Trust Accounting Income & Taxation After Tax Reform

Federal quick reference guide to the Tax Cuts and Jobs Act.

Prior to tax reform, the rules governing the income taxation of trusts and estates were considered complex and intimidating by many. While the same holds true after the enactment of the Tax Cuts and Jobs Act (TCJA), the income tax landscape has shifted due to the various changes under the TCJA. This increased the importance of understanding the interplay between taxable income and trust accounting income (TAI), two concepts discussed in this article and essential to determining the income tax liability of a trust, an estate and its beneficiaries. This article discusses these two important concepts and looks at how the TCJA affected income tax planning for trusts and estates.

Taxable Income vs. TAI

Before exploring the effect of various changes under the TCJA, it’s important to first have an understanding of the rules that previously—and continue to—apply. Generally speaking, the taxable income of a trust or estate is computed in a manner similar to an individual with the added hybrid element that the incidence of taxation follows the recipient of the income earned. For example, the trust/estate is generally responsible for the income tax liability on amounts retained by the trust/estate, and the beneficiary is generally responsible for the resulting income tax liability on amounts distributed (or required to be distributed) to a beneficiary of the trust/estate. Determining the appropriate distribution of taxable income and the resulting income tax liability to trust beneficiaries, if distributed, requires a thorough understanding of the trust agreement and proper accounting for trust income.

Similar to businesses, trusts have both “book income” and taxable income. The book income of a trust is referred to as TAI and must be calculated in accordance with the terms of the trust agreement and state law. The purpose of calculating TAI is to recognize the difference between whether a particular receipt of income or payment of expense is intended for the current income beneficiary or to be retained for future distribution to remainder beneficiaries.

The taxable income of a trust is generally calculated in accordance with the Internal Revenue Code (IRC). Unique to trusts is a tax-law concept called distributable net income (DNI), which provides a ceiling on the amount of taxable income distributed to a trust’s beneficiaries. This ensures total taxable income is taxed only once to the entity, the beneficiary or a combination of both. This DNI ceiling is compared to the amount of actual or required distributions made to the beneficiaries. If actual or required distributions are greater than zero but less than DNI, then taxable income would be split between the trust and its beneficiaries. If actual or required distributions exceed DNI, then taxable income on TAI would be distributed entirely to a trust’s beneficiaries.

What creates complexity and tax planning opportunities is the difference between taxable income and TAI, as these amounts generally aren’t the same amount. In addition, a trust reaches the highest marginal tax bracket of 37 percent at just $12,500 of taxable income for 2018, versus $600,000 for married individuals filing jointly. Depending on the marginal tax bracket of trust beneficiaries, it may be more tax-efficient to distribute taxable income to the beneficiaries by making additional distributions of trust income or principal—provided the trust agreement allows the trustee to make such distributions within his or her duty to both income and principal beneficiaries.

Effect of Tax Law Changes on Trusts

With an understanding of the relationship between taxable income and TAI, let’s take a look at the effect of the below tax law changes on nongrantor trusts and the possible result of such tax law changes.

Tax Law Change

General Effect on TAI & DNI

Possible Result

  • $10,000 cap on state & local real & personal property taxes not attributed to a trade or business & the greater of income or sales tax paid[1] for each trust/estate

  • Increased bonus depreciation applicable percentage to 100 percent through 2022 for qualified property placed in service after September 27, 2017, & expanded definition of qualified property by removing requirement that original use begins with taxpayer[2]

  • Repealed the deduction for miscellaneous 2% itemized deductions[1][3]

  • Nonpassive losses limited to $250,000; excess loss treated as net operating loss & carried forward

TAI < DNI

Increased taxable income to the trust without additional distributions of TAI

  • Deduction of 20% of domestic qualified business income (QBI); subject to limitations once taxable income reaches $157,500. Read our white paper for more information on the QBI deduction[1]

TAI > DNI

Less taxable income than previous years due to new deduction


 

 


Example: In tax year ending December 31, 2018, ABC Irrevocable Trust receives $250,000 of interest and dividend income, pays investment management fees of $40,000 and pays state income taxes of $12,000. The trust agreement provides for income and principal allocations to be in accordance with the Uniform Principal and Income Act and distribution of all income to beneficiary A.

 

TAI

Taxable Income – Before TCJA

Taxable Income – After TCJA

Interest & dividends

$250,000

$250,000

$250,000

Investment fees

($20,000)[4]

($35,000)[5]

̶

State income taxes

($12,000)

($12,000)

($10,000)

   Total TAI or DNI

$218,000

$203,000

$240,000

Beneficiary distributions

$218,000

 

 

Income distribution deduction (income reported by beneficiary)[6]

n/a

$203,000

$218,000

Exemption

n/a

(300)

($300)

   Total Taxable Income

n/a

($300)

$21,700


As you can see in this example, this trust will now owe tax where it previously would not have.

Conclusion

It’s important for fiduciaries and trustees to understand the possible effects of the tax law changes included in the TCJA. There may be planning opportunities to reduce the overall tax paid by both the trust and its beneficiaries, such as making an IRC §663(b) election—commonly referred to as the 65-day rule. This election treats distributions made within the first 65 days of any taxable year of an estate or a trust as made on the last day of the preceding taxable year.

Contact Kori or consult with your BKD trusted advisor for more information.

 

[1]Tax years beginning after December 31, 2017, and before January 1, 2026.

[2]80, 60, 40 and 20 percent bonus depreciation for property placed in service in 2023 to 2026, respectively. Excludes certain property used in regulated public utility businesses and property used in a trade or business that has floor plan financing indebtedness; includes qualified film, television and live theatrical productions.

[3]IRS clarified in Notice 2018-61 that deductions for costs paid or incurred in connection with the administration of the estate or trust and that would not have been incurred if the property were not held in such trust or estate aren’t considered a miscellaneous 2 percent itemized deduction and are thus unaffected by the TCJA.

[4]Uniform Principal and Income Act allocates one-half to both principal and income ($40,000/2 = $20,000).

[5]Subject to miscellaneous 2 percent floor: $40,000 - ($250,000 x 2%) = $35,000.

[6]Income distribution deduction is the lesser of DNI or actual or required distributions.

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