On Monday, September 21st, the IRS issued final regulations addressing the ability of trusts and estates to deduct administrative expenses, despite the 2017 Tax Cuts and Jobs Act's suspension of miscellaneous itemized deductions through 2025. The final regulations largely mirror the proposed regulations issued in May (read our article on the proposed regulations, IRS Issues Proposed Regulations on Trust and Estate Deductions).
Most importantly, the final rules provide guidance on the treatment of expenses which result in excess deductions – deductions exceeding a trust or estate’s income in the final year that are passed on to beneficiaries when the trust or estate terminates. Consistent with the proposed rules, the final rules provide that the excess deductions retain the character of the specific underlying expense, and require fiduciaries to categorize the excess deductions into one of three categories – an administrative expense that is deductible when computing adjusted gross income (i.e., an above-the-line deduction), a non-miscellaneous itemized deduction that is not subject to the 2% limitation (e.g., state and local income taxes), or a miscellaneous itemized deduction that is subject to the 2% limitation and disallowed through 2025 under TCJA (e.g., investment management fees).
The final rules also confirm that the character and amount of the excess deductions is determined by allocating the deductions among the trust or estate’s income as provided under IRC §652. Those regulations provide that all deductible expenses directly attributed to a certain class of income are allocated to that class of income, and that deductions which are not directly attributable to one class of income may be allocated to any item of income at the trustee’s discretion provided that a proportionate amount of the deduction is allocated to tax-exempt income, as applicable. This discretion presents an opportunity to maximize the tax benefit of the excess deductions.
As an illustration, consider the following updated example from the final regulations. Assume an estate’s income and deductions in its final year are as follows: total income of $6,500, consisting of taxable interest of $500, dividends of $3,000, rental income of $2,000, and capital gain of $1,000, and total deductions of $17,500, consisting of probate fees of $1,500, estate tax preparation fees of $8,000, and legal fees of $2,500 (collectively, IRC §67(e) deductions), personal property taxes of $3,500 (itemized deductions), and rental real estate expenses of $2,000. There are two beneficiaries – A (75%) and B (25%).
Pursuant to the regulations under IRC §652, the $2,000 of rental real estate expenses are allocated to the $2,000 of rental income. The executor may, in his discretion allowed under the regulations, allocate the $3,500 of personal property taxes and $1,000 of the IRC §67(e) deductions to the remaining $4,500 of income (thus maximizing the amount of the excess deductions which are considered above-the-line deductions). Therefore, the excess deductions on the termination of the estate are $11,000, consisting entirely of IRC §67(e) deductions which are deductible when computing gross income. Beneficiary A will be allocated $8,250 of above-the-line deductions, and beneficiary B will be allocated $2,750 of above-the-line deductions.
The final regulations provide clarity on determining the character and amount of, as well as the method for allocating, excess deductions that beneficiaries of a terminated estate or non-grantor trust may claim on their individual income tax returns. Under the rules, fiduciaries have discretion which allows them to maximize the tax benefit of these deductions. Please contact your HBK advisor to discuss how these final regulations may impact your tax situation.