On December 22, 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law by President Trump. Most of the provisions affecting estates and trusts are temporary; they commence in 2018 and are scheduled to expire after 2025. While there is minimal mention in the new law of its specific applicability to fiduciary income taxation, Internal Revenue Code (IRC) section 641(b) instructs that the taxable income of an estate or trust is to be computed in the same manner as of an individual unless otherwise indicated. Further guidance is anticipated as the IRS begins implementation.
As under previous tax law, estates and trusts reach the highest bracket quickly. The tax brackets for estates and trusts for 2018 have been changed as follows: for taxable income under $2,550, 10%; for taxable income from $2,550 to $9,149, 24%; from $9,150 to $12,499, 35%; over $12,500, 37%. After 2018, the tax brackets will be adjusted annually for inflation.
Owners of pass-through entities.
There is a new 20% deduction for qualified business income from a partnership, LLC, S corporation, or sole proprietorship. This deduction will be available for estates and trusts, and will be passed through to income beneficiaries or retained by the fiduciary in a manner similar to allocating distributable net income. Rules similar to 2017-law IRC Section 199 will apply for allocating between fiduciaries and beneficiaries any W-2 wages and unadjusted basis of qualified property based on W-2 wages and capital. Generally, when a trust or estate owns an interest in an active business, it may be allocated a share of the domestic production activities deduction (DPAD) on a Form K-1 for this business. The DPAD is required to be allocated between the fiduciary and beneficiaries pursuant to the rules set forth under IRC section 199. The same allocation rules apply to the 20% deduction for qualified business income. Further guidance is needed, however, on this allocation as it applies to the 20% deduction.
Capital gains and dividends.
The maximum rates of 15% and 20% on long-term capital gains and qualified dividends have remained unchanged, but the income levels for such rates have been modified to provide that capital gains are taxed at 0% when taxable income is under $2,600; at 15% when under $12,700; and at 20% when higher.
Alternative minimum tax (AMT).
While corporate AMT has been eliminated and the individual AMT exemption has been, at least temporarily, significantly increased, IRC section 55(d)(1)(D) has remained unchanged, leaving the statutory AMT exemption amount for estates and trusts at $22,500 and the statutory exemption phaseout threshold amount at $75,000 of AMT income. The TCJA will, however, adjust these amounts annually for inflation.
The personal exemptions for individuals are repealed, but the TCJA leaves the exemptions for estates and trusts unchanged. IRC section 642(b) extends personal exemptions to estates and trusts; therefore, the personal exemption remains deductible by an estate ($600) and trust ($100 or $300). Personal exemptions for qualified disability trusts have been set at $4,150 for years when the personal exemption is zero.
Many of the itemized deduction rules have changed:
- The cap for deducting home mortgage interest has been reduced from $1 million to $750,000 for mortgages incurred after December 15, 2017. Interest on home equity lines is no longer deductible. It is uncertain how this will apply to trusts that own real estate for personal use.
- The deduction for state and local income, property, and sales taxes (SALT) is capped at $10,000 (IRC section 164). No deduction in 2017 is allowed for prepayment of 2018 state and local income taxes. The SALT cap excludes foreign income and all real property taxes paid in connection with carrying on a trade or business or an activity described in IRC section 212 (i.e., relating to expenses for the production of income). These new rules also apply to trusts and estates under IRC section 641(b). Because many trusts and estates hold assets for investment purposes, the activities could be classified as “for the production of income,” allowing taxes to be deductible. Further guidance will be needed to determine if there are any exceptions available to estates and trusts.
- The charitable contribution percentage limitation for cash contributions made by individuals has been modified, but there is no mention of modifications to the unlimited charitable deduction for estates and trusts under IRC section 642(c). This deduction remains unchanged.
- Miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor have been repealed under the new IRC section 67(g). The TCJA is silent on the IRC section 67(e) deductions estates and trusts may take in connection with expenses for the administration of a trust or estate that would not have been incurred if the property were not held as such. These deductions include trustee commissions, attorney fees, appraisals, and trust accountings; it appears that they should still be permitted as deductions. The deduction for federal estate tax paid (income in respect of a decedent) under IRC section 691(c) also continues to be deductible.
Net operating losses (NOLs).
For losses arising in tax years after 2017, the NOL deduction is limited to 80% of taxable income. The TCJA eliminates the two-year carryback of NOLs but permits NOLs to be carried forward indefinitely. It also should be noted that net business deductions for noncorpo-rate taxpayers will be limited to $500,000 per year with the balance, if any, added to a NOL carryforward.
The new law contains various other changes worth noting, including the following:
Electing small business trusts (ESBT).
A nonresident alien individual is now permitted to be a potential current beneficiary of an ESBT. In addition, the charitable contribution deduction of an ESBT is now determined by the rules applicable to individuals, as opposed to the rules applicable to trusts.
The contribution limitation to ABLE accounts by the designated beneficiary has been increased. After the overall limitation on contributions is reached (i.e., the annual gift tax exemption amount, $15,000 for 2018), an ABLE account’s designated beneficiary can contribute an additional amount, up to the lesser of 1) the federal poverty line for a one-person household or 2) the individual’s compensation for the tax year.
Taxable income attributable to the unearned income of a child will be subject to the tax rates applicable to estates and trusts, at both ordinary and capital gains rates.
Estate, gift, and generation-skipping transfer (GST) taxes.
The TCJA did not repeal the estate, gift, and GST taxes; instead, they are retained at the 40% tax rate. Other related provisions of note are as follows:
- The estate, gift, and GST tax exemptions have been doubled; the basic exclusion amount of $5 million will increase to $10 million and indexed for inflation (from $5,600,000 to $11,200,000 for 2018). The TCJA does not specifically mention GST tax under this provision; however, since the GST tax exemption is based on the basic exclusion amount, it will be increased accordingly. This is not a permanent increase; the exemption will revert back to $5 million (increased for inflation) in 2026 unless further changes are made.
- The estate and gift tax exemption remains unified.
- The step-up in basis to fair market value at date of death remains.
- The annual exclusion remains and will continue to be adjusted for inflation ($15,000 for 2018).
State tax implications.
Before taking advantage of the increased federal estate tax exemption, it is important to consider the applicable state estate and inheritance tax laws—there may be state estate tax payable even though no federal estate tax is due. The TCJA may also prompt changes in state tax laws. The following are a few states worth noting:
- New York. The New York estate tax exemption was designed to match the federal estate tax exemption in 2019, calculated on a base of $5 million, indexed annually for inflation. It appears that this base will not automatically increase to match the new federal exemption.
- New Jersey. New Jersey repealed its estate tax, but the inheritance tax still exists. The inheritance tax is imposed on nonlineal heirs such as nieces and nephews and is not currently subject to adjustment or tied in any way to the federal changes.
- Hawaii, Maine, and Washington, D.C. The estate tax exemption in these three jurisdictions is designed to double along with the federal estate tax exemption under the TCJA. Legislation may be put in place to change conformity with the federal exemption.
- Maryland. Maryland’s estate tax exemption is scheduled to increase to $4 million in 2018 (from $3 million for 2017), and is also scheduled to match the federal estate tax exemption amount in 2019 (although there are already calls by state lawmakers to decouple from the federal exemption). Maryland will also permit portability between spouses beginning in 2019. Maryland’s inheritance tax is not tied to any federal exemption and is not expected to change.
- Connecticut. The estate and gift tax exemption will increase to $2.6 million in 2018 (from $2 million in 2017); it will further increase to $3.6 million for 2019, and then is scheduled to meet the federal exemption amount in 2020, as indexed annually for inflation.
- Massachusetts. The state exemption is currently $1 million and is not scheduled to change.
As with much of the TCJA, its actual impact on estates and trusts remains to be determined. Further guidance is needed from the IRS, and until such guidance is provided, uncertainty remains.