The Tax Cuts and Jobs Act (TCJA) has had broad-reaching impact on all taxpayers for 2018 and going forward. This includes U.S. persons who are beneficiaries of foreign non-grantor trusts.
As a result of the TCJA suspending the deduction for miscellaneous itemized deductions, which includes the deduction for investment management fees, trust distributable net income (DNI) is likely to be higher in 2018 than it was in prior years. Therefore, to avoid accumulation of income and later imposition of the onerous “throwback” tax rules, foreign trusts will likely have to make larger distributions (before March 6, 2019) to their U.S. beneficiaries to clear out all 2018 DNI. This will result in more taxable income and higher tax liabilities for the U.S. beneficiaries on their personal income tax returns. Finally, if a trust has insufficient cash available to pay those larger distributions (since it used the cash to pay those non-deductible investment management fees), it may have to sell assets to generate cash, which could result in an unexpected increase in DNI for 2019. This cycle could continue until 2026, when miscellaneous itemized deductions may be reinstated or indefinitely if the miscellaneous itemized deductions are not reinstated.
Let’s take a step back and review how we got here.
Every trust is presumed to be a foreign trust unless it meets both the court test and the control test. A trust meets the first test if a court within the U.S. is able to exercise primary supervision over the administration of the trust. A trust meets the control test if one or more U.S. persons have the authority to control all substantial decisions of the trust with no other person having the power to veto any of the substantial decisions. In other words, if one foreign person has authority to make one substantial decision, the control test is not met, and the trust is a foreign trust.
A foreign trust will be considered a grantor trust if either (i) the trust is revocable and, upon revocation, the assets re-vest in the settlor, or (ii) during the lifetime of the settlor and the settlor’s spouse, the only beneficiaries of the trust are the settlor and/or the settlor’s spouse.
A grantor trust is essentially disregarded for income tax purposes. The grantor or owner of the trust, usually the Settlor or other person making contributions to the trust, will be considered the owner of the trust and that person will continue to be subject to U.S. income tax on the income derived by the trust. A non-grantor trust is a separate taxpayer.
U.S. Income Taxation during a Settlor’s Life
Distributions made from a foreign grantor trust to a U.S. beneficiary during the lifetime of the settlor are typically considered gifts to the beneficiary from the settlor. The U.S. beneficiary has an obligation to file IRS Form 3520 to report receipt of any and all distributions from a foreign trust, even if the amount is just $1. Should the trust make a distribution to the settlor, who then makes a gift to a U.S. beneficiary, the beneficiary must file IRS Form 3520 only when the aggregate value of all such gifts exceeded $100,000 during the year.
While both of these circumstances subject U.S. beneficiaries to reporting obligations, they do not expose beneficiaries to U.S. income tax on the gifts/distributions they receive. On the other hand, when a corporation or partnership owned by a foreign grantor trust or its settlor makes a “gift” to U.S. beneficiaries, the IRS may recharacterize the transfer as a taxable dividend to the U.S. recipient. Furthermore, when gifts came from a foreign corporation or partnership owned by the trust or the settlor in 2018, the reporting threshold for Form 3520 is only $16,076. For this reason, direct transfers from a foreign corporation or partnership to a U.S. beneficiary should be avoided.
U.S. Income Taxation after a Settlor’s Death
A trust that was a grantor trust during the settlor’s life will be considered a foreign non-grantor trust for U.S. income tax purposes upon the settlor’s death. In additional to being reportable on Form 3520, any distributions to a U.S. beneficiary after that point are subject to U.S. income tax to the extent that the foreign non-grantor trust has current or accumulated income.
Distribution of a non-grantor trust’s current DNI to a U.S. beneficiary is taxable to the beneficiary and the character of that income generally flows through from the trust. Therefore, distributions attributable to the trust’s qualified dividend income or long-term capital gain entitles the beneficiaries to a reduced U.S. tax rate of 20 percent plus the 3.6 percent net investment income tax (NIIT). On the other hand, distributable net income that is not distributed in the same year becomes accumulated (undistributed) net income (UNI). Distributions of UNI are subject to a complicated set of “throwback tax” rules which allocate the UNI over the amount of time the trust has been in existence and imposes income tax, plus an interest charge, as if the income had been distributed pro rata over the accumulation period. The tax rate may be as high as 39.6%, plus NIIT and the interest charge may be substantial depending on the length of time that the trust has been in existence.
The trustee of the foreign trust typically provides an annual Foreign Non-Grantor Trust Beneficiary Statement to help beneficiaries understand and apply the appropriate U.S. tax treatment to the distributions they receive from foreign non-grantor trusts.
Impact of TCJA
Trusts are generally treated like individuals for tax purposes. For example, under the TCJA, a foreign trust that files a U.S. income tax return because it has income from a U.S. business, will face a top tax rate of 37 percent, reduced from 39.6 percent, on taxable income in excess of $12,500. At the same time, the TCJA reduces or eliminates many of the deductions to which trusts were previously entitled, including a new $10,000 limit on the deduction for state and local income taxes.
More importantly, the new tax law’s suspension of miscellaneous itemized deductions is likely to have a dramatic impact on the U.S. tax liability of U.S. beneficiaries of foreign trusts. These items, including tax-preparation fees, investment-management fees and unreimbursed business expenses, are no longer deductible for purposes of computing a trust’s DNI for 2018. The good news, however, is that expenses paid in the administration of an estate or a trust and that would not have been incurred if the property were not held in such estate or trust and that were not subject to the 2 percent adjusted gross income (AGI) limitation under prior law and are still fully deductible to the trust. This includes trustee fees and accounting, legal, and tax-return preparation fees to the extent such fees would not have otherwise been incurred by an individual.
In order to avoid the accumulation of income and the application of the throwback tax in future years, many foreign trusts will distribute all their DNI on an annual basis. Since it is difficult to compute a trust’s income for the year prior to the last day of the year, Section 663(b) of the tax code allows a trustee of a foreign trust to annually elect to treat a distribution in one year as though it was made on the last day of the prior year, as long as the distribution is made within the first 65 days of that next year. Thus, a calendar-year trust can make a distribution on or before March 6, 2019, to clear out all of its DNI from 2018 as long as it files its election with the IRS on or before June 15, 2019.
In order to make the 663(b) distribution on or before that 65th day, the trustee may find that they do not have sufficient cash on hand because they used the cash to pay those investment management fees. In that case, they may decide to sell assets which would potentially create additional gain that would be included in DNI for that year and the cycle starts all over again.
If you are a trustee of a foreign trust, you might consider starting the DNI computation process a little earlier this year to make sure that there is sufficient time to generate the cash needed to make the 663(b) distribution. If you are the beneficiary of a foreign trust, you might want to communicate with the trustee to make sure they are aware of these new rules.
The advisors and accountants with Berkowitz Pollack Brant work with settlors, trustees and beneficiaries of foreign trusts to help them understand and comply with U.S. tax and reporting obligations and to compute DNI and UNI.
About the Author: Arthur Dichter, JD, is a director of International Tax Services with Berkowitz Pollack Brant, where he works with multi-national businesses and high-net worth foreign individuals to structure their assets and build wealth in compliance with U.S. and foreign income, estate and gift tax laws. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
As you wind down your holiday celebrations, it’s important to remember that the federal income tax filing deadlines for 2018 are just around the corner. To avoid the burden and stress of last-minute preparations, consider taking the time now to do some advance planning and get your tax house in order.
Gather Relevant Records
Whether you forgot to save your 2018 tax records or you stuffed them into shoe boxes or file folders throughout the year, now is the time to get all of your documents organized for the April tax-filing deadline. For example, if you contributed cash or other assets to a charitable organization in 2018 and you plan to itemize your deductions for the year, you will need to substantiate those contributions with either a bank record of the canceled check or a written communication from the charity that received your gift.
After the first of the New Year, you will start to receive W-2 wage statements from your employer(s) and/or 1099 statements of nonemployee compensation, royalties and rental income paid to you in 2018. You should also keep an eye out for other tax forms that specify additional income you received during the year in the form of Social Security benefits, interest income, dividends and/or capital gains. Similarly, make it a point to hold on to statements that detail the expenses you paid, including student and mortgage loan interest, state and local sales tax and contributions to retirement accounts, which you may be able to deduct from your taxable income. Because you will need these documents to file your federal and state income tax returns, consider organizing them in a folder and scanning them to save electronically on computers, back-up hard drives and/or flash drives. If you work with an accounting firm that prepares your annual tax returns, ask if it has a secure portal through which you may upload and store those documents temporarily.
The IRS’s online tool that helps taxpayers retrieve transcripts of their previously filed tax returns should be used only as a last resort, since it has been the target of data breaches and email phishing scams.
Know How Long to Hold Records
As a general rule, the IRS recommends taxpayers hold onto their tax returns and supporting documentation for a minimum of three years. However, you should consider keeping those documents for at least seven years, which is the length of time the IRS has to audit a previously filed return that understates income by more than 25 percent. If you failed to file a tax return for any year or if you filed a fraudulent return, there is no statute of limitations, and the IRS can audit you at any time in the future. Therefore, you may consider keeping certain documents, such as those relating to the purchase and sales of real estate and securities, for an even longer period of time.
Know How to Dispose of Documents
Tax records contain your personal information, including your social security number and bank and financial account details, which can get into the wrong hands and result in fraud and/or identify theft. Therefore, it is critical that you shred documents you are disposing of and wipe computer hard drives and any mobile devices on which you store sensitive data.
If you are unsure of what documents you need to meet your tax-filing obligations, how best to retain those documents and for how long, please contact your tax advisors.
About the Author: Adam Slavin, CPA, is a senior manager with Berkowitz Pollack Brant’s Tax Services practices, where he provides tax planning and consulting services to high-net-worth individuals and closely held business. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
The IRS is providing penalty relief to the millions of taxpayers it says may have fallen short of their total tax liabilities for 2018 due to the revamp of the U.S. tax code under the Tax Cuts and Jobs Act (TCJA).
Thanks, in part, to the efforts of the accounting profession, including of the American Institute of CPAs (AICPA), the IRS recognizes that many individual taxpayers may not have properly adjusted their withholding and estimated tax payments to reflect the provisions of the new law. As a result, taxpayers who paid at least 85 percent of their total tax liabilities for last year through withholding and/or estimated tax payments can avoid underpayment penalties. Typically, a penalty waiver requires taxpayers to have paid 90 percent of their tax liabilities during the tax year.
U.S. taxes are based on a pay-as-you-go system for which individual taxpayers are required by law to pay most of their tax obligations during the year, either by having federal taxes withheld from their paychecks or by making quarterly estimated tax payments directly to the IRS. While the federal tax withholding tables released by the IRS in early 2018 reflected the lower tax rates and higher standard deductions under the TCJA law, they did not consider all of the changes brought about the new law. Despite efforts by the IRS and CPAs to encourage taxpayers to get a paycheck checkup and confirm that they had enough taxes withheld from their paychecks, many taxpayers did not submit revised W-4 withholding forms to their employers or increase their estimated tax payments.
According to the IRS, many taxpayers filing their 2018 will be surprised to learn they owe additional taxes to the federal government. To avoid an unexpected tax bill in future years, taxpayers should meet with their advisors and accountants during the first half of 2019 to confirm the accuracy of their estimated tax payments and to check the withholding on their most recent paychecks to ensure they are having enough tax withheld from their wages based on their filing status, number of dependents and other factors.
About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director with the Taxation and Financial Services practice of Berkowitz Pollack Brant Advisors and Accountants, where he provides tax and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached in the CPA firm’s Ft. Lauderdale office at (954) 712-7000 or via email at info@bpbcpa.com.
On Jan. 15, 2019, the New York Department of Taxation and Finance finally issued its response to the Supreme Court’s June 2018 decision in South Dakota v. Wayfair, which expands states’ abilities to impose sale tax reporting and collection responsibilities on out-of-state vendors regardless of whether or not the sellers have a substantial physical presence in their jurisdiction.
The court’s decision in Wayfair represents a significant shift in state sales tax administration, moving from a purely physical presence test to one that considers the number of transactions and sales volume that a vendor makes in a particular state. While most states were quick to enact economic nexus legislation based on South Dakota’s 200 transactions or $100,000 in sales threshold as established in Wayfair, a handful, including New York, took their time.
According to New York’s recent guidance, businesses without a physical presence in the state are required to register as New York sales tax vendors and collect and remit sales tax when they met the following criteria during the immediately preceding four sale quarters:
- the vendor conducted more than 100 sales of tangible personal property for delivery, and
- the vendor made more than $300,000 of tangible personal property sales into the state.
New York’s imposition of economic nexus is effective immediately. Businesses that meet the law’s sales threshold tests should register with the state if they have not done so already.
It is important for businesses to recognize that New York’s sales tax economic nexus law differs in many ways from the standard established by Wayfair. For example, New York’s test considers both the number of sales into the state and the dollar value of those transactions. Therefore, an out-of-state vendor that makes a mere 15 sales totaling more than $1 million during the year to customers in the state may not be required to collect and remit state sales tax. Even though sales volume exceeds the $300,000 threshold, the vendor does not meet the number of transactions test.
In addition, although the language of New York’s tax law refers specifically to sales of tangible personal property, businesses that sell services to customers in the state may not be entirely free from state sales tax administration responsibilities. For example, because New York considers software to be taxable tangible property, sales of services that are tied to the use of that software may also be subject to sales tax but the vendor may not be required to register with the states.
Finally, sellers should recognize that New York’s economic nexus test is not based on a calendar year. Rather, sellers must measure their sales during the state’s sales specific tax quarters, which are March 1 through May 31, June 1 through August 31, September 1 through November 30, and December 1 through February 29.
The advisors and accountants with Berkowitz Pollack Brant’s State and Local Tax (SALT) practice help with individuals and businesses across the globe maintain tax efficiency while complying with often conflicting federal, state and local tax laws.
About the Author: Michael Hirsch, JD, LLM, is a senior manager of Tax Services with Berkowitz Pollack Brant’s state and local tax (SALT) practice, where he helps individual and business to meet their corporate, state and local tax reporting requirements. He can be reached at the CPA firm’s Fort Lauderdale, Fla., office at (954) 712-7000, or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
The prospect of having a vacation property that you can use as your own personal retreat for part of the year and lease to others in return for rental income during other times is appealing to many individuals. However, it is important to understand the tax implications of renting your residential property, whether it be a house, an apartment, a room or a boat, to ensure that you maximize the potential benefits without incurring unexpected tax liabilities.
In general, rental income is taxable unless you rent out a residential property 14 days or less during a calendar year. Once you hit the 15-day mark, you must report and pay taxes on any and all payments you receive for renting out the property during the year. However, under U.S. tax laws, you may be able to offset the rental income and reduce your tax liabilities if you qualify to deduct the expenses incurred for renting the property, including advertising, cleaning and maintenance, mortgage interest, property insurance and taxes. Your eligibility to take those deductions depends on the amount of time you spend renting the property as a business as compared to the amount of time you spend enjoying the property for personal use.
Personal-Use Residence vs. Rental-Use Business Property
The IRS classifies vacation homes as either personal residences used by you or your family members or rental business property.
A property is considered a personal residence when:
- You rent out the property to others for more than 14 days during the year; and
- You enjoy the property for personal use during a period of time that exceeds 14 days or 10 percent of the days you rent out the home at fair market price.
Conversely, the IRS will consider a vacation home to be rental income property for which you may be able to claim tax deductions for eligible business expenses when:
- You rent out the property to others for more than 14 days during the year; and
- You enjoy the property for personal use during a period of time that does NOT exceed the greater of 14 days of the year, or 10 percent of the days you rent out the home at fair market process.
When calculating the number of days your home is used for personal vs. rental use, you must disregard any days in which the property was vacant or was undergoing maintenance and repairs. In addition, careful attention should be paid to the days in which you rent the property for less than the fair market rate, perhaps to a family owner or friend, which the IRS considers to be personal use.
Tax Treatment of Multi-Use Vacation Property
When a vacation home qualifies as rental property, you must allocate property taxes, costs for repairs and improvements and other potentially deductible business expenses between the actual days you rent out the property and the days you use it for personal enjoyment. As a rule, you may only deduct amounts that are proportional to the actual number of days you rent the property to non-family members. In addition, when you operate a property as a rental business, you may qualify to deduct up to $25,000 in losses per year from the rental income you earn. While you may not deduct rental expense in excess of the gross rental income limitation ( less the rental portion of mortgage interest, real estate taxes, and casualty losses, and rental expenses like realtors’ fees and advertising costs), you may be able to carry forward some of these rental expenses to the next year.
Due to the new tax law’s significant increase in the standard deduction, fewer taxpayers will take the time and effort to itemize many of the deductions they previously relied on to reduce their taxable income in prior years. Moreover, the tax law places significant restrictions on deductions for mortgage interest and property taxes, thereby limiting the potential tax savings that rental property owners can yield. For example, the mortgage interest apportioned to the personal use of a rental property may not be considered as an itemized deduction if the taxpayers did not use the property for more than 14 days.
Other Rules, Limitations and Exceptions to the Rules
Vacation homes classified as rental property may generate deductible losses for taxpayers whose rental expenses exceed their rental income. However, under the passive activity loss (PAL) rules, taxpayers may deduct losses from passive activities, including renting real estate, only from income that they generate from similarly passive activities. You may not, for example, deduct the losses from passive rental activities from the income you earn as wages from your full-time job. Any losses that do not qualify for a deduction under the PAL rules in the current year may be carried over into future years to be deducted when you have additional passive income or when you sell the rental property that created the passive losses.
There is an exception to the PAL rules that allows “certain” taxpayers who actively participate in rental activities and have adjusted gross income (AGI) of less than $100,000 to potentially deduct up to $25,000 of annual passive rental real estate losses from current year income. In addition, depending on the number of hours you spend materially participating in the delivery of real estate services, you may qualify as a real estate professional which means, the rule treating rental activities as automatically passive would no longer apply.
On a final note, if your property is located near the site of a major, multi-day event that attracts out-of-state visitors, such as the Miami International Boat Show, Art Basel or the South Beach Food and Wine Festival, you may be able to generate tax-free rental income as long as you do not rent out your property for 15 days or more during the year. This is especially beneficial in today’s economy, for which homeowners can quickly and easily market their properties, often, at unusually high short-term rates via services such as Airbnb and VRBO. In these circumstances, however, the property owner will not qualify as a business operator and will not be able to deduct any portion of expenses for repairs, maintenance, cleaning or rental agency fees.
Before handing over the keys to your vacation home, seek the guidance of professional accountants and advisors to help you navigate the complexity of the tax laws and maximize your earnings without increasing your tax liabilities.
About the Author: Angie Adames, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where she provides tax and consulting services to real estate companies, manufacturers and closely held business. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.
