In the Tax Cuts and Jobs Act (TCJA), Congress eliminated the ability of individuals to claim miscellaneous itemized deductions beginning with their 2018 income tax returns. In Notice 2018-61 the IRS explains how this rule will impact trusts and estates whose returns are computed in a manner similar to that of individuals, but with some modifications found at IRC §67(e).
IRC §67(g), added by the Tax Cuts and Jobs Act, provides the following:
(g) Suspension for taxable years 2018 through 2025
Notwithstanding subsection (a), no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.
A “miscellaneous itemized deduction” is defined at IRC §67(b) as any “itemized deduction” other than those listed from §67(b)(1)-(12). That list includes the deductions found in the other sections of Form 1040 Schedule A.
Under IRC §63(d), an itemized deduction is defined as follows:
(d) Itemized deductions
For purposes of this subtitle, the term “itemized deductions” means the deductions allowable under this chapter other than—
(1) the deductions allowable in arriving at adjusted gross income,
(2) the deduction for personal exemptions provided by section 151, and
(3) the deduction provided in section 199A.
Deductions allowed in arriving at adjusted gross income are enumerated at IRC §62 for an individual. That calculation is modified for trusts and estates at IRC §67(e) as follows:
(e) Determination of adjusted gross income in case of estates and trusts
For purposes of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual, except that—
(1) the deductions for costs which 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 trust or estate, and
(2) the deductions allowable under sections 642(b), 651, and 661,
shall be treated as allowable in arriving at adjusted gross income. Under regulations, appropriate adjustments shall be made in the application of part I of subchapter J of this chapter to take into account the provisions of this section.
Reg. §1.67-4 provides details on the determination of expenses that meet the test of IRC §67(e)(1) and are not treated as an itemized deduction when incurred by a trust or estate.
Some commentators had expressed a concern that IRC §67(g) would serve to block all deductions for a trust or estate other than those that an individual would be able to deduct in computing adjusted gross income or which were listed as not miscellaneous itemized deductions in the list found at IRC §67(b). If that position was taken by the IRS and sustained by the Courts, the trust would have lost deductions for items such as trustee’s fees, along with accounting and legal fees.
The good news is that Notice 2018-61 provides that IRC §67(g) does not serve to block deductions that are allowed under IRC §67(e)(1) and Reg. §1.674-4. Those items are not miscellaneous itemized deductions to the trust or estate and thus not barred as a deduction.
The Notice provides:
For the taxable years during which it is effective, section 67(g) denies a deduction for miscellaneous itemized deductions. Section 67(b) defines miscellaneous itemized deductions as itemized deductions other than those listed therein. Section 63(d) defines itemized deductions by excluding personal exemptions, section 199A deductions, and deductions used to arrive at adjusted gross income. Therefore, neither the above-the-line deductions used to arrive at adjusted gross income nor the expenses listed in section 67(b)(1) – (12) are miscellaneous itemized deductions. Section 62(a) defines adjusted gross income of an individual, and section 67(e) provides that the adjusted gross income of a trust or estate is determined in the same way as for an individual, except that expenses described in section 67(e)(1) and deductions pursuant to sections 642(b), 651, and 661 are allowable as deductions in arriving at adjusted gross income. Thus, section 67(e) removes the expenses described in section 67(e)(1) from the category of itemized deductions (and thus necessarily also from the subset of miscellaneous itemized deductions) and instead treats them as above-the-line deductions allowable in determining adjusted gross income under section 62(a). Therefore, the suspension of the deductibility of miscellaneous itemized deductions under section 67(a) does not affect the deductibility of payments described in section 67(e)(1).
The trust will also be able to claim a deduction for itemized deductions that are not miscellaneous itemized deductions. As the Notice points out:
For example, section 691(c) deductions (relating to the deduction for estate tax on income in respect of the decedent), which are identified in section 67(b)(7), remain unaffected by the enactment of section 67(g)).
But, just like individuals, the items treated as miscellaneous itemized deductions by Reg. §1.67-4 will not be deductible in computing the trust or estate’s taxable income.
However, an expense that commonly or customarily would be incurred by an individual (including the appropriate portion of a bundled fee) is affected by section 67(g) and thus is not deductible to the estate or non-grantor trust during the suspension of section 67(a). Nothing in section 67(g) impacts the determination of what expenses are described in section 67(e)(1).
The Notice concludes with a statement regarding the regulations that the Treasury Department plans to release in this area:
The Treasury Department and the IRS intend to issue regulations clarifying that estates and non-grantor trusts may continue to deduct expenses described in section 67(e)(1) and amounts allowable as deductions under section 642(b), 651 or 661, including the appropriate portion of a bundled fee, in determining the estate or non-grantor trust’s adjusted gross income during taxable years, for which the application of section 67(a) is suspended pursuant to section 67(g). Additionally, the regulations will clarify that deductions enumerated in section 67(b) and (e) continue to remain outside the definition of “miscellaneous itemized deductions” and thus are unaffected by section 67(g).
The Notice does discuss one deduction that goes from a trust or estate to beneficiaries that has been left in an odd state of limbo under the new law. In particular, what happens to the beneficiaries’ deduction for excess deductions on termination of a trust or estate under IRC §642(h)(2)?
The Notice points out:
…§1.642(h)-2(a) provides that if, on the 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) (relating to personal exemption) or section 642(c) (relating to charitable contributions) in excess of gross income, the excess is allowed under section 642(h)(2) as a deduction (section 642(h)(2) excess deduction) to the beneficiaries. However, the section 642(h)(2) excess deduction is allowed only in computing the taxable income of the beneficiaries and must be taken into account in computing the items of tax preference of the beneficiaries. Therefore, a section 642(h)(2) excess deduction is not used in computing the beneficiaries’ adjusted gross income and is treated as a miscellaneous itemized deduction of the beneficiaries. See sections 63(d) and 67(b).
What makes this quirky is that, under the new law, the §642(h)(2) amount only contains items that were deductible to the trust or estate on the final year return—and, thus, do not contain miscellaneous itemized deductions. But since the §642(h)(2) deduction itself is an itemized deduction to the individual beneficiary, is this deduction now lost to beneficiaries?
The Notice discusses this issue as follows:
The section 642(h)(2) excess deduction may include expenses described in section 67(e). As previously discussed, prior to enactment of section 67(g), miscellaneous itemized deductions were allowed subject to the restrictions contained in section 67(a). For the years in which section 67(g) is effective, miscellaneous itemized deductions are not permitted, and that appears to include the section 642(h)(2) excess deduction. The Treasury Department and the IRS are studying whether section 67(e) deductions, as well as other deductions that would not be subject to the limitations imposed by sections 67(a) and (g) in the hands of the trust or estate, should continue to be treated as miscellaneous itemized deductions when they are included as a section 642(h)(2) excess deduction. Taxpayers should note that section 67(e) provides that appropriate adjustments shall be made in the application of part I of subchapter J of chapter 1 of the Code to take into account the provisions of section 67.
The Notice asks for comments to be submitted on how deductions described in IRC §67(e) that make their way into the §642(h)(2) amount should be dealt with in the post-TCJA era.