On May 7, 2020, the Treasury released proposed regulations regarding the deductibility of certain excess deductions reported to beneficiaries on Schedule K-1 as well as formalized the guidance regarding the definition of miscellaneous itemized deductions for trusts and estates. These proposed regulations are retroactive to taxable years beginning after Dec. 31, 2017 and affect estates, non-grantor trusts and their beneficiaries.
Miscellaneous deductions for trusts and estates
The Tax Cuts and Jobs Act (TCJA) introduced section 67(g) to the tax code which prevented the deduction of miscellaneous itemized deductions for individual taxpayers as well as trusts and estates for taxable years beginning after Dec. 31, 2017. Section 67(e) provides that certain expenses which are paid or incurred in connection with the administration of the estate or trust, and which would not have been incurred if the property were not held in an estate or trust, are allowable in arriving at adjusted gross income (AGI). Questions arose regarding the deductibility of these expenses given the new TCJA suspension of miscellaneous itemized deductions defined in that same section.
On July 13, 2018, the IRS issued Notice 2018-61 announcing proposed regulations would be coming and would clarify that expenses under section 67(e) remain deductible in determining AGI. Additionally, the deduction for the personal exemption, the deduction for distributions made by trusts currently distributing income and the deduction for distributions made by trusts accumulating income continue to be allowed in determining AGI.
The proposed regulations modify existing regulations to clarify that expenses under section 67(e) remain deductible in determining AGI and are not subject to disallowance under section 67(g).
Excess deductions on termination of trusts and estates
Of more interest is the treatment of deductions in excess of income in the final year of a trust or estate. Often assets have been distributed across many years, so once a trust or estate arrives at its final reporting year, the income is less than the expenses incurred in the final year. This excess is typically referred to as “excess deductions on termination” under section 642(h)(2).
The TCJA enactment of section 67(g) resulted in confusion as to the tax treatment of excess deductions reported by trusts and estates to its beneficiaries in their final filing year. Prior to TCJA deductions in excess of the gross income (other than a net operating loss or a capital loss) were distributed to beneficiaries and deductible as miscellaneous itemized deductions. While TCJA did not affect the deductibility of the net operating loss and capital loss carryovers under 642(h)(1), the treatment of the excess deductions was unclear. Notice 2018-61 explained that the Treasury and IRS were studying whether some or all of these deductions should be deductible in the hands of the beneficiary, but provided no guidance.
Under the new proposed regulations, excess deductions under section 642(h) in the final year will be divided into three buckets:
- Amounts allowed in arriving at AGI
- Ex. Net operating loss carryovers, capital loss carryovers, section 67(e) deductions
- Non-miscellaneous itemized deductions
- Ex. Non-business state income tax and real estate tax
- Miscellaneous itemized deductions
- Ex. Investment management fees
The deductions will retain their character in the hands of the beneficiary and the fiduciary must separately state the three classes of deductions which may be limited when claimed by the beneficiary. The proposed regulations follow the allocation rules under the section 652 regulations. Expenses directly attributable to one class of income must be allocated to that class of income. Expenses in excess of their specific class of income and expenses not directly attributable to one class of income will be allocable to any item of income, but a portion must be allocated to tax exempt income
.The proposed regulations also include new examples to illustrate the application of these new rules.
Fiduciaries and beneficiaries have the opportunity to amend 2018 and 2019 fiduciary and individual tax returns so that beneficiaries can claim the excess deductions on previously filed tax returns. The proposed regulations do not address the treatment of the investment interest expense carryover. The proposed regulations provide that an item of deduction succeeded to by a beneficiary remains subject to any additional applicable limitation.