On May 7, 2020, the Treasury Department and IRS issued long-awaited proposed regulations on the issue of the ability of beneficiaries to deduct excess deductions on termination of estates and non-grantor trusts after the addition of section 67(g) of the Internal Revenue Code (the “Code”), which disallows miscellaneous itemized deductions for the tax periods beginning after December 31, 2017, and before January 1, 2026.
An important take away from the proposed regulations is that estate and trust administration expenses under section 67(e) (including attorney’s fees, fiduciary commissions, probate fees, appraisal fees, etc.), which are an above-the-line deduction at the estate or trust level, retain their character so that beneficiaries can claim an above-the-line deduction on their individual income tax returns if such deductions are part of the section 642(h)(2) excess deductions upon termination of an estate or non-grantor trust.
Section 642(h)(2) of the Code permits beneficiaries succeeding to the property of an estate or non-grantor trust to deduct excess deductions in the year of termination of the estate or trust. The excess deduction may be comprised of different character or types of deductions, including: (1) those deductions allowable in arriving at adjusted gross income (e.g., section 67(e) deductions), (2) itemized deductions, and (3) miscellaneous itemized deductions currently disallowed under section 67(g). However, for decades excess deductions have been grouped together and treated as a miscellaneous itemized deduction to the beneficiaries in the year of termination of the estate or trust.
The miscellaneous itemized deduction treatment was due to existing Treasury Regulation (“Treas. Reg.”) § 1.642(h)-2(a), which provides that such excess deductions are “not allowed in computing adjusted gross income.” Since Treas. Reg. § 1.642(h)-2(a) precluded excess deductions from being “above-the-line” (allowable in arriving at adjusted gross income) to the beneficiaries and such excess deductions are not specifically excluded under a list of deductions contained in section 67(b), the resulting treatment was a miscellaneous itemized deduction subject to a two percent floor based upon adjusted gross income.
Since the purpose of section 642(h) is to avoid the wasting of deductions upon termination of an estate or trust, the addition of section 67(g) to the Code caused many to question whether Treas. Reg. § 1.642(h)-2(a) is incorrect as new section 67(g) would completely eliminate the ability of beneficiaries to utilize such deductions. The IRS recognized this as an issue in need of clarity and in Notice 2018-61 requested comments on the impact of section 67(g) on section 642(h), specifically with regard to estate and trust administration expenses which, under section 67(e), are not miscellaneous itemized deductions (and instead are treated as an above-the-line deduction) at the estate or trust level.
On May 7, 2020, the Treasury Department and the IRS issued proposed regulations addressing the impact of section 67(g) on section 642(h), and specifically the treatment of section 67(e) expenses that are part of the excess deductions distributed to the beneficiaries in the year of termination of an estate or trust.
The proposed regulations no longer treat all excess deductions upon termination of an estate or trust as one miscellaneous itemized deduction. Instead, the proposed regulations provide that each deduction comprising the excess deductions under section 642(h) retains, in the hands of the beneficiary, its character as either (1) an above-the-line deduction, (2) an itemized deduction, or (3) a miscellaneous itemized deduction. The proposed regulations require that the fiduciary separately identify deductions that may be limited when claimed by the beneficiaries (e.g., SALT deduction limited by section 164(b)(6)).
Therefore, under the proposed regulations beneficiaries of terminating estates and trusts will be entitled to an above-the-line deduction to the extent that estate and trust administration expenses under section 67(e) are included in excess deductions. This is very important for beneficiaries of estates and trusts as they stand to benefit from the deduction irrespective of whether they itemize or claim the standard deduction on their individual income tax returns.
Proposed Regulation (“Prop. Reg.”) § 1.642(h)-2(c)(2) provides the following example:
“Assume that a trust distributes all its assets to B and terminates on December 31, Year X. As of that date, it has excess deductions of $18,000, all characterized as allowable in arriving at adjusted gross income under section 67(e). B, who reports on the calendar year basis, could claim the $18,000 as a deduction allowable in arriving at B’s adjusted gross income for Year X. However, if the deduction (when added to B’s other deductions) exceeds B’s gross income, the excess may not be carried over to any year subsequent to Year X.”
Additionally, Prop. Reg. § 1.67-4 was issued in an effort to help differentiate estate and trust administration expenses which are an above-the-line deduction under section 67(e) from other expenses that constitute miscellaneous itemized deductions. Prop. Reg. § 1.67-4 provides as follows:
“(a) In general –
(1) Section 67(e) deductions.
(i) An estate or trust (including the S portion of an electing small business trust) not described in §1.67-2T(g)(1)(i) (a non- grantor trust) shall compute its adjusted gross income in the same manner as an individual, except that the following deductions (Section 67(e) deductions) are allowed in arriving at adjusted gross income:
(A) Costs that are paid or incurred in connection with the administration of the estate or trust, which would not have been incurred if property were not held in such estate or trust; and
(B) Deductions allowable under section 642(b) (relating to the personal exemption) and sections 651 and 661 (relating to distributions).
(ii) Section 67(e) deductions are not itemized deductions under section 63(d) and are not miscellaneous itemized deductions under section 67(b). Therefore, section 67(e) deductions are not disallowed under section 67(g).
(2) Deductions subject to 2-percent floor. A cost is not a section 67(e) deduction and thus is subject to both the 2-percent floor in section 67(a) and section 67(g) to the extent that it is included in the definition of miscellaneous itemized deductions under section 67(b), is incurred by an estate or non-grantor trust (including the S portion of an electing small business trust), and commonly or customarily would be incurred by a hypothetical individual holding the same property.”
Estates, trusts, and their beneficiaries may rely on the proposed regulations for taxable years beginning after December 31, 2017, and on or before the date the proposed regulations become final.
The proposed regulations are favorable to beneficiaries of estates and trusts that terminate in and after 2018. There may be circumstances where amended fiduciary and individual income tax returns are warranted. The current version of Schedule 1 (Additional Income and Adjustments to Income) to Form 1040 does not provide a line to report the section 67(e) deduction so a separate statement may be needed for any amended returns. However, it is expected that Schedule 1 will be updated in the future to include a line to report the deduction.
It is important that fiduciaries of estates are cognizant of the proposed regulations and administer estates with these rules in mind. Additionally, state law fiduciary duties may require that fiduciaries file fiduciary income tax returns (Form 1041) for estates that might not otherwise be required to file a return (due to minimal or no income generated by the estate) solely in order to issue Form K-1 so that the beneficiaries can report their share of the section 67(e) deduction on their individual income tax returns as an above-the-line deduction in the year of the estate termination.