Final Regulations and Planning Opportunities for Deductions on Estates and Non-grantor Trusts
On September 21, the Internal Revenue Service (IRS) issued final regulations providing guidance for decedents’ estates and non-grantor trusts, clarifying that certain deductions for such estates and non-grantor trusts are not miscellaneous itemized deductions. In addition, the final regulations clarify that excess deductions upon the termination of an estate or non-grantor trust are not affected by the suspension of miscellaneous itemized deductions for tax years 2018 through 2025. These final regulations also provide some guidance on determining the character, amount, and allocation of the excess deductions.
The Tax Cuts and Jobs Acts (TCJA) prohibits individuals, estates, and non-grantor trusts from claiming miscellaneous itemized deductions for any taxable year beginning after December 31, 2017, and before January 1, 2026. These final regulations clarify that the following deductions are allowable in calculating adjusted gross income and are not miscellaneous itemized deductions:
- Estate or trust administrative costs that would not have been incurred if the property were not held in the estate or trust;
- The personal exemption of an estate or non-grantor trust; and
- Distribution deductions for trusts distributing current income and for estates and trusts accumulating income.
Examples of fully deductible expenses for estates and non-grantor trusts (on federal Form 1041) include trustee fees, executor fees, accounting and legal fees, expenses to maintain and preserve property of an estate when the property cannot be distributed to the beneficiaries, and certain appraisal fees. This list is not all-inclusive, and you should further consult with your tax advisor as to the deductibility of specific expenditures incurred by an estate or non-grantor trust.
Investment advisory fees generally have been classified as miscellaneous itemized deductions and treated as non-deductible for tax years 2018–2025. The final regulations state that investment advisory fees charged to an estate or non-grantor trust exceeding those customarily charged to a hypothetical individual investor are fully deductible. For example, incremental costs of investment advice beyond the amount that normally would be charged to an individual investor, or incremental advisory costs attributable for specialized balancing of interests of various beneficiaries, may be fully deductible. Trustees and executors should review filed 2018 and 2019 tax returns, and discuss with their tax advisors as to whether an opportunity to file amended returns and claim tax refunds exists.
Excess Deductions on Termination of an Estate or Trust
The final regulations adopted the previously released proposed regulations, but clarified that beneficiaries of a trust or an estate may claim all or part of excess deductions in the last year of an estate or trust. These deductions are allowed before, after, or together with the same character of deductions separately allowable to the beneficiary. An example is accounting fees. These are deductible by the estate or non-grantor trust, but in the hands of the beneficiary would be miscellaneous itemized deductions and not allowed. The final regulations provide clarity that these deductions would generally be fully deductible by the beneficiary succeeding the estate or non-grantor trust property.
The Treasury has released guidance on how to report these excess deductions on the beneficiary’s Form 1040. The guidance indicates that the excess deductions should be reported on Form 1040, Schedule 1, as a negative item. In this guidance, the Treasury confirmed that the rules and limitations governing excess deductions from non-grantor trusts and estates will not apply to any net operating losses. This holds true even if the loss is generated by activity of the non-grantor trust or estate in its final year (separate rules apply to net operating losses from a business that flow to an estate or non-grantor trust, and generally, net operating losses will be carried over to beneficiaries succeeding estate or non-grantor trust property). In effect, an individual beneficiary receiving a “final” Schedule K-1 from an estate or non-grantor trust can claim excess deductions on termination of an estate or non-grantor trust, regardless of whether the beneficiary itemizes (uses Schedule A). Therefore, this presents yet another opportunity to review with your tax advisors whether amending 2018 and 2019 Forms 1040 (individual tax return) to claim certain excess deductions may yield a tax refund.
We caution you to keep in mind that not all states conform to the federal law, and for estates and non-grantor trusts that file state income tax returns, further review with tax advisors is very important. For example, under California and New York law, investment advisory fees continue to be fully deductible for state income tax purposes. Contrast this to the federal law, which provides for a federal deduction on certain incremental investment advisory fees.
In closing, trustees and executors should review with tax advisors how these final regulations apply to their facts and circumstances. For more information, contact your Marcum Trusts and Estates tax advisor, or Lance Lvovsky, CPA at 954.320.8077 or firstname.lastname@example.org.