September 23, 2020
IRS finalizes rules on estate and non-grantor trust deductions not considered miscellaneous itemized deductions for which TCJA suspended deductibility
In final regulations (TD 9918) under IRC Section 67(g), the IRS has clarified that certain deductions allowed to an estate or non-grantor trust under IRC Section 67(e) are not miscellaneous itemized deductions, and thus are not affected by suspension of the deductibility of miscellaneous itemized deductions enacted by the Tax Cuts and Jobs Act (TCJA). 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.
IRC Section 67(g), added by the TCJA, 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:
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 IRC Section 67(e) allows certain additional deductions.
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. However, the former regulations (i.e., those in effect prior to the current final regulations) treated excess deductions under IRC Section 642(h)(2) on termination of an estate or trust as a single miscellaneous itemized deduction for the beneficiary that could be disallowed under IRC Section 67(g).
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. In Notice 2018-61, the IRS also asked for comments on how IRC Section 67(g) affects the beneficiary's ability to deduct amounts comprising the IRC Section 642(h)(2) excess deduction on the termination of an estate or trust. For details, see Tax Alert 2018-1451.
In May 2020, the IRS issued proposed regulations (REG-113295-18) under IRC Sections 67 and 642. The proposed regulations specified that certain deductions allowed to an estate or non-grantor trust are not miscellaneous itemized deductions, and thus are not affected by the TCJA's suspension of the deductibility of miscellaneous itemized deductions. For additional background and discussion of the proposed regulations, see Tax Alert 2020-1267.
The final regulations adopt the proposed regulations with some modifications. The final regulations, like the proposed regulations, are limited in scope to the effect of IRC Section 67(g) on (1) the deductibility of certain expenses that are described in IRC Section 67(b) and (e) and incurred by estates and nongrantor trusts, and (2) the treatment of excess deductions on termination of an estate or trust under IRC Section 642(h).
IRC Section 67 regulations
Consistent with the proposed regulations, the final regulations under Treas. Reg. Section 1.67-4 clarify that expenses described in IRC Section 67(e) remain deductible in determining the adjusted gross income of an estate or non-grantor trust during the tax years in which IRC Section 67(g) applies. The final regulations in this section adopt the proposed rules without modification.
IRC Section 642(h) regulations
The final regulations in Treas. Reg. Section 1.642(h)-2(a) adopt the general rule included in the proposed regulations. Under this rule, beneficiaries of a terminated estate or trust may claim excess deductions from the estate's or trust's last tax year under IRC Section 642(h)(2) (except for personal exemptions under IRC Section 642(b) and charitable deductions under IRC Section 642(c)). The final regulations in this section, however, include some modifications in response to comments, described later.
Under Treas. Reg. Section 1.642(h)-2(b)(2) of the final regulations, the provisions of Treas. Reg. Section 1.652(b)-3 are used to allocate each item of deduction among the classes of income in the year of a trust's termination for purposes of determining the character and amount of the excess deductions under IRC Section 642(h)(2). In response to a comment, the final regulations clarify that beneficiaries may claim all or part of the excess deductions under IRC Section 642(h)(2) before, after or together with deductions of the same character that are separately allowable to the beneficiary under the Code.
Example 2 in Treas. Reg. Section 1.642(h)-5(b) of the final regulations illustrates computations under IRC Section 642(h)(2). Various commenters pointed out that the proposed version of this example, which includes rental real estate taxes as an expense, could raise several issues beyond what the example aims to illustrate. To remedy this, the final regulations adopt a suggestion to modify the example to avoid these issues by having rental real estate expenses entirely offset rental income with no unused deduction. In addition, in response to comments, the IRS further revised Example 2 in the final regulations to include personal property tax paid by the trust rather than taxes attributable to rental real estate. Finally, the IRS also modified Example 2 to illustrate the application of trustee discretion as found in Treas. Reg. 1.652(b)-3(b) and (d).
The final regulations apply to tax years beginning after their date of publication in the Federal Register. Taxpayers may choose to apply the amendments to Treas. Reg. Section 1.67-4 and Treas. Reg. Sections 1.642(h)-2 and 1.642(h)-5 in the final regulations to tax years beginning after December 31, 2017, and on or before the date of publication of the final regulations in the Federal Register.
Other than a couple of clarifying additions and a tweaking of Example 2, the final regulations mirror the proposed regulations.
The final regulations under IRC Section 67 were unnecessary as the plain language of IRC Section 67(e) would lead to the conclusions set forth in Treas. Reg. Section 1.67-4. This regulation, however, responds to the requests of taxpayers, and settles any confusion some may have had as to the correct interpretation of IRC Section 67(e) in light of IRC Section 67(g).
The regulations under IRC Section 642(h) are much more helpful and taxpayer-favorable. Prior to the release of the regulations, many practitioners believed that IRC Section 67(e) excess deductions could change their character in the hands of the beneficiary and become itemized deductions. For example, tax preparation fees, which would be deductible by a trust or estate, would be a miscellaneous itemized deduction in the hands of a beneficiary. The regulations remedy this recategorization by creating 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). The final regulations further clarify that beneficiaries may claim all or part of the excess deductions before, after or together with deductions of the same character that are separately allowable to the beneficiary.
A couple of commentators requested revisions to Example 1 in Treas. Reg. Section 1.642(h)-5 to take into account the amendments to IRC Section 172(b)(1)(D) under the Coronavirus Aid, Relief and Economic Security (CARES) Act. Those amendments allow a beneficiary to carry back (five years) the NOL carryover from the terminated estate or trust for tax years after December 31, 2017, and before January 1, 2021. The Preamble notes that the phrase in IRC Section 642(h)(1), "the estate or trust has a net operating loss carryover," means that the estate or trust incurred an NOL and either already carried it back to the earliest allowable year under IRC Section 172 or elected to waive it under IRC Section 172(b)(3) and now is limited to carrying over the remaining NOL. Because the NOL is a carryover for the estate or trust, the beneficiary of that NOL may, under IRC Section 642(h)(1), only carry it forward. Therefore, the final regulations do not adopt these comments.