Editor: Howard Wagner, CPA
The IRS published proposed regulations (REG-113295-18) on May 11, 2020, to clarify that certain deductions allowed to an estate or nongrantor trust are not miscellaneous itemized deductions and, thus, are unaffected by the suspension of miscellaneous itemized deductions for tax years beginning after 2017 and before 2026. The proposed regulations also explain how, on the termination of an estate or nongrantor trust, to determine the deductions in excess of gross income to which beneficiaries succeed. The proposed rules affect estates, nongrantor trusts (including the S portion of an electing small business trust (ESBT)), and their beneficiaries.
Some portions of the proposed regulations are new, but others simply follow the language in Notice 2018-61, which basically said that the IRS intended to maintain the deductibility of certain administrative costs incurred by estates and trusts. The proposed regulations make clear that some deductions, including deductions for administrative expenses, are still available despite the suspension of miscellaneous itemized deductions by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Because of the consistency between Notice 2018-61 and this portion of the proposed regulations, many commentators believe it is unlikely there will be changes to it in the final regulations.
Another portion of the proposed regulations explains how the TCJA's changes affect "excess deductions" — deductions exceeding an estate's or trust's income in its last tax year that typically pass to beneficiaries when the trust or estate terminates. This topic is the focus of the present discussion.
Prior to the proposed regulations, the excess deductions were combined into a single amount that the beneficiary would treat entirely as miscellaneous itemized deductions, which are not deductible through 2025. Now, however, these excess deductions are to be divided among three categories of expenses. This taxpayer-favorable change allows the expenses that are still allowable as deductions to be identified separately from expenses that are not deductible.
Despite this stated goal, the proposed regulations do not provide clarity on exactly how to compute the allocation among the three types of deductions that make up the excess deductions. Practitioners need to know the choices available when making these allocations, in order to advise trustees and personal representatives about how to achieve the best tax outcome for the beneficiaries who ultimately claim the excess deductions.
Under the general rule of Sec. 67, miscellaneous itemized deductions are deductible by individuals only to the extent they exceed 2% of the individual's adjusted gross income (AGI). Sec. 67(b) provides that all itemized deductions are subject to the 2% floor except for a specified list, which includes, among others, deductions for certain types of interest, state and local taxes, casualty losses, medical expenses, and charitable contributions.
Sec. 67(e) generally states that an estate's or nongrantor trust's AGI is computed in the same manner as for an individual. However, certain additional expenses are deductible in computing AGI, such as costs incurred for the administration of the estate or trust that would not have been incurred if the property were not held in the trust or estate. Not only are these costs not treated as miscellaneous itemized deductions, they are not considered to be itemized deductions at all.
The TCJA added Sec. 67(g), which disallows all miscellaneous itemized deductions for tax years beginning after 2017 and before 2026.
Notice 2018-61 addressed the interplay of Sec. 67(e) and new Sec. 67(g). It announced that future regulations will provide that costs described in Sec. 67(e) for an estate or trust will continue to be deductible in computing AGI.
Notice 2018-61 also requested comments regarding the interplay of Sec. 67(g) with the previously mentioned rules for excess deductions on termination of a trust or estate, found in Sec. 642(h)(2). Notice 2018-61 basically left unanswered how to treat these excess deductions after the TCJA. The proposed regulations treat the topic, however.
The proposed regulations adopt some of the comments the IRS received in response to Notice 2018-61. For instance, the proposed regulations provide that instead of the beneficiary reporting a single, aggregate miscellaneous itemized deduction for the final year of the estate or trust, the various costs comprising the Sec. 642(h)(2) excess deduction on termination retain their character for the beneficiary as one of the following:
- An amount allowed in arriving at AGI, such as a net operating loss, a capital loss, or the costs of administration of the estate or trust (see Secs. 62 and 67(e));
- A non-miscellaneous itemized deduction that is allowed in computing taxable income, such as a deductible state or local tax expense (see Sec. 63(d)); or
- A miscellaneous itemized deduction that is currently disallowed (see Sec. 67(g)).
The proposed regulations require the fiduciary to separately identify on the Schedule K-1, Beneficiary's Share of Income, Deductions, Credits, etc., these three components of the excess deductions that may be limited when claimed by the beneficiary, as specified in the instructions to Form 1041, U.S. Income Tax Return for Estates and Trusts, and the beneficiary's Schedule K-1 (Prop. Regs. Sec. 1.642(h)-2(b)). This requirement will result in more complexities for preparers of fiduciary income tax returns.
Under the proposed regulations, the practical problem for taxpayers lies in determining how to allocate the various costs incurred by the estate or trust among (or against) the various types of income, in order to establish the character of the remaining "excess deductions." The proposed regulations simply state that deductions that are "directly attributable to a class of income" are allocated to that income, and any remaining expenses are "allocated in accordance with . . . §1.652(b)-3(b)." The cited regulation (written in 1956) describes the method of allocating expenses against or among classes of income for the purpose of determining what classes of income comprise "distributable net income," in connection with determining the character of the net income distributed to (and thus taxable to) a beneficiary on Schedule K-1. This regulation gives the trustee broad discretion to allocate expenses against any type of income, which (if done properly) can result in the Schedule K-1 to the beneficiary reporting to him or her the most preferable type(s) of income (e.g., qualified dividends rather than ordinary interest).
Under the proposed regulation on excess deductions, then, the same concept appears to be applicable but in the exact opposite manner. In applying this regulation to situations where expenses exceed the income in the final year of an estate or nongrantor trust, the trustee is (in essence) given discretion to apply the taxable income against any class of expenses. If the trustee allocates income against miscellaneous itemized deductions first, then there will be more fully deductible "administration expenses" left behind as part of the excess deductions on termination.
Example 1: In a year when income exceeds expenses, the trustee goes through "three steps" in allocating the expenses among the various classes of income. First, the expenses that can be directly identified as relating to specific income are offset against that class of income. For example, if the estate or trust has rental income, the expenses directly related to the rental activity are deducted against the rental income. Next, the indirect expenses are allocated between taxable and tax-exempt income. Any remaining deductions after allocation to tax-exempt income can be offset against the remaining types of income in any way the personal representative or trustee may select. If the estate or trust has only interest and qualified dividend income remaining, the personal representative or trustee will likely decide to offset expenses first against the interest income, and any remaining expenses will then be used to offset qualified dividend income. The Schedule K-1 will therefore only report "net" qualified dividend income to the beneficiary on Schedule K-1, which will be taxed at the preferential income tax rates available for qualified dividend income.
Example 2: If the same concepts are applied in a final year of an estate or trust where expenses exceed the income, a similar allocation process will be followed. The first two steps are the same as in Example 1, with "direct expenses" as well as "indirect expenses" allocable to tax-exempt income being addressed first. However, to the extent that the remaining expenses exceed the remaining income, the personal representative or trustee can choose which items of income to allocate to the expenses. Assume a trust has $850 of interest income, $500 of legal fees that are administrative expenses, $400 of state income tax, and $600 of investment advisory fees. Before these proposed regulations, since the expenses ($1,500) exceed the income ($850), the beneficiary would have reported a $650 miscellaneous itemized deduction. Now, however, in order to achieve the best income tax result for the beneficiary, the $850 of income should be allocated first to the $600 of investment advisory fees, since they are a disallowed miscellaneous itemized deduction. The remaining $250 of interest income could be offset against $250 of the $400 of income taxes, leaving $150 of taxes. Thus, the $650 reported to the beneficiary on his or her Schedule K-1 as an "excess deduction on termination" will include $150 of income taxes, which would be an itemized deduction, subject to the $10,000 limitation, plus the entire $500 of administration fees, which can reduce his or her AGI. Thus, the methodology is to allocate income first to miscellaneous itemized deductions, followed by itemized deductions, and then to administration expenses.
The proposed regulations apply to tax years beginning after the date they are published as final regulations. However, estates, nongrantor trusts, and their beneficiaries may rely on the rules in the proposed regulations for tax years beginning after Dec. 31, 2017. This provides practitioners an opportunity to advise clients of potential tax refunds that may be available to an individual beneficiary who originally filed Form 1040, U.S. Individual Income Tax Return, reflecting the entire excess deduction as a disallowed miscellaneous itemized deduction.
Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Contributors are members of or associated with Crowe LLP.