The IRS has issued the final regulations dealing with the post-TCJA treatment of excess deductions on termination in TD 9918.[1]

Previously Reg. §1.642(h)-2 had treated excess deductions on the termination of an estate or trust as miscellaneous itemized deductions for the beneficiary. The Tax Cuts and Jobs Act (TCJA) added IRC §67(g), effective for tax years beginning in 2018, that provided individuals would no longer receive a deduction for miscellaneous itemized deductions.

In Notice 2018-61 the IRS indicated that the agency was considering whether the treatment of such items as miscellaneous itemized deductions was appropriate following the effective date of IRC §67(g). In May of 2020 the IRS released proposed regulations (REG-113295-18) that would provide that the nature of such deductions would be determined by their treatment at the trust level. The final regulations adopt the proposed regulations with some modifications.

IRC §67(e) Treatment Overrides IRC §67(g) Disallowance

Some had worried when the TCJA was passed that expenses that are treated as incurred because an asset is in a trust and deductible in computing the trust’s adjusted gross income would be treated as nondeductible due to IRC §67(g). The final regulations clarify that IRC §67(e) removes those expenses from the bar on deduction found at IRC §67(g).

(ii) Not disallowed under section 67(g). 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]

No Guidance on Impact of §67(e) on Computation of the Alternative Minimum Tax

The preamble provides that these regulations will not provide any guidance on whether such deductions under IRC §67(e) are or are not deductible in computing a trust or estate’s alternative minimum tax. The preamble notes:

Two commenters requested that the regulations address the treatment of deductions described in section 67(e)(1) and (2) in determining an estate or non-grantor trust’s income for alternative minimum tax (AMT) purposes. The commenters suggested that such deductions are allowable as deductible in computing the AMT. The treatment of deductions described in section 67(e) for purposes of determining the AMT is outside the scope of these regulations concerning the effects of section 67(g); therefore, these regulations do not address the AMT. Further, no conclusions should be drawn from the absence of a discussion of the AMT in these regulations regarding the treatment of deductions described in section 67(e) for purposes of determining the AMT.[3]

Treatment of Excess Deductions on Termination by the Beneficiary

The final regulations add in the body of the regulations, rather than a conclusion provided in an example, that the deductions retain their nature in the hands of the beneficiary. The added text is found at Reg. §1.642(h)-2(a)(2):

(2) Treatment by beneficiary. A beneficiary may claim all or part of the amount of the deductions provided for in paragraph (a) of this section, as determined after application of paragraph (b) of this section, before, after, or together with the same character of deductions separately allowable to the beneficiary under the Internal Revenue Code for the beneficiary’s taxable year during which the estate or trust terminated as provided in paragraph (c) of this section.[4]

The character of the expense is detailed at Reg. §1.642(h)-2(b)(1):

(b) Character and amount of excess deductions--(1) Character. The character and amount of the excess deductions on termination of an estate or trust will be determined as provided in this paragraph (b). 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 Internal Revenue 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.[5]

As was provided by the proposed regulations, the nature of the deductions passing out is determined by the trust or estate by using the mechanisms found in Reg. §1.652(b)-3 for determining the nature of income that makes up distributable net income of the trust or estate. The estate or trust determines the nature of the excess deductions using the following three steps:

Deductions directly allocable to a class of income must be allocated to that class of income, using provisions found at Reg. §1.652(b)-3(a). For instance, real estate taxes paid on rental property would be used to offset that rental income.
Any income remaining after the allocation of direct expenses is then subjected to the allocation of remaining deductions in accordance with provisions found at Reg. §1.652(b)-3(b) and (d). Generally, the trustee is allowed to exercise discretion in allocating remaining deductions, meaning that the trustee can attempt to offset less favored deductions for individuals at this level by using them against remaining income. So the trustee could take remaining real estate taxes subject to the $10,000 annual deduction limit that were allowed on the trust return against interest income and other investment income to remove the deduction from the calculation of excess deductions on termination. As well, if expenses directly related to a class of income exceeded that income, that excess deduction also becomes available to offset other income in this step.
Finally, once all income has been eliminated, the remaining deductions comprise the excess deductions on termination, allocated to the beneficiaries in accordance with Reg. §1.642(h)-4.[6]

The trustee would normally strive to have the excess deductions on termination be made up of items of deduction allowed in the computation of adjusted gross income for the trust or estate, which normally would produce the most favorable result for the beneficiary.

As was mentioned in our article discussing the proposed regulations, the IRS’s detailed example of allocating expenses[7] in the proposed regulations appeared to improperly treat the real estate taxes on the rental as being an itemized deduction when computing the make-up of excess deductions on termination. The IRS received a number of comments on this issue and others in the example, and revised that example:

Multiple commenters noted that Example 2 raises several issues that could be potentially relevant to that example, such as whether the decedent was in a trade or business and the application of section 469 to estates and trusts. To avoid these issues, which are extraneous to the point being illustrated, one commenter suggested that the example be revised so that the entire amount of real estate expenses on rental property equals the amount of rental income. The Treasury Department and the IRS did not intend to raise such issues in the example and consider both issues to be outside the scope of these regulations. Accordingly, the Treasury Department and the IRS adopt the suggestion by the commenter and modify Example 2 to avoid these issues by having rental real estate expenses entirely offset rental income with no unused deduction.

Commenters also noted that Example 2 does not properly allocate rental real estate expenses because the example characterizes the rental real estate taxes as itemized deductions. These commenters asserted that real estate taxes on property held for the production of rental income are not itemized deductions but instead are allowed in computing gross income and cited to section 62(a)(4) as providing that ordinary and necessary expenses paid or incurred during the taxable year for the management, conservation, or maintenance of property held for the production of income under section 212(2) that are attributable to property held for the production of rents are deductible as above-the-line deductions in arriving at adjusted gross income. One commenter suggested that, if the goal of Example 2 is to illustrate state and local taxes passing through to the beneficiary, then the example should include state income taxes rather than real estate taxes on rental real estate. The Treasury Department and the IRS have revised this example in the final regulations to include personal property tax paid by the trust rather than taxes attributable to rental real estate.

Lastly, commenters noted that Example 2 does not demonstrate the broad range of trustee discretion in §1.652(b)-3(b) and (d) for deductions that are not directly attributable to a class of income, or deductions that are, but which exceed such class of income, respectively. In response to these comments, the Treasury Department and the IRS have modified Example 2 to illustrate the application of trustee discretion as found in §1.652(b)-3(b) and (d).[8]

The revised example reads as follows:

Example 2, Computations Under Section 642(h)(2), Reg. §1.642(h)-5(b)

(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
Rent - $2,000
Capital Gain - $1,000

Total Income: $6,500

Deductions:

Section 62(a)(4) deductions:

Rental real estate expenses - $2,000

Section 67(e) deductions:

Probate fees - $1,500
Estate tax preparation fees - $8,000
Legal fees - $2,500

Non-miscellaneous itemized deductions:

Personal property taxes - $3,500

Total deductions: $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), the $2,000 of rental real estate expenses is allocated to the $2,000 of rental income. In the exercise of the executor’s discretion pursuant to §1.652(b)–3(b), D’s executor allocates $3,500 of personal property taxes and $1,000 of section 67(e) deductions to the remaining income. As a result, the excess deductions on termination of the estate are $11,000, all consisting of section 67(e) 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, all consisting of section 67(e) deductions. F’s share of the excess deductions is $2,750, also all consisting of section 67(e) deductions.

4) Separate statement. If the executor instead allocated $4,500 of section 67(e) deductions to the remaining income of the estate, the excess deductions on termination of the estate would be $11,000, consisting of $7,500 of section 67(e) deductions and $3,500 of personal property taxes. The non-miscellaneous itemized deduction for personal property taxes may be subject to limitation on the returns of both B and C’s trust under section 164(b)(6)(B) and would have to be separately stated as provided in §1.642(h)–2(b)(1).

Reporting Excess Deductions on Termination Information by an Estate or Trust

While not addressed in the regulation text, in the preamble the IRS discusses how this information is to be reported to beneficiaries. The preamble states:

Section 1.642(h)-2(b)(1) of the proposed regulations provides that 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. Commenters requested that the Treasury Department and the IRS provide guidance on how the excess deductions are to be reported by both the terminated estate or trust and by its beneficiaries. The Treasury Department and the IRS released instructions for beneficiaries that chose to claim excess deductions on Form 1040 in the 2019 or 2018 taxable year based on the proposed regulations. In addition, the Treasury Department and the IRS plan to update the instructions for Form 1041, Schedule K-1 (Form 1041), and Form 1040, U.S. Individual Income Tax Return, for the 2020 and subsequent tax years to provide for the reporting of excess deductions that are section 67(e) expenses or non-miscellaneous itemized deductions.[9]

The instructions for 2018 and 2019 referenced above are found on the IRS website.[10]

The IRS notes that since some states do not conform to §67(g), some taxpayers may need access to miscellaneous itemized deduction excess deduction information for state tax purposes. However, the agency declined to provide information for such reporting in the regulations since the matter is not one that impacts federal returns.

The Treasury Department and the IRS are aware that the income tax laws of some U.S. states do not conform to the Code with respect to section 67(g), such that beneficiaries may need information on miscellaneous itemized deductions of a terminated estate or trust. However, because miscellaneous itemized deductions are currently not allowed for Federal income tax purposes, that information is not needed for Federal income tax purposes. Therefore, it would not be appropriate to modify Federal income tax forms to require or accommodate the collection of such information while this deduction is suspended. Estates, trusts, and beneficiaries are advised to consult the relevant state taxing authority for information about deducting miscellaneous itemized expenses on their state tax returns[11]

Trustees will likely find they will receive requests to prepare this information for beneficiaries even when no return is required to be file in the state where the beneficiary resides.

Net Operating Loss Clarification

Some commenters had requested the IRS change one example found in the regulations to illustrate how a beneficiary would carry back a net operating loss carryover passed out by the estate or trust. In the preamble the IRS responds by noting that, in fact, beneficiaries are not now, or were they under pre-TCJA law, able to carry such a loss back:

Section 642(h)(1) provides a specific rule that allows the beneficiary to succeed to a net operating loss carryover of the estate or trust and deduct the amount of the net operating loss over the remaining carryover period that would have been allowable to the estate or trust but for the termination of the estate or trust. The phrase in section 642(h)(1) “the estate or trust has a net operating loss carryover’” means that the estate or trust incurred a net operating loss and either already carried it back to the earliest allowable year under section 172 or elected to waive the carryback period under section 172(b)(3), and now is limited to carrying over the remaining net operating loss. Accordingly, because the net operating loss is a carryover for the estate or trust, the beneficiary succeeding to that net operating loss may, under section 642(h)(1), only carry it forward.[12]

The IRS added a specific reference to this rule in Example 1, found at Reg. §1.642(h)-5(a), and notes that the beneficiaries cannot carry back a net operating loss carryover passed out of a trust or estate in its final year.

Effective Date and Impact on Pre-2018 Years

The final regulations apply to years beginning after the regulations are published in the Federal Register, but the proposed regulations may be relied upon for years beginning after December 31, 2017 and before the final regulations are published.[13]

The IRS explicitly deals with a question some had raised with regard to the proposed regulations—does the change in the nature of excess deductions on termination mean that this treatment should have been applied in prior years? And, therefore, would it be appropriate to file claims for refund where a taxpayer would have paid less tax in a pre-2018 tax year (the taxpayer was subject to the alternative minimum tax, did not itemize deductions or had some or all of the excess deductions offset by the 2% of adjusted gross income floor for miscellaneous itemized deductions)?

The IRS answer argues that the prior treatment was an appropriate interpretation of the provision that was within the discretion of the IRS, and thus will not allow taxpayers to use this new view of excess deductions on termination for years beginning before 2018:

One commenter requested that §1.642(h)-2 of the proposed regulations be applied retroactively not only to taxable years beginning after December 31, 2017, but to all open years. The commenter asserted that the existing regulation treating excess deductions on termination of an estate as a miscellaneous itemized deduction was in error. As an example, the commenter argues that the current regulations mistakenly describe section 67(e) expenses as an exception to the rules applicable to miscellaneous itemized deductions, and therefore requested that the final regulations be applicable to all open years. The Treasury Department and the IRS have the authority to treat an excess deduction on termination of an estate or trust as a single miscellaneous itemized deduction. See section 642(h). The suspension under section 67(g) of miscellaneous itemized deductions caused the Treasury Department and the IRS to reconsider the treatment of excess deductions under section 642(h)(2) because the Treasury Department and the IRS do not interpret section 67(g) as suspending such deductions allowable under section 642(h)(2). The Treasury Department and the IRS interpret section 67(g) as not disallowing excess deductions succeeded to beneficiaries from terminated estates and trusts under section 642(h)(2). Therefore, taxpayers may rely on these regulations as of the effective date of section 67(g), but not for earlier periods.[14]

[1] TD 9918, September 21, 2020 (release date by IRS – the date published in the Federal Register will be the official date the regulations are treated as issued), https://www.irs.gov/pub/irs-drop/td-9918.pdf (retrieved September 26, 2020)

[2] Reg. §1.67-4(a)(1)(ii)

[3] TD 9918, Preamble, SUMMARY INFORMATION, Summary of Comments and Explanations, A. Section 67

[4] Reg. §1.642(h)-2(a)(2)

[5] Reg. §1.642(h)-2(b)(1)

[6] Reg. §1.642(h)-2(b)(2)

[7] Ed Zollars, “Proposed Regulations Upon Which Taxpayers May Rely Issued For Excess Deductions on Termination,” Current Federal Tax Developments website, May 8, 2020, https://www.currentfederaltaxdevelopments.com/blog/2020/5/8/proposed-regulations-upon-which-taxpayers-may-rely-issued-for-excess-deductions-on-termination (retrieved September 26, 2020)

[8] TD 9918, Preamble, SUMMARY INFORMATION, Summary of Comments and Explanations, B. Section 642(h), 7. Example 2

[9] TD 9918, Preamble, SUMMARY INFORMATION, Summary of Comments and Explanations, B. Section 642(h), 3. Reporting of excess deductions

[10] Reporting Excess Deductions on Termination of an Estate or Trust on Forms 1040, 1040-SR, and 1040-NR for Tax Year 2018 and Tax Year 2019, IRS website, September 19, 2020 revision, https://www.irs.gov/forms-pubs/reporting-excess-deductions-on-termination-of-an-estate-or-trust-on-forms-1040-1040-sr-and-1040-nr-for-tax-year-2018-and-tax-year-2019 (retrieved September 26, 2020)

[11] TD 9918, Preamble, SUMMARY INFORMATION, Summary of Comments and Explanations, B. Section 642(h), 3. Reporting of excess deductions

[12] TD 9918, Preamble, SUMMARY INFORMATION, Summary of Comments and Explanations, B. Section 642(h), 6. Example 1

[13] TD 9918, Preamble, SUMMARY INFORMATION, Summary of Comments and Explanations, C. Applicability Dates

[14] TD 9918, Preamble, SUMMARY INFORMATION, Summary of Comments and Explanations, C. Applicability Dates