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

(Parker Tax Publishing May 2020)

In recently issued proposed regulations upon which taxpayers can immediately rely, the IRS clarified that certain expenses of estates and non-grantor trusts are not miscellaneous itemized deductions are thus are not affected by the Code Sec. 67(g) suspension of the deductibility of miscellaneous itemized deductions for tax years beginning after December 31, 2017, and before January 1, 2026. The proposed 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. REG-113295-18.

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) the 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.

In Notice 2018-61, the IRS announced that it would be issuing proposed regulations on the effect of Code Sec. 67(g) on the deductibility of certain expenses described in Code Sec. 67(b) and Code Sec. 67(e) incurred by estates and non-grantor trusts. The notice stated that the regulations would clarify 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.

Notice 2018-61 also requested comments regarding the effect of Code Sec. 67(g) on the ability of a beneficiary to deduct amounts comprising the Code Sec. 642(h)(2) excess deduction on the termination of an estate or trust. 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 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) (relating to the personal exemption) or Code Sec. 642(c) (relating to charitable contributions) in excess of gross income for such year, then such carryover or such excess is allowed as a deduction to the beneficiaries succeeding to the property of the estate or trust. The Code Sec. 642(h)(2) excess deduction may be comprised of several types of deductions including: (1) those deductions allowable in arriving at adjusted gross income under Code Sec. 62 and Code Sec. 67(e); (2) itemized deductions under Code Sec. 63(d) allowable in computing taxable income; and (3) miscellaneous itemized deductions currently disallowed under Code Sec. 67(g). In Notice 2018 - 61, the IRS explained that it was studying whether Code Sec. 67(e) deductions, as well as other deductions not subject to the limitations imposed by Code Sec. 67(a) and Code Sec. 67(g) in the hands of the estate or trust, should continue to be treated as miscellaneous itemized deductions when included as a Code Sec. 642(h)(2) excess deduction.

IRS Clarifies That Sec. 67(e) Expenses Are Deductible

The IRS has now issued proposed regulations in REG-113295-18. Prop. Reg. Sec. 1.67-4 provides that Code Sec. 67(g) does 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 Code Sec. 67(e)(2) because such deductions are allowable in arriving at AGI and are not miscellaneous itemized deductions under Code Sec. 67(b).

Each Sec. 642(h)(2) Excess Deduction Retains Its Separate Character

With respect to the Code Sec. 642(h)(2) excess deduction, the proposed regulations provide that each deduction comprising the Code Sec. 642(h)(2) excess deduction retains its separate character, specifically (1) as an amount allowed in arriving at AGI; (2) as a non-miscellaneous itemized deduction; or (3) as a miscellaneous itemized deduction. The character of these deductions, the IRS stated, does not change when succeeded to by a beneficiary on termination of the estate or trust. Further, the proposed regulations require that the fiduciary separately state (i.e., separately identify) deductions that may be limited when claimed by the beneficiary 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 IRS also adopted a practitioner's suggestion that the principles under Reg. Sec. 1.652(b)-3 be 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). Prop. Reg. Sec. 1.652(b)-3 provides that deductions directly attributable to one class of income are allocated to that income. Any remaining deductions that are not directly attributable to a specific class of income, as well as any deductions that exceed the amount of directly attributable income, may be allocated to any item of income (including capital gains), but a portion must be allocated to tax-exempt income, if any. The proposed regulations provide that the character and amount of each deduction remaining after application of Prop. Reg. Sec. 1.652(b)-3 comprises the excess deductions available to the beneficiaries succeeding to the property as provided under Code Sec. 642(h)(2).

Example: On January 31, 2020, Al dies leaving a will that provides for the distribution of all of Al's estate equally to Bob and an existing trust for Carla. The period of administration of the estate terminates on December 31, 2020, at which time all the property of the estate is distributed to Bob and the trust. For tax purposes, Bob and the trust report income on a calendar year basis. During the period of administration, the estate has the following items of income and deductions: $2,500 interest income, $3,000 business income for total income of $5,500; $5,000 of business expenses (including administrative expenses allocable to business income), $9,800 of administrative expenses not allocable to business income that would not have been incurred if property had not been held in a trust or estate (i.e., Code Sec. 67(e) deductions) for a total deduction of $14,800. Bob and the trust are each allocated $1,000 of the $2,000 unused net operating loss carryover of the terminated estate ($5,500 gross income - $7,500 ($14,800 total deductions - $7,300 ($9,800 allowable non-business expenses less non-business income of $2,500) = $2,000 NOL carryover). Neither Bob nor the trust can carry back any of the net operating loss of Al's estate made available to them under Code Sec. 642(h)(1). The $7,300 of deductions not taken into account in determining the estate's NOL are excess deductions on termination of the estate under Code Sec. 642(h)(2). Such deductions retain their character as Code Sec. 67(e) deductions and Bob and the trust each are allocated $3,650 of excess deductions based on Bob's and the trust's respective shares of the burden of each cost. The NOL carryovers and excess deductions are not allowable directly to Carla, the trust beneficiary. To the extent the distributable net income of the trust is reduced by the carryovers and excess deductions, however, Carla may receive an indirect benefit from the carryovers and excess deductions.

Proposed Applicability Date

While the proposed regulations apply to tax years beginning after the date the regulations are published as final regulations in the Federal Register, the IRS stated that estates, non-grantor trusts, and their beneficiaries may rely on the proposed regulations under Code Sec. 67 for tax years beginning after December 31, 2017, and on or before the date the regulations are published as final regulations. Taxpayers may also rely on the proposed regulations under Code Sec. 642(h) for tax years of beneficiaries beginning after December 31, 2017, and on or before the date the regulations are published as final regulations in the Federal Register in which an estate or trust terminates.

One practitioner requested that the IRS clarify that expenses incurred during an estate's fiscal year beginning before January 1, 2018, which properly are characterized as miscellaneous itemized deductions, remain deductible as such even if some of the costs were paid after January 1, 2018. The IRS noted that Code Sec. 67(g) applies to tax years beginning after December 31, 2017, and, therefore Code Sec. 67(g) would not apply to an estate's or trust's tax years beginning before that date.

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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