IRS Issues Rules to Preserve Some Deductions for Trusts, Estates and Their Beneficiaries
By: Juliya L. Ismailov
Clients often ask us whether their trust should be a "grantor" or "non-grantor" trust. This is an income tax concept (rather than a gift or estate tax concern). It goes to whether the grantor or creator of the trust, or the trust entity itself, will report and pay annual income taxes on behalf of the trust. This is a separate issue from whether the trust will be "counted" as part of the individual's estate, thus generating estate taxes.
One can have a trust fully protected from estate taxes, from which the grantor derives no benefits, while still having the ability to pay income taxes on behalf of this trust. This type of trust is referred to as a "grantor trust." Some individuals prefer to pay the trust's income taxes because it helps them to further "deplete" the size of the estate remaining in their name, leaving less assets upon their death that would incur estate taxes. It will also leave more assets in the trust for the beneficiaries. Others prefer to maximize their own reserves, letting the trust (and effectively its beneficiaries) pay taxes using the assets in the trust. This is referred to as a "non-grantor trust."
Grantor trusts are pure flow-through entities for income tax purposes and require filing a simple informational income tax return, Form 1041, leaving the reporting of the trust's annual financials to the grantor's Form 1040. Non-grantor trusts, on the other hand, complete a full Form 1041, reporting their income and deductions, such as expenses paid and distributions made to beneficiaries.
With this background in mind, for non-grantor trusts and estates that are treated similarly for income tax reporting, as for individual taxpayers like the grantors reporting income on behalf of a grantor trust, deductions for expenses paid are valuable since they allow the taxpayer to reduce the amount of taxable income. After the enactment of the 2017 Tax Jobs and Cuts Act ("2017 Act"), which disallowed miscellaneous itemized deductions (also known as the "below-the-line" deductions) for years 2018 through 2025, there was confusion among tax practitioners as to: (i) how a non-grantor trust or estate's deductions are affected under the 2017 Act's disallowance of below-the-line deductions, and (b) whether excess deductions remaining in the final year of a trust or estate, and passed through to the beneficiaries, are also disallowed under the 2017 Act.
To address these concerns, on May 7, 2020, the IRS issued proposed
regulations clarifying that: (a) certain trust and estate specific expense deductions (i.e., those related to the trust and estate administration that would not apply to individual taxpayers) are allowed under the 2017 Act; and (b) certain “excess deductions” passed on to estate and trust beneficiaries, if separately stated, are allowed under the 2017 Act. “Excess deductions” of a trust or estate result from a loss carryover from prior years and any deductions incurred in the final year of a trust or estate. Normally these are deducted by individual beneficiaries in the final year in which the trust or estate terminates.
These carryover deductions fall into a number of categories, one of which is miscellaneous itemized deductions disallowed under the 2017 Act. However, because of a lack of guidance under the 2017 Act, a technical reading of section 642 would cause such excess deductions on termination of an estate or trust to be treated as a single miscellaneous itemized deduction disallowed under the 2017 Act until year 2026. This means many trusts and estates may choose to continue to exist, and incur further administrative expenses unnecessarily, for another 5 years just to afford their beneficiaries this carryover deduction opportunity.
To provide relief, the new regulations allow the trust or estate to separately state the trust or estate's excess deductions by category, allowing the beneficiary to use those deductions that are not considered below-the-line and disallowed by the 2017 Act. As a result, even though the beneficiaries may still lose the disallowed below-the-line deductions, with the economics better adjusted, the trustee or executor can make a more balanced decision regarding whether to terminate the trust or estate currently or wait until the disallowed deductions may be again allowed for the beneficiaries.