In Notice 2018-61, 2018-31 I.R.B. 278 (7/30/2018), the Internal Revenue Service has confirmed that administration expenses of trusts and estates that were fully deductible before the enactment of the 2017 tax act are still fully deductible for income tax purposes, notwithstanding the elimination of “miscellaneous itemized deductions” under the 2017 tax act.
To understand the change made by the 2017 tax act, P.L. 115-97, commonly known as the Tax Cuts and Jobs Act of 2017 (although that name was deleted from the bill), and the issue addressed by Notice 2018-61, it necessary first to understand how administration expenses were treated under prior law.
Under section 67 of the Internal Revenue Code, “miscellaneous itemized deductions” are allowed only to the extent that the total of the deductions exceed 2% of adjusted gross income.
Most expenses of administering an estate or trust are deductible by reason of I.R.C. section 212, which allows deductions for amounts paid or incurred “for the production or collection of income” and “for the management, conservation, or maintenance of property held for the production of income,” as well as expenses “in connection with the determination, collection, or refund of any tax,” and deductions under section 212 are generally within the definition of “miscellaneous itemized deductions” in section 67(b). However, there is a special rule for estates and trusts, because section 67(e) states that the deductions allowed in determining the adjusted gross income of an estate or trust include “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.”
So, under prior law the administration expenses of an estate or trust had to be divided into two different categories:
- Expenses which would not have been incurred if the property were not held in the estate or trust (such as fiduciary fees and tax return preparation fees) were fully deductible; and
- Expenses which would have been incurred whether or not the property were held in the estate or trust (such as investment advisory expenses) were deductible only to the extent that they exceeded 2% of adjusted gross income.
2017 Tax Act
The 2017 tax act eliminated any income tax deduction for “miscellaneous itemized deductions” for the years 2018 through 2025. Commentators and practitioners generally agreed that the second category of expenses (expenses that were subject to the 2% floor) are no longer deductible, but there has some uncertainty about whether the first category of expenses were still deductible. According to Notice 2018-61, they are still fully deductible.
According to Notice 2018-61, the section 212 deductions of an estate or trust are not miscellaneous itemized deductions because they are not “itemized deductions.” Itemized deductions are defined by I.R.C. section 63(d) as deductions other than those used to determine “adjusted gross income.” Because section 67(e) provides a definition of “adjusted gross income” that allows deductions for expenses in the first category, and so those deductions are used to determine adjusted gross income, they are not within the definition of “itemized deductions” in section 63(d) and are therefore not miscellaneous itemized deductions.
Excess Deductions on Termination
Although Notice 2018-61 allows estates and trusts to continue to take deductions for administration expenses that would not have been incurred if the property were not held in the estate or trust (the first category of expenses, not subject to the 2% floor), the notice does not say whether beneficiaries may take deductions for those expenses when an estate or trust terminates.
When an estate or trust has deductions in excess of income in the final year of the estate or trust, the excess deductions are allowed as deductions for the beneficiaries under I.R.C. section 642(h). For the beneficiaries, section 642(h) deductions are miscellaneous itemized deductions that are no longer deductible. The issue presented by Notice 2018-61 is whether the character of the administration expenses as deductible for the estate or trust under section 67(e) might be preserved for the beneficiaries, so that the beneficiaries can continue to claim the same expenses that were allowable to the estate or trust.
The notice says that the Treasury and the IRS are studying the issue and intend to propose regulations, and comments from practitioners on the issue are requested. (The addresses for submitting comments are in the notice.)