Recently Released Proposed Regulations Address Treatment of Excess Deductions on Termination of Trusts and Estates

On May 11, 2020, Treasury published taxpayer-friendly proposed regulations clarifying that expenses incurred in connection with the administration of a non-grantor trust or an estate that would not have been incurred if the property were not held in such trust or estate are not miscellaneous itemized deductions.  More importantly, the regulations provide that excess deductions passing out to a beneficiary on the termination of a non-grantor trust or an estate are not per se miscellaneous itemized deductions. 

These proposed regulations were prompted by 2017’s Tax Cuts and Jobs Act (TCJA), which disallows 2% miscellaneous itemized deductions incurred in the 2018-2025 tax years. Of particular significance is that Treasury has reversed the longstanding position that excess deductions passing out to a beneficiary on the termination of a trust or an estate are miscellaneous itemized deductions in the hands of the beneficiary, regardless of the character of the deductions.  

Rather, the proposed regulations provide that excess deductions passing out to a trust or beneficiary retain the character they had with the trust or estate; in other words, if they were not a miscellaneous itemized deduction for the trust or estate, they will not be a miscellaneous itemized deduction for the beneficiary. Now that trusts and estates cannot deduct miscellaneous itemized deductions through 2025, however, none of the excess deductions passing out to a beneficiary will be classified as such.   

Furthermore, the proposed regulations elaborate on the categories of deductions that fall under excess deductions, including: (1) deductions permitted in arriving at the trust or estate’s adjusted gross income, such as costs that are paid or incurred in connection with the administration of a trust or estate and would not have been incurred if the property were not held in such trust or estate (e.g., trustee, legal, and accounting fees), (2) non-miscellaneous itemized deductions (these commonly include state and local income tax), and (3) miscellaneous itemized deductions, which include expenses commonly incurred by an individual owning the same property (e.g., investment management and custodial fees). As a result of these proposed regulations, the amount and character of any excess deductions will need to be reported to the beneficiary, and, until 2026, none of these deductions will include nondeductible miscellaneous itemized deductions.     

These proposed regulations apply to taxable years beginning after the date the final regulations are published in the Federal Register, although taxpayers can rely on them for taxable years beginning after December 31, 2017.  Planning point: Taxpayers who reported excess deductions from a trust or estate as a 2% miscellaneous itemized deduction in the 2018 or 2019 tax years may want to consider amending their returns to take advantage of these new proposed regulations.