Clarification of itemized deductions for trusts and estates

Editor: Michael D. Koppel, CPA (Retired)/PFS/CITP

According to IRS Notice 2018-61, Treasury and the IRS intend to issue regulations providing clarification of the effect of newly enacted Sec. 67(g) on the ability of trusts and estates to deduct certain expenses. Sec. 67(g), which was enacted by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, suspends miscellaneous itemized deductions for tax years 2018-2025.

The pending regulations are anticipated to clarify that the costs of trust or estate administration that are deductible under Sec. 67(e)(1) are not miscellaneous itemized deductions and, therefore, their deductibility has not been suspended by Sec. 67(g). Treasury and the IRS have also stated that the new regulations will address the impact of Sec. 67(g) on the ability of beneficiaries to deduct an estate’s or a trust’s excess deductions upon termination of the estate or trust.

The language of Sec. 67(g) created confusion as to whether expenses deductible under Sec. 67 were eliminated under this provision as well, or if it applied only to miscellaneous itemized deductions subject to the 2% threshold. Expenses that are paid or incurred in the administration of an estate or trust and that would not have been incurred if the property were not held in such an estate or trust are deductible under Sec. 67(e)(1). Expenses deductible under Sec. 67(e) include costs paid for tax preparation fees for most returns, appraisal fees, and certain fiduciary expenses, as outlined in Regs. Sec. 1.67-4. Costs that are not deductible under this section are those that customarily would be incurred by a hypothetical individual holding the same property, such as ownership costs (e.g., homeowners association fees, insurance, and maintenance). Because Sec. 67(e) explicitly states that deductions for administration costs are an adjustment against adjusted gross income, not an itemized deduction, many practitioners argued that Sec. 67(g) did not apply to these deductions.

Fortunately, Treasury and the IRS agreed with that reading of the Code, and the notice indicates that the future regulations will clarify that trusts and estates will continue to be able to deduct expenses described in Sec. 67(e)(1) as well as amounts allowable as deductions under Secs. 642(b) (personal exemption), 651, and 661 (income distribution deductions). In addition, the notice states that the regulations will make clear that deductions detailed in Secs. 67(b) and (e) continue to remain outside the definition of “miscellaneous itemized deductions” and thus are unaffected by Sec. 67(g).

One area not clarified under the notice is the treatment of excess deductions on termination and whether they may be carried over to beneficiaries succeeding to the property of the estate or trust. Notice 2018-61 indicates that Treasury and the IRS are studying whether Sec. 67(e) deductions that are not considered miscellaneous itemized deductions to a trust or estate should continue to be considered as miscellaneous itemized deductions when included by a beneficiary as an excess deduction in the year of termination under Sec. 642(h)(2). Notice 2018-61 says that “[f]or the years in which section 67(g) is effective, miscellaneous itemized deductions are not permitted, and that appears to include the section 642(h)(2) excess deduction.” Treasury and the IRS intend to issue regulations addressing this issue.

As part of the process of studying the matter, Treasury and the IRS are seeking public comments on whether amounts deductible under Sec. 642(h)(2) should be analyzed separately from other miscellaneous itemized deductions when applying Sec. 67. The notice does not contain a time frame for the comment period, nor has an estimated issuance date been provided for the regulations. Until further guidance is issued, it appears the IRS will be taking the position that excess deductions on termination are not currently deductible by beneficiaries.

Planning

Bundled fees continue to be a planning area as they have been since the issuance of the Sec. 67 regulations in 2014. Investment management and advisory fees charged under the normal course of asset management continue to be an itemized deduction and therefore will be disallowed as a deduction under Sec. 67(g). Unbundling fees has become more important than ever in arriving at deductible amounts.

The Sec. 67(g) guidance does not, unfortunately, apply to the limitation on the deduction for state and local taxes (SALT) under new Sec. 164(b)(6) created by the TCJA. For trusts that will be subject to the $10,000 SALT limitation, it is worth considering some planning opportunities. While changing trust situs is one option to avoid state and local taxes altogether, it often is not practical with family member trustees.

A simpler option might be available for trustees filing one tax return for separate share trusts: consider bifurcating the trust into separately filing trusts. Care will need to be taken to avoid running afoul of the multiple-trust rules under Sec. 643(f). However, most separate share trusts do not meet the “substantially the same primary beneficiary or beneficiaries” rule of Sec. 643(f)(1), and so they should be able to be separated. Creating separately filing trusts for the separate shares might be worthwhile in the case of multiple separate shares and when the trusts will experience a significant loss in SALT deductions.

Finally, planning for new trusts should include considering the allowance of charitable deductions written into the trust document at the discretion of the trustee. Trusts and estates are allowed to make tax-deductible charitable contributions only if the trust document explicitly allows for it. Many trust documents do not have this provision. While the IRS is attempting to close the loophole allowing for a state tax credit combined with a federal charitable deduction (see proposed regulations in REG-112176-18), it might be helpful in the long run for the trust to be able to consider this option. Even with the proposed regulations that would limit the federal charitable deduction to the excess paid over the credit benefit, there may be cases where this could be beneficial for a trust. Therefore, it may be worth adding this flexibility into the trust document.

EditorNotes

Michael D. Koppel, CPA (Retired)/PFS/CITP, is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.