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 final regulations.
Before the TCJA, beneficiaries who received passthrough final-year estate and trust excess deductions could claim them as miscellaneous itemized deductions subject to the 2%-of-AGI floor. Since “2% deductions” are not available between tax years 2018-2025 due to TCJA, regulations clarify how beneficiaries may potentially deduct some passthrough items.
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 (Form 1041). 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 § 67(g) which 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 regulations
Reg. § 1.642(h)-2 would require fiduciaries to separately identify the various excess deductions and place them into three categories:
- an amount allowed in arriving at the trust’s or estate’s AGI,
- a non-miscellaneous itemized deduction,
- 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).
Beneficiaries may claim all or part of the excess deductions under §642(h)(2) before, after, or together with the same character of deductions separately allowable to the beneficiary.
Additionally, 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:
- it was necessarily incurred during the estate or trust’s administration, and
- 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.
The final regulation clarified that fiduciaries can transfer net operating losses to beneficiaries when the estate or trust terminates. The NOL is carried to the taxable year of the beneficiary in which the estate or trust terminates.
Schedule K-1 (Form 1041) Changes
The fiduciary will report excess deductions on Schedule K-1 (Form 1040) in Box 11 with Code A or B.
- Box 11, code A (Excess deductions-Section 67(e) expenses): A final estate or non-grantor trust return with excess deductions under §67(e), where the trust or estate was terminated, will report those excess deductions to the beneficiary on Schedule K-1, box 11, code A. The beneficiary may deduct the excess deductions as an adjustment to income. The beneficiary will report this amount as a write-in on Schedule 1 (Form 1040), Part II, line 22. On the dotted line next to line 22, the beneficiary will enter the amount of the expense using code ED67(e). The beneficiary will include the expense in the total amount reported on line 22.
- Box 11, code B (Excess deductions-Non-miscellaneous itemized deductions): A final estate or non-grantor trust return with excess deductions that are non-miscellaneous itemized deductions, where the trust or estate was terminated, will report those expenses to the beneficiary on Schedule K-1, box 11, code B. The beneficiary may deduct the excess deductions on the applicable line on Schedule A (Form 1040). The fiduciary will provide the beneficiary with a statement of allowable deductions.
A beneficiary who doesn’t have enough income in the relevant tax year to absorb the entire deduction from Schedule K-1, Box 11 Code A or B cannot carry the balance over to any succeeding year.
Check state rules to determine if any miscellaneous itemized deductions subject to the 2% floor that are not deductible on the federal return might be deductible on the state return.
These regulations are effective for tax years starting after October 19, 2020 when they were 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 October 19, 2020. 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 October 19, 2020 in which an estate or trust terminates.
For more information on the final regulations see T.D. 9918.
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.