When tax writers approach the next round of tax reform, number one on their list should be to eliminate double taxation. Nothing contributes more to economic distortions than taxing the same income two (or more) times. Embracing a “single tax system,” on the other hand, would eliminate those distortions and encourage more investment and job creation.
The brouhaha over the new Section 68 haircut on itemized deductions suggests we’ve got a long way to go on that front. Here’s how CNBC describes the problem:
The deduction cap is imposed on trusts and estates, the experts said, which was unexpected. Even if a trust gave all its income to its beneficiaries, it would have to pay taxes on a portion of that income, according to their interpretation of the document.
While the consequences are steeper for trusts and estates of the ultra-wealthy, trusts with as little as $16,000 in income would also be subject to additional taxes, the experts said.
“There is potentially an element of double taxation,” said Dan Griffith, director of wealth strategy at Huntington Bank. “This is something that is going to affect somebody with a $400,000 special-needs trust. It’s not just going to be something that $100 million dynasty trusts suffer with.”
Griffith said he is especially concerned about trusts that are obligated to distribute all their income. Trusts will either have to sell assets to pay the taxes, sacrificing future investment returns, or reduce their distributions to beneficiaries, he said.
The Joint Committee on Taxation’s (JCT) Blue Book raised the profile of this issue by suggesting that the double tax outlined above was both the correct interpretation of the new statute and reflective of congressional intent. But is it, and was it? No, not.
What’s Affected
Contrary to the Blue Book, how the Section 68 haircut applies to deductions unique to trusts and estates is entirely unclear. As noted in a Tax Notes article Monday:
Does section 68 apply to special fiduciary deductions that only apply to trusts and estates — not individuals? Many fiduciary deductions, including those under sections 67(e), 642(b), 642(c), 651, and 661, function as mechanisms for allocating income to beneficiaries or charities. Applying section 68 could undermine subchapter J’s quasi-conduit principles and risk double taxation at the fiduciary and beneficiary levels.
Why is this important? The CNBC story above includes a nice illustration. So does the Tax Notes article:
Assume the DEF Trust received ordinary interest income of $1 million, had no expenses, and distributed $1 million to a beneficiary. The DEF Trust should have a distribution deduction of $1 million under sections 651 or 661. However, if the 2/37ths limitation under section 68 applies to fiduciary distribution deductions, then the DEF Trust will be subject to tax on $53,189.19 [($1 million – $16,000) * 2/37 = $53,189.19]. The beneficiary would still be subject to tax on the entire $1 million distribution of ordinary income, and that beneficiary’s itemized deductions would also be limited by 2/37ths under section 68. In effect, the application of section 68 to fiduciary distribution deductions would create a double tax of the same income to both the trust and the beneficiary, which would contradict the legislative intent for taxing trusts and estates under subchapter J.
Applying new Section 68 to all allowable trust and estate deductions results in a 2-percentage point increase in their effective tax rate, starting with income as low as $16,000. That is because all the trust’s taxable distributions to beneficiaries would be subject to tax, while 5.4% of the same income would be subject to tax at the trust or estate level. Income from active S corporations is at risk here, too. Consider how this would function with an estate (or a 645 trust) holding S corporation shares. This result could diminish the value of the 199A deduction by more than a quarter.
Clear Statutes, Opaque Intent
The key phrase in the Tax Notes citation above, however, is if the limitation applies to fiduciary distribution deductions. The Blue Book issued last month concluded that section 68 applies to estates and trusts in footnote 102 on page 26. But the Blue Book is not the definitive authority, nor is it legislative history — rather it is post-enactment secondary authority. Regarding the legislative history, the Tax Notes piece says this:
Neither the statutory text nor the legislative history directly addresses the application of the new limitation to preferential-rate income or to deductions unique to trusts and estates. The current statutory framework risks unintended results — such as double taxation and erosion of long-standing quasi-conduit principles — and requires targeted legislative or regulatory clarification.
Our S-Corp advisors agree. New Section 68(a) says “In the case of an individual, the amount of itemized deductions otherwise allowable for the taxable year (determined without regard to this section) shall be reduced….” The first sentence of section 642(b) however, says “The taxable income of an estate or trust shall be computed in the same manner as in the case of an individual, except as otherwise provided in this part.” [Italics added.]
The italicized language in these two statutes is key, as the disputed deductions are unique to trusts and estates, and are provided in Part I of Subchapter J of the Internal Revenue Code (“Estates, trusts, and beneficiaries”). They clearly fit within the “except as otherwise provided in this part” language. Furthermore, S-Corp is not aware of any contemporaneous expression of intent – that is, actual legislative history — that suggests legislators intended to tax more than 100 percent of trust or estate income in any circumstances.
Treasury Should Act
The combination of clear statutory text and opaque intent should be sufficient for Treasury to craft language that limits the scope of Section 68 to itemized deductions that are available to individuals only and exclude deductions that are merely income allocation provisions applicable to estates and trusts.
As the language of Reg. §1.67-4(a)(1) states: “An estate or trust…must compute its adjusted gross income in the same manner as an individual, except that the following deductions…are allowed in arriving at adjusted gross income:…(B) Deductions allowable under…sections 651 and 661 (relating to distributions)”. This is especially important as the function of sections 651 and 661 is simply to allocate income between the estate or trust and its beneficiaries, rather than to give a tax benefit, such as for a charitable contribution.
The Tax Notes author agrees. His options to clarify the provision and avoid double taxation include:
- “Congress could amend section 68to clarify that it applies only to deductions computed “in the same manner as in the case of an individual.” This would exclude fiduciary-specific deductions under sections 67(e), 642(b), 642(c), 651, and 661, preserving the quasi-conduit structure of trusts and estates.”
- “[I]f section 68is intended to apply to charitable deductions under section 642(c) but not to the unique administrative expenses of trusts and estates or to the deductions allowed under sections 642(b), 651, and 661, Treasury could issue regulations under section 68 — similar to reg. section 1.67-4(a)(1)(ii) — clarifying that those deductions are not itemized deductions within the meaning of section 63(d).”
This position and recommendations are consistent with comments from the AICPA, the NYSBA Tax Section, and ACTEC.
You can add S-Corp to that list. The JCT’s position on new Section 68 is unsupported by the statute, the tax history of trusts and estates, and the understanding of those who voted on last year’s tax bill. It is also contrary to all other secondary authorities. The bottom line is Congress and the Treasury should be spending their time eliminating harmful double taxation, not stumbling their way into new instances of it.