Changing 1041's Ways: TCJA's Effect on Fiduciary Income Tax.
Two substantial changes involve the limitation on state and local tax deductions, and the elimination of deduction for miscellaneous expenses.
A complex trust that's accumulating income and not paying out income to a beneficiary may have to pay more tax, thanks to the TCJA. The limit on state and local taxes (SALT) deductions, and the elimination of most miscellaneous itemized deductions, will directly impact the bottom line on the 1041 return. A complex trust with significant amounts of those types of expenses will have more taxable income and more income tax.
But how does the TCJA affect a simple trust--or similarly, a complex trust for which the trustees have discretion and decide to pay out most or all of the accounting income? The answer: It's pretty hard to generalize.
Here are a few scenarios to demonstrate what may happen.
Cases in Point
Start with the most basic possibility, which would be a simple trust with no expenses at all. The gross income is required to be distributed to the income beneficiary, and the accounting income matches the distributable net income (DNI). With no deductions, the rules regarding SALT and miscellaneous deductions are moot.
Now change that basic example. Suppose this hypothetical simple trust has expenses for trustee fees, accounting fees and some legal fees, as well as no property taxes or miscellaneous itemized deductions. Under the Uniform Principal and Income Act (UPIA), half of those administrative expenses are required to be charged to income, and half to principal. The UPIA provision could be overruled by provisions in the trust document so be sure to read this thoroughly.
Thus, the net fiduciary accounting income will be higher than the DNI as calculated in Schedule B of Form 1041, and the beneficiary gets a reduction in income taxes. Fiduciary accounting income is higher because only half of those administrative expenses are charged to accounting income, while both halves are deductible on Form 1041. The deduction on the 1041 reduces DNI, the taxable income flowing from the trust to the beneficiary. (For a discussion of exempt income and the apportioning of expenses, see "10-4, Form 1041" in the August 2018 issue of California CPA.)
Consider a more involved example. Assume the same simple trust as above, except there are expenses for investment advisory fees and custodial fees as well. In 2017 and prior, those fees would have reduced taxable income on Form 1041 (after reduction by 2 percent of AGI). In prior years, those would have had a similar effect to fully deductible expenses, and often would have given the income beneficiary the benefit of reduced taxable income, i.e., taxable income less than the cash required for distribution. But for 2018-25, the federal 1041 will not have a deduction for those 2 percent type miscellaneous expenses. And the beneficiary loses some of the previous benefit of reduced taxable income.
If the miscellaneous expenses are relatively minor compared to other expenses, the overall effect will simply be partial elimination of a benefit to the beneficiary who used to get cash flow in excess of taxable income. But if the miscellaneous expenses are substantial, and exceed the other deductions, we will end up with DNI in excess of accounting income, and the trust will end up paying tax on some ordinary income after using up the $300 standard deduction. The fiduciary's deduction for distribution to beneficiary is the lesser of accounting income or DNI. The accounting income is reduced by half the miscellaneous expenses, while the DNI is no longer reduced by any of the miscellaneous expenses. That can lead to the trust being taxed at ordinary income rates. While we're accustomed to having capital gain taxed in a simple trust, we may see more situations in which the trust also pays tax on some ordinary income.
A complex trust accumulating income could pay more income tax. If the trust has property taxes or income taxes that exceed $10,000 per year, the trust will lose some deductions and pay more federal tax. CPAs should consider working with trustees on timing of payments of state income tax to even out amounts year-to-year, and thereby minimize loss of deduction due to the limit. For a simple trust, either the trust or the beneficiary may be hurt by the limit on deduction, depending on several factors.
Big Capital Gain Strategies
If a simple trust has a substantial capital gain one year and the gain is taxed to the trust, that may lead to state income tax in excess of the $10,000 limit on deduction. In California, there's no special rate for capital gains and the California income tax can reach $10,000 on about $145,000 of capital gain. Assuming the capital gain is taxed to the trust and not distributed to the beneficiary (see "A Question of Trust" in the August 2017 issue of California CPA), the state income tax obligation may exceed the $10,000 limit. An obvious strategy would be to calculate and pay some state income tax (up to $10,000) during the year in which the gain occurs, and the rest the next year.
A bit of a quirk happens for the year a simple trust pays substantial California income tax: The beneficiary gets a break on federal taxes. The taxes paid reduce taxable income, but do not reduce fiduciary accounting income. State income taxes paid would (normally) be charged to corpus of the trust, not to income, and accounting income would not be reduced by income taxes charged to corpus.
Mutual Fund Capital Gain Distributions
An extra challenge is created when mutual funds pay out capital gain distributions in December, and the CPA doesn't find out the details until well into tax season the following year, which is too late to pay estimated tax to the state. Some planning ahead with estimated tax payments to the state in the same year as the gain may prove advantageous.
Property taxes paid by a trust also can be an issue. If the trust owns real estate in California, and perhaps doesn't have an old Proposition 13 base to rely on, the county property taxes can easily exceed the $10,000 limit. If the property is rental property, there's no new problem, since property taxes on rental properties get reported on Schedule E and are not subject to the new SALT limit. If the property is not rental property, but perhaps a residence occupied by a beneficiary, the trustee and beneficiary could work together to determine if there's an advantage to having the beneficiary pay some of the properly taxes.
Estate income taxes would be impacted by the TCJA the same as other fiduciaries, with the added option of electing a fiscal year and possibly wrapping up an estate and filing final income tax returns.
Qualified Business Income Deduction
Fiduciaries may have an opportunity to take advantage of the new qualified business income (QBI) deduction. Rules for trusts are similar to those for individuals for calculations of QBI, which can generate the new deduction of 20 percent of QBI. If there's an operating business or management of rental properties in the trust, there will be the extra calculations as described in IRS Publication 535 to determine limitations.
The deduction follows the income. So, for a complex trust, the deduction would be calculated on the trust's federal tax return. For a simple trust, or a complex trust paying out income, sufficient information must be provided to beneficiaries via Schedule K-1 with attachment to allow them to take advantage of the deduction. If part of the income is distributed, there would be a sharing of QBI between the trust and beneficiary. Even trusts without business or rental income may benefit from the QBI deduction: dividend distributions from REITs also qualify as QBI, and would flow to beneficiaries along with income distributions.
California Rules Unchanged
There has been no change for California Form 541. The computation of the 2 percent exclusion for miscellaneous deductions still applies. As a result of these changes, preparing fiduciary income tax returns has become much more challenging for the next several years.
BY WILLIAM DOWNS, CPA & JOHN WOODFORD, CPA
William Downs, CPA is a sole practitioner in Sherman Oaks. John Woodford, CPA is a partner at RWS. You can reach them at email@example.com and firstname.lastname@example.org.
1041: Getting It Right
We're offering a series of courses starting in November titled, "Preparing Form 1041--Getting It Right," as well as a workshop webcast on the topic starting at the end of August. If you're interested in these or other offerings on the topic, type "1041" in the search field at calcpa.org/RSVP for the full array of listings.
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|Title Annotation:||regulatory update|
|Author:||Downs, William; Woodford, John|
|Date:||Aug 1, 2019|
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