Expense Method Depreciation and Trusts

Overview

The Tax Cuts and Jobs Act (TCJA) increased the maximum amount a taxpayer may expense under IRC §179 to $1 million.  The TCJA also increased the phase-out threshold amount to $2.5 million for tax years beginning after 2017.  The $1 million and $2.5 million amounts are indexed for inflation for tax years beginning after 2018.  

Is property held in trust eligible to be expensed under I.R.C. §179?  That’s a big issue for farm and ranch families (and others).  Trusts are a popular part of many estate and business plans, and if property contained in them is not eligible for I.R.C. §179 their use could be costly from an income tax standpoint. 

Trusts and eligibility for I.R.C. §179 - that’s the topic of today’s post.   

Does the Type of Trust Matter?

I.R.C. §179(d)(4) states that an estate or trust is not eligible for I.R.C. §179.  That broad language seems to be all inclusive – all types of trusts and in addition to estates are included.  If that is true, that has serious implications for estate planning for farmers and ranchers (and others).  Revocable living trusts are a popular estate planning tool in many estate planning situations, regardless of whether there is potential for federal estate tax.  If property contained in a revocable trust (e.g., a “grantor” trust) is not eligible for I.R.C. §179, that can be a significant enough income tax difference that would mean that the estate plan should be changed to not utilize a revocable trust. 

Grantor trusts.  A grantor trust is a trust in which the grantor, the creator of the trust, retains one or more powers over the trust.  Because of this retained power, the trust's income is taxable to the grantor.  From a tax standpoint, the grantor is treated as the owner of the trust with the result that all items of income, loss, deduction and credit flowing through to the grantor during the period for which the grantor is treated as the owner of the trust.  I.R.C. §671; Treas. Reg. § 1.671-3(a)(1); Rev. Rul. 57-390, 1957-2 C.B. 326.   Another way of stating the matter is that a grantor trust is a disregarded entity for federal income tax purposes.  C.C.A. 201343021 (Jun. 17, 2013).  Effectively, the grantor simply treats the trust property as their own. 

This is the longstanding position of the IRS.  In Rev. Rul 85-13, 1985-1 C.B. 184, the IRS ruled that a grantor of a trust where the grantor retains dominion and control resulted in the grantor being treated as the trust owner.  In other words, a grantor is treated as the owner of trust assets for federal income tax purposes to the extent the grantor is treated as the owner of any portion of the trust under I.R.C. §§671-677.  In the ruling, the IRS determined that a transfer of trust assets to the grantor in exchange for the grantor's unsecured promissory note did not constitute a sale for federal income tax purposes. The facts of the ruling are essentially the same as those at issue in Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984).  In Rothstein, while the court found the trust at issue to be a grantor trust, the court concluded that the trust was separate from the taxpayer.  But, in the 1985 ruling based on the same facts, the IRS stated that it would not follow Rothstein and reasserted its position that a taxpayer is deemed to own the assets contained in a grantor trust for federal tax purposes. 

Thus, there is substantial authority for the position that property contained in a grantor trust, such as a revocable living trust, is eligible for expense method depreciation under I.R.C. §179.  The grantor is the same thing for tax purposes as the grantor trust.

Irrevocable trusts.  An irrevocable trust can't be modified or terminated without the beneficiary's permission. The grantor, having transferred assets into the trust, effectively removes all rights of ownership to the assets and control over the trust assets. This is the opposite of a revocable trust, which allows the grantor to modify the trust.  That means that an irrevocable trust is a different entity from the taxpayer and the property contained in the trust is not eligible for expense method depreciation under I.R.C. §179 pursuant to I.R.C. §179(d)(4), unless the grantor retains some degree of power over trust income or assets.  For instance, a common situation when an irrevocable trust will be treated by the IRS as a grantor trust is when the grantor retains a five percent or larger reversionary interest in the trust property.  The same result occurs when the grantor retains any significant level of administrative control over the trust such as discretionary authority to distribute trust property to the grantor or the power to borrow money from the trust without paying a market rate of interest.    

Pass-Through Entities and Irrevocable Trusts

The 20 percent deduction for qualified business income under I.R.C. §199A in effect for tax years beginning after 2017 and before 2026 for taxpayers with business income that are not C corporations, may spark increased interest in pass-through entities.  With respect to a pass-through entity, though, questions concerning the use of I.R.C. §179 arise when an irrevocable trust has an ownership interest in the entity.  Under Treas. Reg. § 1.179-1(f)(3), a trust that is a partner or S corporation shareholder is barred from deducting its allocable share of the I.R.C. §179 depreciation that is elected at the entity level.  The pass-through entity’s basis in the I.R.C. §179 property is not reduced to reflect any portion of the I.R.C. §179 expense that is allocable to the trust or estate.  Consequently, the entity claims a regular depreciation deduction under I.R.C. §168 with respect to any depreciable basis that results from the inability of a non-grantor irrevocable trust or the estate to claim its allocable portion of the I.R.C. §179 depreciation.  Id.  The irrevocable trust or estate does not benefit from the entity’s I.R.C. §179 election. 

Conclusion

A revocable living trust, as a grantor trust, can claim I.R.C. §179 depreciation.  Thus, that common estate planning vehicle won’t present an income tax planning disadvantage by taking I.R.C. §179 depreciation off of the table.  However, when an irrevocable trust is involved, the result is different, unless the trust contains language that gives the grantor sufficient control over trust income or assets.  Business property that is contained in an irrevocable trust is generally not eligible for I.R.C. §179 depreciation.  But, trust language may change that general result.  In addition, if a pass-through entity claims I.R.C. §179 depreciation, none of that depreciation flows to the irrevocable trust (or estate).  That means that the entity will need to make special basis adjustments so that the deduction (or a portion thereof) is not wasted.  Likewise, the depreciation should be “separately stated items” on the K-1 whenever an irrevocable trust or an estate owns an interest in the entity.  Likewise, existing partnership agreements may need to be modified so that I.R.C. §179 deductions are allocated to non-trust partners and other expenses to owners of interests that are irrevocable trusts and estates.  

This potential difference in tax treatment between revocable grantor trusts and irrevocable trusts should be considered as part of the overall tax planning and estate/business planning process.