The long-awaited proposed regulations on the effect of IRC §67(g) on trusts and estates have now been issued by the IRS.[1]  The big item in the proposed regulations is an explanation of the treatment of excess deductions on termination under IRC §642(h)(2) after the Tax Cuts and Jobs Act provided, in IRC §67(g), that miscellaneous itemized deductions would no longer be deductible on individual income tax returns.

Existing Reg. §1.642(h)-1 provided that such deductions are “allowed only in computing taxable income and must be taken into account in computing the items of tax preference of beneficiaries; it is not allowed in computing adjusted gross income.” This holding led to such deductions being treated as miscellaneous itemized deductions prior to the TCJA addition of §67(g).

The IRS had requested guidance in Notice 2018-61 regarding whether such a treatment was appropriate given the addition of IRC §67(g) in the Tax Cuts and Jobs Act.  These proposed regulations contain the IRS’s initial conclusions in this area.

Effective Date and Ability to Rely on the Proposed Regulations

The IRS guidance contains the following information regarding the proposed effective date and the ability of taxpayers to rely on these proposed regulations in the interim.

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

Advisers should note that these regulations will affect returns already filed for 2018 and 2019, which may require the preparation of amended Forms 1041 and 1040 to obtain tax refunds for beneficiaries of trusts that distributed excess deductions on termination.

IRC §67(e) Deductions

The IRS has decided to revise the beginning of Reg. §1.67-4 to clarify costs in a trust described in IRC §67(e) as well as those that are miscellaneous itemized deductions.  The clarified Proposed Reg. §1.67-4(a) reads:

§1.67-4. Costs paid or incurred by estates or non-grantor trusts.

(a) In general--(1) Section 67(e) deductions.

(i) An estate or trust (including the S portion of an electing small business trust) not described in §1.67-2T(g)(1)(i) (a non- grantor trust) shall compute its adjusted gross income in the same manner as an individual, except that the following deductions (Section 67(e) deductions) are allowed in arriving at adjusted gross income:

(A) Costs that are paid or incurred in connection with the administration of the estate or trust, which would not have been incurred if the property were not held in such estate or trust; and

(B) Deductions allowable under section 642(b) (relating to the personal exemption) and sections 651 and 661 (relating to distributions).

(ii) Section 67(e) deductions are not itemized deductions under section 63(d) and are not miscellaneous itemized deductions under section 67(b). Therefore, section 67(e) deductions are not disallowed under section 67(g).

(2) Deductions subject to 2-percent floor. A cost is not a section 67(e) deduction and thus is subject to both the 2-percent floor in section 67(a) and section 67(g) to the extent that it is included in the definition of miscellaneous itemized deductions under section 67(b), is incurred by an estate or non-grantor trust (including the S portion of an electing small business trust), and commonly or customarily would be incurred by a hypothetical individual holding the same property.

Excess Deductions on Termination

The more significant guidance is provided by the IRS on the issue of the treatment of excess deductions on termination.  The proposed regulations no longer treat the total of excess deductions on termination as a miscellaneous itemized deduction in the hands of the beneficiary allocated the deduction. 

Rather the proposed regulations provide:

Each deduction comprising the excess deductions under section 642(h)(2) retains, in the hands of the beneficiary, its character (specifically, as allowable in arriving at adjusted gross income, as a non-miscellaneous itemized deduction, or as a miscellaneous itemized deduction) while in the estate or trust. An item of deduction succeeded to by a beneficiary remains subject to any additional applicable limitation under the Code and must be separately stated if it could be so limited, 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., or successor forms.[2]

The amount and allocation of excess deductions on termination are determined as follows:

• Each deduction directly attributable to a class of income is allocated in accordance with the provisions in Reg. §1.652(b)-3(a);

• To the extent of any remaining income after application of the prior rule deductions are allocated in accordance with the provisions in Reg. §1.652(b)-3(b) and (d) (the general rules for allocation of income and deductions in computing what makes up distributable net income of a trust or estate); and

• Deductions remaining after the application of the prior two rules comprise the excess deductions on termination of the estate or trust. These deductions are allocated to the beneficiaries succeeding to the property of the estate or trust in accordance with Reg. §1.642(h)-4.[3]

The IRS provides the following example which makes clear those deductions retain their nature in the hands of the beneficiary or beneficiaries.  As such, the trust will have to inform beneficiaries of the nature of the expenses after the allocation of expenses against income.

Example (Proposed Reg. §1.642(h)-2(c)(2))

Assume that a trust distributes all its assets to B and terminates on December 31, Year X. As of that date, it has excess deductions of $18,000, all characterized as allowable in arriving at adjusted gross income under section 67(e). B, who reports on the calendar year basis, could claim the $18,000 as a deduction allowable in arriving at B's adjusted gross income for Year X. (emphasis added) However, if the deduction (when added to B's other deductions) exceeds B's gross income, the excess may not be carried over to any year subsequent to Year X.

The allocation of expenses will follow the rules used in computing the make up of distributable net income (DNI) found at Reg. §1. 652(b)-3(b) and (d).  Items of expense that are directly allocable to a class of income are first allocated to that class per Reg. §1.652(b)-3(a):

All deductible items directly attributable to one class of income (except dividends excluded under section 116) are allocated thereto.[4]

The regulation provides an example of such directly allocated items.

Example

For example, repairs to, taxes on, and other expenses directly attributable to the maintenance of rental property or the collection of rental income are allocated to rental income. See § 1.642(e)-1 for treatment of depreciation of rental property. Similarly, all expenditures directly attributable to a business carried on by a trust are allocated to the income from such business.

If the deductions directly attributable to a particular class of income exceed that income, the excess is applied against other classes of income in the manner provided in paragraph (d) of this section.[5]

The paragraph (d) noted in the example is Reg. §1.652(b)-3(d) which provides:

To the extent that any items of deduction which are directly attributable to a class of income exceed that class of income, they may be allocated to any other class of income (including capital gains) included in distributable net income in the manner provided in paragraph (b) of this section, except that any excess deductions attributable to tax-exempt income (other than dividends excluded under section 116) may not be offset against any other class of income. See section 265 and the regulations thereunder. Thus, if the trust has rents, taxable interest, dividends, and tax-exempt interest, and the deductions directly attributable to the rents exceed the rental income, the excess may be allocated to the taxable interest or dividends in such proportions as the fiduciary may elect. However, if the excess deductions are attributable to the tax-exempt interest, they may not be allocated to either the rents, taxable interest, or dividends.[6]

Expenses not directly allocable to a class of income are allocated at the discretion of the trustee to any item of income used in computing DNI, in accordance with Reg. §1.652(b)-3(b) which provides:

The deductions which are not directly attributable to a specific class of income may be allocated to any item of income (including capital gains) included in computing distributable net income, but a portion must be allocated to nontaxable income (except dividends excluded under section 116) pursuant to section 265 and the regulations thereunder.[7]

The regulation explains the rule by using the following example:

Example

For example, if the income of a trust is $30,000 (after direct expenses), consisting equally of $10,000 of dividends, tax-exempt interest, and rents, and income commissions amount to $3,000, one-third ($1,000) of such commissions should be allocated to tax-exempt interest, but the balance of $2,000 may be allocated to the rents or dividends in such proportions as the trustee may elect.

The fact that the governing instrument or applicable local law treats certain items of deduction as attributable to corpus or to income not included in distributable net income does not affect allocation under this paragraph. For instance, if in the example set forth in this paragraph the trust also had capital gains which are allocable to corpus under the terms of the trust instrument, no part of the deductions would be allocable thereto since the capital gains are excluded from the computation of distributable net income under section 643(a)(3).[8]

The IRS provides a comprehensive example of such an allocation of excess deductions on termination in Proposed Reg. §1.642(h)-5(b)(2).

Example

Example 2. Computations under section 642(h)(2) — (1) Facts. D dies in 2019 leaving an estate of which the residuary legatees are E (75%) and F (25%). The estate's income and deductions in its final year are as follows:

Income

• Dividends - $3,000

• Taxable interest - $500

• Rents - $2,000

• Capital Gain - $1,000

Thus, total income in the final year is $6,500

Deductions

IRC §67(e) Deductions

• Probate fees - $1,500

• Estate tax preparation fees - $8,000

• Legal fees - $4,500

Total §67(e) deductions (those used in computing the trust’s adjusted gross income) are $14,000

Itemized Deductions

• Real estate taxes on rental property - $3,500

Total deductions are $17,500.

(2) Determination of character. Pursuant to §1.642(h)-2(b)(2), the character and amount of the excess deductions is determined by allocating the deductions among the estate's items of income as provided under §1.652(b)-3. Under §1.652(b)-3(a), $2,000 of real estate taxes is allocated to the $2,000 of rental income. In the exercise of the executor's discretion pursuant to §1.652(b)-3(b) and (d), D's executor allocates $4,500 of section 67(e) deductions to the remaining $4,500 of income. As a result, the excess deductions on termination of the estate are $11,000, consisting of $9,500 of section 67(e) deductions and $1,500 of itemized deductions.

(3) Allocations among beneficiaries. Pursuant to §1.642(h)-4, the excess deductions are allocated in accordance with E's (75 percent) and F's (25 percent) interests in the residuary estate. E's share of the excess deductions is $8,250, consisting of $7,125 of section 67(e) deductions and $1,125 of real estate taxes. F's share of the excess deductions is $2,750, consisting of $2,375 of section 67(e) deductions and $375 of real estate taxes. The real estate taxes on rental property must be separately stated as provided in §1.642(h)-2(b)(1).[9]

However, this author believes this example has a couple of issues.  First, it appears the example erroneously treats the real estate taxes on a rental property as an itemized deduction.  IRC §67(e) provides that a trust generally computes its income in the same manner as an individual, with certain additional deductions allowed in the computation.  IRC §62(a)(4) provides that deductions related to a rental property under IRC §212 are deductible in computing adjusted gross income and, by extension, are not itemized deductions.

In the author’s view the example erroneously treats the excess of real estate taxes over the amount of rental income as an itemized deduction.  Rather, this should be, along with the §67(e) expenses paid, treated as an expense allowed as a deduction in computing adjusted gross income per Proposed Reg. §1.642(h)-2(b)(1).  The only item reported to the beneficiaries would be $11,000 of deductions allowed in computing adjusted gross income.

But even if those taxes were miscellaneous itemized deductions, not allocating them first against other income of the trust would normally be a poor tax move by the trustee.  Reg. §1.652(b)-3(d) cited in the proposed regulations as the method to use to apply expenses to trust income specifically uses an example of applying excess rental deductions against such “above the line” income.[10]  So even in that case, there would be $11,000 of §67(e) deductions only remaining as excess deductions on termination, deductible by the beneficiaries in computing their own adjusted gross income.

[1] REG-113295-18, May 7, 2020, https://s3.amazonaws.com/public-inspection.federalregister.gov/2020-09801.pdf?utm_medium=email&utm_campaign=pi+subscription+mailing+list&utm_source=federalregister.gov (retrieved May 8, 2020)

[2] Proposed Reg. §1.642(h)-2(b)(1)

[3] Proposed Reg. §1.642(h)-2(b)(2)

[4] Reg. §1.652(b)-3(a)

[5] Reg. §1.652(b)-3(a)

[6] Reg. §1.652(b)-3(d)

[7] Reg. §1.652(b)-3(b)

[8] Reg. §1.652(b)-3(b)

[9] Proposed Reg. §1.642(h)-5(b)(2)

[10] “Thus, if the trust has rents, taxable interest, dividends, and tax-exempt interest, and the deductions directly attributable to the rents exceed the rental income, the excess may be allocated to the taxable interest or dividends in such proportions as the fiduciary may elect.”