with the multiple trust rule. After illustrating how trusts can in fact surmount the requirements to avoid having substantially the same primary beneficiary, and thus be respected under the newly formulated multiple trust regulations, the following language appears: “Under these facts, there are significant non-tax differences between the substantive terms of the two trusts, so tax avoidance will not be presumed to be a principal purpose for the establishment or funding of the separate trusts. Accordingly, in the absence of other facts or circumstances that would indicate that a principal purpose for creating the two separate trusts was income tax avoidance, the two trusts will not be aggregated and treated as a single trust for Federal income tax purposes under this section [highlight added].” Thus, the Treasury/IRS are suggesting that if there is a “principal purpose” of income tax avoidance the trusts can be aggregated even if the other two conjunctive requirements of the statute are complied with. That interpretation is clearly contrary to the statute and it is not clear that it could be upheld.
Although grantor trusts have been the default planning tool for wealthy clients, in the current tax environment, many clients, even those that may not be “wealthy” may realize income tax benefits from creative uses of non-grantor trusts. Practitioners, especially those who have believed that they did not have to get involved with “estate planning” or who viewed their clients as not being sufficiently wealthy to benefit from estate planning, need to reconsider how important non-grantor trust planning is for their clients.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.