Recent developments in estate planning.

AuthorRansome, Justin
PositionPart 1

EXECUTIVE SUMMARY

* The IRS issued final regulations clarifying that the deductions allowed to nongrantor trusts and estates under Sec. 67(e) are not miscellaneous itemized deductions and thus are not affected by the temporary suspension of miscellaneous itemized deductions under the law known as the Tax Cuts and Jobs Act. The regulations also offer guidance on how excess deductions are treated when an estate or trust terminates.

* The California Court of Appeal held that all of a trust's California-source income was subject to California tax, regardless of the residency of the trust's fiduciaries. The court further held that the beneficiary of the trust in question was a contingent beneficiary because the trustees had complete discretion in deciding if and when to make distributions to the beneficiary.

* The IRS Office of Chief Counsel issued advice regarding the commutation of a qualified terminable interest property (QTIP) trust, finding that a surviving spouse's commutation of her QTIP was a disposition of her qualifying income interest in the trust that was subject to Sec. 2519 and, further, that the commutation and the distribution of the trust's property to the surviving spouse were separate gift transfers by separate donors, the surviving spouse and the remainder beneficiaries, and therefore not offsetting reciprocal gifts.

* The Office of Chief Counsel advised that the beneficiary of a foreign trust became subject to U.S. federal gift tax when he indirectly transferred assets from dissolution of the trust to a bank account he did not own. The taxpayer's transfer of the assets was not a Sec. 2518 qualified disclaimer because the transfer was made at the direction of the taxpayer.

This article is the first part of an annual update on recent developments in estate planning. It covers trust and gift tax issues. The second part, in the November issue, will focus on estate tax developments. The update below discusses deductions available to a trust or estate, how California taxes trusts' income, qualified terminable interest property trusts, and other matters. The period covered is from July 2020 through June 2021.

Trusts

Expense deduction

In final regulations issued in October 2020, (1) Treasury and the IRS addressed deductions available to a trust or estate. The regulations clarify that deductions allowed to an estate or nongrantor trust under Sec. 67(e) are not miscellaneous itemized deductions and thus are unaffected by suspension of the deductibility of miscellaneous itemized deductions. Sec. 67(e) deductions are:

* Estate or trust administration costs that would not have been incurred if the property were not held in the estate or trust;

* The personal exemption of an estate or nongrantor trust; and

* Deductions for distributions of income to beneficiaries of the estate or trust.

The regulations also provide guidance for beneficiaries succeeding to the property of a terminating estate or trust when that entity has expenses in excess of income in the year of termination.

Background: Sec. 67(g), added by the law known as the Tax Cuts and Jobs Act (TCJA), (2) suspends the deduction of miscellaneous itemized deductions for tax years 2018 through 2025. For purposes of Sec. 67, miscellaneous itemized deductions are itemized deductions other than those listed in Secs. 67(b)(1) through (12).

The adjusted gross income (AGI) of an estate or trust generally is computed for Sec. 67 purposes in the same manner as AGI for an individual, but the Sec. 67(e) deductions are also allowed in computing AGI.

With respect to excess deductions on the termination of an estate or trust, Sec. 642(h) allows beneficiaries succeeding to the property of the estate or trust to deduct (1) a Sec. 172 net operating loss (NOL) carryover and a Sec. 1212 capital loss carryover of the terminating estate or trust; and (2) certain deductions that exceed gross income for its last year (excess deductions). In the past, the excess deductions were treated in the hands of the beneficiary as a single miscellaneous itemized deduction that was subject to the 2% floor for deductibility and potentially to disallowance under Sec. 67(g).

In July 2018, the IRS issued Notice 2018-61 announcing its intention to issue regulations clarifying the effect of Sec. 67(g) on the deductibility of expenses described in Secs. 67(b) and (e) that are incurred by estates and nongrantor trusts. In the same notice, the IRS also asked for comments on how Sec. 67(g) affects the ability of the beneficiary to deduct amounts comprising the Sec. 642(h)(2) excess deduction on the termination of an estate or trust.

In May 2020, Treasury and the IRS issued proposed regulations (3) addressing these matters.

Final regulations: The final regulations issued in October 2020 adopt the proposed regulations with some modifications. Consistent with the proposed regulations, the final regulations clarify that items described in Sec. 67(e) remain deductible in determining the AGI of an estate or nongrantor trust during the tax years in which Sec. 67(g) applies, which are 2018 through 2025 (Regs. Sec. 1.67-4). The final regulations in this section adopt the proposed rules without modification.

With respect to excess deductions, the final regulations also adopt the general rule included in the proposed regulations. Under this rule, if an estate or trust, on termination, has deductions for its last tax year in excess of gross income--not counting the deductions allowed under Sec. 642(b) (personal exemption) or Sec. 642(c) (charitable deduction)--the excess deductions are allowed as items of deduction to the beneficiaries succeeding to the property of the terminated estate or trust (Regs. Sec. 1.642(h)-2(a)).

Rather than treating all excess deductions as miscellaneous itemized deductions, the regulations assign the deductions to three categories:

  1. Deductions allowable in calculating AGI under Secs. 62 and 67(e);

  2. Itemized deductions under Sec. 63(d) that are allowed in calculating taxable income; and

  3. Miscellaneous itemized deductions (which are temporarily disallowed under the TCJA).

    For example, tax preparation fees that would be deductible by a trust or estate in computing AGI are deductible by the beneficiary in computing the beneficiary's AGI (rather than as a miscellaneous itemized deduction under prior law).

    The final regulations in this section include some modifications in response to comments, described below.

    First, for purposes of determining the character and amount of the excess deductions under Sec...

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