The record-high lifetime exemption amount currently in effect means that fewer families are affected by gift and estate taxes. As a result, the estate planning focus for many people has shifted from transfer taxes to income taxes. However, the Tax Cuts and Jobs Act (TCJA) imposed limitations on certain itemized deductions that affected many taxpayers.
The TCJA imposed a $10,000 limitation on combined state and local income taxes and property taxes while also increasing standard deductions to $12,000 for a single filer and $24,000 for a joint filer. These changes made it much more difficult for most taxpayers to itemize their deductions and impacted traditional tax planning strategies. However, strategies are still available that will allow you to deduct both state and local income taxes and property taxes over the $10,000 limit.
The use of one or several nongrantor trusts can be an effective option to reduce income taxes. Nongrantor trusts offer a way around the itemized deduction limitations imposed by the TCJA and may increase the overall benefit of the newly-created qualified business income (QBI) deduction.
What is a nongrantor trust?
A nongrantor trust is simply a trust that is a separate taxable entity from the grantor, or creator of the trust. The trust owns the assets it holds and is responsible for taxes on any income those assets generate. A grantor trust, in contrast, is one in which the grantor retains certain powers and, therefore, is treated as the owner for income tax purposes.
Both grantor and nongrantor trusts can be structured so that contributions are considered “completed gifts” for transfer tax purposes (thereby removing contributed assets from the grantor’s taxable estate). Traditionally, grantor trusts have been the estate planning tool of choice because the trust’s income is taxed to the grantor. This ultimately reduces the size of the grantor’s estate and allows the trust assets to grow tax-free, leaving more wealth for beneficiaries. Essentially, the grantor’s tax payments serve as an additional tax-free gift.
With less emphasis today on gift and estate tax savings, nongrantor trusts have become a viable option for individuals to reduce their overall income tax liabilities while still maintaining their estate planning strategy.
How can nongrantor trusts reduce income taxes?
Nongrantor trusts may offer a way to avoid the itemized deduction limitations imposed by the TCJA. By placing assets in nongrantor trusts, it may be possible to increase your deductions, because each trust enjoys its own $10,000 state and local income tax and property tax deduction.
For example, Randy and Kate, a married couple filing jointly, pay well over $10,000 per year in state income taxes. They also own two homes, each of which generates $20,000 per year in property taxes. Under the TCJA, the couple’s state and local income tax deduction is limited to $10,000, which covers a portion of their state income taxes, but they receive no tax benefit for the $40,000 they pay in property taxes.
To avoid this limitation, Randy and Kate transfer the two homes to an LLC, together with assets that earn approximately $40,000 per year in income. Next, they give 25% LLC interests to four nongrantor trusts. Each trust earns around $10,000 per year, which is offset by its $10,000 property tax deduction. Essentially, this strategy allows the couple to deduct their entire $40,000 property tax bill.
In addition to avoiding the itemized deduction limitations, nongrantor trusts also enjoy their own qualified business income deduction. This deduction can be as much as 20% of a taxpayer’s qualified business income from a pass-through entity (partnership or S-Corp) or sole proprietorship; C-Corporations and their owners are not eligible for this deduction. However, the qualified business income deduction itself has several limitations, one of which disallows an individual’s entire QBI deduction if their adjusted gross income is over a certain threshold.
Since a nongrantor trust is a separate taxable entity, it is allowed its own QBI deduction. If structured correctly, an individual taxpayer not eligible for his or her own QBI deduction, or whose deduction is being limited, may be able to maximize their overall QBI deduction by spreading business income across one or several nongrantor trusts. Since this would involve gifting shares or interests in a company to the nongrantor trusts and potentially triggering transfer taxes, this option should be considered as part of an overall estate planning strategy.
Beware the multiple trust rule
If you’re considering this strategy, be aware that the tax code contains a provision that treats multiple trusts with substantially the same grantors and beneficiaries as a single trust if their purpose is tax avoidance. To ensure that this rule doesn’t erase the benefits of the nongrantor trust strategy, designate a different beneficiary for each trust.
If you would like additional information about other ways to reduce your future tax liabilities, please contact a Yeo & Yeo tax professional.