Maximizing excess deductions on termination.

• Author: Keene, David
• Position: Estates and trusts

Tax savings can be optimized if the executor (or trustee), CPA and attorney work together to plan when to pay an estate's or trust's expenses, close the entity and take deductions in the termination year. Through the use of a comprehensive example, this article explains how to maximize the tax benefits available in the final year of an estate or trust.

If an estate or trust has a loss in its final year, it can (with some adjustments discussed below) be passed through to the beneficiaries, allowing them a deduction on their returns. Losses in a nontermination year cannot be passed through to beneficiaries. To the extent a loss is comprised of nonbusiness deductions, the entity cannot carry it back or forward (only business deductions, as defined by Sec. 172(d)(4), can be carried to other years, as part of a net operating loss (NOL)). Thus, an estate's or trust's loss comprised of nonbusiness deductions will be lost as a tax benefit by either the entity or its beneficiaries, unless incurred in the entity's termination year.

Accordingly, some thought should be given to the tinting of nonbusiness deductions toward the end of the estate's or trust's existence. Further, consideration of other factors (including the creation of a short final year for the entity) may greatly increase the tax benefits available to the beneficiaries. The tax benefits available by distributing the excess deductions on termination (EDOTs) in the final year can be maximized by:

* Understanding the concept and mechanics of computing the EDOT deduction.

* Comprehending the factors contributing to the amount and timing of EDOTs over which the executor or trustee has control (including an analysis of when to end the entity's final year).

* Communication and teamwork between the CPA, attorney and executor or trustee to allow such planning to take place.

This article explores how the beneficiaries' tax benefits can be maximized if the executor or trustee and the professionals involved in the administration of an estate or trust engage in proper planning.

What Is an EDOT?

The taxation of beneficiaries and the corresponding distribution deduction of trusts and estates are addressed in Secs. 651 and 652 (for simple trusts) and Secs. 661 and 662 (for estates and complex trusts). These sections provide the methods for determining a beneficiary's income from an estate or trust and the entity's distribution deduction, but do not provide a method for passing through losses. Were it not for other sections providing special rules, an entity's loss would never result in a tax benefit to beneficiaries. The following sections allow deductions and losses to be passed through to beneficiaries:

1. Secs. 642(e), 167(d) and 611(b), which provide for an allocation of depreciation and depletion deductions to beneficiaries.

2. Sec. 691 (c), which allows the recipient of income in respect of a decedent a deduction for the Federal estate tax attributable to that item.

3. Sec. 642(h)(1), which allows beneficiaries the entity's unused capital losses and NOLs in the termination year only.

4. Sec. 642(h)(2), which allows deductions to beneficiaries if the entity's deductions exceed its gross income (i.e., if it has EDOTs) in the termination year only.

Thus, #1 and #2 above allow special deductions to be allocated to beneficiaries, while #3 and #4 above provide an opportunity for beneficiaries to capture tax benefits from an estate's or trust's tax loss; this article focuses on #4.

Sec. 642(h) provides that, if on termination of an estate or trust, (1) it has a Sec. 172 NOL carryover or a Sec. 1212 capital loss carryover (CLC) or (2) for its last tax year, it has deductions (other than the personal exemption or charitable deductions) in excess of termination year gross income, the carryover or excess is allowed as a deduction to the entity's beneficiaries, as prescribed by regulations. While this appears to be straightforward, what if an NOL and/or CLC is also available in the termination year? Regs. Sec...