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George F. Bearup, J.D. Senior Legal Trust Advisor

19-Nov-21

Final Regulations on Trust and Estate Deductions

Take-Away: The IRS a year ago issued Final Regulations, effective October 18, 2020,  which confirm that income tax deductions allowed for some costs that are incurred in the administration of a trust or an estate will continue to be tax deductible, notwithstanding the suspension of miscellaneous itemized deductions under the 2017 Tax Act. The Final Regulations also address the character, amount and allocation of ‘unused’ losses or income tax deductions that are in excess of the estate or trust’s gross income that a beneficiary can use when the estate or trust  terminates.

Disclaimer: This is really technical stuff. Feel free to move onto the sports page or the comics.

Background: The 2017 Tax Act added IRC 67(g). That new section prohibits individual taxpayers from claiming miscellaneous itemized income tax deductions for any taxable year beginning in 2018 and ending January 1, 2026.

Income Tax Deductions for Trusts and Estates: Prior to the adoption of IRC 67(g), miscellaneous itemized deductions were allowed to reduce a taxpayer’s adjusted gross income (AGI) but only if the amount of the deductions exceeded 2% of the taxpayer’s adjusted gross income (AGI.)  IRC 67(e) provides that for purposes of IRC 67, an estate or non-grantor trust computes its AGI in the same manner as an individual taxpayer. However, some additional tax deductions are treated as allowable in arriving at the trust or the estate’s AGI.

Excepted Deductions for Estates and Trusts: Those additional income tax deductions that are available to trusts and estates include:

  • (i) the deduction for costs that are paid or incurred in connection with the administration of an estate or trust which would not have been incurred if the property were not held in the estate or trust;
  • (ii) deductions allowable under IRC 642(b), which deals with the personal exemption of an estate or a non-grantor trust;
  • (iii) deductions allowable for trusts under IRC 651, i.e. trusts that distribute their current income; and
  • (iv) deductions allowable for trusts under IRC 661, i.e. trusts that accumulate their current income.

Deductions Still Available to Trusts and Estates: Therefore, IRC 67(e) removes the deductions just described in (i) through (iv) from the definition of miscellaneous itemized deductions under IRC 63(d). Consequently, under the Final Regulations, the definitions of miscellaneous itemized deduction found in IRC 67(b) does not include the tax deductions described in (i) through (iv) above.  Instead, the Final Regulations treat them as deductions that are allowable to determine the trust or estate’s AGI under IRC 62(a) for the reported year.

Loss Carryovers to Trust and Estate Beneficiaries: The Final Regulations also address IRC 642(h). IRC 642(h) provides that if, on the termination of an estate or a trust, the estate or the trust has either (i) a net operating loss carryover under IRC 172, or (ii) a capital loss carryover under IRC 1212, or (iii) for the last taxable year of the estate or the trust, tax deductions (other than deductions allowed under IRC 642(b) that relates to the personal exemption claimed by the estate or trust, or IRC 642(c) that relates to a charitable contribution deduction) are in excess of the estate or trust’s gross income for such year, then the carryover loss or the excess tax deductions will be allowed as items of deductions to the beneficiaries that succeed to the property of the estate or trust that is distributed to them. The character of these income tax deductions does not change when succeeded to by a beneficiary on the termination of the estate or trust, and the deduction remains subject to any limitations applicable under the Tax Code in the computation of the beneficiary’s income  tax liability. Accordingly, these loss carryovers and excess income tax deductions will not be treated as miscellaneous itemized deductions  and therefore they will be available to reduce the estate or trust beneficiary’s adjusted gross income in the year of their receipt. Unfortunately the IRS declined the request by many banks to update IRS Form K-1 to provide information on excess tax deductions to assist beneficiaries with their state income tax returns.

Conclusion: The importance of these Final Regulations is that they confirm that income deductions claimed pursuant to IRC 67(e), such as fees charged by trustees and personal representatives and costs paid or incurred by fiduciaries in connection with the administration of a trust or an estate which would not have otherwise been incurred, are not disallowed by the temporary suspension (until 2026) of miscellaneous itemized deductions imposed by IRC 67(g). While this is admittedly turgid stuff to read or decipher, it is extremely important when you consider that a non-grantor trust’s accumulated income in excess of $13,050 will be subject to a federal income tax rate of 37% along with the 3.8% net investment income surtax. Consequently, any permissible income tax deduction will go a long way to save significant income taxes faced by a trust or an estate.