I. INTRODUCTION
The Tax Cuts and Jobs Act (the “TCJA”) issued in December 2017, made an impact on practitioners and their clients.1 The effect of the TCJA was felt for the first time in 2018, making significant changes throughout the code.2 Of the many changes, Section 199A of the Internal Revenue Code (the “IRC”) was a newly enacted deduction generally allowing up to a twenty percent deduction on qualified business income (“QBI”).3 There were no regulations issued for guidance at the time the TCJA was enacted.4 It was not until August 16, 2018 that the proposed regulations were issued.5 However, such proposals were withdrawn after they received much criticism.6 The final regulations on Section 199A were ultimately issued on February 8, 2019.7 Despite the final regulations being issued, much confusion and lack of guidance still remain.8
Trusts are commonly used for asset protection9 and with the new changes, there are still various ways to use trusts to help taxpayers reduce and save money on their income tax return, especially business owners. Of the numerous uses for trusts, including control over family businesses,10 taking advantage of the Section 199A deduction may be a brief – compared to the potential grand scheme of the life of a trust – but popular use for a trust regarding the grantor and the beneficiaries of the same.11 The focus of this Article will be on the finalized regulations and the use and practicality of trusts to apply for the Section 199A deduction. Furthermore, trust drafters will need to be aware of the family dynamics as the Section 199A regulations – along with the anti-abuse rules – incorporate the multiple trust rule stated in Section 643(f) and reiterated in the Section 1.643(f)-1 regulations.12
This Article explores the intricacies and benefits of the Section 199A deduction and a general description of the final regulations. Part II of this Article discusses the Section 199A deduction, the technicalities, and operational component of the same.13 Part III of this Article discusses how individuals and relevant passthrough entities (“RPE”) have the ability to aggregate similar businesses they own to either qualify or even maximize on their Section 199A deduction.14 Part IV of this Article discusses the Section 199A calculation for RPEs and trusts, including the difference for trusts in calculating the Section 199A deduction before and after the final regulations.15 Finally, Part V concludes with a summary of the main takeaways the final regulations left tax planners with.
II. SECTION 199A DEDUCTION
A. How the Statute Operates
Generally, it appears there are six scenarios on how the statute operates, each one triggering different parts of the statute.16 There six scenarios are: (1) operating a qualified trade or business and generating taxable income under threshold amount and has no W-2 wages with no qualified property; (2) operating in a specified service trade or business and generating taxable income less than the threshold amount; (3) operating a qualified trade or business and generating taxable income over threshold amount by more than $50,000 (or $100,000 in the case of jointly filed returns); (4) operating a specified service trade or business and generates income over threshold amount by more than $50,000 (or $100,000 in the case of a joint filed return); (5) operating a qualified trade or business and the taxable income is over the threshold amount but not more than $50,000 (or $100,000 in the case of a joint filed return); and (6) operating a specified service trade or business and generating taxable income over threshold amount but not more than $50,000 (or $100,000 in the case of a joint filed return).17 The Section 199A deduction states that taxpayers other than corporations are allowed a deduction equal to the lesser of either the combined qualified business income amount of the taxpayer or twenty percent of the excess of the taxable income of the taxpayer over the net capital gain of the taxpayer in that same year.18 Section 199A(b)(1) states combined qualified business income amount is defined the amount in Section 199A(b)(2) plus “[twenty] percent of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnership income of the taxpayer for the taxable year.”19 Section 199A(b)(2) determines the deductible amount for any qualified20 trade or business as the lesser of either “[twenty] percent of the taxpayer’s qualified business income21 with respect to the qualified trade or business,”22 or “the greater of [fifty] percent of the W–2 wages with respect to the qualified trade or business, or the sum of [twenty-five] percent of the W–2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition (“UBIA”) of all qualified property.”23
B. The Threshold Amount and Modifications to Section 199A Deduction
Section 199A allows the deduction stated above without modification if an individual does not exceed the $157,000 – subject to inflation – threshold amount.24 The phase in limit of Section 199A(b)(3)(B) generally provides two alternatives once the threshold is exceeded but does not exceed $207,500 for single returns and $415,000 for those filing jointly.25 Where Section 199A(b)(2)(A) is greater than Section 199A(b)(2)(B) then the determination of deductible amount for each trade or business under Section 199A(b)(2) shall be applied without regard to the Section 199A(b)(2)(B) amount.26 However, we must reduce the Section 199A (b)(2)(A) amount by the Section 199A(b)(3)(B)(ii) amount.27 The Section 199A(b)(3)(B)(ii) reduction amount in Section 199A(b)(2)(A) requires one to: use the difference between the Section 199(b)(2)(A) and Section 199A(b)(2)(B).28 However, where the Section 199A(b)(2)(B) amount is greater than the Section 199A(b)(2)(A) amount, the deduction shall be calculated without any special adjustment.29
C. Own a Trade or Business – And Guess What, Rental is Included
The initial reaction to there being a trade or business was confusing at first and guidance was subsequently issued stating that, not only will a trade or business for Section 199A deduction be the same as the Section 162 definition for a trade or business, but it will also include rental real estate enterprise activity (“REEA”).30 So long as the such activity meets the safe harbor requirements, the same will be eligible to qualify for the Section 199A deduction for both individuals and RPEs.31 As reminded in the IRS’ notice, this is only a safe harbor and if the Section 199A deduction is being claimed but fails to meet the defined activity level of a REEA, one may have a more difficult time claiming the deduction.32
An REEA is defined as “an interest in real property held for the production of rents and may consist of an interest in multiple properties [and] must hold the interest directly or through an entity disregarded as an entity separate from its owner under Section 301.7701-3.”33 Additionally, taxpayers must treat each REEA property as a separate or individual properties which are similar as a single enterprise.34 The example provided distinguishing similar or separate use is commercial and residential real property.35 To qualify for the REEA safe harbor certain elements must be met.36
The safe harbor includes:37 (1) each property or separate enterprise having their own books and records evidencing income and expenses; (2) for tax years ending prior to January 1, 2023, at least 250 hours of rental services38 are performed on each rental enterprise and for years ending subsequent to that for any three of the five consecutive years, the 250-hour minimum is met;39 and (3) and starting this year, the taxpayer maintains and contemporaneously updates its records.40 As a final note, rental property used as a personal residence or vacation home, including triple net leases are not eligible to qualify for the safe harbor.41
D. A Slight Focus on What a Specified Service Trade or Business (“SSTB”) Really is – And, oh Yeah, Don’t be an Employee
As nerally stated above,42 taxpayers with a specified service trade or business are limited in taking advantage of the Section 199A deduction once a taxpayer is within the “phase-in” range, which would reduce the amount allowable to deduct, or above the phase-in range, which would phase-out the taxpayer and prevent any deduction at all.43 However, there are specified tests for qualifying under the de minims rule exception to the SSTB phase out split between those that make over $25 million.44 For those who have gross receipts of at least $25 million, if those that have less than ten percent of the activities attributed to those specifically excluded under the regulations then such activities will not be considered a SSTB.45 For those in excess of the $25 million in gross receipts, the taxpayer will be considered as having a SSTB if at least five percent of the activities of the trade or business are attributed to activities enumerated in the statute.46
Additionally, one should be wary to those trades or businesses providing services or property to a SSTB because such are subject to the regulations as well.47 Specifically, if a trade or business is commonly owned by at least fifty percent ownership through related parties pursuant to Sections 267 and 707(b), and such trade or business provides services or property to a SSTB, then such portion of ownership will be considered as a SSTB for Section 199A purposes.48 For example – as provided in the regulations – Partnership 1 operates a SSTB and Partnerships 2 and 3 do not.49 However, the partners of Partnership 1 are also the partners of Partnerships 2 and 3, which also provide services and property to Partnership 1.50 Because of the common ownership, Partnerships 2 and 3 will not be deemed a SSTB, which in turn will make it more difficult to qualify for the Section 199A deduction.51
As a final add-on being an employee severely hinders the ability to taking advantage of the Section 199A deduction, not by being “phased-in” or “phased-out,” but entirely.52 None of the Section 199A items that are usually available for business owners to use for the deduction are able to be taken into account as an employee to take advantage of the same.53 Essentially, “income from the trade or business of performing services as an employee refers to all wages [within the meaning of Section 3401(a)] and other income earned in a capacity as an employee, including payments described in [Treas. Regs. Section] 1.6041-2(a)(1)” will not be calculated into the taxpayer’s Section 199A deduction.54
Moreover, the regulations take the position that great weight will be given to the federal classification of the person and it is immaterial for work done as an employee, outside the usual scope of employment.55 However, such presumption of being in the trade or business of being an employee is only rebuttable by the taxpayer, and not the IRS, if “a showing by the individual that, under Federal tax law, regulations, and principles (including common-law employee classification rules), the individual is performing services in a capacity other than as an employee.”56
E. The not so Special Treatment for Taxpayers Whose Income is Classified as a SSTB
Although the general rule denies the Section 199A deduction to specified service trade or business, a special exception exists for those whose taxable income is under $207,500 for single returns and $415,000 for those filing jointly.57 There are two portions to this exception: (1)58 those under the threshold amount and (2) those over the threshold amount but under the $50,000 ($100,000 for those filing a joint return). For taxpayers who fall within the phase in zone, only the “applicable percentage”59 will be taken into account in applying the taxpayer’s Section 199A deduction.60
For those who bear the burden of running a more “successful” specified service trade or business generating taxable income over the threshold amount plus either the $50,000 or $100,000 cushion, the applicable percentage will cause the taxpayer to “phase out” of the deduction.61 As a result, many specified service trade or businesses’ Section 199A deduction will be significantly reduced or denied completely.62
III. AGGREGATION: POSSIBILITY TO GET A HIGHER DEDUCTION MADE EASIER
The Section 199A regulations acknowledge the fact that taxpayers could own more than one trade or business.63 The regulations further follow that for purposes of calculating qualified business income, the taxpayer has the option64 to aggregate their trade or business into one.65 This aggregation availability to taxpayers can be beneficial to maximize on your deduction amount, even if the taxpayer has low W-2 or very little qualified property for purpose of calculating the qualified business income.66 Aggregating multiple businesses can be beneficial in the sense that in doing so, this can help individuals increase the ability to qualify for qualified business income and increase its Section 199A deduction amount.67 In order for a taxpayer to be eligible to qualify for aggregation, the same must satisfy certain elements.68
The elements a taxpayer must satisfy are (1)69 “[t]he same person or group of persons, directly or by attribution under [Sections] 267(b)70 or 707(b),[71] owns [fifty] percent or more of each trade or business to be aggregated;” (2)[72] such ownership “exists for a majority of the taxable year, including the last day of the taxable year, in which the items attributable to each trade or business to be aggregated are included in income;” (3)[73] “[a]ll of the items attributable to each trade or business to be aggregated are reported on returns with the same taxable year, not taking into account short taxable years;” (4)[74] “[n]one of the trades or businesses to be aggregated is a specified service trade or business;[75] and (5) the trades or businesses to be aggregated must be able to satisfy two of the three following factors: (a)[76] “provide products, property, or services that are the same or customarily offered together;” (b)[77] “share facilities or share significant centralized business elements;”[78] and (c) “operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.”[79]
A. Aggregating for Individuals
Individual taxpayers are allowed to aggregate, so long as such individuals the aggregation is not done inconsistently with the aggregation principals provided in the Section 199A regulations.[80] If an individual decides to aggregate, the individual must aggregate also the items required to be calculated for purposes calculating qualified business income.[81] However, “[a]n individual may not subtract from the trades or businesses aggregated by an RPE but may aggregate additional trades or businesses with the RPE’s aggregation if the rules of this section are otherwise satisfied.”[82]
Upon aggregation, an individual must test aggregation, for purposes of qualifying for the Section 199A deduction, in all subsequent years.[83] The ability for an individual to aggregate is based on a facts and circumstances situation.[84] In other words, if the dynamics of their trades or businesses change such that the businesses are no longer able to satisfy the aggregation test, the individual will lose the ability to aggregate for Section 199A purposes.[85] Notwithstanding the above-mentioned, individuals also have the ability to add additional trades or businesses if the facts permit the same to pass the aggregation test.[86] It should be noted that for those who are fortunate enough to be owners of an RPE – directly or by attribution – such individuals must report the aggregated trades or business of the same.[87]
As provided in a simple example,[88] A owns 100% of a catering business and a restaurant through disregarded entities. Both businesses share a centralized purchasing system and accounting office.[89] A’s website and print material advertise both businesses.[90] The catering business uses the restaurant kitchen to prepare its food, employs its own staff, and owns equipment not used in the restaurant.[91] Here, because A owns more than fifty percent of the business, the first element will be met.[92] Additionally, A’s businesses provide services that are customarily offered together or are the same because “both businesses offer prepared food to customers.”[93] Furthermore, A’s businesses are share facilities or share significant centralized business elements because “the two businesses share the same kitchen facilities in addition to centralized purchasing, marketing, and accounting.”[94] Henceforth, A may treat both businesses a single trade or business for aggregation purposes under Section 199A.[95]
B. Aggregating for Relevant Passthrough Entities
Similar to individuals, RPEs may also choose to aggregate as long as such aggregation is not inconsistent with the aggregation principals provided in the Section 199A regulations.[96] Moreover, owners of the RPEs are also given the option to aggregate in different manners from the owners of the same RPE if the RPE itself does not choose to aggregate.[97] However, although the aggregation reporting and consistency requirements are similar to individuals as well,[98] an RPE may not aggregate a newly acquired trade or business if it is one of an aggregated “lower-tier RPE.”[99] Similar to individuals[100], failure to report required information,[101] the Commissioner may disaggregate a trade or business for purposes of the Section 199A deduction and will not be able to aggregate the same for three years.[102]
As an example, a trust wholly owns three LLCs.[103] “LLC1 operates a trucking company that delivers lumber and other supplies sold by LLC2.”[104] LLC2’s lumber yard business supplies LLC3 with building materials for its construction business.[105] All three LLCs have a “centralized human resources department, payroll, and accounting department.”[106] Here, because the trust owns more than fifty percent of the LLCs, the first element will be met.[107] Furthermore, the trust’s businesses share facilities or share significant centralized business elements because they have “centralized human resources department, payroll, and accounting department.”[108] The trust can also meet the supply chain interdependencies element because all three of the business are operated in coordination with each other or rely amongst themselves.[109]
IV. SPECIAL SECTION 199A CALCULATION RULES FOR RPE AND TRUSTS – SUBTLE CONFUSION FOR TAX PLANNERS REMAIN
Although Section 199A only refers to application of trusts very seldomly, the regulations extensively direct how the Section 199A deduction is to be applied to trusts.[110] The Section 199A regulations state that, for purposes of the Section 199A deduction, trusts are to be treated as both individuals for certain purposes and as RPE[111] for others.[112] Similarly, beneficiaries are treated the same as receiving income from RPE(s) for those portions of Section 199A income and deductions allocated to it.[113] Thus, we must turn to the regulations discussing RPEs to determine the Section 199A deduction for trusts.[114] However, one should note that not all of the Section 1.199A-6 regulations apply to trusts for purposes of the deduction calculation.[115]
- Section 199A Deduction Principals for Grantor Trusts
In order for the trust to not be considered a disregarded entity for purposes of the Section 199A deduction, the trust must not be a grantor trust.[116] A trust will be considered as a disregarded entity under the grantor trust rules when the grantor contains in the trust – generally – reversionary interests,[117] powers to control beneficial enjoyment,[118] certain administrative powers,[119] a power to revoke the same,[120] income for the benefit of the grantor,[121] the person other than the grantor is treated as a substantial owner,[122] or when there is a foreign trust with at least one United States beneficiary.[123]
If the trust was created and it happened to be able to attain the benefits of the Section 199A deduction, but the trust was determined to be a grantor trust, the trust itself would lose the benefits of the Section 199A deduction and would only be allowable to the grantor.[124] In other words, if the grantor creates multiple trusts – but they are deemed to be grantor trusts – the trusts will be disregarded for purposes of the Section 199A deduction. Therefore, the grantor creating the grantor trust would include all Section 199A items, and not the alleged trust.[125] So, in effect, the grantor would be limited to the $157,500 (or 200% thereof) threshold amount instead of allowing a separate threshold amount computation in the situation where there are multiple trusts.[126] However, as a result of the trust being disregarded, the anti-abuse rules will be easier to trigger if the intent of the grantor is to avoid federal income tax because all that needs to be triggered is such element.[127]
B. Section 199A Deduction Principals for Non-Grantor Trusts
Non-grantor trusts are treated differently than grantor trusts for purposes of calculating the Section 199A deduction, one of them being that the Section 199A deduction is done at the entity level.[128] The qualified business income deduction must be allocated in accordance with Treasury Regulations Section 1.652.[129] Therefore, “[a]ll deductible items directly attributable to one class of income . . . are allocated thereto.”[130] Similar to an example provided in Treasury Regulations Section 1.652,[131] if there are “qualified items of income, gain, deduction, and loss”[132] resulting from a taxpayer’s trade or business such qualified items are to be allocated to the same for purposes of calculating the qualified business income of the trust.
Additionally, such expenditures attributed to qualified items of income will also be attributed to the same.[133] It appears to be that if such deductions attributed to qualified business income – calculated from the qualified items of income – exceed such income, the excess[134] “may be allocated to any other class of income (including capital gains) included in distributable net income.”[135] Additionally, for those qualified business income deductions that do not have a specific attribution to a specific item of income, those deductions may be allocated to any item of income in computing distributable net income.[136] However, any depletion[137] or depreciation[138] deductions taken in the trust, no matter how they are to be allocated between the trust and the beneficiary, are to be included in the qualified business income computation of the trust.[139] Therefore, for purposes of calculating the qualified business income at the trust level, the trust instrument will be generally be ignored.[140]
Furthermore, qualified business income, and all other items used to attain the qualified business income deduction, is allocated to the trust and the beneficiary according to the trust’s distributable net income[141] regardless of distributions made.[142] For purposes of the Section 199A deduction, the trust’s or estate’s DNI is determined with regard to the separate share rule of section 663(c),[143] but without regard to Section 199A.[144] In other words, when there is a single complex trust[145] with multiple beneficiaries, the trust’s DNI will not include qualified business income if it is not required to be distributed. Here, because each beneficiaries’ share is to be treated as a separate trust, it appears to be that each beneficiary of a complex trust – upon distribution – will also be allowed to take a Section 199A deduction upon distribution, if such distribution is made as a result of the “separate trust rule.”[146]
If there is no DNI, however, no beneficiary will be able to take the Section 199A deduction, as the deduction will only be granted at the trust level.[147] Allowing a beneficiary to take such allocation without any DNI – or any income at all – would be a windfall for both the beneficiary and the trust because the trust would get a deduction for any distributions made[148] and the beneficiary would get a Section 199A deduction if the same were to occur.[149] It is important to note that a trust is to take into account for Section 199A purposes all deductions for distributions for that current year prior[150] to determining whether the trust has taxable income over the Section 199A threshold amount.[151] This was a different position taken in the proposed regulations as such stated the Section 199A deduction was to be taken into account before the distributions were made.[152] However, this received much criticism[153] because this would essentially be counting income twice and would cause the trust to be over the threshold amount. In turn, as a result of this new availability to reduce the taxable income at the trust level, the trust will be able to better increase its flexibility[154] for Section 199A planning.
C. The Step-by-Step Approach in Calculating the Deduction – The Sole Guidance Provided by the Section 199A Regulations
The Section 199A regulations do provide an example as to calculate the Section 199A deduction for both the trust and its beneficiaries, but again fail to provide an example of one triggering the anti-abuse rules and one triggering the multiple trust rule.[155] However, the regulations do provide clarity in the step-by-step method explained below.[156] The facts provide that a complex trust (“Trust”) is a twenty-five percent owner in a family partnership operating and owning a restaurant generating qualified business income and has W-2 wages as provided in the regulations.[157] In addition, the trust is an irrevocable testamentary trust, of which A and B are the sole beneficiaries.[158] Furthermore, A and B are the remaining seventy-five percent owners of the family partnership.[159] The Trust states the trustee is to distribute fifty percent of DNI to A, a discretionary beneficiary, and twenty-five percent of the DNI to B, who is a current income beneficiary.[160]
The first step is to determine the Trust’s distributive share of the partnership’s income. The family partnership generates $55,000 and incurs $45,000 in expenses properly allocated to the Trust.[161] Of the $45,000 in expenses, $25,000 are W-2 wages.[162] The net of the activity allocated to the results in $10,000 DNI allocated to the trust.[163] Furthermore, we must also determine other trust activity for the possibility for a trust and its beneficiaries to aggregate – which they do in the example – under Section 1.199A-4.[164] The Trust also has a 100% interest in an LLC that operates a bakery.[165] The LLC generates $100,000 of income and incurs $155,000 in expenses all allocated to the bakery.[166] Of the $155,000 expenses, $50,000 are W-2 wages, $75,000 are rental fees, $25,000 comprise of miscellaneous fees, and the remaining $5000 are depreciation deductions.[167] Moreover, the trust incurs $25,000 dividend income, $15,000 taxable interest, and $15,000 tax-exempt interest.[168] Additionally, the bakery owns $125,000 UBIA (used for qualified property purposes in calculating the Section 199A deduction).[169]
The second step is to calculate a trust’s directly allocable expenses. Here, because the family partnership expenses are directly attributable to the Trust, for purposes of calculating the DNI, the Trust would have income of $55,000 from the family partnership allocated to it and $100,000 from the LLC, for a total of $155,000.[170] The Trust would also have $45,000 in expenses attributed to it from the family partnership and $155,000 from the LLC’s expenses, for a total of $200,000.[171] The Trust also incurs $1000 of the $3000 in trustee fees and $1000 of the $5000 in state and local taxes.[172] The trust is to allocate the $47,000 excess business deductions as follows: “$15,000 to the interest income, resulting in $0 interest income, $25,000 to the dividends, resulting in $0 dividend income, and $7000 to the tax exempt interest.”[173]
Next, a trust must allocate the deductions not directly attributable to its expenses.[174] Because there are $2000 of trustee expenses and $4000 of state and local tax expenses left over, the trust must allocate such “excess” expenses to the remaining tax-exempt interest income.[175] The Trust’s DNI is $2000 at this point and is to distribute $1000 to A and $500 to B.[176] The remaining twenty-five percent of the DNI is retained in the Trust.[177] In this scenario, as a result of the DNI consisting entirely of tax-exempt income, the Trust does not deduct any of the amounts distributed to A and B.[178]
After determining the taxable income at the trust level after the distributions made, we now turn to the Section 199A deduction calculation.[179] To determine the Section 199A deduction, we must first look at the qualified items to determine whether the deduction can be made.[180] For W-2 wages, the Trust had $25,000 W-2 wages attributed from the family partnership and $50,000 from the LLC, for a total of $75,000.[181] For qualified property, the Trust had $125,000 of UBIA and a QBI of negative $47,000.[182] Now that the proper allocations and calculations are made, the Section 199A deduction can be properly calculated for A, B, and the Trust.[183]
i. A’s Calculation
Because the Trust is to allocate fifty percent of DNI to A, A must also be allocated fifty percent of W-2 wages and QBIA.[184] Therefore, A will have $37,500 of W-2 wages allocated to it and $62,500 UBIA of qualified property from the Trust.[185] Because A may also aggregate – pursuant to the facts in the example – Section 199A qualified items outside the interest of the Trust as well.[186] Outside the Trust, A will have $2500 of W-2 wages and $25,000 of QBIA of qualified property.[187] A has $40,000 in W-2 wages and $87,500 in QBIA of qualified property.[188] In addition, A has QBI of $100,000 from outside the Trust and a negative $23,500 allocated to it from inside the Trust.[189] Recall that A had fifty percent distribution and the Trust had a negative $47,000 QBI, so A will have $76,500 total in QBI.[190]
The facts assume A has a total income of $357,500.[191] A’s “tentative” deductible QBI deduction of 20% x QBI is $15,300.[192] Because the tentative QBI must be either the lesser of 20% x QBI or the limitation, we must do that calculation as well.[193] The limitation provides that QBI will be either the greater of either 50% x $40,000 of W-2 wages is $20,000, or 25% of W-2 wages plus 2.5% of unadjusted basis immediately after acquisition (“UBIA”) of qualified property which is $12,187.50.[194] Because the tentative deductible QBI is lesser than the “greater of” calculation, the Section 199A deduction for A is $15,300.[195]
ii. B’s Section 199A Deduction Calculation
The facts provide B has no other QBI from outside the Trust and is under the threshold amount, allowing B to not be limited in its QBI calculation by its W-2 wages.[196] B was allocated twenty-five percent of the Trust’s distribution, so B will also be allocated twenty-five percent of the QBI in the Trust as well.[197] Therefore B’s QBI is negative $11,750.[198] Therefore, B will not be allowed a Section 199A deduction but will be allowed to carryover the loss to the following year pursuant to Section 199A(c)(2).[199]
ii. The Trust’s Calculation
As a result of not distributing the Trust’s DNI, twenty-five percent of the DNI is allocated to the Trust.[200] Because the Trust did not have any QBI, the Trust’s negative $11,500 is not allowed to be taken and will be allocated to the following year.[201]
D. Section 199A Anti-Abuse Rules and Section 643(F) Multiple Trust Rules
Tax planners should be wary of the purpose of creating such trusts if the priority of the trust was to qualify for the Section 199A deduction, as such trusts will be disregarded in determining the Section 199A threshold amount.[202] It should be noted that the anti-abuse rule goes not only for multiple trust, but also for single trusts that that have the intent of avoiding taxes through the application of Section 199A.[203] Furthermore, it had been nearly thirty-four years since the enactment of Section 643(f), the multiple trust rule, that – along with the Section 199A final regulations – Treasury Regulations Section 1-643(f)-1 was finally enacted as well.[204] For purposes of the income taxation of trusts, if two or more trusts created after August 16, 2018, (1) have the same or substantially the same grantor or grantors; (2) substantially the same beneficiary or beneficiaries; and (3) if the primary purpose for creating the trust is to avoid income tax purposes, then the trusts will be aggregated and be treated as a single trust.[205] Additionally, spouses will be treated as the same person for purposes of the anti-abuse rules.[206]
The anti-abuse rules were first introduced in the proposed regulations as a result of the IRS fearing multiple trusts would be created to – without anticipating a change calculating Section 199A deductions after the trust distribution deductions pursuant to Sections 651 and 661 – reduce the taxable income of the individual via multiple trusts under the threshold amount.[207] By establishing the proposed regulation, and then the final regulations for Section 643(f), this would allow the Secretary to enforce the anti-abuse rules for purposes of attempting to circumvent the Section 199A deduction limitations.[208]
Although the anti-abuse rule provided by the Section 199A regulations require three elements to be satisfied to trigger the multiple trust rule for purposes of aggregating income to qualify under the threshold amount, it appears the IRS’ central element of concern is the primary purpose of creating the trust.[209] Moreover, the purpose of the anti-abuse rule for multiple trusts in the proposed regulations provided that where “multiple trusts entered into or modified before August 16, 2018, the determination of whether an arrangement involving multiple trusts is subject to treatment under section 643(f) will be made on the basis of the statute and the guidance provided regarding that provision in the legislative history of section 643(f).”[210] Therefore, it is clear that the IRS was attempting to incorporate the anti-abuse rule through the use of the multiple trust rule as well.[211]
However, the anti-abuse rules in the proposed regulations did not escape criticism prior to being finalized,[212] let alone leave confusion.[213] At first, the multiple trust rule stated “[t]rusts formed or funded with a significant purpose of receiving a deduction under section 199A will not be respected for purposes of section 199A. See also [Section] 1.643(f)-1 of the regulations.”[214] According to the commenters, such phrasing was likely to cause confusion primarily because of the word “significantly,” in addition to the inclusion of Section 1.643(f)-1 into the regulations.[215]
As a result of the feedback from commenters,[216] the final regulations provided the anti-abuse rules use a primary purpose standard and the same be applied to whether there were multiple trusts or a single one.[217] However, despite such requests for clarification on the application of the multiple trust rule, the Treasury did not[218] provide additional guidance on what a substantially same primary beneficiary or grantor were.[219] In fact, the Treasury encouraged commenters to provide feedback on how guidance should be given to applying the multiple trust rule.[220] However, instead, the Treasury directed those to the legislative history in enacting Section 643(f) for application of the multiple trust rule to apply for the 199A deduction.[221]
E. Why Were Both the Multiple Trust Rule and the Anti-Abuse Rule Enacted?: The Practicality of the Multiple Trust Rule and the Regulations
It almost appears as if the enactment of the multiple trust rule and the anti-abuse rule would be moot if there was one without the other, however, a careful reading of the statute and the applicable regulations, they seem to complement each other.[222] At first, it seems useless to enact the same for purposes of “disregarding” the various trusts attempting to qualify for the Section 199A deduction because, as stated above,[223] if the primary purpose of creating a trust is to avoiding federal income taxation, then a trust will not be respected regardless of there being more than one.[224] However, it appears that different tests will be used in determining which test to use against the trusts.[225]
For purposes of the multiple trust rule, the Treasury directs us to use the tests dating back from 1984 because it states to use the legislative history of the enactment of Section 643(f).[226] Furthermore, the test in using the anti-abuse rule will be dating back from December 22, 2018.[227] Therefore, in looking at both tests separately, each appears to complement the other in preventing drafters stating that the creation of a trust – or multiple trusts – were not for the purposes of creating the availability of the Section 199A deduction.[228] In drafting such trusts, one must be careful in triggering the multiple trust rule because as a result of trying to avoid any federal income tax – not just attempting to get under the Section 199A deduction – the multiple trusts will be treated as a single trust for purposes not limited to the Section 199A deduction.[229]
Although there were many questions,[230] the legislative history is to allegedly[231] give us more guidance on how to not trigger the multiple trust rule.[232] The reason to adding the multiple trust rule, as provided by the House Committee on Ways and Means, was to prevent the use of numerous trusts to circumvent federal taxation.[233] The original fear was a scenario providing an individual making $1 million and creating ten separate identical trusts to only have the trusts include $100,000 each for a lower effective tax rate on the undistributed income of the trust.[234] This scenario creating multiple trusts with similar grantor and beneficiaries to be a potential use to lower income tax for the individual.[235] However, there appears to be sparse guidance because Section 1.643(f)-1 adopted the explanation of the statute.[236] In other words, there is no additional guidance, but simply a restatement of their explanation.[237]
Even though the legislative history to Section 643(f) is a bit repetitive for purposes of the Section 199A deduction, one key explanation is that contingent beneficiaries are irrelevant for purposes of the Section 643(f) analysis.[238] A similar explanation is provided for amongst the “grantors” of multiple trusts as well.[239] It appears the legislative history is providing for the prevention of using a strawman to prevent the triggering of the multiple trust rule.[240] An example provided by the legislative history where the trusts will be treated as one trust generally provides that where the grantor creates four trusts and each trust provides for a different variety of the same beneficiaries.[241]
Additionally, although Section 1.643(f)-1 provides that trusts will not be considered a single trust as long as there is no principal purpose to avoid federal income tax, the legislative history provides a conjunctive test of there being “substantial independent purposes, and tax avoidance is not a principal purpose for the existence of separate trusts”[242] for those entered into before the effective date. The “compliant” example where the trusts will not be aggregated as in the legislative history generally provides a mother creating two irrevocable trusts.[243] The first trust for the son as the sole income beneficiary for life, and the daughter is the remainder beneficiary.[244] The second is a complex trust providing that the daughter is the current income beneficiary and remainder beneficiary, and the son is a current discretionary beneficiary.[245]
Although withdrawn, it is likely worth taking a look at the examples in the proposed regulations to see how a trust would have survived or failed the multiple trust rule for purposes of attaining the Section 199A deduction.[246] As the only guidance – besides the 1984 legislative history – this would likely get us to understand what the treasury had in mind in reflecting the legislative history when enacting the multiple trust rule as it applies to Section 199A.[247] It should be noted the examples in the proposed regulations are somewhat similar to the examples provided in the suggested legislative history in enacting the multiple trust rule.[248]
A owns two businesses and because of its income, A exceeds the Section 199A deduction threshold amount.[249] Furthermore, A does not have enough items of income under Section 199A to maximize on its deduction.[250] As a result, A creates three trusts, “Trust 1 for the benefit of A’s sister, B, and A’s brothers, C and D; Trust 2 for the benefit of A’s second sister, E, and for C and D; and Trust 3 for the benefit of E.”[251] All three trusts are complex trusts and each trust agreement is very similar to the other.[252] It is clear at this point the trust is created for purposes of the Section 199A deduction.[253] A later creates a family partnership and contributes half of each of its business to the family partnership and later on contributes a fifteen percent interest in the partnership to each trust.[254] Additionally, the trustee, under the partnership agreement, does not have any authority to distribute any of the partnership’s interest unless the general partner, A, would approve.[255] Here, the trusts would be aggregated and treated as a single trust in attempting to qualify and maximize on the Section 199A deduction.[256]
In its second and final example, X, the grantor, establishes two irrevocable trusts each separately benefiting the son, G, and daughter, H.[257] G is the mandatory life income beneficiary of the trust and H is the remainderman.[258] Furthermore, H is the discretionary income beneficiary of the second trust and allows the trustee to pay for H’s “education, support, and maintenance.”[259] From the second trust, “[the trustee also may pay income or corpus for G’s medical expenses.”[260] Conversely, H is the remainderman and will receive the corpus when G dies.[261] According to the Treasury, the trusts have significant “non-tax differences,” and will not be the principal purpose of establishing or funding the trust.[262] Absent additional facts that indicate the creation or funding of the trusts was for tax avoidance purposes, the trusts will not be considered as a single trust for Federal income tax purposes under the Section 199A deduction.[263]
It should be noted that because the creation of the trust must pass the anti-abuse rule’s scrutiny, there is nothing to be said throughout the life of the trust.[264] That is, there are no examples or guidance given for the treatment of a trust, which was originally created and then subsequently eligible for the Section 199A deduction.[265] For example, imagine a person creates a trust similar to the second example above in Year 1, but instead, in Year 2, the trust is restructured throughout its existence to qualify for the sole purpose of the 199A deduction. The Section 1.643(f)-1 regulations on the multiple trust rule may address this issue during the course of the trust by stating that multiple trusts will be treated as a single trust if “for contributing additional cash or other property to such trusts is the avoidance of federal income tax.”[266] However, it appears the limitation on the Section 199A deduction regarding the multiple trusts rule would be avoided by using a single trust.[267]
That being said, the anti-abuse rules might address this issue because Treasury Regulations Section 1.199A-6(d)(3)(vii) states “[a] trust formed or funded” would be subject disregarding the trust.[268] Although forming the trust refers to the inception – which may evidence the principal purpose of the trust – the regulation also states that the funding of the trust will also trigger the same treatment of the anti-abuse rules and disregard the trust for Section 199A purposes.[269] Therefore, it appears the Section 199A anti-abuse rule and the Section 643(f)-1 regulations may cover their basis on many different ways of avoiding the potential “single-trust treatment.”[270] Despite the difference in the proposed regulations and the final regulations, guidance remains to be a concern regarding the anti-abuse rules and time is shortening as this continues to be a temporary deduction.[271]
V. CONCLUSION
Despite the criticism received for the lack of guidance and over-reaching from the co-enactment of the anti-abuse rule in the Section 1.199A regulations and guidance of the multiple trust rule under Treasury Regulations Section 1.643(f)-1, the IRS has as a priority, to issue guidance on the use of the Section 199A deduction and its application on trusts.[272] Although the deduction was recently enacted, as stated earlier, the deduction will not be here forever.[273] Notwithstanding the briefness of the deduction, the same appears to benefit business owners who hire employees rather than independent contractors, and encourages the same to continue doing business in such a manner to qualify for a bigger deduction.[274] Additionally, Section 199A enables those managing trusts to be able to qualify the beneficiaries of a trust to the deduction if properly managed and administered.[275] Furthermore, settlors and those drafting trusts need to be careful in creating and managing the trust – or multiple trusts – for the sole purposes of triggering the anti-abuse rule and the multiple trusts rule.[276] Should either of the two get triggered the trust will be disregarded for Section 199A purposes and will implicate negative tax consequences on all interested parties.[277]
*Victor Gabuardi, Esq. LL.M. (taxation) – I would like to take this moment to thank my family, friends, and mentors who have helped me throughout my law school career. I am thankful for the opportunity to learn at, not only at one of the greatest law schools in the nation, but also the greatest tax LL.M. program here at the University of Florida. I would also like to thank the professors at the LL.M. for their help in furthering my understanding of the Code in ways I would not have been able to on my own. I would like to also thank the professors at my J.D. program at St. Thomas University School of Law for helping me further my career in tax law. As a final thanks, I would like to thank St. Thomas University School of Law’s Law Review in selecting this Note to being published. This experience, from the first day of law school, to graduating from the LL.M., has been second to none. The friendships, especially the memories I have gained, along with my classmates – including the skills attained from the LL.M. – will be cherished forever. All statutory sources cited below are to the Internal Revenue Code and its applicable regulations.