Pass-Through Tax Break Can Benefit Boxed-Out Service Businesses After All

Non-Grantor Trust Strategy

In past years, clients have typically favored grantor trusts because they offer a greater degree of flexibility should circumstances change in the future.  However, the tax reform legislation has added new tax appeal to the non-grantor trust.  Using a non-grantor trust can now allow a small business owner to separate ownership of the business among the trust entities, allowing each trust/owner to receive up to $157,500 in income annually in order to qualify for the full QBI deduction.

In order to qualify as a non-grantor trust that can benefit from its own tax treatment, the trust must be structured so that distributions from the trust require the consent of an "adverse party," which is a person with a substantial interest in the trust.  This adverse party could be an adult child or other relative (using a spouse would cause the trust to be categorized as a grantor trust, although the spouse could be the trust beneficiary).

Currently existing grantor trusts can typically be converted into non-grantor trusts (even if the original grantor trust is irrevocable).

While this strategy could potentially prove valuable to small business clients in service industries, it is important to note that the IRS has not approved it, so a degree of risk does exist.  Further, IRC Section 643(f) provides that multiple trusts created by the same client could be treated as a single trust (but no regulations to this effect have been issued, so until such regulations are released, the trusts should be treated as separate entities).

The client still must be aware that a non-grantor trust can be significantly less flexible than a grantor trust (making it more difficult to transfer or substitute assets), and that the new QBI deduction will technically expire after 2025 absent Congressional action to renew it for future years.

Conclusion

The 20% QBI deduction can generate substantial tax savings for pass-through business entities in 2018-2025—but small service business owners will often need to take fairly involved planning steps in order to fully take advantage of the new tax break.

• See previous coverage of small business planning in Advisor's Journal.
• Read in-depth analysis of trust planning, at Advisor's Main Library.
• Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.