The Internal Revenue Service and the Treasury Department issued final regulations (final regs) on Sept. 21, 2020. They make clear that estates and nongrantor trusts can take deductions for expenses under Internal Revenue Code Section 67(e) and that excess deductions on termination of an estate or nongrantor trust will retain their character in the hands of the beneficiary as in the hands of the terminating estate or trust.
IRC Section 67(e) Expenses Allowed
The final regs under Section 67(g) clarify the treatment of Section 67(e) expenses incurred by estates and nongrantor trusts in light of the suspension of miscellaneous itemized deductions. The final regs implement the prior proposed regulations (proposed regs), which were issued on May 7, 2020, without substantive changes in most respects (TD9918). Itemized deductions are those allowable other than: (1) deductions allowable in arriving at adjusted gross income (AGI); (2) deductions for personal exemptions under IRC Section 151; and (3) the deduction provided in IRC Section 199A. Miscellaneous itemized deductions are those itemized deductions other than deductions described in Section 67(b)(1)-(12). Deductions for costs paid or incurred in the administration of an estate or nongrantor trust that wouldn't have been incurred had the property not been held in such estate or trust, such as tax preparation fees and appraisal fees, aren't listed in Section 67(b).
Section 67(g) was introduced by the 2017 Tax Cuts and Jobs Act (TCJA) and disallowed miscellaneous itemized deductions for taxable years beginning after Dec. 31, 2017. The suspension of miscellaneous itemized deductions is effective until the end of 2025. Some were concerned that the IRS might have characterized Section 67(e) expenses as miscellaneous itemized deductions. If so, the TCJA would have eliminated the ability of estates and nongrantor trusts to deduct these expenses, which are uniquely incurred by estates and nongrantor trusts. In 2018, the IRS and Treasury had issued Notice 2018-61, which announced pending regs and confirmed the deductibility of Section 67(e) expenses by removing those expenses from the category of itemized deductions.
The final regs regarding costs paid or incurred by estates or nongrantor trusts are substantively identical to the proposed regs, which revised Treasury Regulations Section 1.67-4 to clarify that Section 67(e) expenses are neither miscellaneous itemized deductions nor itemized deductions on the basis that such expenses are treated as above-the-line deductions allowed in determining AGI (Notice 2018-61, at 5).
The preamble notes that treatment of Section 67(e) expenses for purposes of the alternative minimum tax weren't addressed as requested by commenters, as this question is outside the scope of the regs, which focused on clarifying the effects of Section 67(g).
Excess Deductions
The issue of whether excess deductions would be deductible by a beneficiary was more difficult. Notice 2018-61 acknowledged this open question. The proposed regs had clarified whether beneficiaries could claim excess deductions of a terminating estate or nongrantor trust as a Section 642(h)(2) excess deduction. These deductions wouldn't individually be considered miscellaneous itemized deductions, but prior regs had treated excess deductions on termination as a single miscellaneous itemized deduction. The proposed regs had adopted an approach advocated in a comment, providing that excess deductions should be segregated to determine the character, amount and manner for allocating deductions to beneficiaries, with each item of expenses categorized as: (1) an amount allowed in arriving at AGI; (2) a nonmiscellaneous itemized deduction; or (3) a miscellaneous itemized deduction. In the preamble to the final regs, IRS and Treasury, in response to a comment on the proposed regs, clarified that the characterization of excess deductions as a miscellaneous itemized deduction predates Section 67(g) and affirmed the appropriateness of treating excess deductions as having the same character in the hands of the beneficiary as in the hands of the estate or nongrantor trust. This approach is also consistent with the legislative history of Section 642(h), which sought to avoid "wasted" deductions. The final regs amplify the treatment of excess deductions from the proposed regs by adding a provision confirming that deductions will retain the same character in the hands of the beneficiary and provide that the deductions may be claimed before, after or together with the same character of deductions separately allowable to the beneficiary.
Example 2 of the proposed regs confused practitioners, and garnered comment, due to its apparent treatment of real estate taxes on rental property as an itemized deduction, despite being an expense allowed in arriving at AGI. In the final regs, the example was revised such that rental expenses didn't exceed rental income to avoid the ambiguity caused by the prior language of the example. Additionally, Example 2 was revised, in line with a comment made by the American College of Trust and Estate Counsel, to permit allocation of personal property tax to income, with Section 67(e) expenses passed out to the beneficiary. The changes to Example 2 from the proposed regs confirm that deductions can be selectively allocated to income or chosen as deductions to be carried out to the beneficiary.
Application
In the preamble to the final regs, the IRS and Treasury provide guidance as to the reporting of excess deductions. IRS and Treasury had released instructions for beneficiaries choosing to rely on the proposed regs on Form 1040 for the applicable years. Updated instructions for Form 1041, Schedule K-1 (Form 1041) and Form 1040 will be forthcoming to provide guidance for reporting of excess deductions. The preamble also notes that the instructions and forms won't be updated to require collection of information regarding miscellaneous itemized deductions. As such, taxpayers needing this information for state return filings where state law doesn’t entirely conform with federal tax law will need to obtain guidance from state taxing authorities. Taxpayers can choose to apply the final regs to taxable years beginning after Dec. 31, 2017, and on or before publication of the final regs in the Federal Register.