The Pass-Through Income Deduction for Charitable Remainder Trusts
by Brent W. Nelson and Rachel M. Sass
On January 18, 2019, the Internal Revenue Service (IRS) issued final regulations implementing the new pass-through income deduction for qualified business income (QBI) received from pass-through entities (such as sole proprietorships, partnerships, and S corporations), commonly known as the “Pass-Through Income Deduction.”1 Concurrent with the final regulations, the IRS also proposed new regulations, which provide guidance for whether a charitable remainder trust (CRT) and its beneficiaries may claim the Pass-Through Income Deduction.2 The Pass-Through Income Deduction was enacted under the Tax Cuts and Jobs Act (TCJA), and for the first time, allows many individuals who own interests in pass-through entities to deduct up to 20% of their QBI.
A CRT is an irrevocable trust that has two beneficial interests—one non-charitable and one charitable: first, set distributions are payable to at least one non-charitable beneficiary each year for a term of years or the lifetime of an individual, and second, the balance of the trust, after the term of years or the lifetime, is paid to one or more charities.3 The CRT must also meet other requirements to qualify as a CRT.
Assuming the CRT qualifies as such, then it is generally not subject to income tax and contributions to the trust may be eligible (in part) for the income tax charitable deduction. However, certain excise taxes applicable to charities may apply to CRTs, including a 100% excise tax on the CRT’s unrelated business taxable income (UBTI). UBTI includes income from a trade or business the CRT regularly carries on that is not substantially related to its charitable purpose.
While a CRT may pay no tax on its non-UBTI income, the non-charitable beneficiaries typically must pay tax on distributions under a tiered system. Under the tiered system, each taxable year, the CRT’s income is assigned to one of three categories: ordinary income, capital gains, or other income. Items of income in each category are further assigned to classes, arranged from highest to lowest tax rates applicable to each item of income or gain. The categories and classes are thus tiered from top to bottom based on the highest to lowest tax rate on the taxable items. Each distribution from the CRT to non-charitable beneficiaries is then treated as being made sequentially from the highest to lowest available classes of items on a dollar-for-dollar basis. The net effect is that the highest taxed items are paid first, before any lower taxed items, and the non-charitable beneficiary is compelled to pay tax of the same character as the distributions made.
New Guidelines for Charitable Remainder Trusts
The IRS’ proposed regulations clarify that CRTs, by themselves, are not eligible for the Pass-Through Income Deduction. The non-charitable beneficiaries of CRTs, however, are eligible for the deduction on their shares of distributed QBI.
The Pass-Through Income Deduction does not apply to CRTs because (1) CRTs are not subject to income tax under the Code, and (2) the 100% excise tax on UBTI is not treated as an income tax and therefore not eligible to be offset by an income tax deduction such as the Pass-Through Income Deduction.
In contrast, the non-charitable beneficiaries of CRTs are eligible for the Pass-Through Income Deduction on their shares of distributed QBI. As taxable recipients, the non-charitable beneficiaries must determine and apply their own deductible amount in accordance with the Pass-Through Income Deduction rules, taking into account any QBI, qualified real estate investment trust (REIT) dividends, and qualified publicly traded partnership (PTP) income (all of which are used to calculate the Pass-Through Income Deduction) received from the CRT. The distributions to non-charitable beneficiaries are filtered through the tiered-system rules as follows:
- First, QBI, qualified REIT dividends, and qualified PTP income is allocated to the classes of income within the ordinary income category based on the tax rate that normally would apply to ordinary income (not taking into account the Pass-Through Income Deduction), and is treated as distributed from the CRT to the beneficiary only when all of the other classes of income within the ordinary income category subject to a higher rate of tax have been exhausted.
- Next, the CRT beneficiary is treated as receiving a proportionate amount of any QBI, qualified REIT dividends, and qualified PTP income that is distributed along with other income in the same class within the ordinary income category. If the CRT is distributing QBI, qualified REIT dividends, or qualified PTP income to more than one beneficiary in a taxable year, then the distribution of that income is treated as made to the beneficiaries proportionately, based on their respective shares of the total QBI, qualified REIT dividends, and qualified PTP income distributed for that year.
Furthermore, the proposed regulations provide that the amount of any of the CRT’s W-2 wages or unadjusted basis of qualified property (UBIA), which are also included for calculating certain taxpayer’s Pass-Through Income Deduction, will be allocable to the non-charitable beneficiaries based on their share of the CRT’s total QBI that is distributed to them for that year. Thus, as the proposed regulations explain, if the CRT distributes 10% of the QBI to a non-charitable beneficiary during the tax year and retains 90% of the QBI, then 10% of the W-2 wages and UBIA of qualified property is allocated to the non-charitable beneficiary and 90% is retained in the CRT.
While the new proposed regulations make it clear that CRTs are not eligible for the Pass-Through Income Deduction, non-charitable beneficiaries of CRTs may be able to claim this beneficial deduction on their distributions from the CRT. Taxpayers interested in learning more about the benefits of establishing a CRT and claiming the Pass-Through Income Deduction should consult with an estate and tax professional familiar with these rules.
- The final IRS Regulations can be accessed here: https://www.irs.gov/pub/irs-drop/td-reg-107892-18.pdf. A discussion of the intricacies of the Pass-Through Income Deduction is beyond the scope of this alert. The Pass-Through Income Deduction is complex and takes into account many features. The rules related to the Pass-Through Income Deduction are found in Section 199A of the Internal Revenue Code of 1986, as amended (the “Code”), and the regulations thereunder.
- The proposed IRS Regulations can be accessed here: https://www.irs.gov/pub/irs-drop/REG-134652-18.pdf.
- CRTs are governed by Section 664 of the Code and the regulations thereunder, plus certain excise tax, gift, and estate tax provisions of the Code and regulations relating to charities.