Excess Deductions on Trust Termination
There has been some confusion related to the deductibility of excess deductions flowing through to beneficiaries from a non-grantor trust or estate on Form 1041K1 upon termination of the trust or estate. Prior to the passage of the TCJA excess deductions on the termination of a trust/estate were included as part of the beneficiary’s tier 2 (subject to the 2% of AGI limitation) miscellaneous itemized deductions. However, TCJA suspended the deduction for tier 2 deductions for years 2018 through 2025, leading many to believe:
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That the pass-through expenses at termination were no longer deductible by the beneficiary and
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They were no longer deductible on the 1041.
The IRS subsequently issued Notice 2018-61 notifying taxpayers that the IRS intended to issue regulations dealing with the issue, which they did in October 2020 (TD 9918).
The gist of those regulations is that if an estate or trust has an excess deduction resulting from total deductions being greater than its gross income in the estate’s or trust's last tax year, a beneficiary can deduct the excess deductions, depending on its character, as:
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An adjustment to gross income (reported on the 1041 K-1 in box 11, coded A and deducted by the beneficiary on 1040 Schedule 1, part II, line 24k – 2021),,
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A non-miscellaneous itemized deduction (reported on the 1041 K-1 in box 11, coded B and deducted on the applicable line of Schedule A), or
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A miscellaneous itemized deduction (not deductible through 2025 because of the TCJA suspension of deductions subject to the 2% of AGI reduction).
Typically, the costs paid or incurred in connection with the administration of the estate or trust which would not have been incurred if the property were not held in an estate or non-grantor trust will fall into category 1 above. An example is tax preparation fees that would be deductible by a trust or estate in computing AGI – these fees, to the extent they are excess deductions, are deductible by the beneficiary in computing the beneficiary's AGI (prior law treated these as a miscellaneous itemized deduction). Another example of a Code A expense is a carryover of an NOL that isn’t absorbed by the income of the trust or estate in its final year. This carryover NOL is allowed to the beneficiaries succeeding to the property of the estate or trust.
An example of a non-miscellaneous itemized deduction (category 2) would be real estate taxes.
It is up to the trustee or executor (or more probably the preparer of the 1041)to determine the character of excess deductions and provide the details of these expenses to the beneficiaries.
If a beneficiary doesn’t have enough income to absorb the entire excess deduction for the year it is reported on the K-1, the beneficiary cannot carry the balance over to any succeeding year.