On Thursday, May 7th, the IRS issued proposed regulations addressing the ability of trusts and estates to deduct administrative expenses after the Tax Cuts and Jobs Act (TCJA) of 2017 eliminated miscellaneous deductions that are subject to a 2% adjusted gross income limitation through 2025. In general, the proposed regulations confirm that a trust or estate may still take a deduction for expenses that would not have been incurred if the property the expenses relate to were not held by a trust or estate. In addition, the proposed regulations confirmed that a trust or estate may still deduct the personal exemption allowed for estates and non-grantor trusts, and the distribution deduction for income that is distributed to beneficiaries of the trust or estate. The proposed rules are generally in line with the guidance that was previously published by the IRS in Notice 2018-61.
Prior to the enactment of the TCJA, individuals, trusts, and estates were allowed to deduct certain expenses described under Internal Revenue Code (IRC) § 67, to the extent that the total of these expenses exceeded 2% of the individual, trust, or estate’s adjusted gross income. Under these rules, administrative expenses of an estate or trust that would normally be subject to this 2% limitation were deductible in full so long as they were paid or incurred in connection with the administration of the estate or trust, and would not have been incurred if the property were not held in the trust or estate.
Over the years there has been significant litigation over what expenses are truly considered unique to a trust or estate, and thus are fully deductible. It is generally agreed that administration expenses of an estate (e.g. probate costs, appraisal fees, and storage fees) are considered unique expenses and are therefore deductible. In addition, fiduciary fees, accounting fees, legal fees, and tax return preparation fees have been recognized as fully deductible by trusts and estates. However, investment management fees and other expenses related to investment income have generally not been considered unique to a trust or estate and have therefore been subject to the 2% limitation.
The Tax Cuts and Jobs Act of 2017 and Notice 2018-61
The TCJA changed the rules relating to miscellaneous deductions and eliminated the ability of individuals, trusts, and estates to deduct expenses that are described under IRC § 67. As a result, it was not entirely clear whether expenses of a trust or estate that fell within the exception to the 2% limitation were also considered nondeductible under the TCJA. In response to this confusion, the IRS issued Notice 2018-61 which generally explained that these administrative expenses would still be deductible.
The Proposed Regulations
The proposed regulations confirm that administrative expenses of a trust or estate are not considered miscellaneous itemized deductions subject to the 2% limitation; and, therefore, are still deductible. In addition, the proposed regulations take the position that excess deductions – expenses in excess of a trust or estate’s income that are passed out to the beneficiaries on a final income tax return – retain the character of the specific expense. This means that a portion of the excess deduction may be an administrative expense that is deductible when computing adjusted gross income, a non-miscellaneous itemized deduction that is not subject to the 2% limitation, or a miscellaneous itemized deduction that is subject to the 2% limitation. 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.
For example, 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 $4,500 (collectively, IRC § 67(e) deductions), and real estate taxes on the rental property of $3,500 (itemized deductions). There are two beneficiaries – A (75%) and B (25%).
According to the proposed regulations, the excess deductions are allocated under IRC § 652. Pursuant to those regulations, $2,000 of the real estate taxes is allocated to the $2,000 of rental income. Furthermore, assume that in his discretion allowed under the regulations, the executor allocates $4,500 of the IRC § 67(e) deductions to the remaining $4,500 of income. Therefore, the excess deductions on the termination of the estate are $11,000, consisting of $9,500 of IRC § 67(e) deductions (deductible when computing gross income) and $1,500 of itemized deductions (non-2% deductions). Beneficiary A will be allocated $7,125 of above-the-line deductions and $1,125 of itemized deductions, and beneficiary B will be allocated $2,375 of above-the-line deductions and $375 of itemized deductions.
While the proposed regulations provide much-needed clarity of deductions that are still allowable for trusts and estates, there are still some unanswered questions that the final regulations may address when they are eventually released. Please contact your HBK advisor to discuss what effect these proposed regulations may have on your tax situation.