Trusts (other than grantor trusts), decedent’s estates, and bankruptcy estates must file an annual income tax return, Form 1041, to report their income and expenses. They are primarily pass-through entities where beneficiaries report their share of items on their personal returns. The Tax Cuts and Jobs Act (P.L 115-97) made many significant changes impacted these entities and their beneficiaries.
There have been dramatic changes to the tax brackets for estate and trusts, which apply to income that is not distributed to beneficiaries. Instead of the former seven brackets, starting in 2018 there are only four brackets. Taxable income up to $2,550 is taxed at 10 percent. Taxable income over this amount but not over $9,150 is taxed at 24 percent. Taxable income over $9,150 but not over $12,500 is taxed at 35 percent. And taxable income over $12,500 is taxed at 37 percent (down from the 39.6 percent rate that applies in 2017).
After 2018, these brackets will be indexed for inflation, using the new inflation adjustment under the C-CPI-U. This new benchmark is likely to result in smaller increases. These brackets are set to sunset after 2025.
It is noteworthy that the tax brackets for estates and trusts are the same that will be used to figure the kiddie tax on unearned income for 2018 through 2025 (there is no change in the definition of children subject to this tax computation). Previously, the parent’s top tax bracket was used for this purpose. Until now, because the kiddie tax was lower than the tax on fiduciary income, there was a tax savings to distributing trust income to a minor child. But with the kiddie tax in parity with the tax on fiduciary income, trustees may want to split the income between the minor child and the trust.
An estate is allowed a deduction of $600. A trust is allowed a deduction of $100; $300 if it is required to distribute all its income currently. These exemption amounts have not been changed under the new law. They are not adjusted annually for inflation.
Because of the elimination of the personal and dependency exemptions for individuals for 2018 through 2025, the exemption amount for a disability trust which is tied to these exemptions has been changed for this period (Code §642(b)(2)(C)). For these years, $4,150 is substituted for the exemption amount. This dollar amount will be adjusted for inflation after 2018.
Expenses That Are and Are Not Deductible
The new law eliminated some deductions that have previously been allowed, such as investment management fees and personal casualty or theft losses not resulting from a Presidentially-declared disaster. Fiduciaries now may prefer accounts that charge commissions for transactions, where such costs are deducted from sales proceeds when securities are sold, instead of using managed accounts, where fees are no longer deductible.
However, some expenses remain deductible:
• Amortized bond premiums and original issue discount (OID)
• Charitable distributions under the terms of a will, trust, or other governing instruction
• Depreciation and depletion
• Disaster losses in Presidentially-designated areas
• Federal estate tax on income in respect of a decedent (Code §691(c)).
• Interest expense under existing rules
• Net operating losses from a business (under new carryforward rules)
• State and local taxes on entity-owned businesses
The new 20 percent deduction for pass-through entities applies to trusts and estates (Code §199A). In computing the deduction, W-2 wages and the unadjusted basis of qualified property must be allocated between fiduciaries and beneficiaries to determine the W-2 and capital limitations (Code §199A(f)(1)(B)).
Deductions for Fiduciary Fees and Certain Other Costs
For 2017 returns, fiduciary fees are taken into account in figuring fiduciary income and are deductible on Form 1041. Starting in 2018, it is not entirely clear how the new law impacts the deduction for fiduciary fees and certain other costs. The new law bars an individual from deducting miscellaneous itemized deductions for 2018 through 2025 (Code §67(g)); this applies to fiduciaries as well. Essentially this refers to itemized deductions subject to the 2 percent-of-adjusted gross income floor. Until now there has been an exception to the bar on miscellaneous itemized deductions for costs that would not have been incurred if property were not held in a trust or estate (Code §67(e)). These non-2 percent items have included fiduciary fees and the domestic production activities deduction (which has been repealed by the new law).
Whether this exception continues to apply under the new law is not certain. If the exception does apply, then fiduciary fees and these other costs would still be deductible.
Another uncertainty is whether the $10,000 limit on the deduction for state and local taxes that applies to individuals starting in 2018 also applies to fiduciary returns. It may be that the exception to the cap for personal and real property taxes incurred for the production of income under Code §212 would permit a deduction for all such taxes where, for example, all of a trust’s activities are managing investments held for the production of income.
IRS guidance on these unclear matters is essential. The determination of whether fiduciary fees are deductible will affect the amount of taxable income reported to beneficiaries on their Schedules K-1.
There are two changes impacting electing small business trusts (ESBTs). First, such trust can now have a nonresident alien beneficiary; this will not prevent the trust from being a permitted shareholder of an S corporation. Second, the computation of the charitable contribution deduction for electing small business trusts is changed after 2017 (Code §641(c)(2)(E)). The contribution deduction is determined by rules generally applicable to individuals, rather than rules applicable to trusts. The adjusted gross income (AGI) limitation is figured in the same way as in the case of an individual, except that deductions for costs paid in connection with the administration of the trust and which would not have been incurred if the property were not held in the trust are allowable in arriving at AGI.
The alternative minimum tax, which has been repealed for C corporations, continues to apply to estates and trusts. The exemption amount, which has been increased substantially for individuals in 2018 through 2025, has not been changed for estates and trusts. For 2018 the AMT exemption amount for estates and trusts is $24,600. This amount can be adjusted annually for inflation.
For estates and trusts and their fiduciary returns, some things are clear: tax rates are different and there are many changes to understand. And many rules, such as the 3.8 percent net investment income tax on estates and trusts, have not changed. However, there are other matters that await IRS guidance.
Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink and senior consultant to Citrin Cooperman & Company.