Law Offices of Bradley J. Frigon 6500 S. Quebec St. Suite 330 Englewood, CO

Transcription

1 2018 National Conference on Special Needs Planning and Special Needs Trusts Tax Reform and Year End Tax Planning for Self Settled and Third Party Trusts Bradley J. Frigon October 18, 2018 Law Offices of Bradley J. Frigon 6500 S. Quebec St. Suite 330 Englewood, CO

2 Introduction On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA). The text of the Act extends nearly 500 pages. This legislation is considered the most significant overhaul of the U.S. tax code since Beginning January 1, 2018, the new law will impact individuals, trusts, estates, and businesses in a variety of ways. Generally, the new tax law alters individual income taxation, reduces corporate income taxes, and introduces a new form of taxing the earnings from certain pass through entities.

3 New Tax Rates The Act changes the federal income tax brackets and corresponding tax rates for individuals, trusts, and estates for the covered years. Covered years for the tax act begin in 2018 and sunsets at the end of The following chart summarizes the differences between the 2018 tax rates that were scheduled to go into effect in 2017, and tax rates and brackets under the Act.

4 Unmarried Individuals 2017 If Taxable Income is Between: The Tax Due is: $0 $9,325 10% of taxable income $9,325 $37,950 $ % of the amount over $9,325 $37,950 $91,900 $5, % of the amount over $37,950 $91,900 $191,650 $18, % of the amount over $91,900 $191,650 $416,700 $46, % of the amount over $191,650 $416,700 $418,400 $120, % of the amount over $416,700 $418,400 + $121, % of the amount over $418,400

5 Unmarried Individuals 2018 If Taxable Income is Between: The Tax Due is: $0 $9,525 10% of taxable income $9,526 $38,700 $ % of the amount over $9,525 $38,701 $82,500 $4, % of the amount over $38,700 $82,501 $157,500 $14, % of the amount over $82,500 $157,501 $200,000 $32, % of the amount over $157,500 $200,001 $500,000 $45, % of the amount over $200,000 $500,001 + $150, % of the amount over $500,000

6 Married Individuals Filing Joint Returns and Surviving Spouses 2017 If Taxable Income is Between: The Tax Due is: $0 $18,650 10% of taxable income $18,650 $75,900 $1, % of the amount over $18,650 $75,900 $153,100 $10, % of the amount over $75,900 $153,100 $233,350 $29, % of the amount over $153,100 $233,350 $416,700 $52, % of the amount over $233,350 $416,700 $470,700 $112, % of the amount over $416,700 $470,700 + $131, % of the amount over $470,700

7 Married Individuals Filing Joint Returns and Surviving Spouses 2018 If Taxable Income is Between: The Tax Due is: $0 $19,050 10% of taxable income $19,051 $77,400 $1, % of the amount over $19,050 $77,401 $165,000 $8, % of the amount over $77,400 $165,001 $315,000 $28, % of the amount over $165,000 $315,001 $400,000 $64, % of the amount over $315,000 $400,001 $600,000 $91, % of the amount over $400,000 $600,000 + $161, % of the amount over $600,000

8 New Tax Rates The tax rates for individuals, estates, and trusts increase each year after 2018 based on the chained consumer price index for all urban consumers ( C CPI U ). A chained CPI takes into account anticipated consumer shifts from products whose prices increase, to products whose prices do not increase or increase at a lower rate. A chained CPI should cause smaller inflation adjustments and higher tax levels over the long term. The tax brackets and rates, but not the changes to indexing, sunset on December 31, For taxable years beginning after 2025, the brackets and rates revert to the brackets and rates in effect (as adjusted for inflation) as of December 31, 2017.

9 Modification and Elimination of Deductions and Credits Available to Individuals The standard deduction amounts will increase to: $12,000 for individuals, $18,000 for heads of household, $24,000 for married couples filing jointly and surviving spouses. Ifyouareage65orover,blindordisabled,youcan tack on $1,300 to your standard deduction ($1,600 for unmarried taxpayers).

10 Personal and Dependent Exemptions are Eliminated In 2017, taxpayers claimed a personal exemption for themselves, their spouse (if married filing jointly) and each qualifying child or qualifying relative. Each exemption reduced taxable income by over $4,150 in Under the TCJA, personal and dependent exemptions are eliminated from 2018 through 2025.

11 New Credit for Non Child Dependents Available Through 2025 The TCJA allows a new $500 nonrefundable credit for dependents who do not qualify for the child tax credit. Taxpayers can claim this credit for children who are too old for the child tax credit, as well as for non child dependents. There is no SSN requirement to claim this credit, so taxpayers can claim the credit for children with an Individual Tax Identification Number (ITIN) or an Adoption Tax Identification Number (ATIN) if they otherwise qualify.

12 New Credit for Non Child Dependents Available Through 2025 Both the taxpayer and the dependent must be a resident of the United States, and the dependent must meet all of the 'usual' requirements for being a dependent. To claim a non child as a dependent, the taxpayer must provide over 50% of the individual s support, and the individual must have less than $4150 of income. Additionally, the individual must be closely related to the taxpayer or live with the taxpayer the entire year. Taxpayers cannot claim the credit for themselves or their spouse (if MFJ).

13 Many Itemized Deductions Eliminated, Limited or Modified Fully eliminated Miscellaneous itemized deductions subject to the 2 percent floor Employee business expenses Tax preparation fees Investment interest expenses Grantor Trust Administration Expenses (Trustee fees, legal, accounting etc.) Personal casualty and theft losses (except for certain losses in certain federally declared disaster areas)

14 Many Itemized Deductions Eliminated, Limited or Modified Limited State and local income taxes (SALT) or state and local sales tax, plus real property taxes. During the covered years, individuals may deduct state, local, and foreign taxes only when incurred in connection with a trade or business. However, an exception permits individuals to deduct up to $10,000 for the aggregate of state and local (but not foreign) property and income taxes whether or not incurred in connection with a trade or business.

15 Many Itemized Deductions Eliminated, Limited or Modified Limited Home mortgage interest has several modifications: Interest on a home equity loan is no longer deductible (including for existing mortgages). Interest on a new home mortgage is limited to interest paid on a maximum of $750,000 ($375,000 if MFS) of a new mortgage taken out after December 14, Taxpayers with a mortgage taken out before December 15, 2017 can continue to claim home mortgage interest on up to $1 million ($500,000 if MFS) going forward; the $1 million ($500,000 if MFS) limit continues to apply to a refinanced mortgage incurred before December 15, 2017.

16 Many Itemized Deductions Eliminated, Limited or Modified Medical expenses remain deductible. For 2017 and 2018, medical expenses are deductible to the extent they exceed 7.5% of AGI. In 2019, the threshold will increase to 10% of AGI. Elimination of the tax deduction for alimony for the paying exspouse on new divorce agreements executed after December 31, 2018 while excluding the alimony from the income of the recipient ex spouse. The Affordable Care Act s individual mandate penalty imposed for individuals not having health insurance is repealed beginning in 2019.

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18 Changes to ABLE Accounts Tax Reform also opens up ABLE accounts to receive some, or even all of the beneficiary s earnings, as long as his/her total earnings are below the Federal Poverty limit (and the beneficiary does not participate in his/her employer s retirement plan). Such contributions can be made on top of the $15,000 annual contribution limit. The Federal Poverty level is $12,060 for a single person in The Saver s Credit of up to $1,000 is also available to the designated beneficiary of an ABLE account (no one else) for certain contributions to that account. First, the designated beneficiary must be an eligible lowerincome taxpayer. Second, because the Saver s Credit is a non refundable credit, it is only worthwhile if the designated beneficiary actually owes tax. So, for many designated beneficiaries, it will take a contribution of at least $2,000 to earn the $1,000 credit.

19 Qualified Business Income (QBI) One of the key provisions in the Act is a 20% deduction for the qualified business income (QBI) of non corporate taxpayers under new code 199A. This section is effective for tax years after 2017 and sunsets on December 31, 2025 unless extended by Congress. TCJA reduced the tax rates on C corporations by reducing rate from 35% to 21%. To treat pass through entities the same as C corporations, the 20% deduction for QBI was added to the Act to give pass through entities a comparable tax break. The 20% QBI deduction, in theory, reduces the tax rate from a maximum of 37% to a maximum of 29.6%.

20 What Qualifies as a Pass Through Entity The deduction applies to non corporate taxpayers, including sole proprietorships, partnerships, LLCs, S corporations, trusts, estates, qualified cooperatives and real estate investment trusts (REITs). For partnerships or S corporations, the deduction applies at the partner or shareholder level, and each partner or shareholder takes into account his or her allocable share of the deduction.

21 Qualified Trade or Business A qualified trade or business is any trade or business other than: (1) a specified service trade or business, or (2) the trade or business of performing services as an employee.

22 Qualified Trade or Business Neither the Code nor the regulations provided an all purpose definition of a Qualified Trade or Business. Thus, the definition has been left to the courts. The case law is summarized as follows. Determining whether an individual is carrying on a trade or business requires an examination of the facts involved in each case. To be engaged in a trade or business, an individual must be involved in an activity with continuity and regularity, and the primary purpose for engaging in the activity must be to produce income or profit.

23 Qualified Trade or Business A sporadic activity, a hobby, or an amusement diversion does not qualify. Expenses incident to caring for one's own investments, even on a large enough scale to require an office and staff, are not deductible as paid or incurred in carrying on a trade or business. Holding one's self out to others as engaged in the selling of goods or services isn t required.

24 Qualified Business Income (QBI) The term qualified business income means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. It refers to the taxpayer s net income after payment of wages, business expenses and other deductions for the business and includes rental income.

25 Application of the Deduction The 20% deduction applies only for income tax purposes and does not reduce net investment income tax, Medicare tax or the self employment tax. The deduction is not allowed in computing adjusted gross income (AGI), but rather is applied against taxable income. Although the 20% deduction is an itemized deduction, it is not subject to any of the limitations on such deductions.

26 Basic Calculation The statute gives eligible taxpayers a deduction equal to the lesser of (1) 20% of the combined qualified business income (QBI) of the taxpayer, or (2) 20% of taxable ordinary income. Combined qualified business income is: (1) The ordinary income from each qualified trade or business, plus (2) 20% of the qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (QPTP) income IRC 199A(a).

27 Basic Calculation Example: Joe, a single taxpayer is the sole proprietor of an auto repair shop. Joe leases the store building. Joe s net profit from his shop is $90,000 and he has no capital gains or other income. Joe claims the new $12,000 standard deduction, making his taxable income $78,000 ($90,000 $12,000), Joe s 199A deduction is the lesser of: (1) 20% of his business income from the store (.2 x $90,000 = $18,000) or (2) 20% of his taxable ordinary income (.2 x $78,000 = $15,600) Because Joe s tentative deduction ($18,000) exceeds 20% of his taxable income ($15,600), his deduction is limited to $15,600, reducing his taxable income from $78,000 to $62,400. Because Joe is in the 22% marginal income tax bracket, he saves $3,432 in taxes (.22 x $15,600).

28 Basic Calculation Example: Janet owns several florist stores. Her net income is $280,000 from her business. She has no other income. Janet s husband, Bill, is a stay at home dad with no income. Janet and Bill claim the $24,000 standard deduction for married taxpayers filing jointly, giving them $256,000 ($280,000 $24,000) of taxable income. Janet s tentative 199A deduction is $56,000 (.2 x $280,000). However, her deduction can t exceed 20% of taxable income over net capital gains. 20% of Janet s taxable income is $51,200 (.2 x $256,000), so her 199A deduction is reduced from $56,000 to $51,200.

29 Specified Service Trade Or Business (SSTB) Limitations Under the general rule, the 199A deduction does not apply to specified service businesses. These businesses include any business involving the performance of services in the fields of: health, law, accounting, actuarial science, performing arts, consulting,

30 Specified Service Trade Or Business (SSTB) Limitations athletics, financial services, brokerage services, or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more owners or employees. Also included are businesses that involve the performance of services that consist of investing and investment management, trading, or dealing in securities.

31 Congress Hates Us Proposed regulation 1.199A 5(b)(2)(iii) defines law as services in the field of law. The term performance of services in the field of law means the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacity as such. The performance of services in the field of law does not include the provision of services that do not require skills unique to the field of law, for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.

32 Congress Hates Us Proposed Regulation 1.199A 5(b)(2)(vii) defines the term performance of services in the field of consulting means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such. The performance of services in the field of consulting does not include the performance of services other than advice and counsel. This determination is made based on all of the facts and circumstances of a person's business.

33 Phase Out of the Deduction Taxpayers in the list of prohibited service businesses can still claim a 20% deduction if their income is below a certain level. For married taxpayers filing jointly, the threshold level is $315,000 and for all other taxpayers, $157,500. As income rises above these levels, the deduction is gradually phased out. For married taxpayers filing jointly, the phaseout is complete at income of $415,000 and for all other taxpayers at income of $207,500.

34 Phase Out of the Deduction Example: John is a married lawyer with a solo practice that generates net income of $450,000. Because John s taxable income exceeds $415,000, his 199A deduction is completely phased out.

35 Phase Out of the Deduction Example: Tracy is a single taxpayer and the sole owner of an accounting business. His income from the business is $189,500 and he has no other income. Tracy claims a $12,000 standard deduction, making his taxable income $177,500. Tracy s tentative IRC 199A deduction is $37,900 (.2 x $189,500). Because his taxable income exceeds $157,500, this deduction is phased out. Tracy s $177,500 of taxable income is 40% through the phase out range ($20,000/$50,000) so he loses 40% of the QBI deduction. Thus, Tracy s deduction is reduced by $15,160 (.4 x $37,900). This leaves Tracy with a $22,740 QBI deduction ($37,900 tentative deduction $15,160 phase out amount). The taxable income limitation doesn t apply because 20% of taxable income (.2 x 177,500 = $35,500) exceeds $22,740.

36 Aggregation Rules Recently, the IRS released 500 pages of proposed regulations. The proposed regulations make it clear that a specified service business cannot separate into various pass through entities to get around the limitations on service related business.

37 Aggregation Rules Example: Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB under paragraph (a)(6) of this section.

38 APPLICATION OF TCJA TO TRUSTS AND ESTATES Estates and Trusts Original 2017 Tax Brackets If Taxable Income is Between: The Tax Due is: $0 $2,550 15% of taxable income $2,550 $6,000 $ % of the amount over $2,550 $6,000 $9,150 $1, % of the amount over $6,000 $9,150 $12,500 $2, % of the amount over $9,150 $12,500 + $3, % of the amount over $12,500

39 APPLICATION OF TCJA TO TRUSTS AND ESTATES Estates and Trusts Original 2018 Tax Brackets If Taxable Income is Between: The Tax Due is: $0 $2,550 10% of taxable income $2,551 9,150 $ % of the amount over $2,550 $9,151 $12,500 $1, % of the amount over $9,150 Over $12,500 $3, % of the amount over $12,500

40 Miscellaneous Itemized Deduction Prior to 2018, Code 67 allows a deduction for certain "miscellaneous itemized deductions" only to the extent such expenses exceed 2% of the adjusted gross income (AGI). For a trust that is a taxpayer, gross taxable income consists of gross income minus all allowable deductions. For individuals, estates, and trusts, miscellaneous itemized deductions for any taxable year are allowed only to the extent that the aggregate of such deductions exceeds 2% of adjusted gross income.

41 Miscellaneous Itemized Deduction Current regulations clarify which trust expenses are subject to the 2% floor. The regulations provide that a deduction forcoststhatarepaidorincurredinconnectionwiththe administrationoftheestateortrustandthatwouldnot have been incurred if the property were not held in such trust or estate, and various deductions attributable to distributions, are treated as allowable in determining adjusted gross income without regard to the 2% threshold. In other words, certain deductions are allowable in arriving at AGI (that is, they are "above the line"), and therefore are not subject to the 2% floor.

42 Miscellaneous Itemized Deduction The test to determine if a trust expense was an above the line deduction is determined if the amount of the claimed deduction: (1) is paid or incurred in connection with the administrationoftheestateortrust;and(2)wouldnothave been incurred if the property were not held in the trust or estate. A fiduciary fee is a typical example of such an administration expense that would not commonly or customarily be incurred by an individual. Therefore, a fiduciary fee related to trust or estate administration is an allowable deduction in arriving at AGI, and is not subject to the 2% floor.

43 Miscellaneous Itemized Deduction In Notice , IRS announced that it intends to issue regs that clarify the effect of new Code Sec. 67(g) on the deductibility of certain expenses that are incurred by estates and non grantor trusts. The new regs will clarify that estates and non grantor trusts may continue to deduct an expense that is described in Cod Sec. 67(e)(1) or is allowable under Code Sec 642(b), Code Sec. 651 or Code Sec. 661, including the appropriate portion of a bundled investment fees, in determining the estate or nongrantor trust s adjusted gross income, even while the application of Code Sec. 67(a) is suspended under Code Sec. 67(g) for individual taxpayers.

44 Grantor Trusts For grantor trusts, items of income and expense pass through to the grantor, and the trust is disregarded as a separate taxable entity. Thus, administration expenses for a grantor trust are attributed to the grantor/owner. Under the law that was in effect for 2017, those expenses were subject to the 2% floor. Under the new law, for tax years beginning after December 31, 2017 and before January 1, 2026, the entire deduction for miscellaneous itemized expense is eliminated for individual taxpayers.

45 Grantor Trusts Example One: In 2018, the taxable income of an irrevocable First Party Special Needs Trust is $77,000. $30,000 is from interest and $47,000 is from non qualified dividends. All income is from money invested in mutual funds and bonds. Beneficiary A is a single person, the sole beneficiary of the trust and has no other personal income or deductions. The trust has the following expenses: fiduciary fees 10,000, Legal Fees 5,000, accounting fees $1,500 and investment advisory fees of $25,000. The Trust is a grantor trust and the beneficiary is the owner of Trust under I.R.C No distributions were made to the beneficiary in 2018.

46 Grantor Trust Because the trust is a grantor trust, all of the income and expenses are attributable to Beneficiary A even though no distributions were made from the trust. The trust expenses for trustee, legal, accounting and investment advisory fees are categorized as miscellaneous itemized deductions subject to the 2% floor to the beneficiary. Miscellaneous itemized deductions for individuals were eliminated by the TCJA. Therefore, the beneficiary may not deduct any of these fees. In 2018, the standard deduction for a single person is $12,000. Accordingly, the trust beneficiary will not have any itemized deductions and will pay tax on $65, ($77,000 minus $12,000 standard deduction). The beneficiary s tax liability for 2018 is calculated as follows:

47 Grantor Trust Taxable Income Taxable Income $77, Less Standard Deduction $12, Gross Income $65, Trust Tax Liability $ 0.00 Beneficiary Tax $10, If a beneficiary was under the age of 18, Kiddie Tax rates would increase tax owed by beneficiary to $21,

48 Grantor Trust Using the same example as above but applying 2017 rules, the beneficiary tax results are calculated as follows: Gross Income $65, Miscellaneous Itemized deductions: $40, Personal Exemption $ 4, Taxable Income $20, Tax Due 2017 $ 2, Tax Due 2018 $10,239.50

49 Complex Trust Example Two: In 2018, the taxable income of an irrevocable trust is $77,000. $30,000 is from interest and $47,000 is from non qualified dividends. Beneficiary A is the sole beneficiary of the trust and has no other personal income or deductions. The trust has the following expenses: fiduciary fees 10,000, Legal Fees 5,000, accounting fees $1,500 and investment advisory fees of $25,000. The Trust is a separate taxable entity and the beneficiary is not the owner of any portion of Trust under I.R.C The trust is a complex trust and qualifies as a Qualified Disability Trust. No distributions were made to or for the benefit of the beneficiary in The total tax liability for the Trust is calculated as follows:

50 Complex Trust Taxable Income for Trust Taxable Income $30, Dividends $47, Total Income $77, Less Deductions Trustee fees $10, Legal Fees $ 5, Accounting fees $ 1, Investment advisory fees $23,871.00

51 Complex Trust Taxable Income for Trust Gross Income $36, Less Exemption (QDT) $ 4, Taxable Income $32, Trust Tax Liability $10, Medicare Surtax 3.8% $ 1, Total Federal Tax Trust $11, Beneficiary Tax Liability $ 0.00

52 Complex Trust Same facts as Example Two, except that the trust distributes $35,000 to the beneficiary and the trust is not a grantor trust. Taxable Income for Trust Interest $30, Dividends $47, Total Income $77, Less Deductions Trustee fees $10, Legal Fees $ 5, Accounting fees $ 1, Investment advisory fees $23,871.00

53 Complex Trust Same facts as Example Two, except that the trust distributes $35,000 to the beneficiary and the trust is not a grantor trust. Taxable Income for Trust Interest $30, Dividends $47, Total Income $77, Less Deductions Trustee fees $10, Legal Fees $ 5, Accounting fees $ 1, Investment advisory fees $23, Distribution Deduction $35, Trust Exemption (QDT) $ 4, Taxable Income $0.00 Trust Tax $0.00

54 Complex Trust Taxable Income for Beneficiary Trust Distribution $35, Standard Deduction $12, Taxable Income $23, Tax Beneficiary $ 2,570.00

55 Comparisons Grantor Trust Tax Example One: 2017 Beneficiary Tax $ 2, Beneficiary Tax $10, Kiddie Tax $21, Complex Trust Tax Example Two with no distribution to beneficiary 2018 Trust Tax $10, Beneficiary Tax $ 0.00 Complex Trust Example Two with distribution of $35,000 to beneficiary Taxable Income $ 0.00 Trust Tax $ 0.00 Beneficiary Tax $ 2,570.00

56 Qualified Disability Trust Although TCJA eliminated personal exemptions for individuals, the personal exemption for a Qualified Disability Trust remains in place. For 2018, the exemption is $4, The QDT exemption will be indexed for inflation.

57 (SALT) Limitation During the covered years, individuals may deduct state, local, and foreign taxes only when incurred in connection with a trade or business. However, an exception permits individuals to deduct up to $10,000 for the aggregate of state and local (but not foreign) property and income taxes whether or not incurred in connection with a trade or business.

58 (SALT) Limitation The $10,000 limitation for state, local property and income taxes does not apply to taxes incurred in connection with a trade or business. Taxes that are deductible on Schedule C, Schedule E or Schedule F and personal and real property taxes incurred for an activity described in Code 212, which relates to expenses for the production of income are fully deductible. Generally, the activities that relate to the production of income include managing investments in federally taxable securities.

59 (SALT) Limitation Because many trusts and estates hold assets for investment (and ultimate distribution) to beneficiaries, thecaponthedeductionforstateandlocaltaxesmay have limited impact on trusts and estates that pay personal taxes or real property taxes. If all of the activities of a trust can be characterized as for the production of taxable income, then under this exception, the state personal and real property taxes paid by the trust should still be fully deductible. At this time, it is unclear if a trust holding only investments will qualify as a trade or business and thus avoid the SALT $10, limitation.

60 Changes to the Kiddie Tax Under the New Tax Law The Tax Increase Prevention and Reconciliation Act of 2005, which was signed into law on May 17, 2006, provide that the Kiddie Tax applies until a child reaches age eighteen. For 2017, the threshold for the Kiddie Tax meaning the amount of unearned net income that a child can take home without paying any federal income tax is $1,050. All unearned income in excess of $2,100 is taxed at the parent s tax rate.

61 Changes to the Kiddie Tax Under the New Tax Law Starting in 2018, the tax rate of the child s parent no longer matters. Under the new tax law, unearned income of a child will be taxed at the rate paid by trusts and estates. Parents did not pay the top rate of 37% unless their taxable income exceeded $600,000. Trusts and estates, on the other hand, pay the top tax rate of 37% if their taxable income exceeds only $12,500. Thus, a child receiving investment income will pay much higher taxes on that money than their parents would pay. This change in tax rates will have a major affect on Special Needs Trusts with large principal balances.

62 Changes to the Kiddie Tax Under the New Tax Law Kiddie Tax. Taxable Income Tax Due up to $2,550 10% up to $9,150 24% up to $12,500 35% on excess over $12,500 37%

63 Changes to the Kiddie Tax Under the New Tax Law The Kiddie Tax generally applies to the unearned income of a child, regardless of the source of the property generating the income or when the property was transferred to the child. Accordingly, when parents, grandparents, and friends gift income producing assets, combined with the child's own unearned income, the gifted assets that generate income may be subject to the Kiddie Tax. Because a trust generally is a taxpaying entity, the Kiddie Tax applies to a child beneficiary of the trust only to the extent of taxable distributions from the trust to the child beneficiary (under 652(a) or 662(a)) during the taxable year. The income from property in a UGMA or UTMA custodianship also is subject to the Kiddie Tax.

64 Changes to the Kiddie Tax Under the New Tax Law The Kiddie Tax applies to unearned income for children under the age of 19 and college students under the age of 24. For purposes of the Kiddie Tax, unearned income is defined as income that is not attributable to earned income as defined in 911(d)(2). In general, under 911(2), earned income, is defined to include wages, salaries, professional fees, and other amounts received for personal services rendered. Earned income to a child is not subject to the Kiddie Tax. Earned income, for Kiddie Tax purposes, also includes any amounts included in the child's income under 652 and 662 during a taxable year if the child is a beneficiary of a 642(b)(2)(C)(ii) qualified disability trust. Clearly, passive investment income (e.g., interest, dividends, mineral royalties, etc., including passive investment income on invested earned income) is subject to the Kiddie Tax. Social Security and pension benefits paid to the child also are included in unearned income.

65 Changes to the Kiddie Tax Under the New Tax Law An exception to the application of the Kiddie Tax was added for distributions from a QDT as defined in 642(b)(2)(C)(ii). Specifically, for purposes of the Kiddie Tax rules, any amount included in the income of such child under 652 and 662 during a taxable year shall be considered earned income of such child for such taxable year. Section 652 references a trust where all the income is required to be distributed (a simple trust). Section 662 references a trust that may accumulate or distribute income (a complex trust). Section 652 and 662 do not apply to a grantor trust.

66 Changes to the Kiddie Tax Under the New Tax Law To take it another step, is unearned income from the child s own assets subject to the Kiddie Tax? The Kiddie Tax was designed to stop parents from shifting income to their children by transferring assets to the child and then having the income earned from the transferred asset taxed at the child s rate. A first party SNT is funded with the child s assets not the parent s assets. As a result, there is no income tax motivation for the transaction. Nonetheless, the regulations state that the Kiddie Tax is imposed on all unearned income regardless of its source. Reg. 1.1(i) 1T, provides as follows:

67 Changes to the Kiddie Tax Under the New Tax Law Will a child be subject to tax under section 1(i) on net unearned income that is attributable to gifts from persons other than the child's parents or attributable to assets resulting from the child's earned income? Yes. The tax imposed by section 1(i) applies to all net unearned income of the child, regardless of the source of the assets that produced such income. Thus, the rules of section 1(i) apply to income attributable to gifts not only from the parents but also from any other source, such as the child's grandparents. Section 1(i) also applies to unearned income derived with respect to assets resulting from earned income of the child, such as interest earned on bank deposits.

68 Changes to the Kiddie Tax Under the New Tax Law The regulation seems ambiguous. The question portion of the regulation asks about gifts from persons other than the child s parents or attributable to assets created from the child s earned income. But the first sentence of the answer states that the Kiddie Tax applies to all net unearned income of the child regardless of the source of the assets that produced such income. Based upon the statute and regulations, unearned income from a first party SNT grantor trust that is allocated to a child under the age of eighteen is subject to the Kiddie Tax. This means the tax is computed at the parent s rate and not the child s rate if the income is derived from a grantor trust. If the income is derived from a simple trust under 652 or complex trust under 662, the QDT exception of 642(b)(2)(C)(ii) applies and the income is taxed at the child s rate and not to at the parent s rate.

69 Application to New Code Section 199a to Trusts and Beneficiaries Proposed Regulation 1.199A 6(d) contains special rules for applying section 199A to trusts and decedents estates. To the extent that a grantor or another person is treated as owning all or part of a trust under sections 671 through 679 (grantor trust), the owner will compute its QBI with respect to the owned portion of the trust as if that QBI had been received directly by the owner.

70 Grantor Trusts To the extent that the grantor or another person is treated as owning all or part of a trust under sections 671 through 679, such person computes its section 199A deduction as if that person directly conducted the activities of the trust with respect to the portion of the trust treated as owned by the grantor or another person.

71 Non Grantor Trusts and Estates A trust or estate must calculate its QBI, W 2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income. The QBI of a trust or estate must be computed by allocating qualified items of deduction described in section 199A(c)(3) in accordance with the classification of those deductions under 1.652(b) 3(a), and deductions not directly attributable within the meaning of 1.652(b) 3(b) (other deductions) are allocated in a manner consistent with the rules in 1.652(b) 3(b). Any depletion and depreciation deductions described in section 642(e) and any amortization deductions described in section 642(f) that otherwise are properly included in the computation of QBI are included in the computation of QBI of the trust or estate, regardless of how those deductions may otherwise be allocated between the trust or estate and its beneficiaries for other purposes of the Code.

72 Take Aways from Tax Act A beneficiary of a grantor trust with high trust administration expenses in excess of the beneficiary s standard deduction will incur substantially higher income tax. Children under the age of 18 who are beneficiaries of a grantor trust will be adversely impacted by the new tax rules. Potential tax benefits to creating multiple complex trusts if a separate purpose for each trust can be established. For most special needs beneficiaries, the new QBI 20% deduction will be of little benefit. When planning for third party trusts, drafting attorneys should consider funding assets that will quality for QBI to higher income beneficiaries.

73 Take Aways from Tax Act TCJA is extraordinarily complex. It will take several years before the IRS issues regulations to clarify complex provisions of the new law. Primary impact is to a Grantor Trust adverse if beneficiary is under 18 and subject to the Kiddie Tax. Pros Grantor Trust large capital gain, income. Cons GrantorTrustwithhighadministrativeexpenses that are now disallowed as a miscellaneous itemized deduction.