The Internal Revenue Service and the Treasury Department issued proposed regulations (proposed regs) on May 7, 2020, clarifying the impact of Internal Revenue Code Section 67(g) on the ability of estates and nongrantor trusts to take certain deductions for administrative expenses under IRC Section 67(e) and the treatment of excess deductions under IRC Section 642(h) on the termination of an estate or nongrantor trust.
Impact of Section 67(g)
Section 67(g), introduced by the 2017 Tax Cuts and Jobs Act (TCJA), disallows miscellaneous itemized deductions for taxable years beginning after Dec. 31, 2017. Section 67(b) defines “miscellaneous itemized deductions” as itemized deductions other than those described in Section 67(b)(1)–(12). Itemized deductions are those allowed other than: (1) deductions allowable in arriving at adjusted gross income (AGI); (2) deductions for personal exemptions; and (3) the deduction under IRC Section 199A. In general, miscellaneous itemized deductions include, but aren’t limited to, unreimbursed employee expenses; expenses paid or incurred for the production or collection of income or for the determination, collection or refund of tax and hobby expenses. Like other provisions of the TCJA, the repeal of miscellaneous itemized deductions is set to expire at the end of 2025 (IRC Section 63(d)).
Section 67(e) provides that an estate or trust computes its AGI in the same manner as an individual, with the following additional deductions allowed: (1) for costs paid or incurred in connection with estate or trust administration that wouldn’t have been incurred had the property not been held in the estate or trust; (2) under IRC Section 642(b) (deductions pertaining to the personal exemption of an estate or nongrantor trust), IRC Section 651 (deductions for trusts distributing current income only) and Section 661 (deductions for trusts accumulating income or distributing corpus).
After the passage of the TCJA, there was some question and concern among practitioners about the application of new Section 67(g) to trust expenses that weren’t otherwise subject to the limitation contained in Section 67(a) and were deductible under Section 67(e). The loss of miscellaneous itemized deductions was painful for many taxpayers, and some feared that the provisions of Section 67(g) would compound this pain for nongrantor trusts and estates by preventing deductions previously taken under Section 67(e). Notice 2018-61 clarified this concern, stating that Section 67(e) expenses remain deductible by nongrantor trusts and estates. This is the case because Section 67(e) provides that those expenses are treated as above-the-line deductions allowed in determining AGI and are thus removed from the category of itemized deductions (Notice 2018-6, at 5).
Costs Paid or Incurred by Estates or Nongrantor Trusts
The proposed regs under Treasury Regulations Section 1.67-4 are consistent with the guidance previously given in Notice 2018-61. The proposed regs revise Treas. Regs. Section 1.67-4 to make clear that Section 67(e) expenses aren’t itemized deductions (or miscellaneous itemized deductions) and that an estate or trust shall be allowed deductions for: (1) costs paid or incurred in connection with the administration of the estate or trust that wouldn’t have been incurred if the property weren’t held in such estate or trust, and (2) deductions relating to the personal exemption, to trusts distributing current income only or to trusts accumulating income or distributing corpus (Effect of Section 67(g) on Trusts and Estates, 85 Fed. Reg. 91 (May 11, 2020)).
Excess Deductions on Termination of an Estate or Trust
Perhaps even more importantly, the proposed regs address the question of whether beneficiaries may claim excess deductions of a terminating estate or trust as a Section 642(h)(2) excess deduction. These wouldn’t be considered miscellaneous itemized deductions to estates or nongrantor trusts, but under existing regulations, excess deductions on termination of a nongrantor trust or estate are treated as a miscellaneous itemized deduction that would otherwise be disallowed under Section 67(g). Treasury and IRS had requested comments on the ability of a beneficiary to deduct amounts comprising the excess deduction on termination and whether the separate amounts comprising the excess deduction should be separately analyzed (Notice 2018-61, at 8).
Comments supported segregation of the excess deduction items. In the proposed regs, the IRS and Treasury adopted the suggestion that Section 642(h)(2) excess deductions should be segregated to determine the character, amount and manner for allocating excess deductions to beneficiaries, rather than grouping all expenses together. Each expense comprising the excess deduction will retain its character among the following categories of expenses: (1) an amount allowed in arriving AGI; (2) a nonmiscellaneous itemized deduction; or (3) a miscellaneous itemized deduction. The character of the deductions will remain the same in the hands of the beneficiary. The fiduciary of the estate or trust will need to identify deductions that may be limited when claimed by the beneficiary.
Additionally, in determining the character and amount of excess deductions, IRS and Treasury adopted a suggestion from commenters that items of deduction should be allocated among the classes of income in the year of termination according to principles under Treas. Regs. Section 1.652(b)-3, which direct that deductions attributable to a class of income are allocated to that income. Any remaining deductions not specifically allocated to a class of income, as well as any deductions in excess of attributable income, can then be allocated to any item of income (but tax-exempt income must be included). Any remaining deductions will retain their character and comprise the excess deductions available to beneficiaries.
Overall, the proposed regs on excess deductions are favorable and address the concerns raised by commenters on this issue, including potential prolonging of estate or trust administration to fully use deductible expenses at the estate or trust level, if the deductions comprising the excess deduction weren’t segregated.
Remaining Questions
Commenters had requested that the IRS and Treasury address the question of whether Section 67(e) expenses of a nongrantor trust or estate are deductible for purposes of the alternative minimum tax (AMT). The IRS and Treasury declined to address this question, indicating that the treatment of Section 67(e) expenses for purposes of determining the income of an estate or a nongrantor trust is outside the scope of the proposed regs. Accordingly, the deductibility of 67(e) expenses for AMT purposes remains unconfirmed.
One of the examples in the proposed regs illustrating the mechanics of the computations under Section 642(h)(2) is confusing. Example 2 describes real estate taxes on rental property as an itemized deduction. However, as an expense that’s allowed in arriving at AGI, it’s unclear why the expense is categorized as an itemized deduction.
Lastly, the IRS and Treasury indicated that they’re continuing to review issues relating to Sections 67 and 642 and may issue further guidance on questions outside the scope of the proposed regs.
Reliance on Proposed Regs and Comments Requested
Taxpayers may rely on the proposed regs for tax years beginning after Dec. 31, 2017, and on or before the date the final regulations are published.
IRS and Treasury have requested comments on the proposed regs by June 25, 2020.