Tax News Update    Email this document    Print this document  

The IRS has issued proposed regulations (REG-113295-18) under IRC Section 67(g) clarifying that certain deductions allowed to an estate or non-grantor trust are not miscellaneous itemized deductions, and thus are not affected by the Tax Cuts and Jobs Act's suspension of the deductibility of miscellaneous itemized deductions. These deductions are: (1) estate or trust administration costs 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; and (3) distribution deductions for trusts distributing current income and for estates and trusts accumulating income.

Background

The new guidance proposes regulations under IRC Sections 67 and 642. Added to the code by the Tax Cuts and Jobs Act (TCJA), IRC Section 67(g) suspends the deduction of certain miscellaneous itemized deductions for tax years 2018 through 2025. For purposes of IRC Section 67, miscellaneous itemized deductions are defined as:

• Itemized deductions other than those listed in IRC Section 67(b)(1) through (12)
• Personal exemptions
• IRC Section 199A deductions
• Above-the-line deductions

Adjusted gross income is generally defined in IRC Section 62(a) as gross income minus deductions listed in IRC Section 62(a)(1) through (21). Itemized deductions, defined in IRC Section 62(d), do not include (1) deductions allowable in computing AGI, (2) deductions for personal exemptions under IRC Section 151, or (3) the IRC Section 199A deduction.

The adjusted gross income (AGI) of an estate or trust generally is computed for IRC Section 67 purposes in the same manner as AGI for an individual, although certain additional deductions are allowed. Specifically, IRC Section 67(e) allows these items to be factored into determining AGI:

• Deductions for costs paid or incurred in connection with the administration of the trust or estate if those costs would not have been incurred if the property were held by an individual
• Deductions available under:
• IRC Section 642(b) (the personal exemption)
• IRC Section 651 (income distribution deduction for trusts distributing current income only)
• IRC Section 661 (income distribution deduction for estates and trusts accumulating income or distributing corpus)

IRC Section 67(e) effectively removes these deductions from being itemized deductions under IRC Section 63(d) and treats them as deductions that may be taken in calculating adjusted gross income under IRC Section 62(a).

In July 2018, the IRS issued Notice 2018-61 to announce its intention to issue regulations clarifying the effect of IRC Section 67(g) on the deductibility of certain expenses described in IRC Section 67(b) and (e) that are incurred by estates and non-grantor trusts. The notice foreshadowed that the regulations would clarify that expenses described in IRC Section 67(e) are deductible in determining the AGI of an estate or non-grantor trust for the tax years in which IRC Section 67(e) applies (i.e., tax years 2018 through 2025). (For details, see Tax Alert 2018-1451.)

IRC Section 642(h) allows beneficiaries succeeding to estate or trust property to deduct the carryover or excess if, upon termination, the estate or trust has: (1) an IRC Section 172 net operating loss (NOL) carryover or an IRC Section 1212 capital loss carryover; or (2) deductions for its last tax year that exceed gross income for the year. The excess deduction under IRC Section 642(h)(2), however, may only be allowed in computing taxable income, must be taken into account in computing the beneficiaries' tax preference items, and may not be utilized in computing gross income (Reg. Section 1.642(h)-2(a)). This means that the existing regulations treat excess deductions on termination of an estate or trust as a single miscellaneous itemized deduction for the beneficiary that may be disallowed under IRC Section 67(g).

An excess deduction under IRC Section 642(h)(2) may be comprised of (1) deductions allowable in calculating AGI under IRC Sections 62 and 67(e); (2) itemized deductions under IRC Section 63(d) allowable in calculating taxable income; and (3) miscellaneous itemized deductions, which are currently disallowed under the TCJA.

In Notice 2018-61, the IRS asked for comments on how IRC Section 67(g) affects the ability of the beneficiary to deduct amounts comprising the IRC Section 642(h)(2) excess deduction on the termination of an estate or trust, and specifically whether the separate deductions that comprise the IRC Section 642(h)(2) excess deduction should be analyzed separately when applying IRC Section 67.

Proposed regulations

Reg. Section 1.67-4. Commenters agreed with the IRS's statements in Notice 2018-61 that deductions outlined in IRC Section 67(e)(1) and (2) are not miscellaneous itemized deductions and thus disallowed under IRC Section 67(g). Therefore, the proposed regulations would amend the language in Reg. Section 1.67-4 to clarify that IRC Section 67(g) does not prevent an estate or non-grantor trust from claiming a deduction for expenses described in IRC Section 67(e)(1) or (2), as these deductions are not miscellaneous itemized deductions.

IRC Section 642(h) regulations

In response to comments, the proposed regulations provide that each deduction comprising the IRC Section 642(h)(2) excess deduction retains its separate character as (1) an amount allowed in arriving at AGI; (2) a non-miscellaneous itemized deduction; or (3) a miscellaneous itemized deduction.

The character of the deductions does not change when succeeded to by a beneficiary or when the estate or trust terminates. The proposed regulations would also require the fiduciary to separately identify deductions that may be limited when the beneficiary claims those deductions.

The proposed regulations also adopt a suggestion to use the principles under Reg. Section 1.652(b)-3 to allocate each deduction among the classes of income in the year the estate or trust terminates to determine the character and amount of the excess deductions under IRC Section 642(h)(2).

Under Reg. Section 1.652(b)-3(a), deductions that are directly attributable to one class of income are allocated to that income. The proposed regulations would treat the amount and character of any remaining deductions, after applying Reg. Section 1.652(b)-3, as excess deductions available to beneficiaries under IRC Section 642(h)(2).

The proposed regulations would also (1) add an example to illustrate the rule for determining the character of excess deductions in Prop. Reg. Section 1.642(h)-2 and (2) update the current example in Reg. Section 1.642(h)-5 to account for changes in the code since June 1965, when the example was last modified.

Proposed applicability date

The proposed regulations would apply to tax years that begin after the date the final regulations are published in the Federal Register. Nonetheless, estates, non-grantor trusts and their beneficiaries may rely on the proposed regulations under IRC Section 67 for tax years beginning after December 31, 2017, until final regulations are published in the Federal Register. Taxpayers may rely on the proposed regulations under IRC Section 642(h) for beneficiaries' tax years beginning after December 31, 2017, until the final regulations are published.

Comments and hearing requests

The IRS invites comments on the proposed regulations to be submitted electronically. A public hearing will be scheduled if a taxpayer requests one. Comments and hearing requests are due by June 25, 2020.

Implications

The proposed regulations under Reg. Section 1.67-4 are not particularly interesting. For many, they are simply reducing Notice 2018-61 to regulation form. The really interesting changes are in the regulations under IRC Section 642(h).

Until the release of these proposed regulations, the regulations under IRC Section 642(h) had not been amended since 1978. The concepts of "miscellaneous itemized deductions" and their associated AMT preference status were created in 1986. For more than 30 years, beneficiaries who were allocated excess deductions rarely saw the benefit of them, due to the 2% and 3% AGI limitations and the AMT preference status. It took the complete repeal of these deductions by the TCJA, albeit temporarily, to prompt the IRS to delve into what "excess deductions" really are. The regulations are generally consistent with the fine line that subchapter J walks between treating estate and trusts as entities versus treating them as pass-through-type entities. These regulations would simply treat the estate or trust as a pass-through entity in the final year, such that the beneficiary steps into the shoes of the trust for purposes of determining the character of the excess deductions.

The regulations create three categories: (1) deductions allowable in calculating AGI under IRC Sections 62 and 67(e); (2) itemized deductions under IRC Section 63(d) that are allowed in calculating taxable income; and (3) miscellaneous itemized deductions, which are temporarily disallowed under the TCJA. This is a logical approach that is very taxpayer-friendly.

The updated and new examples in Reg 1.642(h)-5 are a bit confusing and will likely need some revision in the final regulation package. For instance, example 1 is confusing as to why the beneficiary cannot carry back an NOL created by estate/trust if IRC Section 172 allows the carryback (it is possible that these regulations were written and largely final before CARES Act permitted carrybacks for 2018–2020). Real estate taxes that example 2 notes as an itemized deduction may not actually be an itemized deduction by reason of IRC Section 62(a)(4) and would be suspended by IRC Section 469 and added to basis in the rental property when distributed to the beneficiaries under IRC Section 469(j)(12).

———————————————