Effect of Section 67(g) on Trusts and Estates, 66219-66226 [2020-21162]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 85, Number 202 (Monday, October 19, 2020)]
[Rules and Regulations]
[Pages 66219-66226]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-21162]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9918]
RIN 1545-BO87


Effect of Section 67(g) on Trusts and Estates

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations clarifying that the 
following deductions allowed to an estate or non-grantor trust are not 
miscellaneous itemized deductions: Costs paid or incurred in connection 
with the administration of an estate or non-grantor trust that would 
not have been incurred if the property were not held in the estate or 
trust, the personal exemption of an estate or non-grantor trust, the 
distribution deduction for trusts distributing current income, and the 
distribution deduction for estates and trusts accumulating income. 
Therefore, these deductions are not affected by the suspension of the 
deductibility of miscellaneous itemized deductions for taxable years 
beginning after December 31, 2017, and before January 1, 2026. The 
final regulations also provide guidance on determining the character, 
amount, and allocation of deductions in excess of gross income 
succeeded to by a beneficiary on the termination of an estate or non-
grantor trust. The final regulations affect estates, non-grantor trusts 
(including the S portion of an electing small business trust), and 
their beneficiaries.

DATES: 
    Effective date: These regulations are effective on October 19, 
2020.
    Applicability dates: For dates of applicability, see Sec. Sec.  
1.67-4(d), 1.642(h)-2(f) and 1.642(h)-5(c).

FOR FURTHER INFORMATION CONTACT: Margaret Burow at (202) 317-5279 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to Income Tax Regulations (26 CFR 
part 1) under sections 67 and 642 of the Internal Revenue Code (Code). 
On May 11, 2020, the Department of Treasury (Treasury Department) and 
the IRS published a notice of proposed rulemaking (REG-113295-18) in 
the Federal Register (85 FR 27693) containing proposed regulations 
under sections 67 and 642(h) (proposed regulations). The Summary of 
Comments and Explanation of Revisions section of this preamble 
summarizes the provisions of sections 67 and 642(h) and the provisions 
of the proposed regulations, which are explained in greater detail in 
the preamble to the proposed regulations.
    On July 17, 2020, the Treasury Department and the IRS published in 
the Federal Register (85 FR 43512) a notice of public hearing on the 
proposed regulations scheduled for August 12, 2020. The Treasury 
Department and the IRS received no requests to speak at a hearing in 
response to that notice. On August 5, 2020, the Treasury Department and 
the IRS published in the Federal Register (85 FR 47323) a cancellation 
of the notice of public hearing.
    The Treasury Department and the IRS received written and electronic 
comments in response to the proposed regulations. All comments were 
considered and are available at www.regulations.gov or upon request. 
After full consideration of the comments received, this Treasury 
decision adopts the proposed regulations with modifications described 
in the Summary of Comments and Explanation of Revisions.

Summary of Comments and Explanation of Revisions

    Most of the comments addressing the proposed regulations are 
summarized in this Summary of Comments and Explanation of Revisions. 
Comments merely summarizing or interpreting the proposed regulations or 
recommending statutory revisions are not discussed in this preamble. 
The Treasury Department and the IRS continue to study comments on 
issues related to sections 67 and 642(h) that are beyond the scope of 
these regulations, which may be discussed in future guidance if 
guidance on those issues is published. The scope of the proposed 
regulations and these regulations is limited to the effect of section 
67(g) on the deductibility of certain expenses described in section 
67(b) and (e) that are incurred by estates and non-grantor trusts and 
the treatment of excess deductions on termination of an estate or trust 
under section 642(h). This Summary of Comments and Explanation of 
Revisions also describes each of the final rules contained in this 
document.

A. Section 67

    Section 67(g) was added to the Code on December 22, 2017, by 
section 11045(a) of Public Law 115-97, 131 Stat. 2054, 2088 (2017), 
commonly referred to as the Tax Cuts and Jobs Act (TCJA). Section 67(g) 
prohibits individual taxpayers from claiming miscellaneous itemized 
deductions for any taxable year beginning after December 31, 2017, and 
before January 1, 2026. Prior to the TCJA, miscellaneous itemized 
deductions were allowable for any taxable year only to the extent that 
the sum of such deductions exceeded two percent of adjusted gross 
income. See section 67(a). Section 67(b) defines miscellaneous itemized 
deductions as itemized deductions other than those listed in section 
67(b)(1) through (12).

[[Page 66220]]

    Section 67(e) provides that, for purposes of section 67, an estate 
or trust computes its adjusted gross income in the same manner as that 
of an individual, except that the following additional deductions are 
treated as allowable in arriving at adjusted gross income: (1) The 
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 estate or trust, and (2) 
deductions allowable under section 642(b) (concerning the personal 
exemption of an estate or non-grantor trust), section 651 (concerning 
the deduction for trusts distributing current income), and section 661 
(concerning the deduction for estates and trusts accumulating income). 
Accordingly, section 67(e) removes the deductions described in section 
67(e)(1) and (2) from the definition of itemized deductions under 
section 63(d), and thus from the definition of miscellaneous itemized 
deductions under section 67(b), and treats them as deductions allowable 
in arriving at adjusted gross income under section 62(a). Section 67(e) 
further provides regulatory authority to make appropriate adjustments 
in the application of part I of subchapter J of chapter 1 of the Code 
to take into account the provisions of section 67.
    The proposed regulations under Sec.  1.67-4 clarify that expenses 
described in section 67(e) remain deductible in determining the 
adjusted gross income of an estate or non-grantor trust during the 
taxable years in which section 67(g) applies. Accordingly, section 
67(g) does not deny an estate or non-grantor trust (including the S 
portion of an electing small business trust) a deduction for expenses 
described in section 67(e)(1) and (2) because such deductions are 
allowable in arriving at adjusted gross income and are not 
miscellaneous itemized deductions under section 67(b). Commenters 
agreed with the proposed amendments. These regulations adopt the 
proposed regulations under Sec.  1.67-4 without modification.
    Two commenters requested that the regulations address the treatment 
of deductions described in section 67(e)(1) and (2) in determining an 
estate or non-grantor trust's income for alternative minimum tax (AMT) 
purposes. The commenters suggested that such deductions are allowable 
as deductible in computing the AMT. The treatment of deductions 
described in section 67(e) for purposes of determining the AMT is 
outside the scope of these regulations concerning the effects of 
section 67(g); therefore, these regulations do not address the AMT. 
Further, no conclusions should be drawn from the absence of a 
discussion of the AMT in these regulations regarding the treatment of 
deductions described in section 67(e) for purposes of determining the 
AMT.
    One commenter suggested that the Treasury Department and the IRS 
exercise their regulatory authority under section 67(e) to exempt 
cemetery trusts under section 642(i) and qualified funeral trusts 
(QFTs) under section 685 from the application of section 67(g). The 
commenter stated that the primary type of expense incurred by these 
trusts is investment advisory expenses, the tax treatment of which 
differs under the Code from management expense. That is, trust 
management expenses generally are allowable in computing adjusted gross 
income under section 67(e)(1), while trust investment advisory expenses 
are miscellaneous itemized deductions. See Sec.  1.67-4(b)(4). The 
commenter asserted that it was not the intent of Congress to disallow 
investment advisory expenses incurred by cemetery and funeral trusts 
when Congress enacted section 67(g).
    The commenter suggested that exercising the regulatory authority 
under section 67(e) in this manner would be consistent with the 
exercise of regulatory authority under section 1411 to exempt section 
642(i) cemetery perpetual care funds and QFTs. See Sec.  1.1411-3(b)(1) 
(providing that certain types of trusts, including section 642(i) 
cemetery perpetual care funds, are excepted from the net investment 
income tax) and Sec.  1.1411-3(b)(2) (providing a special rule for QFTs 
that, for purposes of calculating any tax under section 1411, section 
1411 and the regulations thereunder are applied to each QFT by treating 
each beneficiary's interest in the trust as a separate trust). As 
stated in the preamble to TD 9644 (78 FR 72393), the Treasury 
Department and the IRS exercised their regulatory authority under 
section 1411 to exclude cemetery trusts from the net investment income 
tax because, by benefiting an operating company, such trusts are 
considered similar to the business trusts that are excluded from the 
operation of section 1411. The preamble also states that QFTs are not 
excluded from the application of the net income investment tax, but 
that the section 1411 tax is calculated consistent with the taxation of 
QFTs under chapter 1. The commenter noted that they advocated the 
treatment of each beneficiary's interest in the QFT as a separate trust 
because such treatment reduces the likelihood of the QFT beneficiaries 
being subject to the net investment income tax. The Treasury Department 
and the IRS continue to consider these comments but providing an 
exemption for cemetery and funeral trusts under section 67(g) is 
outside the scope of these regulations.

B. Section 642(h)

1. In General
    Section 642(h) provides that if, on the termination of an estate or 
trust, the estate or trust has: (1) A net operating loss carryover 
under section 172 or a capital loss carryover under section 1212, or 
(2) for the last taxable year of the estate or trust, deductions (other 
than the deductions allowed under section 642(b) (relating to the 
personal exemption) or section 642(c) (relating to charitable 
contributions)) in excess of gross income for such year, then such 
carryover or excess will be allowed as a deduction, in accordance with 
the regulations prescribed by the Secretary of the Treasury or his 
delegate (Secretary), to the beneficiaries succeeding to the property 
of the estate or trust.
    Section 1.642(h)-2(a), as articulated in the proposed regulations 
and these final regulations, provides that if, on termination of an 
estate or trust, the estate or trust has for its last taxable year 
deductions (other than the deductions allowed under section 642(b) or 
section 642(c)) in excess of gross income, the excess deductions are 
allowed under section 642(h)(2) as items of deduction to the 
beneficiaries succeeding to the property of the terminated estate or 
trust.
2. Character and Amount of Excess Deductions
    Section 1.642(h)-2(b)(1) of the proposed regulations provides that 
each deduction comprising the excess deductions under section 642(h)(2) 
retains, in the hands of the beneficiary, its character (specifically, 
as allowable in arriving at adjusted gross income, as a non-
miscellaneous itemized deduction, or as a miscellaneous itemized 
deduction) while in the estate or trust. The character of these 
deductions does not change when succeeded to by a beneficiary on 
termination of the estate or trust. Furthermore, an item of deduction 
succeeded to by a beneficiary remains subject to any limitation 
applicable under the Code in the computation of the beneficiary's tax 
liability.
    One commenter noted that section 642(h) states that excess 
deductions on termination of an estate or trust are to

[[Page 66221]]

be ``allowed as a deduction, in accordance with regulations prescribed 
by the Secretary'' and that there is no express authority to treat 
excess deductions as miscellaneous or non-miscellaneous itemized 
deductions (or tax preference items for AMT purposes). The Treasury 
Department and the IRS disagree with this comment. The characterization 
of these excess deductions as a single miscellaneous itemized deduction 
in the current regulations was made before the enactment of section 
67(g) and served as an administrative convenience. Making a change to 
that characterization is now appropriate to reflect the temporary 
disallowance of miscellaneous itemized deductions under section 67(g) 
since the regulations were written and is a proper exercise of the 
Secretary's specific grant of regulatory authority in section 642(h).
    Another commenter requested that non-miscellaneous itemized 
deductions included in excess deductions be fully deductible by the 
beneficiary and not subject to a second level of limitation applicable 
on the beneficiary's return, because the amounts already would have 
been subject to limitation on the return of the estate or trust. The 
commenter provided an example of a terminated trust that paid $25,000 
of state income tax, for which the trust is limited to a $10,000 
deduction under section 164(b)(6)(B) for taxable years beginning after 
December 31, 2017, and before January 1, 2026. In the commenter's 
example, the entire amount of the allowable $10,000 deduction was 
passed through to the beneficiary as an excess deduction on termination 
of the trust. The excess of state income tax over the $10,000 
limitation ($15,000) would not pass through as an excess deduction to 
the beneficiaries in this circumstance because the excess amount was 
not deductible to the trust. Excess state income tax on termination of 
the estate or trust may, however, pass through to a beneficiary if the 
estate or trust had insufficient income to absorb the entire $10,000 of 
state income tax deduction. In that circumstance, the commenter opined 
that the limitation under section 164(b)(6)(B), having already been 
applied at the trust level, should not again be applied at the 
beneficiary level. The Treasury Department and the IRS carefully 
considered the comment but determined that beneficiaries remain subject 
to the limitation in section 164(b)(6)(B). The Treasury Department and 
the IRS found no authority to exempt such items from the application of 
any limitations applicable to the beneficiary under the Code. The 
excess deductions retain their character in the hands of the 
beneficiary on termination of the trust, and all applicable limitations 
apply to all of the beneficiary's items of that character, regardless 
of their origin.
    One commenter noted that, under Sec.  1.641(c)-1(j), if an electing 
small business trust (ESBT) election terminates or is revoked and the S 
portion has a net operating loss or capital loss carryover or 
deductions in excess of gross income, then any such loss, carryover or 
excess deductions are allowed as a deduction, in accordance with the 
regulations under section 642(h), to the trust or to the beneficiaries 
succeeding to the property of the trust if the entire trust terminates. 
However, the commenter also noted that under the TCJA, section 
641(c)(2)(E) was amended to provide that ESBT charitable contributions 
are deductible under section 170, rather than under section 642(c), so 
that, unlike other trust charitable deductions, an ESBT's charitable 
deduction could constitute part of the excess deductions on termination 
of the trust. The commenter stated that neither the legislative history 
nor the explanation of the staff of the Joint Committee on Taxation 
addressed whether this result was intended. The Treasury Department and 
the IRS note that charitable contribution deductions under both 
sections 170 and 642(c) are non-miscellaneous itemized deductions under 
sections 63(d) and 67(b)(4) to the estate or trust and maintain that 
such character is retained in the hands of the beneficiary in these 
regulations. Although the Treasury Department and the IRS continue to 
consider the application of section 170 to ESBT charitable 
contributions under section 641(c)(2)(E), this issue is outside the 
scope of these regulations.
    Another commenter requested clarification of whether an excess 
deduction on termination of a trust or estate that is allowed in 
determining the net investment income under section 1411 of the estate 
or trust remains deductible in the hands of the beneficiary in 
determining the net investment income of the beneficiary under section 
1411. These final regulations provide that each excess deduction 
retains its separate character as a section 67(e) deduction, non-
miscellaneous itemized deduction, or miscellaneous itemized deduction 
in the hands of the beneficiary. Whether a deduction retains its 
character as allowable in computing the net investment income of the 
beneficiary, however, is outside the scope of these regulations.
3. Reporting of Excess Deductions
    Section 1.642(h)-2(b)(1) of the proposed regulations provides that 
an item of deduction succeeded to by a beneficiary remains subject to 
any additional applicable limitation under the Code and must be 
separately stated if it could be so limited, as provided in the 
instructions to Form 1041, U.S. Income Tax Return for Estates and 
Trusts, and the Schedule K-1 (Form 1041), Beneficiary's Share of 
Income, Deductions, Credit, etc. Commenters requested that the Treasury 
Department and the IRS provide guidance on how the excess deductions 
are to be reported by both the terminated estate or trust and by its 
beneficiaries. The Treasury Department and the IRS released 
instructions for beneficiaries that chose to claim excess deductions on 
Form 1040 in the 2019 or 2018 taxable year based on the proposed 
regulations. In addition, the Treasury Department and the IRS plan to 
update the instructions for Form 1041, Schedule K-1 (Form 1041), and 
Form 1040, U.S. Individual Income Tax Return, for the 2020 and 
subsequent tax years to provide for the reporting of excess deductions 
that are section 67(e) expenses or non-miscellaneous itemized 
deductions.
    The Treasury Department and the IRS are aware that the income tax 
laws of some U.S. states do not conform to the Code with respect to 
section 67(g), such that beneficiaries may need information on 
miscellaneous itemized deductions of a terminated estate or trust. 
However, because miscellaneous itemized deductions are currently not 
allowed for Federal income tax purposes, that information is not needed 
for Federal income tax purposes. Therefore, it would not be appropriate 
to modify Federal income tax forms to require or accommodate the 
collection of such information while this deduction is suspended. 
Estates, trusts, and beneficiaries are advised to consult the relevant 
state taxing authority for information about deducting miscellaneous 
itemized expenses on their state tax returns.
4. Determinations of Deductions in Year of Termination of the Trust
    Section 1.642(h)-2(b)(2) of the proposed regulations provides that 
the provisions of Sec.  1.652(b)-3 are used to allocate each item of 
deduction among the classes of income in the year of termination for 
purposes of determining the character and amount of the excess 
deductions under section 642(h)(2). Accordingly, the amount of each 
separate deduction remaining after application of Sec.  1.652(b)-3 
comprises

[[Page 66222]]

the excess deductions available to the beneficiaries succeeding to the 
property of the estate or trust as provided under section 642(h)(2). In 
addition, as previously explained, an item of deduction succeeded to by 
a beneficiary remains subject to any additional applicable limitation 
under the Code. Furthermore, Sec.  1.642(h)-2(c) of the proposed 
regulations provides that excess deductions are allowable only in the 
taxable year of the beneficiary in which or with which the estate or 
trust terminates. That is, excess deductions of a terminated estate or 
trust may not carry over to a subsequent year of the beneficiary.
    One commenter requested that these regulations provide an ordering 
rule clarifying whether excess deductions on termination of a trust 
allowed as a deduction to the beneficiary are claimed before, after, or 
ratably with the beneficiary's other deductions, particularly when the 
amount of the excess deductions and other deductions exceed the 
beneficiary's gross income. These final regulations clarify that 
beneficiaries may claim all or part of the excess deductions under 
section 642(h)(2) before, after, or together with the same character of 
deductions separately allowable to the beneficiary under the Code.
    That commenter also requested that the final regulations include an 
exception for investment interest expense under section 163(d) from the 
general rule that excess deductions on termination of a trust or estate 
may be claimed only in the beneficiary's taxable year during which the 
trust or estate terminated. That section permits the carryforward of 
investment interest under section 163(d)(2) to the taxpayer's 
subsequent taxable years if the taxpayer is unable to deduct the 
investment interest in the current taxable year. The commenter stated 
that the disallowance of the carryover of section 642(h)(2) excess 
deductions should not apply to those excess deductions that are no 
longer treated as miscellaneous itemized deductions under the proposed 
regulations, and that carryover should be permitted to the extent 
otherwise permitted under the Code. The preamble to the proposed 
regulations states that addressing suspended deductions under section 
163(d) is beyond the scope of the regulations and the same is true of 
these final regulations.
    A commenter requested that the amount of a beneficiary's net 
operating loss carryover to a later taxable year under section 172 
should include all of the beneficiary's section 642(h)(2) excess 
deductions that are section 67(e) deductions, as deductions that are 
attributable to the beneficiary's trade or business and thus deductions 
attributable to a trade or business under section 172(d)(4). Section 
642(h) makes it clear that a net operating loss carryover under 
paragraph (1) of that section is separate and distinct from the excess 
deductions on termination described in paragraph (2) of that section. 
Furthermore, Sec.  1.642(h)-2(d) provides that a deduction based upon a 
net operating loss carryover generally will not be allowed to 
beneficiaries under both paragraphs (1) and (2) of section 642(h). 
Therefore, an excess deduction allowable to the beneficiary under 
section 642(h)(2) is not a net operating loss carryover succeeded to by 
the beneficiary under section 642(h)(1) and (with one exception) a net 
operating loss carryover is not an excess deduction on termination. 
Moreover, these regulations provide that it is the character of the 
excess deductions as section 67(e) deductions, non-miscellaneous 
itemized deductions, and miscellaneous itemized deductions, and not the 
character of a deduction as attributable to a trade or business, that 
is retained in the hands of the beneficiary. Thus, whether section 
642(h)(2) excess deductions that are section 67(e) deductions may be 
included in a beneficiary's net operating loss carryovers under section 
172, separate from those it succeeds to from a terminated estate or 
trust, is beyond the scope of these regulations. Because Sec.  
1.642(h)-2(a) is clear that excess deductions on termination of an 
estate or trust are not carried over to future years and that such 
deductions are separate from a net operating loss carryover from the 
estate or trust, the Treasury Department and the IRS do not adopt this 
comment.
6. Example 1
    Section 1.642(h)-5(a), Example 1, of the proposed regulations 
(Example 1) updates an existing example illustrating computations under 
section 642(h) when there is a net operating loss. Section 1.642-
5(a)(2)(ii) of Example 1 explains that the beneficiaries of the trust 
cannot carry back any of the net operating loss of the terminating 
estate that was made available to them under section 642(h)(1).
    Two commenters requested that Example 1 be revised to take into 
account the amendments to section 172(b)(1)(D) under sec. 2302(b) of 
the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-
136, 134 Stat. 281 (2020) (CARES Act), by allowing a beneficiary to 
carry back the net operating loss carryover the beneficiary succeeds to 
under section 642(h)(1) for net operating losses arising in taxable 
years beginning after December 31, 2017, and before January 1, 2021. 
Under section 2303 of the CARES Act, net operating losses arising in 
taxable years beginning after December 31, 2017, and before January 1, 
2021, generally may be carried back five years before being carried 
forward. One of these commenters further requested confirmation that a 
beneficiary is allowed a carryback of the net operating loss under 
section 642(h)(1) for net operating losses of an estate or trust 
arising in taxable years ending before January 1, 2018, to the extent 
the beneficiary succeeds to a net operating loss carryover attributable 
to those net operating losses on a termination of the estate or trust 
between January 1, 2018, and December 31, 2020.
    Unless otherwise provided under the Code, a net operating loss 
incurred by a taxpayer may only be used as a deduction by that taxpayer 
and cannot be transferred to another taxpayer for use by that other 
taxpayer. Calvin v. U.S. 354 F.2d 202 (10th Cir. 1965), Mellott v. 
U.S., 257 F.2d 798 (3d Cir. 1958). As an exception to this general 
principle, section 642(h) provides that if, on termination of an estate 
or trust, the estate or trust has a net operating loss carryover under 
section 172, then such carryover is allowed as a deduction, in 
accordance with the regulations prescribed by the Secretary, to the 
beneficiaries succeeding to the property of the estate or trust. 
Section 1.642(h)-1(a) provides that if, on the termination of an estate 
or trust, a net operating loss carryover under section 172 would be 
allowable to the estate or trust in a taxable year subsequent to the 
taxable year of termination but for the termination, a carryover is 
allowed under section 642(h)(1) to the beneficiaries succeeding to the 
property of the estate or trust. In addition, Sec.  1.642(h)-1(b) 
provides that the first taxable year of the beneficiary to which the 
net operating loss will be carried over is the taxable year of the 
beneficiary in which or with which the estate or trust terminates.
    Section 642(h)(1) provides a specific rule that allows the 
beneficiary to succeed to a net operating loss carryover of the estate 
or trust and deduct the amount of the net operating loss over the 
remaining carryover period that would have been allowable to the estate 
or trust but for the termination of the estate or trust. The phrase in 
section 642(h)(1) ``the estate or trust has a net operating loss 
carryover' '' means that the estate or trust incurred a net

[[Page 66223]]

operating loss and either already carried it back to the earliest 
allowable year under section 172 or elected to waive the carryback 
period under section 172(b)(3), and now is limited to carrying over the 
remaining net operating loss. Accordingly, because the net operating 
loss is a carryover for the estate or trust, the beneficiary succeeding 
to that net operating loss may, under section 642(h)(1), only carry it 
forward.
    The CARES Act amendments to section 172(b) mentioned by the 
commenters allow taxpayers a five-year carryback of certain net 
operating losses incurred by that taxpayer. The CARES Act amendments do 
not change the result that a beneficiary succeeding to the net 
operating loss carryover of a terminated estate or trust may only 
carryover that net operating loss in the same manner as the terminated 
estate or trust, but for the termination. Consequently, the Treasury 
Department and the IRS do not adopt these comments and add a citation 
to Sec.  1.642(h)-1 to reference the rule that a beneficiary that 
succeeds to a net operating loss carryover of a terminated estate or 
trust may only carry forward the net operating loss.
7. Example 2
    Section Sec.  1.642(h)-5(b), Example 2, of the proposed regulations 
(Example 2) demonstrates computations under section 642(h)(2). The 
expenses in Example 2 include rental real estate taxes in an attempt to 
illustrate a deduction subject to limitation under section 164(b)(6) to 
the beneficiary that must be separately stated as provided in Sec.  
1.642(h)-2(b)(1).
    Multiple commenters noted that Example 2 raises several issues that 
could be potentially relevant to that example, such as whether the 
decedent was in a trade or business and the application of section 469 
to estates and trusts. To avoid these issues, which are extraneous to 
the point being illustrated, one commenter suggested that the example 
be revised so that the entire amount of real estate expenses on rental 
property equals the amount of rental income. The Treasury Department 
and the IRS did not intend to raise such issues in the example and 
consider both issues to be outside the scope of these regulations. 
Accordingly, the Treasury Department and the IRS adopt the suggestion 
by the commenter and modify Example 2 to avoid these issues by having 
rental real estate expenses entirely offset rental income with no 
unused deduction.
    Commenters also noted that Example 2 does not properly allocate 
rental real estate expenses because the example characterizes the 
rental real estate taxes as itemized deductions. These commenters 
asserted that real estate taxes on property held for the production of 
rental income are not itemized deductions but instead are allowed in 
computing gross income and cited to section 62(a)(4) as providing that 
ordinary and necessary expenses paid or incurred during the taxable 
year for the management, conservation, or maintenance of property held 
for the production of income under section 212(2) that are attributable 
to property held for the production of rents are deductible as above-
the-line deductions in arriving at adjusted gross income. One commenter 
suggested that, if the goal of Example 2 is to illustrate state and 
local taxes passing through to the beneficiary, then the example should 
include state income taxes rather than real estate taxes on rental real 
estate. The Treasury Department and the IRS have revised this example 
in the final regulations to include personal property tax paid by the 
trust rather than taxes attributable to rental real estate.
    Lastly, commenters noted that Example 2 does not demonstrate the 
broad range of trustee discretion in Sec.  1.652(b)-3(b) and (d) for 
deductions that are not directly attributable to a class of income, or 
deductions that are, but which exceed such class of income, 
respectively. In response to these comments, the Treasury Department 
and the IRS have modified Example 2 to illustrate the application of 
trustee discretion as found in Sec.  1.652(b)-3(b) and (d).

C. Applicability Dates

    The proposed regulations provide that the changes to Sec. Sec.  
1.67-4, 1.642(h)-2, and 1.642(h)-5 apply to taxable years beginning 
after the date the regulations are published as final. The preamble to 
the proposed regulations explains that estates, non-grantor trusts, and 
their beneficiaries may rely on the proposed regulations under section 
67 for taxable years beginning after December 31, 2017, and on or 
before the date these regulations are published as final. Taxpayers may 
also rely on the proposed regulations under section 642(h) for taxable 
years of beneficiaries beginning after December 31, 2017, and on or 
before the date the regulations are published as final, in which an 
estate or trust terminates.
    One commenter requested that Sec.  1.642(h)-2 of the proposed 
regulations be applied retroactively not only to taxable years 
beginning after December 31, 2017, but to all open years. The commenter 
asserted that the existing regulation treating excess deductions on 
termination of an estate as a miscellaneous itemized deduction was in 
error. As an example, the commenter argues that the current regulations 
mistakenly describe section 67(e) expenses as an exception to the rules 
applicable to miscellaneous itemized deductions, and therefore 
requested that the final regulations be applicable to all open years. 
The Treasury Department and the IRS have the authority to treat an 
excess deduction on termination of an estate or trust as a single 
miscellaneous itemized deduction. See section 642(h). The suspension 
under section 67(g) of miscellaneous itemized deductions caused the 
Treasury Department and the IRS to reconsider the treatment of excess 
deductions under section 642(h)(2) because the Treasury Department and 
the IRS do not interpret section 67(g) as suspending such deductions 
allowable under section 642(h)(2). The Treasury Department and the IRS 
interpret section 67(g) as not disallowing excess deductions succeeded 
to beneficiaries from terminated estates and trusts under section 
642(h)(2). Therefore, taxpayers may rely on these regulations as of the 
effective date of section 67(g), but not for earlier periods.
    The final regulations apply to taxable years beginning after 
October 19, 2020. Pursuant to section 7805(b)(7), taxpayers may choose 
to apply the amendments to Sec.  1.67-4 and Sec. Sec.  1.642(h)-2 and 
1.642(h)-5 set forth in this Treasury decision to taxable years 
beginning after December 31, 2017, and on or before October 19, 2020.

Special Analysis

    These regulations are not subject to review under section 6(b) of 
Executive Order 12866 pursuant to the Memorandum of Agreement (April 
11, 2018) between the Treasury Department and the Office of Management 
and Budget regarding review of tax regulations. Therefore, a regulatory 
impact assessment is not required.
    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that these regulations will not have a significant 
economic impact on a substantial number of small entities. This 
certification is based on the fact that the amount of time necessary to 
report the required information will be minimal in that it requires 
fiduciaries of estates and trusts to provide on the Schedule K-1 (Form 
1041) issued to beneficiaries information that is already maintained 
and reported to the IRS on Form 1041. Moreover, it should take an 
estate or trust no more than 2 hours to satisfy the information 
requirement in these regulations. Accordingly, the

[[Page 66224]]

Secretary certifies that the rule will not have a significant economic 
impact on a substantial number of small entities.
    Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking that preceded these regulations was submitted to the Chief 
Counsel for the Office of Advocacy of the Small Business Administration 
for comment on its impact on small businesses, and no comments were 
received.

Paperwork Reduction Act (PRA)

    The collection of information related to these regulations under 
section 642(h) is reported on Schedule K-1 (Form 1041), Beneficiary's 
Share of Income, Deductions, Credits, etc., and has been reviewed in 
accordance with the Paperwork Reduction Act (44 U.S.C. 3507) and 
approved by the Office of Management and Budget under control number 
1545-0092.
    The collection of information in these regulations is in Sec.  
1.642(h)-2(b)(1). The IRS requires this information to ensure that 
excess deductions on an estate's or trust's termination that are 
subject to additional applicable limitations retain their character 
when taken into account by beneficiaries on their returns. The 
respondents will be estates, trusts, and their fiduciaries.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget. Books 
or records relating to a collection of information must be retained as 
long as their contents may become material in the administration of any 
internal revenue law. Generally, tax returns and tax return information 
are confidential, as required by section 6103.

Drafting Information

    The principal author of these regulations is Margaret Burow of the 
Office of Associate Chief Counsel (Passthroughs and Special 
Industries). Other personnel from the Treasury Department and the IRS, 
however, participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries for Sec. Sec.  1.67-4, 1.642(h)-2, and 1.642(h)-5 in numerical 
order to read in part as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.67-4 also issued under 26 U.S.C. 67(e).
* * * * *
    Section 1.642(h)-2 also issued under 26 U.S.C. 642(h).
    Section 1.642(h)-5 also issued under 26 U.S.C. 642(h).
* * * * *


0
Par. 2. Section 1.67-4 is amended by revising paragraph (a) and the 
heading of paragraph (d) and adding two sentences to the end of 
paragraph (d) to read as follows:


Sec.  1.67-4   Costs paid or incurred by estates or non-grantor trusts.

    (a) Deductions--(1) Section 67(e) deductions--(i) In general. An 
estate or trust (including the S portion of an electing small business 
trust) not described in Sec.  1.67-2T(g)(1)(i) (a non-grantor trust) 
must compute its adjusted gross income in the same manner as an 
individual, except that the following deductions (section 67(e) 
deductions) are allowed in arriving at adjusted gross income:
    (A) Costs that are paid or incurred in connection with the 
administration of the estate or trust that would not have been incurred 
if the property were not held in such estate or trust; and
    (B) Deductions allowable under section 642(b) (relating to the 
personal exemption) and sections 651 and 661 (relating to 
distributions).
    (ii) Not disallowed under section 67(g). Section 67(e) deductions 
are not itemized deductions under section 63(d) and are not 
miscellaneous itemized deductions under section 67(b). Therefore, 
section 67(e) deductions are not disallowed under section 67(g).
    (2) Deductions subject to 2-percent floor. A cost is not a section 
67(e) deduction and thus is subject to both the 2-percent floor in 
section 67(a) and section 67(g) to the extent that it is included in 
the definition of miscellaneous itemized deductions under section 
67(b), is incurred by an estate or non-grantor trust (including the S 
portion of an electing small business trust), and commonly or 
customarily would be incurred by a hypothetical individual holding the 
same property.
* * * * *
    (d) Applicability date. * * * Paragraph (a) of this section applies 
to taxable years beginning after October 19, 2020. Taxpayers may choose 
to apply paragraph (a) of this section to taxable years beginning after 
December 31, 2017, and on or before October 19, 2020.


0
Par. 3. Section 1.642(h)-2 is amended by:
0
1. Revising paragraph (a).
0
2. Redesignating paragraph (b) as paragraph (d) and adding a heading 
for newly redesignated paragraph (d).
0
3. Redesignating paragraph (c) as paragraph (e) and adding a heading 
for newly redesignated paragraph (e).
0
4. Adding new paragraphs (b) and (c) and paragraph (f).
    The revisions and additions read as follows:


Sec.  1.642(h)-2   Excess deductions on termination of an estate or 
trust.

    (a) Excess deductions--(1) In general. If, on the termination of an 
estate or trust, the estate or trust has for its last taxable year 
deductions (other than the deductions allowed under section 642(b) 
(relating to the personal exemption) or section 642(c) (relating to 
charitable contributions)) in excess of gross income, the excess 
deductions as determined under paragraph (b) of this section are 
allowed under section 642(h)(2) as items of deduction to the 
beneficiaries succeeding to the property of the estate or trust.
    (2) Treatment by beneficiary. A beneficiary may claim all or part 
of the amount of the deductions provided for in paragraph (a) of this 
section, as determined after application of paragraph (b) of this 
section, before, after, or together with the same character of 
deductions separately allowable to the beneficiary under the Internal 
Revenue Code for the beneficiary's taxable year during which the estate 
or trust terminated as provided in paragraph (c) of this section.
    (b) Character and amount of excess deductions--(1) Character. The 
character and amount of the excess deductions on termination of an 
estate or trust will be determined as provided in this paragraph (b). 
Each deduction comprising the excess deductions under section 642(h)(2) 
retains, in the hands of the beneficiary, its character (specifically, 
as allowable in arriving at adjusted gross income, as a non-
miscellaneous itemized deduction, or as a miscellaneous itemized 
deduction) while in the estate or trust. An item of deduction succeeded 
to by a beneficiary remains subject to any additional applicable 
limitation under the Internal Revenue Code and must be separately 
stated if it could be so limited, as provided in the instructions to 
Form 1041, U.S. Income Tax Return for Estates and Trusts, and the 
Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, 
Credit, etc., or successor forms.

[[Page 66225]]

    (2) Amount. The amount of the excess deductions in the final year 
is determined as follows:
    (i) Each deduction directly attributable to a class of income is 
allocated in accordance with the provisions in Sec.  1.652(b)-3(a);
    (ii) To the extent of any remaining income after application of 
paragraph (b)(2)(i) of this section, deductions are allocated in 
accordance with the provisions in Sec.  1.652(b)-3(b) and (d); and
    (iii) Deductions remaining after the application of paragraph 
(b)(2)(i) and (ii) of this section comprise the excess deductions on 
termination of the estate or trust. These deductions are allocated to 
the beneficiaries succeeding to the property of the estate of or trust 
in accordance with Sec.  1.642(h)-4.
    (c) Year of termination--(1) In general. The deductions provided 
for in paragraph (a) of this section are allowable only in the taxable 
year of the beneficiary in which or with which the estate or trust 
terminates, whether the year of termination of the estate or trust is 
of normal duration or is a short taxable year.
    (2) Example. Assume that a trust distributes all its assets to B 
and terminates on December 31, Year X. As of that date, it has excess 
deductions of $18,000, all characterized as allowable in arriving at 
adjusted gross income under section 67(e). B, who reports on the 
calendar year basis, could claim the $18,000 as a deduction allowable 
in arriving at B's adjusted gross income for Year X. However, if the 
deduction (when added to other allowable deductions that B claims for 
the year) exceeds B's gross income, the excess may not be carried over 
to any year subsequent to Year X.
    (d) Net operating loss carryovers. * * *
    (e) Items included in net operating loss or capital loss 
carryovers. * * *
    (f) Applicability date. Paragraphs (a) through (c) of this section 
apply to taxable years beginning after October 19, 2020. The rules 
applicable to taxable years beginning on or before October 19, 2020 are 
contained in Sec.  1.642(h)-2 as in effect prior to October 19, 2020 
(see 26 CFR part 1 revised as of April 1, 2020). Taxpayers may choose 
to apply paragraphs (a) through (c) of this section to taxable years 
beginning after December 31, 2017, and on or before October 19, 2020.


0
Par. 4. Section 1.642(h)-5 is revised to read as follows:


Sec.  1.642(h)-5   Examples.

    Paragraphs (a) and (b) of this section (Examples 1 and 2) 
illustrate the application of section 642(h).
    (a) Example 1: Computations under section 642(h) when an estate has 
a net operating loss--(1) Facts. On January 31, 2020, A dies leaving a 
will that provides for the distribution of all of A's estate equally to 
B and an existing trust for C. The period of administration of the 
estate terminates on December 31, 2020, at which time all the property 
of the estate is distributed to B and the trust. For tax purposes, B 
and the trust report income on a calendar year basis. During the period 
of administration, the estate has the following items of income and 
deductions:

                       Table 1 to Paragraph (a)(1)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Income:
    Taxable interest..................................            $2,500
    Business income...................................             3,000
                                                       -----------------
        Total income..................................             5,500
------------------------------------------------------------------------


                       Table 2 to Paragraph (a)(1)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Deductions:
    Business expenses (including administrative                    5,000
     expense allocable to business income)............
    Administrative expenses not allocable to business              9,800
     income that would not have been incurred if
     property had not been held in a trust or estate
     (section 67(e) deductions).......................
                                                       -----------------
        Total deductions..............................            14,800
------------------------------------------------------------------------

    (2) Computation of net operating loss. (i) The amount of the net 
operating loss carryover is computed as follows:

                     Table 3 to Paragraph (a)(2)(i)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income..........................................            $5,500
Total deductions......................................            14,800
    Less adjustment under section 172(d)(4) (allowable             7,300
     non-business expenses ($9,800) limited to non-
     business income ($2,500))........................
                                                       -----------------
Deductions as adjusted................................             7,500
                                                       =================
    Net operating loss................................             2,000
------------------------------------------------------------------------

    (ii) Under section 642(h)(1), B and the trust are each allocated 
$1,000 of the $2,000 unused net operating loss carryover of the 
terminated estate in 2020, with the allowance of any net operating loss 
carryover to B and the trust determined under section 172. Neither B 
nor the trust can carry back any of the net operating loss of A's 
estate made available to them under section 642(h)(1). See Sec.  
1.642(h)-1(b).
    (3) Section 642(h)(2) excess deductions. The $7,300 of non-business 
deductions not taken into account in

[[Page 66226]]

determining the net operating loss of the estate are excess deductions 
on termination of the estate under section 642(h)(2). Under Sec.  
1.642(h)-2(b)(1), such deductions retain their character as section 
67(e) deductions. Under Sec.  1.642(h)-4, B and the trust each are 
allocated $3,650 of excess deductions based on B's and the trust's 
respective shares of the burden of each cost.
    (4) Consequences for C. The net operating loss carryover and excess 
deductions are not allowable directly to C, the trust beneficiary. To 
the extent the distributable net income of the trust is reduced by the 
net operating loss carryover and excess deductions, however, C may 
receive an indirect benefit from the carryover and excess deductions.
    (b) Example 2: Computations under section 642(h)(2)--(1) Facts. D 
dies in 2019 leaving an estate of which the residuary legatees are E 
(75%) and F (25%). The estate's income and deductions in its final year 
are as follows:

                       Table 4 to Paragraph (b)(1)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Income:
    Dividends.........................................            $3,000
    Taxable Interest..................................               500
    Rent..............................................             2,000
    Capital Gain......................................             1,000
                                                       -----------------
        Total Income..................................             6,500
------------------------------------------------------------------------


                       Table 5 to Paragraph (b)(1)
------------------------------------------------------------------------
 
------------------------------------------------------------------------
Deductions:
    Section 62(a)(4) deductions:
        Rental real estate expenses...................             2,000
    Section 67(e) deductions:
        Probate fees..................................             1,500
        Estate tax preparation fees...................             8,000
        Legal fees....................................             2,500
                                                       -----------------
            Total Section 67(e) deductions............            12,000
    Non-miscellaneous itemized deductions:
        Personal property taxes.......................             3,500
                                                       -----------------
            Total deductions..........................            17,500
------------------------------------------------------------------------

    (2) Determination of character. Pursuant to Sec.  1.642(h)-2(b)(2), 
the character and amount of the excess deductions is determined by 
allocating the deductions among the estate's items of income as 
provided under Sec.  1.652(b)-3. Under Sec.  1.652(b)-3(a), the $2,000 
of rental real estate expenses is allocated to the $2,000 of rental 
income. In the exercise of the executor's discretion pursuant to Sec.  
1.652(b)-3(b), D's executor allocates $3,500 of personal property taxes 
and $1,000 of section 67(e) deductions to the remaining income. As a 
result, the excess deductions on termination of the estate are $11,000, 
all consisting of section 67(e) deductions.
    (3) Allocations among beneficiaries. Pursuant to Sec.  1.642(h)-4, 
the excess deductions are allocated in accordance with E's (75 percent) 
and F's (25 percent) interests in the residuary estate. E's share of 
the excess deductions is $8,250, all consisting of section 67(e) 
deductions. F's share of the excess deductions is $2,750, also all 
consisting of section 67(e) deductions.
    (4) Separate statement. If the executor instead allocated $4,500 of 
section 67(e) deductions to the remaining income of the estate, the 
excess deductions on termination of the estate would be $11,000, 
consisting of $7,500 of section 67(e) deductions and $3,500 of personal 
property taxes. The non-miscellaneous itemized deduction for personal 
property taxes may be subject to limitation on the returns of both B 
and C's trust under section 164(b)(6)(B) and would have to be 
separately stated as provided in Sec.  1.642(h)-2(b)(1).
    (c) Applicability date. This section is applicable to taxable years 
beginning after October 19, 2020. Taxpayers may choose to apply this 
section to taxable years beginning after December 31, 2017, and on or 
before October 19, 2020.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: September 16, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-21162 Filed 10-16-20; 8:45 am]
BILLING CODE 4830-01-P