Take-Away: Many of the provisions of the 2017 Tax Act (the Act) apply to trusts and estates as well as individuals. But in one respect there is more of an impact on trusts and estates with the temporary suspension of IRC 67(g) miscellaneous itemized deductions until January 1, 2026. The overall impact of that suspension of itemized deductions may encourage fiduciaries to distribute trust property to individual beneficiaries who are in a more advantageous income tax position as a result of the deduction suspension under the  Act.

Background: Deductions for estates and non-grantor irrevocable trusts fall generally into two categories. Above-the-line deductions, including those expenses that arise from a trade or business, which are enumerated in IRC 62(a) and are subtracted from gross income in the calculation of adjusted gross income (AGI). Below-the-line deductions, or itemized deductions, generally include those deductions that are not identified in IRC 62(a); these are expenses that normally deal with profit-oriented activities other than operating a trade or business. The below-the-line deductions are subtracted from adjusted gross income (AGI) and are used to calculate taxable income on which the taxpayer’s actual tax liability is determined. The difference between the two (above-the-line vs. below-the-line) is important, because the below-the-line deductions are subject to limitations that do not apply to above-the-line deductions, and below-the-line itemized deductions are now suspended.

  • History of Equivalency: At one time Congress tried to provide some degree of equivalence between profit-oriented expenses and trade or business expenses that were deductible. That effort to create equivalency between the two types of deductible expenses appeared in IRC 212, which provided that in the case of an individual, all ordinary and necessary expenses paid or incurred during a taxable year: (i) for the production or collection of income; (ii) for the management, conservation or maintenance of property held for the production of income; or (iii) in connection with the determination, collection or refund of any tax, were all income tax deductible.
  • IRC 212: Generally included in IRC 212 expenses were: (i) investment advisory fees; (ii) subscriptions to investment advisory fees; (iii) qualifying attorney’s fees; (iv) expenses for clerical help and office rent incurred in managing investments; (v) fees incurred to collect interest and dividends; (vi) losses on deposits held in insolvent financial institutions; (vii) service charges on dividend reinvestment plans; and (8) trustee’s fees for an individual retirement account if separately billed and paid. [Treas. Reg. 1.67-IT(a)(1)(ii).]
  • IRC 67(a): This Code section requires that taxpayers further divide their itemized deductions (including most of the deductions for profit-oriented activities) into: (i) miscellaneous itemized deductions; and (ii) all other itemized deductions. Describing this provision differently, IRC 67(b) provides that all itemized deductions other than those specified in that section are treated as miscellaneous itemized deductions.
  • Investment Advisory Fees: Because they are not mentioned in IRC 67(b), investment advisory fees,  along with tax preparation fees and other professional fees, e.g. attorney’s fees,  generally are all considered miscellaneous itemized deductions.
  • Two-Percent Floor: Prior to the Act, a taxpayer’s miscellaneous itemized deductions were allowed as an income tax deduction only to the extent that their aggregate value exceeded 2% of the taxpayer’s AGI. Accordingly, these deductions were added together, then reduced (but not below 0) by 2% of the taxpayer’s AGI. The miscellaneous itemized deductions that were disallowed as a result of the 2% floor were permanently lost and could not be carried over to future tax years.
  • Exception to 2% Floor: The former Tax Code then provided an exception to the 2% floor. [IRC 67(e).] IRC 67(e) directs that specific deductions for a trust or estate that would otherwise be a miscellaneous itemized deduction would, instead, be treated as an above-the-line deduction, reducing the taxpayer’s AGI,  dollar-for-dollar. This Code section provides: 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 trust or estate are to be deducted in computing the estate or trust’s AGI. In short, these deductions are not subject to the 2% floor limitation. After the US Supreme Court got involved in the interpretation of this exception in Knight v. Commissioner, (2008), the Regulations clarified that expenses will not be covered by the IRC 67(e) exception if:(i) commonly or customarily the expense would be incurred by a hypothetical individual who holds the same property; it is the type of product or service rendered to the estate or non-grantor trust in exchange for the cost, rather than the description of the cost of that product or service, that is determinative whether the IRC 67(e) exception applies.
  • Commonly and Customarily Incurred by Individuals: Implementing the Supreme Court’s ‘test’, the Regulations identify those types of costs that are commonly an customarily incurred by individuals, which means that they are not covered under the IRC 67(e) exception, and thus they are miscellaneous itemized deductions that are (or were, prior to the 2017  Act) subject to the 2% floor: (i) costs incurred in  defense of a claim against the estate, the decedent, or the grantor trusts that are not related to the existence, validity or administration of the trust or estate; (ii) ownership costs; (iii) tax preparation fees; (iv) investment advisory fees; and (v) appraisal fees. Therefore, when a trust or estate incurs any of these expenses, they are miscellaneous itemized deductions that are subject to the 2% floor.
  • Trust and Estate Expenses : Fees and expenses that fall under the IRC 67(e) exception are limited fiduciary expenses, including: (i) probate court fees; (ii) fiduciary bond premiums; (iii) legal publications costs, like notices to creditors and heirs of the deceased; (iv) costs of certified copies required for the decedent’s death certificate; and (v) the costs associated with the fiduciary’s obligation to provide accountings. [Treas. Reg. 1.67-4(b)(6).] At one time the ‘test’ as to whether a trust or estate expense was available as an above-the-line deduction was thought to be if it was unique to a trust or an estate. But that ‘test’ got dropped by the Supreme Court in favor of whether the expense or fee was ‘commonly and customarily incurred by individuals.’

2017 Tax Act Implications:

  • Suspension of Itemized Deductions: As noted, the Act adds a new IRC 67(g) to the Tax Code which suspends all miscellaneous itemized deductions after 12/31/17 through 12/31/25. Thus, the portion of an estate or trust’s expenses that would previously have been subject to the 2% floor will be now be disallowed completely. This translates to more taxable income reported by the trust or estate (no longer reduced by itemized income tax deductions.)
  • IRC 67(e) Suspended Too? Less clear, however, is the application of the IRC 67(g) suspension to trust and estate expenses that were not previously subject to the 2% itemized deduction floor. Because these common trust and estate expenses are not mentioned in IRC 62(a), but they are instead  dealt with under IRC 67(e) which otherwise dealt with itemized deductions not subject to the 2% floor, IRC 67(e) expenses are, by implication, still miscellaneous itemized deductions (they were just excepted.) Thus, one possible interpretation of the new IRC 67(g) is that those trust and estate expenses that were previously not subject to the 2% floor may now be disallowed as they were, and still are, miscellaneous itemized deduction expenses. Yet IRC 67(e) expressly states that this limited category of deductions are to be taken to arrive at the AGI of a trust or an estate; consequently, by statute, they are defined as not being a miscellaneous itemized deduction. Hopefully the promised Regulations will clarify that the latter interpretation of IRC 67(g) is accurate, and that IRC 67(e) expenses and costs incurred by a trust or an estate will continue to be direct deductions above-the-line in calculating the trust or estate’s AGI. If the IRC 67(e) expenses are included as common below-the-line itemized deductions, then trusts and estates will have even more income that is exposed to income taxation.
  • No Standard Deduction: The standard deduction (which may be taken in lieu of itemized deductions) is not applicable to trusts and estates.
  • $10,000 SALT Limitation: The $10,000 limitation on state and local taxes (SALT) does apply to trusts and estates, like it applies to individuals. Again, the ‘cap’ on this itemized deduction means more trust or estate income will be exposed to income taxation.
  • Income Tax Rates: The lower income tax rates across the board will favor all taxpayers, including trusts and estates (e.g. the highest marginal federal income tax rate is 37%). But the compressed income tax rate structure continues to apply to trusts and estates which exposes accumulated income in a trust or estate to the highest income tax bracket of 37% beginning at $12,500.
  • Distribution Deductions: Due to the compressed income tax rate structure faced by a trust or an estate, with no standard deduction, and perhaps no IRC 67(e) above-the-line deductions, it may make sense for trustees to distribute trust assets to the trust beneficiaries, since the trust or estate is entitled to deduct the lesser of (a) distributable net income or (b) the sum of (i) any amount of income for such taxable year required to be distributed currently, and (ii) any other amounts properly paid or credited or required to be distributed for such taxable year (meaning the beneficiary pays the income tax when income is distributed to the beneficiary from the trust or estate). [IRC 661(a).]

Conclusion: Often trusts are used to keep income or trust assets from falling into the hands of heirs. Sometimes because the heir is incapable of handling the assets or the income that those trust assets generate, or sometimes because the settlor wants to protect those assets from future estate taxes. Or, the settlor perceives the heir to be a spendthrift and the settlor wants to hold the assets in trust to  protect them from the beneficiary’s creditors. As a result, if the tax Act changes now encourage the trustee or personal representative to push income out of the trust or estate and into the hands of the trust beneficiary in order to avoid exposing more taxable income to  the trust or estate’s compressed income tax brackets, that response may ultimately frustrate the settlor’s original purpose in the use of a trust. Hopefully the trust’s material purpose clause will give the trustee some guidance in how to respond to these tax law changes that make it more expensive to accumulate income in a trust or an estate.