Kulzer & DiPadova, P.A.
76 E. Euclid Avenue, Suite 300
Haddonfield, New Jersey 08033-2342

P: 856.795.7744
F: 856.795.8982
E: info@kulzerdipadova.com

News, Articles & Resources

Estate and trust deductions on a fiduciary income tax return post 2017, how does it now work?

Posted In:
Estate and trust deductions on a fiduciary income tax return post 2017, how does it now work?

Tax professionals are often questioned about limitations on tax deductions for income tax purposes and, most of the time, the focus is on the returns of individuals, IRS Form 1040. However, for “fiduciary” returns (a trust or estate) that are filed on Form 1041, there are similar limitations that may apply even though fiduciary returns are substantively different due to the fact that they are “pass through” entities.   One such difference is in the area of the deductions occurring at the end of an estate or trust. The  Tax Cut and Jobs Act of 2017, (“TCJA”) made a variety of changes to the tax code, including deduction limitations, that have created some confusion as applied to estates and trusts.

On a fiduciary return (Form 1041), the income paid to a beneficiary is passed through to that beneficiary and reflected on the Schedule K-1. In a final year of an estate or trust, not only does income pass to a beneficiary, but also losses pass to beneficiary(ies) so activity and expenses are reported to the beneficiary and the beneficiary will receive the tax burden and, if available, the tax benefit associated with any unused tax attributes. I.R.C. 642(h). These attributes include items such as a capital loss or net operating loss carry-forward or simply the expenses incurred because of the existence of the estate or trust. In the final year of an estate or trust, these deductions are called “excess deductions” on termination.

Prior to the enactment of the TCJA, beneficiaries would deduct these excess deductions as miscellaneous itemized deductions on Schedule A to IRS Form 1040. However, for individuals, the TCJA added new I.R.C. Section 67(g), which provides that that no “miscellaneous itemized deductions,” as defined by I.R.C. Section 67(a),[1] are allowed for tax years beginning after 2017 and before 2026.   “

Thus, the statutory elimination of miscellaneous itemized deductions under I.R.C. Section 67(g) created many questions for estates and trusts professionals.  Two of the most important questions that arose under I.R.C. Section 67(g) were (1) whether estates and trusts were prohibited from taking miscellaneous itemized deductions, and (2) whether beneficiaries were prohibited from taking the excess deductions on termination of an estate or trust.

As to the first question, I.R.C. Section 67(e) indicates that adjusted gross income of an estate or trust is to be computed in the same manner as an individual, except that deductions paid or incurred in connection with the administration of an estate or trust are allowed as deductions.  Under I.R.C. 67(e)(1), the only deductions permitted for an estate or trust are those which were incurred because the property was being held by a fiduciary, and not by an individual.   For example, expenses that could be incurred by an individual, such as investment fees for certain investments, would not be deductible by an estate or trust under I.R.C. Section 67(e)(1). However, expenses that could only be incurred by an estate or trust, and not by an individual, such as executor or trustee commissions, would be deductible under I.R.C. Section 67(e)(1). Thus, the TCJA created some confusion on the interplay between I.R.C. Section 67(g) and I.R.C. Section 67(e) as it seemed I.R.C. Section 67(g) could prohibit estates and trust from taking the deductions that were generally allowable to them under I.R.C. Section 67(e).

In IRS Notice 2018-61, the IRS indicated that the Treasury and the IRS “do not believe that [elimination of miscellaneous itemized deductions for a trust or estate] is a correct reading of section 67(g).”  They indicated they planned to issue regulations to that effect.  Thus, it was clear early on that a trust or estate could still claim a current year deduction under I.R.C. Section 67(e) for expenses incurred in administration (such as attorneys’ fees, accountants’ fees, and executors’ fees and commissions) against the estate and trust income.

As to the second question, the uncertainty as to whether I.R.C. Section 67(g) prevented beneficiaries from taking the excess deductions on termination of an estate or trust was not made clear until recently. As discussed above, upon the termination of an estate or trust, the executor or trustee will distribute “excess deductions” to a beneficiary under I.R.C. Section 642(h).  It is not uncommon for such deductions to include attorneys’ fees, accountants’ fees, and executors’ fees and commissions, which are often paid in the final year of administration.

In IRS Notice 2018-61 the Treasury and IRS indicated that they were “studying” whether I.R.C. Section 67(e) deductions “as well as other deductions that would not be subject to the limitations imposed by sections 67(a) and (g) in the hands of a trust or estate, should continue to be treated as miscellaneous itemized deductions when they are included as a section 642(h)(2) excess deduction” on termination.  Thus, it seemed that  the elimination of miscellaneous itemized deductions by the TCJA under I.R.C. Section 67(g) could have prevented a beneficiary from taking excess deductions on termination of an estate or trust..[2]

Last summer, we reported on the proposed regulations, “Estate and Trust Income Tax Return Reporting Changes Posted On: June 04, 2020”, that were foreshadowed by the IRS Notice 2018-61.  These Regulations were finalized last fall and released September 21, 2020 (T.D. 9918) in substantially the same form. The Regulations finally provide some clarity as to whether beneficiaries are permitted to take excess deductions upon the termination of an estate or trust.

The Regulations reverse the longstanding IRS position that all excess deductions passing out to a beneficiary upon the termination of an estate or trust are classified as miscellaneous itemized deductions.  Instead, the Regulations provide that the tax character of the excess deductions is preserved upon closing of the estate or trust and the issuance of a final K-1 to a beneficiary. For purposes of determining whether they are then deductible by the beneficiary, the deductions are divided into three categories: (1) deductions allowable in arriving at adjusted gross income under I.R.C. Sections 62 and 67(e) (i.e., costs that are paid or incurred in connection with the administration of a trust or estate); (2) itemized deductions under I.R.C. Section 63(d) allowable in computing taxable income, including state and local income taxes; and (3) miscellaneous itemized deductions currently disallowed under I.R.C. Section 67(g), including expenses incurred by an individual. Thus, the deductions in category (1) will be allowable to a beneficiary in arriving at adjusted gross income, deductions in category (2) will be allowable by a beneficiary in computing taxable income (and subject to any other limitations, such as the controversial state and local tax limitation imposed by the TCJA), and deductions in category (3) are currently non-deductible by a beneficiary.

However, even after the Regulations were issued, there was still confusion as to how the deductions in category (1) should be reported by a beneficiary, due to the manner that the IRS forms implemented the changes. Rather than deduct the category (1) excess deductions on Schedule A as an itemized deduction, such deductions must now be reported as an adjustment to income in arriving at “Adjusted Gross Income”  (“AGI”) (calculated before reducing income by the standard deduction or by miscellaneous itemized deductions).  The release of Form 1040 included a schedule called “Schedule 1” used to report adjustments to income to arrive at AGI. Yet, in Part 2 for Schedule 1, there is no specified line item for reporting the category (1) excess deductions upon termination of an estate or trust.  Recent guidance from the IRS now suggests the taxpayer receiving category (1) excess deductions on the termination of the estate or trust should simply write “ED 67(e)” and the amount in the “total” on line 22, and include the additional deductible amount even though it is not designated as a listed expense on the schedule.

In sum, the category (1) I.R.C. Section 67(e) “excess deductions” on termination of an estate or trust, usually professional fees and executor commissions, continue to be deductible to the beneficiaries after the final year of the entity. After initially reporting in IRS Notice 2018-61 that the IRS was “studying” the issue because of conflicting statutory provisions in the TCJA, the final Regulations make the “excess deductions” an adjustment to income before considering a standard deduction or itemized deductions. Although Schedule 1 (part 2) to IRS Form 1040 does not contain a place for the deduction, taxpayers can write the deduction into the summary line to claim the tax benefit.

 

[1] “Miscellaneous itemized deductions” allowed on Schedule A to IRS Form 1040 included, in addition to the excess deductions on termination of an estate or trust, expenses such as job expenses, investment expenses or tax preparation fees. These deductions were permitted to the extent they exceeded two (2%) percent of the taxpayers “adjusted gross income.”

[2] Note that I.R.C. Section 642(h)(1) provides that an operating loss carry over under I.R.C. Section 172 or capital loss carry over under I.R.C. Section 1212 pass to a beneficiary, and thus such losses did not appear to be in jeopardy by the revision to I.R.C. Section 67(g).

Sign Up For Our Newsletter