On September 16, 2020, the U.S. Department of Treasury (“Treasury”) and the IRS released final regulations on the deduction of administration expenses of estates and non-grantor trusts under sections[1] 67(e) and (g), and on the treatment of excess deductions in the final year of the estate or non-grantor trust under section 642(h) (the “final regulations”). (https://www.federalregister.gov/documents/2020/10/19/2020-21162/effect-of-section-67g-on-trusts-and-estates)  The final regulations generally adopt the proposed regulations on these sections that were released earlier this year, subject to a few refinements and modifications (the “proposed regulations”). (https://www.federalregister.gov/documents/2020/05/11/2020-09801/effect-of-section-67g-on-trusts-and-estates)

A.  Section 67

Section 67(g) was added to the Code on December 22, 2017 as part of the Tax Cuts and Jobs Act (TCJA). Section 67(g) prohibits individual taxpayers from claiming miscellaneous itemized deductions for any taxable year beginning after December 31, 2017, and before January 1, 2026. Prior to the TCJA, miscellaneous itemized deductions were allowable for any taxable year only to the extent that the sum of such deductions exceeded two percent of adjusted gross income. Section 67(b) defines miscellaneous itemized deductions as itemized deductions other than those listed in section 67(b)(1) through (12).

Section 67(e) provides that, for purposes of section 67, an estate or trust computes its adjusted gross income in the same manner as that of an individual, except that the following additional deductions are treated as allowable in arriving at adjusted gross income: (1) The deductions for costs that are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such estate or trust, and (2) deductions allowable under section 642(b) (concerning the personal exemption of an estate or non-grantor trust), section 651 (concerning the deduction for trusts distributing current income), and section 661 (concerning the deduction for estates and trusts accumulating income). The first category pertains to expenses such as probate fees, estate tax return preparation fees, legal fees relating to the settlement of an estate or a non-grantor trust, and appraisal costs relating to any of the foregoing. These types of expenses—which could be regarded as “unique” to trusts and estates—stand in stark contrast to investment advisory fees and investment management expenses, which are commonly incurred by individuals and therefore are generally not allowable as deductions in arriving at adjusted gross income. Section 67(e) implements this critical distinction by removing the deductions described in section 67(e)(1) and (2) (i.e., those that are “unique” to a trust or estate) from the definition of itemized deductions under section 63(d), and thus from the definition of miscellaneous itemized deductions under section 67(b). As a result, such expenses that are “unique” to a trust or estate are allowable as deductions in arriving at adjusted gross income; moreover, they are not subject to the alternative minimum tax.

Section 67(e) confers upon Treasury and the IRS regulatory authority to make appropriate adjustments to take into account the provisions of section 67. The final regulations under Treas. Reg. § 1.67-4 (consistent with the approach that Treasury and the IRS had taken in the proposed regulations) confirm that expenses described in section 67(e) remain deductible in determining the adjusted gross income of an estate or non-grantor trust during the taxable years in which section 67(g) applies. Accordingly, section 67(g) does not operate to deny an estate or non-grantor trust (including the S corporation portion of an electing small business trust) a deduction for expenses described in section 67(e)(1) and (2), because such deductions are allowable in arriving at adjusted gross income and are not miscellaneous itemized deductions under section 67(b).

B.  Section 642(h)

1.  In General

Section 642(h) provides that if, on the termination of an estate or trust, the estate or trust has: (1) a net operating loss carryover under section 172 or a capital loss carryover under section 1212, or (2) for the last taxable year of the estate or trust, deductions [other than the deductions allowed under section 642(b) (relating to the personal exemption) or section 642(c) (relating to charitable contributions)] in excess of gross income for such year, then such carryover or excess will be allowed as a deduction, in accordance with the regulations prescribed by the IRS, to the beneficiaries succeeding to the property of the estate or trust.

The final regulations (consistent with the proposed regulations) implement this via Treas. Reg. § 1.642(h)-2(a), which provides that if, on termination of an estate or trust, the estate or trust has for its last taxable year deductions [(other than the deductions allowed under section 642(b) or section 642(c)] in excess of gross income, the excess deductions are allowed under section 642(h)(2) as items of deduction to the beneficiaries succeeding to the property of the terminated estate or trust.

2.  Character and Amount of Excess Deductions

The character of the excess deductions is critical; it is preserved in the hands of the beneficiary. Section 1.642(h)-2(b)(1) of the final regulations (consistent with the proposed regulations) provides that each deduction comprising the excess deductions under section 642(h)(2) retains, in the hands of the beneficiary, its character (specifically, as allowable in arriving at adjusted gross income, as a non-miscellaneous itemized deduction, or as a miscellaneous itemized deduction) while in the estate or trust. The character of these deductions does not change when succeeded to by a beneficiary on termination of the estate or trust.  Furthermore, an item of deduction succeeded to by a beneficiary remains subject to any limitation applicable under the Internal Revenue Code (such as in the case of state or local taxes) in the computation of the beneficiary's tax liability.

Section 1.642(h)-2(b)(2) of the final regulations (consistent with the proposed regulations) provides that the amount of the excess deductions in the final year is determined as follows:

(i) Each deduction directly attributable to a class of income is allocated in accordance with the provisions in § 1.652(b)-3(a);

(ii) To the extent of any remaining income after application of paragraph (b)(2)(i) of this section, deductions are allocated in accordance with the provisions in § 1.652(b)-3(b) and (d); and

(iii) Deductions remaining after the application of subparagraphs (i) and (ii) above comprise the excess deductions on termination of the estate or trust. These deductions are allocated to the beneficiaries succeeding to the property of the estate of or trust in accordance with § 1.642(h)-4.

3.  Reporting of Excess Deductions

The final regulations adopted section 1.642(h)-2(b)(1) of the proposed regulations, which provides that an item of deduction succeeded to by a beneficiary remains subject to any additional applicable limitation under the Code and must be separately stated if it could be so limited, as provided in the instructions to Form 1041, U.S. Income Tax Return for Estates and Trusts, and the Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credit, etc. Commenters on the proposed regulations requested that Treasury and the IRS provide guidance on how the excess deductions are to be reported by both the terminated estate or trust and by its beneficiaries. Treasury and the IRS released instructions for beneficiaries that chose to claim excess deductions on Form 1040 in the 2019 or 2018 taxable year based on the proposed regulations. In addition, Treasury and the IRS stated in the preamble to the final regulations that they plan to update the instructions for Form 1041, Schedule K-1 (Form 1041), and Form 1040, U.S. Individual Income Tax Return, for the 2020 and subsequent tax years to provide for the reporting of excess deductions that are section 67(e) expenses or non-miscellaneous itemized deductions.

Treasury and the IRS acknowledged in the preamble to the final regulations that they are aware that the income tax laws of some U.S. states do not conform to the Internal Revenue Code with respect to section 67(g), and that beneficiaries for state reporting purposes may need information on miscellaneous itemized deductions of a terminated estate or trust. However, because miscellaneous itemized deductions are currently not allowed for federal income tax purposes, that information is not needed for federal income tax purposes. Therefore, Treasury and the IRS stated in the preamble to the final regulations that it would not be appropriate to modify federal income tax forms to require or accommodate the collection of such information while this deduction is suspended, and suggested that estates, trusts, and beneficiaries consult the relevant state taxing authority for information about deducting miscellaneous itemized expenses on their state tax returns.

4.  Determinations of Deductions in Year of Termination of the Estate or Trust

Treas. Reg. § 1.642(h)-2(c) provides that excess deductions are allowable only in the taxable year of the beneficiary in which or with which the estate or trust terminates. The final regulations (consistent with the proposed regulations) provide that excess deductions of a terminated estate or trust may not carry over to a subsequent tax year of the beneficiary. 

This principle is illustrated through the following example in the final regulations:

… Assume that a trust distributes all its assets to B and terminates on December 31, Year X.  As of that date, it has excess deductions of $18,000, all characterized as allowable in arriving at adjusted gross income under section 67(e). B, who reports on the calendar year basis, could claim the $18,000 as a deduction allowable in arriving at B's adjusted gross income for Year X.  However, if the deduction (when added to other allowable deductions that B claims for the year) exceeds B's gross income, the excess may not be carried over to any year subsequent to Year X.

5.  Additional Examples in the Final Regulations

The final regulations contain the following two additional examples.

            a.  Example 1 – Net Operating Loss

Section 1.642(h)-5(a), Example 1, of the final regulations (Example 1) updates an existing example illustrating computations under section 642(h) when there is a net operating loss. Section 1.642-5(a)(2)(ii) of Example 1 explains that the beneficiaries of the trust cannot carry back any of the net operating loss of the terminating estate that was made available to them under section 642(h)(1).

The preamble to the final regulations noted that two commenters to the proposed regulations requested that Example 1 be revised to take into account the amendments to section 172(b)(1)(D) under sec. 2302(b) of the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020) (CARES Act), by allowing a beneficiary to carry back the net operating loss carryover the beneficiary succeeds to under section 642(h)(1) for net operating losses arising in taxable years beginning after December 31, 2017, and before January 1, 2021. Under section 2303 of the CARES Act, net operating losses arising in taxable years beginning after December 31, 2017, and before January 1, 2021, generally may be carried back five years before being carried forward.

Treasury and the IRS declined to adopt the commenters’ suggestion.  Accordingly, because the net operating loss is a carryover for the estate or trust, the beneficiary succeeding to that net operating loss may, under section 642(h)(1), only carry it forward.

      b.  Example 2 – Other Issues

Section § 1.642(h)-5(b) (Example 2) of the proposed regulations demonstrates computations under section 642(h)(2).  The expenses in Example 2 include rental real estate taxes in an attempt to illustrate a deduction subject to limitation under section 164(b)(6) to the beneficiary that must be separately stated as provided in § 1.642(h)-2(b)(1).

Multiple commenters to the proposed regulations noted that Example 2 raises several issues that could be potentially relevant to that example, such as whether the decedent was in a trade or business and the application of section 469 to estates and trusts. To avoid these issues, which are extraneous to the point being illustrated, one commenter suggested that the example be revised so that the entire amount of real estate expenses on rental property equals the amount of rental income.

In the preamble to the final regulations, Treasury and the IRS acknowledged that they did not intend to raise such issues in the example and consider both issues to be outside the scope of these regulations.  Accordingly, Treasury and the IRS adopted the suggestion by the commenters and modified Example 2 to avoid these issues by having rental real estate expenses entirely offset rental income with no unused deduction.

Commenters to the proposed regulations also noted that Example 2 of the proposed regulations did not properly allocate rental real estate expenses because the example characterizes the rental real estate taxes as itemized deductions. These commenters asserted that real estate taxes on property held for the production of rental income are not itemized deductions; instead, these are allowed in computing gross income and cited to section 62(a)(4) as providing that ordinary and necessary expenses paid or incurred during the taxable year for the management, conservation, or maintenance of property held for the production of income under section 212(2) that are attributable to property held for the production of rents are deductible as above-the-line deductions in arriving at adjusted gross income. One commenter suggested that, if the goal of Example 2 is to illustrate state and local taxes passing through to the beneficiary, then the example should include state income taxes rather than real estate taxes on rental real estate.

In response to these comments to Example 2 of the proposed regulations, Treasury and the IRS revised this example in the final regulations to include personal property tax paid by the trust rather than taxes attributable to rental real estate.

Lastly, the preamble states that commenters noted that Example 2 to the proposed regulations did not demonstrate the broad range of trustee discretion in § 1.652(b)-3(b) and (d) for deductions that are not directly attributable to a class of income, or deductions that are, but which exceed such class of income, respectively. In response to these comments, Treasury and the IRS modified Example 2 to illustrate the application of trustee discretion as found in § 1.652(b)-3(b) and (d).

            c.  Applicability Dates

The proposed regulations had provided that the changes to §§ 1.67-4, 1.642(h)-2, and 1.642(h)-5 apply to taxable years beginning after the date the regulations are published as final. According to the preamble to the proposed regulations, taxpayers may also rely on the proposed regulations under section 642(h) for taxable years of beneficiaries beginning after December 31, 2017, and on or before the date the regulations are published as final, in which an estate or trust terminates.

The final regulations supplement the guidance provided in the preamble to the proposed regulations by expressly stating that the final regulations shall apply to taxable years beginning after October 19, 2020 (the date of publication of the final regulations in the Federal Register). Taxpayers may choose to apply the amendments to § 1.67-4 and §§ 1.642(h)-2 and 1.642(h)-5 set forth in the final regulations to taxable years beginning after December 31, 2017, and on or before October 19, 2020.

Kevin Matz, CPA, JD, LLM (Taxation), is a partner in both the private client services group and the family office group at the New York City law firm of Stroock & Stroock & Lavan LLP, where his practice is principally devoted to domestic and international estate and tax planning, family office services, estate administration and related litigation. Mr. Matz earned his J.D. from Fordham University School of Law (where he was a Notes & Articles Editor of the Fordham Law Review) and his LL.M. in Taxation from New York University School of Law. He is a Fellow of the American College of Trust and Estate Counsel (“ACTEC”), in which connection he is a Vice-Chair of ACTEC’s Business Planning Committee (and is scheduled to become that committee’s chair in March 2021). Mr. Matz is also Co-Chair of the Taxation Committee of the Trusts and Estates Law Section of the New York State Bar Association, and the Chair of the UJA-Federation of New York’s Trusts and Estates Group. In addition, he is a former Treasurer and Secretary of the NYSSCPA, and a past president of FAE. He also currently serves as a director on the NYSSCPA Board of Directors and as a trustee on the FAE Board of Trustees. Mr. Matz may be contacted at (212) 806-6076 or kmatz@stroock.com.