The Tax Cuts and Jobs Act (TCJA), signed into law in December 2017, made important modifications to the income taxation of trusts and estates for 2018 and beyond. Trust and estate income tax rates and brackets changed, along with deductibility of some estate and trust administrative expenses. Also, a new qualified business income deduction is available, under certain circumstances, that could be as much as 20% of qualified business income.
Trust and estate income tax rates. The TCJA reduces the existing five trust and estate income tax brackets to four, increases the rate in one bracket and reduces the rates in the others. The chart below shows the new estate and trust tax brackets for 2018. These brackets will be indexed for inflation.
|10%||$0 - $2,550|
|24%||$2,551 - $9,150|
|35%||$9,151 - $12,500|
|37%||$12,501 and over|
The highest rate of 37% applies to trust taxable income over $12,500, while a single individual taxpayer does not reach this rate until taxable income of above $500,000. This makes distribution planning important to minimize overall taxes when possible.
Limitation on state, local, and property tax deductions. The TCJA specifically references a $10,000 deduction limit on state and local income taxes and real property taxes for individuals. This $10,000 deduction limit also applies to trusts and estates for tax years beginning in 2018.
Miscellaneous itemized deductions suspended. One of the biggest changes that will impact trust and estate income tax returns is the elimination of miscellaneous itemized deductions that would be subject to the 2% adjusted gross income limitation, such as investment fees. However, there is an exception to the 2% floor for administrative costs paid and incurred by an estate or trust that would not have been incurred if the property was not held in the trust or estate. These expenses include tax preparation, legal and fiduciary fees, which can be large expenses of the trust.
The elimination of miscellaneous deductions subject to the 2% limitation, and the cap on state and real property tax deductions, will have an effect on taxable income that was formerly distributed to beneficiaries, but now, may be taxed at the trust level.
As an example, assume a simple trust has taxable income of $150,000, consisting of interest income of $100,000 and dividend income of $50,000. The trust pays real estate taxes of $12,000 on non-rental trust real estate and also pays investment fees of $20,000. Total expenses are $32,000. Prior to 2018, the trust would have taxable income of $118,000 ($150,000 – $32,000) and that amount would be distributed and taxed to the beneficiary. The trust would not pay tax.
In 2018, this same trust would have taxable income of $140,000 ($150,000 – $10,000). The beneficiaries will be distributed $118,000 ($150,000-$32,000) and pay taxes on $118,000 of income. The trust will now pay tax on $22,000 of income trapped at the trust level, due to the disallowed deductions of that same amount.
Qualified Business Income Deduction. A trust or estate that owns an interest in a pass- through entity or that is engaged in a qualified trade or business potentially may claim a deduction for the taxable year equal to up to 20% of qualified business income for the 2018 tax year. Discussion of the calculation of this deduction is beyond the scope of this article, but be aware, this deduction may be a favorable tax benefit for the trust or its beneficiaries.
As a reminder, California has not conformed to any of the federal TCJA changes and will continue to follow the existing rules. This disconnect will further complicate tax return preparation for most taxpayers. Overall, this tax simplification effort has become tax complication. If you have any questions, please reach out to our Family Wealth and Individual Tax Group.