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Estate and Trust Income Tax Return Reporting Changes

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Authored by Michael Rios (summer law clerk) and Joseph T. Kenney, Esq. 

On May 11, 2020, the United States Treasury published proposed regulations (“Prop. Regs.”)  (REG-113295-18) under the Tax Cuts and Jobs Act of 2017 (TCJA) related to the deductibility of certain expenses incurred by estates and non-grantor trusts. The Prop. Regs. propose amendments to the Income Tax Regulations under sections 67 and 642 of the Internal Revenue Code (I.R.C.). The Prop. Regs. clarify that the current prohibition of miscellaneous itemized deductions under I.R.C. Section 67(g) does not apply to deductions reported by an estate or non-grantor trust under I.R.C. Section 67(e). The Prop. Regs. also reverse the current IRS position on classifying excess deductions under I.R.C. Section 642(h)(2) as miscellaneous itemized deductions. The Prop. Regs. now permit the excess deductions passing out to a beneficiary to retain the same character the deductions had within the trust or estate.

By way of background, I.R.C. Section 67(a) provides that, in the case of an individual, miscellaneous itemized deductions for any taxable year are allowed only to the extent that the aggregate of such deductions exceeds two (2%) percent of adjusted gross income. For estates and non-grantor trusts, I.R.C. Section 67(e) states that the adjusted gross income of an estate or trust is computed in the same manner as in the case of an individual, except that (1) the deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which not have been incurred if the property were not held in such trust or estate, and (2) the deductions allowable under I.R.C. Sections 642(b), 651, and 661, are allowable in arriving at adjusted gross income. In 2017, the TCJA added I.R.C. Section 67(g), which suspends the deductibility of miscellaneous itemized deductions under I.R.C. Section 67(a) for tax years beginning after December 31, 2017, and before January 1, 2026. After its addition, commentators suggested that I.R.C. Section 67(g) might be read to eliminate the ability of estates and non-grantor trusts to deduct the expenses described in I.R.C. Section 67(e).

In July 2018, the IRS issued Notice 2018-61 to clarify the changes made by the TCJA to I.R.C. Section 67 and its effect on the deductibility of expenses incurred by estates and non-grantor trusts, as well as to explain how to report deductions under I.R.C. Section 642(h). The Prop. Regs. were published in response to IRS Notice 2018-61 and the associated comments by taxpayers to the notice.

Prop. Reg. Section 1.67-4 clarifies that deductions under I.R.C. Section 67(e) incurred by an estate or non-grantor trust (including the Subchapter S portion of an electing small business trust) are not miscellaneous itemized deductions subject to disallowance under I.R.C. Section 67(g). Thus, an estate or non-grantor trust may deduct from its adjusted gross income the following items: (1) costs paid or incurred in connection with the administration of the estate or non-grantor trust which would not have been incurred if the property were not held in an estate or trust; (2) the personal exemption of an estate or non-grantor trust under I.R.C. Section 642(b); (3) the distribution deduction for trusts distributing current income under I.R.C. Section 651; and (4) the distribution deduction for estates and trusts accumulating income under I.R.C. Section 661.

Prop. Reg. Section 1.642(h)-2 also reverses 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, and thus disallowed under I.R.C. Section 67(g) after the enactment of the TCJA. Instead Prop. Reg. Section 1.642(h)-2 provides 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. The Prop. Reg. provides that deductions under I.R.C. Section 642(h)(2) can be 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) which includes expenses incurred by an individual.

Thus, the character of these deductions under I.R.C. Section 642(h)(2) will remain the same for the beneficiary as they were in the hands of the trust or estate. If a deduction was not a miscellaneous itemized deduction for the trust or estate, the deduction will not be a miscellaneous itemized deduction for a beneficiary. The Prop. Regs. require the fiduciary to separately identify deductions that may be claimed by a beneficiary on Form 1041.

The Prop. Regs. also include an amended version of I.R.C. Section 1.642(h)-5, and an example illustrating how to determine the character of excess deductions under Prop. Reg. 1.642(h)-2. The Prop. Regs. do not alter I.R.C. Section 1.642(h)-4, and thus excess deductions and carryovers under I.R.C. Section 642(h) are still allocated proportionately where multiple beneficiaries are involved.

The Prop. Regs. apply to tax years beginning after final Treasury Regulations are published. However, estates, non-grantor trusts, and their beneficiaries may now rely on the Prop. Regs. for tax years beginning after December 31, 2017. Thus, an estate or trust that reported excess deductions on termination as miscellaneous itemized deductions in the 2018 or 2019 tax years may want to consider amending these returns to take advantage of the taxpayer-friendly changes in the Prop. Regs.

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