Proposed regulations clarify treatment of final Form 1041 excess deductions

Beneficiaries may be able to claim some deductions that were not deductible by the estate or trust on the final Form 1041 under proposed regulations.

May 26, 2020

Before the TCJA, final-year estate and trust excess deductions were passed through to beneficiaries who, in turn, claimed them as miscellaneous itemized deductions subject to the 2%-of-AGI floor. Since “2% deductions” are not available for tax years 2018-2025, proposed regulations clarify that some passthrough items are potentially deductible. For final Form 1041 deductions, estate and trust fiduciaries must separate passthrough deductions into three categories and provide information to beneficiaries on how to treat the items.

Background on estate and trust final Form 1041 deductions

Section 642(h)(2) allows any deductions in excess of an estate’s or trust’s final-year income to pass through to beneficiaries on a Schedule K-1. Prior to the TCJA, and consistent with Reg. § 1.67-4, an individual beneficiary could then report this amount as a miscellaneous itemized deduction, subject to the 2%-of-AGI limit. The TCJA, however, added new § 67(g) that eliminated miscellaneous “2%” deductions for tax years 2018-2025. The change created confusion both for fiduciaries and for beneficiaries on how to report these excess final year Form 1041 deductions going forward.

In 2018, the IRS sought public commentary from practitioners on new regulations for excess deductions to reflect the new rule in § 67(g). The changes to the regulations largely reflect this public commentary.

Excess final Form 1041 deductions under the proposed regulations

Prop. Reg. § 1.642(h)-2 would require fiduciaries to separately identify the various excess deductions and place them into three categories:

  1. an amount allowed in arriving at the trust’s or estate’s AGI,
  2. a non-miscellaneous itemized deduction,
  3. a miscellaneous itemized deduction, such as tax preparation fees.

The fiduciary will also need to identify any expenses where a deduction to the beneficiary might be limited (e.g., state and local taxes, which are non-miscellaneous itemized deductions). To figure the deductible amount for each category, fiduciaries must use the same rules set out in § 652 and its regulations. These rules distinguish between “direct” expenses (which can be allocated directly to the income to which they relate) and “indirect” expenses (which are not allocable to any specific income category).

Additionally, Prop. Reg. §1.67-4 was updated to clarify that deductions allowed under § 67(e)—generally, deductions allowed for the trust’s or estate’s AGI—are not miscellaneous deductions disallowed under the TCJA’s new rule. To qualify under this section, an expense must meet both the following requirements: (1) it was necessarily incurred during the estate or trust’s administration, and (2) it would not have been incurred if the property to which it relates was not held in an estate or trust. For example, the trust’s fiduciary fees are § 67(e) deductions and thus deductible by beneficiaries.

These regulations will be effective when they are finalized in the federal register. However, estates, non-grantor trusts, and their beneficiaries may rely on the proposed regulations under §67 for taxable years beginning after December 31, 2017, and on or before the date these regulations are published as final regulations. Taxpayers may also rely on the proposed regulations under §642(h) for taxable years of beneficiaries beginning after December 31, 2017, and on or before the date these regulations are published as final regulations in the Federal Register in which an estate or trust terminates.

For more information on the proposed regulations see 26 CFR Part 1, Vol. 85, No. 91

For more on post-death tax planning, see the Insights series on post-death planning for the unprepared:

Part 1: how to identify the personal representative and the estate’s assets.
Part 2: the personal representative’s ongoing responsibilities.
Part 3, income reporting and tax implications for the estate and its beneficiaries.

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