Proposed Regulations Clarify Nongrantor Trust & Estate Deductions
On May 7, 2020, the IRS released anticipated proposed regulations (REG-113295-18) clarifying the deductibility of Section 67(e) administration expenses for nongrantor trusts and estates and addressing the treatment of excess deductions in the year a trust or estate is terminated. These proposed regulations provide formality and clarify guidance earlier provided in Notice 2018-61.
The Internal Revenue Code (IRC) provides that a nongrantor trust or estate computes its adjusted gross income (AGI) in the same manner as an individual, with a few exceptions. Section 67(e) provides one of those exceptions. It allows a nongrantor trust or estate to deduct costs incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in such estate or trust, as well as outlines deductions allowable as personal exemptions and deductions for distributions of income. The Tax Cuts and Jobs Act added §67(g) to the IRC, suspending miscellaneous itemized deductions for tax years 2018 through 2025. Since the addition of §67(g), there have been calls for the IRS to clarify the applicability of §67(g) to §67(e). The proposed regulations under Treas. Reg. §1.67-4 clarify that §67(g) does not deny an estate or nongrantor trust the deductions allowed under §67(e), but the proposed regulations do not further clarify the treatment of such expenses for alternative minimum tax.
Another difference in the taxable income computation in nongrantor trusts and estates, as opposed to individuals, occurs when deductions exceed a taxpayer’s gross income in a given year. When a trust or estate has deductions in excess of its gross income, the loss generally does not carry over and does not pass through to the beneficiary. IRC §642(h), however, provides an exception to this general rule. It allows deductions in excess of gross income to be taken by the beneficiary in the year the trust or estate is terminated. Treas. Reg. §1.642(h)-2(a) provides further guidance and states that an excess deduction is “allowed only in computing taxable income and must be taken into account in computing the items of tax preference of beneficiaries; it is not allowed in computing adjusted gross income.” Therefore, excess deductions on the termination of an estate or trust are allowable as a single miscellaneous itemized deduction. As previously described, §67(g) suspended miscellaneous itemized deductions for tax years 2018 through 2025. As a result, the excess deduction on termination was denied deductibility on the beneficiaries’ return.
Commentators reminded the IRS that the Treas. Reg. §1.642(h)-2 predated the concept of miscellaneous itemized deductions and encouraged the IRS to exercise its regulatory authority to address the error caused by the addition of §67(g). The proposed regulations agree with the commentators. The proposed regulations outline that any excess deductions distributed by a trust or estate to its beneficiaries in the year of termination should not be categorized in a single itemized deduction as they were under Treas. Reg. §1.642(h)-2(a) but rather maintain their character. The excess deduction on termination under proposed regulation §1.642-(h)(2) will now be categorized under one of three buckets: those that would have otherwise been deducted when arriving at AGI at the trust level, amounts that would be itemized deductions after AGI and other miscellaneous deductions.
The proposed regulations allow for estates, nongrantor trusts and their beneficiaries to rely on the proposed regulations for taxable years beginning after December 31, 2017.
For more information on how these proposed regulations affect your trust or estate income tax return, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.