10-4, Form 1041: A Guide on Allocating Expenses to Exempt Income.

• Author: Downs, William
• Position: Estate planning

When you prepare a fiduciary income tax return, there is an allocation of expenses that deserves attention.

If the trust or estate has tax-exempt income and administrative expenses, those administrative (indirect) expenses are not 100 percent deductible. A portion must be allocated to exempt income and, to that extent, not deducted. OK, that's pretty basic. What about the method of allocating?

Instructions to Form 1041 read, "A reasonable proportion of expenses indirectly allocable to both tax-exempt income and other income must be allocated to each class of income."

What Is a 'Reasonable Proportion?'

Your tax preparation software will calculate the non-deductible portion using a fraction: The numerator would be total exempt income, and the denominator of the fraction could be one of the following:

* Total income excluding capital gain;

* Total income including capital gain; or

* Total income plus capital gain distributed to beneficiaries.

Are any of the above options "reasonable?" I would have to start by considering that the administrative expenses--including trustee fees, legal fees, some accounting fees and broker fees--can't be associated only with ordinary income. The fees also would relate to growth-type investments that result in capital gains. Given that logic, it would be appropriate and reasonable to use the second bullet point above, and include realized capital gains in the denominator. And that happens to be the most advantageous calculation, as it minimizes the portion of expenses allocated to exempt income.

Is That the End of the Story?

What if there are no realized gains for some years, and plenty of unrealized gains on assets held for many years? What if the ordinary taxable income is minor, perhaps because interest rates are low and the fraction ends up disallowing most of the administrative expenses? Or going the other direction, what if there's a one-time huge capital gain, and that throws bullet point two above haywire, making the fraction for exempt portion unreasonably small?

Professional tax return preparers need to use judgment to find a reasonable solution.

One reasonable solution might be to use a multi-year, moving average of exempt and total income in the fraction, but pretty cumbersome.

Another solution could be to use the proportion of market values of invested assets, using market value of tax-exempt investments as the numerator and total market value of all investment assets as the denominator. Your tax...