United States

Regulations on excess deductions on termination of an estate or trust

TAX ALERT  | 

On May 7, 2020, the Treasury issued proposed Regulations regarding the deductibility of certain non-grantor trust and estate administration expenses; as well as excess deductions on the termination of an estate or non-grantor trust reported to beneficiaries on Schedule K-1. See our May 8, 2020 alert here. On Sept. 21, 2020, the Treasury issued the final Regulations related thereto. These regulations affect estates and non-grantor trusts, and are applicable to all taxable years beginning after Dec. 31, 2017. Please see final regulations.

Deductions for determining estate or non-grantor trust taxable income: 

As previously noted, the proposed regulations stated that administration expenses which are paid or incurred in connection with the administration of an estate or non-grantor trust, and which would not have been incurred if the property were not held in an estate or non-grantor trust (section 67(e) expenses) would remain deductible in determining adjusted gross income (AGI), and would not be subject to the individual-level suspension of their deductibility under section 67(g). The final regulations reiterate this position, without any modification. The final regulations, however, do not address the application of these deductions for alternative minimum tax purposes.

Termination of non-grantor trusts and estates: 

Unlike a corporate entity, a non-grantor trust or estate often functions with the sole intent of distributing property, or the earnings of the property, to its beneficiaries, with the distributions resulting in a decreased amount of principal each year. As such, in the final year of a non-grantor trust or estate, the various expenses of operating the non-grantor trust or estate will often be greater than the income generated by the non-grantor trust or estate. Section 642(h)(2) refers to this gap as ‘excess deductions’. The proposed regulations divided these deductions into three separate categories, which include amounts allowed in arriving at AGI, non-miscellaneous itemized deductions (most notably disallowed state and local tax (SALT) deductions and miscellaneous itemized deductions. 

The proposed regulations stated that items would be deductible to the beneficiaries and reflected on the final K-1, with the excess deductions retaining their character (of the three abovementioned categories) at the beneficiary level. The final regulations cement this notion, stating that, “[T]he character of these deductions does not change when succeeded to a beneficiary on termination of the estate or non-grantor trust.” Additionally, the Treasury Department and IRS plan to update the instructions to Form 1041, U.S. Income Tax Return for Estates and Trusts, the accompanying Schedule K-1 and Form 1040, U.S. individual Income Tax Return for the 2020 tax year to provide for the reporting of excess deductions that are section 67(e) expenses or non-miscellaneous itemized deductions.

SALT considerations: 

The final regulations also impose the same individual-level limitations on the excess deductions which are succeeded to by a beneficiary. As such, the excess deduction resulting from a state or local tax paid by the non-grantor trust or estate would, in turn, remain limited to the $10,000 maximum set forth in the Tax Cuts & Jobs Act. The final regulations addressed commentary, which argued that if the non-grantor trust or estate had already paid the state and local tax and claimed the deduction, which was also subject to the $10,000 limitation, then the beneficiary should not be subjected again to the same limitation. Treasury determined that it did not have the authority to exempt a beneficiary from the SALT limitation, and thus kept that limitation in effect. 

Reporting of excess deductions and determination of amounts: 

To assist taxpayers, the Treasury has released instructions for the 2018 and 2019 tax years which provide that a beneficiary with excess deductions allowed in arriving at AGI on their personal Form 1040 should deduct the amount as a negative item on Schedule 1. Treasury confirmed that the rules and limitations governing excess deductions from non-grantor trusts and estates do not apply to section 172 net operating loss deductions, even when the net operating loss is generated by the activity of the non-grantor trust or estate in the final year. 

Takeaways: 

The final regulations clarify that certain administration expenses of an estate or non-grantor trust are not affected by the suspension of the deductibility of miscellaneous itemized deductions as a result of the Tax Cuts & Jobs Act.  

They also provide guidance on determining the character, amount and allocation of deductions in excess of gross income which have been succeeded to by a beneficiary on the termination of an estate or non-grantor trust. The provisions remain unchanged from the proposed regulations as to the division of these deductions into three separate categories, which include amounts allowed in arriving at AGI, non-miscellaneous itemized deductions and miscellaneous itemized deductions. The final regulations affect estates, non-grantor trusts (including the S portion of an electing small business trust) and their beneficiaries.

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