IRS clarifies that trusts and estates are permitted certain deductions that are not miscellaneous itemized deductions

The IRS on May 7 issued proposed regulations (REG-113295-18) to clarify that certain deductions are allowed to an estate or nongrantor trust because they are not miscellaneous itemized deductions. According to the proposed rules, which formally adopt guidance first issued in Notice 2018-61, these deductions are not affected by the suspension of the deductibility of miscellaneous itemized deductions for individual taxpayers for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, enacted by the law known as the Tax Cuts and Jobs Act, P.L. 115-97. The proposed regulations also explain how to determine the character, amount, and allocation of deductions in excess of gross income that a beneficiary succeeds to on the termination of an estate or nongrantor trust.

The proposed regulations would allow estates and trusts the following deductions under Sec. 67(e):

• Costs paid or incurred in connection with the administration of an estate or nongrantor trust that would not have been incurred if the property were not held in the estate or trust;
• The personal exemption of an estate or nongrantor trust;
• The distribution deduction for trusts distributing current income to beneficiaries; and
• The distribution deduction for estates and trusts accumulating income.

These rules apply to estates and nongrantor trusts (including the S portion of an electing small business trust) and their beneficiaries.

Notice 2018-61 had left unanswered the question of how to treat Sec. 642(h) excess deductions, which are passed on to beneficiaries when a trust terminates. Under the proposed regulations, each deduction comprising the Sec. 642(h) excess deduction retains its separate character as an amount allowed in arriving at adjusted gross income, as a non-miscellaneous itemized deduction, or as a miscellaneous itemized deduction. The principles under Regs. Sec. 1.652(b)-3 are used to allocate each item of deduction among the classes of income in the year of termination for purposes of determining the character and amount of the excess deductions under Sec. 642(h)(2). The preamble to the proposed regulations confirms that they do not change the allocation method among beneficiaries set forth in Regs. Sec. 1.642(h)-4.

The regulations are proposed to apply to tax years beginning after they are published as final in the Federal Register. In addition, the IRS is permitting estates and nongrantor trusts and their beneficiaries to rely on the Sec. 67 proposed regulations for tax years beginning after Dec. 31, 2017, and on or before the date the regulations are published as final regulations. Taxpayers may also rely on the Sec. 642(h) proposed regulations for beneficiaries’ tax years beginning after Dec. 31, 2017, and on or before the date these regulations are published as final regulations in the Federal Register in which an estate or trust terminates.

On Oct. 31, 2018, the AICPA submitted comments to Treasury and the IRS in response to Notice 2018-61 concerning a beneficiary’s ability to claim excess deductions allowed to the beneficiary upon the termination of a trust or estate under Sec. 642(h)(2).