Final Regs Address the Effect of Sections 67(g) and 642(h) on Trusts and Estates

(Parker Tax Publishing September 2020)

The IRS issued final regulations clarifying that the following deductions allowed to an estate or non-grantor trust are not miscellaneous itemized deductions, and are therefore not affected by the suspension of the deductibility of miscellaneous itemized deductions for tax years beginning after December 31, 2017, and before January 1, 2026: (1) costs paid or incurred in connection with the administration of an estate or non-grantor trust that would not have been incurred if the property were not held in the estate or trust; (2) the personal exemption of an estate or non-grantor trust; (3) the distribution deduction for trusts distributing current income; and (4) the distribution deduction for estates and trusts accumulating income. The final regulations also provide guidance on determining the character, amount, and allocation of deductions in excess of gross income succeeded to by a beneficiary on the termination of an estate or non-grantor trust. T.D. 9918.

Background

Code Sec. 67 generally provides that, in the case of an individual, the miscellaneous itemized deductions for any tax year are allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income (AGI). However, Code Sec. 67(g), enacted into law in the Tax Cuts and Jobs Act of 2017 (TCJA), prohibits individual taxpayers from claiming miscellaneous itemized deductions for any tax year beginning after December 31, 2017, and before January 1, 2026. Code Sec. 67(b) defines miscellaneous itemized deductions as itemized deductions other than those listed in Code Sec. 67(b)(1) through (12).

Code Sec. 67(e) provides that an estate or trust computes its AGI in the same manner as that of an individual, except that the following additional deductions are treated as allowable in arriving at AGI: (1) deductions for costs 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 such estate or trust, and (2) deductions allowable under Code Sec. 642(b) (personal exemption of an estate or non-grantor trust), Code Sec. 651 (deduction for trusts distributing current income), and Code Sec. 661 (deduction for trusts accumulating income). Code Sec. 67(e) further provides the IRS with authority to make appropriate adjustments in the application of Code Sec. 641 through Code Sec. 685 to take into account the provisions of Code Sec. 67.

Code Sec. 642(h) provides that if, on the termination of an estate or trust, the estate or trust has: (1) a net operating loss (NOL) carryover under Code Sec. 172 or a capital loss carryover under Code Sec. 1212, or (2) for the last tax year of the estate or trust, deductions (other than the deductions allowed under Code Sec. 642(b) with respect to the personal exemption or Code Sec. 642(c) with respect to charitable contributions) in excess of gross income for such year, then such carryover or excess will be allowed as a deduction, in accordance with the regulations, to the beneficiaries succeeding to the property of the estate or trust.

Proposed Regulations

In May, the IRS issued proposed regulations (REG-113295-18) clarifying that expenses described in Code Sec. 67(e) remain deductible in determining the AGI of an estate or non-grantor trust during the tax years in which Code Sec. 67(g) applies. Accordingly, under the proposed regulations, Code Sec. 67(g) did not deny an estate or non-grantor trust (including the S portion of an electing small business trust) a deduction for expenses described in Code Sec. 67(e)(1) and (2) because such deductions are allowable in arriving at AGI and are not miscellaneous itemized deductions.

The proposed regulations also provided that if, on termination of an estate or trust, the estate or trust has for its last tax year deductions (other than the deductions allowed under Code Sec. 642(b) or Code Sec. 642(c)) in excess of gross income, the excess deductions are allowed under Code Sec. 642(h)(2) as items of deduction to the beneficiaries succeeding to the property of the terminated estate or trust. The proposed regulations provided that each deduction comprising the excess deductions under Code Sec. 642(h)(2) retains, in the hands of the beneficiary, its character (specifically, as allowable in arriving at AGI, as a non-miscellaneous itemized deduction, or as a miscellaneous itemized deduction) while in the estate or trust and does not change when succeeded to by a beneficiary on termination of the estate or trust. Furthermore, the proposed regulations provided that an item of deduction succeeded to by a beneficiary remains subject to any limitation applicable under the Code in the computation of the beneficiary's tax liability.

In addition, the proposed regulations provided that an item of deduction succeeded to by a beneficiary remains subject to any additional applicable limitation under the Code, and must be separately stated if it could be so limited, as provided in the instructions to Form 1041, U.S. Income Tax Return for Estates and Trusts, and the Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credit, etc.

The proposed regulations provided that the provisions of Reg. Sec. 1.652(b)-3 are used to allocate each item of deduction among the classes of income in the year of termination for purposes of determining the character and amount of the excess deductions under Code Sec. 642(h)(2). Accordingly, the amount of each separate deduction remaining after application of Reg. Sec. 1.652(b)-3 comprises the excess deductions available to the beneficiaries succeeding to the property of the estate or trust as provided under Code Sec. 642(h)(2). Furthermore, the proposed regulations provided that excess deductions are allowable only in the tax year of the beneficiary in which, or with which, the estate or trust terminates. That is, excess deductions of a terminated estate or trust may not carry over to a subsequent year of the beneficiary.

Final Regulations

On September 21, the IRS issued final regulations in T.D. 9918. The final regulations adopt the proposed rule specifying that Code Sec. 67(e) expenses remain deductible in determining an estate or non-grantor trust's AGI during years 2018 - 2025 without modification. In addition, the final regulations provide clarifications and modifications in response to practitioners' comments.

Practitioners requested guidance on how excess deductions are to be reported by terminated estates or trusts and by their beneficiaries. The IRS noted that it released instructions for beneficiaries that chose to claim excess deductions on Form 1040 in the 2019 or 2018 tax year based on the proposed regulations. The IRS also said that it plans to update the instructions for Form 1041, Schedule K-1 (Form 1041), and Form 1040 for the 2020 and subsequent tax years to provide for the reporting of excess deductions that are Code Sec. 67(e) expenses or non-miscellaneous itemized deductions.

One practitioner asked for an ordering rule clarifying whether excess deductions on termination of a trust allowed as a deduction to the beneficiary are claimed before, after, or ratably with the beneficiary's other deductions, particularly when the amount of the excess deductions and other deductions exceed the beneficiary's gross income. In response, the final regulations clarify that beneficiaries may claim all or part of the excess deductions under Code Sec. 642(h)(2) before, after, or together with the same character of deductions separately allowable to the beneficiary.

The proposed regulations included an example illustrating computations under Code Sec. 642(h) when there is an NOL. The example explained that the beneficiaries of the trust cannot carry back any of the NOL of the terminating estate that was made available to them under Code Sec. 642(h)(1). Practitioners requested that the example be revised to take into account the amendments to Code Sec. 172(b)(1)(D) made by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) (Pub. L. 116-136), which generally allows NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021, to be carried back five years before being carried forward. Practitioners asked for the revision to reflect that a beneficiary could carry back the NOL carryover the beneficiary succeeds to under Code Sec. 642(h)(1) for NOLs arising in tax years beginning in 2018, 2019, and 2020.

The IRS responded that, in general, an NOL incurred by a taxpayer may only be used as a deduction by that taxpayer, and cannot be transferred to another taxpayer. An exception is provided, however, in Code Sec. 642(h), which (as noted above) provides that if the terminated estate or trust has an NOL carryover, the carryover is allowed as a deduction to the beneficiaries succeeding to the property of the estate or trust. The IRS reasoned that the use of the word "carryover" in Code Sec. 642(h)(1) means that the estate or trust incurred an NOL and either already carried it back to the earliest allowable year or elected to waive the carryback period, and now is limited to carrying over the remaining NOL. The IRS reasoned that, because the NOL is a carryover for the estate or trust, the beneficiary succeeding to that NOL may, under Code Sec. 642(h)(1), only carry it forward, and the CARES Act amendments do not change this result. Thus, the practitioners' comments were not adopted in the final regulations.

The final regulations apply to tax years beginning after the date of publication in the Federal Register, but taxpayers may choose to apply the amendments to Reg. Sec. 1.67-4, Reg. Sec. 1.642(h)-2, and Reg. Sec. 1.642(h)-5 in T.D. 9918 to tax years beginning after December 31, 2017.

For a discussion of the deductibility of estate and trust administration expenses as miscellaneous itemized deductions, see Parker Tax ¶85,115. For a discussion of the deductibility of unused loss carryovers and excess deductions on the termination of an estate or trust, see Parker Tax ¶53,135.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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