Miscellaneous changes to estate income taxes under Tax Cuts and Jobs Act of 2017

As Benjamin Franklin once famously wrote, "nothing can be said to be certain, except death and taxes." Arguably, nowhere has this saying rang truer than in the context of taxes imposed in connection with an individual's death.

State and federal estate taxes may be the most notorious example of this, to the extent that they are even colloquially referred to as "death taxes"; however, their reach at the federal level has been greatly curtailed and will affect only those individuals who have accumulated substantial wealth. Specifically, the Tax Cuts and Jobs Act of 2017 doubled the prior federal estate tax exemption level, eliminating (at least until 2026) federal estate taxes for individuals with estates less than $11.2 million and for married couples with estates less than $22.4 million. While that increase will allow many estates to avoid paying any federal estate taxes, not all the provisions of the Tax Cuts and Jobs Act of 2017 provide a similarly favorable tax treatment to estates and their beneficiaries.

The administration of an estate can take time - even multiple years - and during that period an estate is subject to income taxes until the final distribution of the estate's assets occurs. Generally, section 67(e) of the Internal Revenue Code (IRC) provides that the adjusted gross income of an estate is determined in the same manner as that of an individual. Additionally, IRC § 67(e)(1) allows an estate to deduct "costs which are paid or incurred in connection with the administration of the estate ... and which would not have been incurred if the property were not held in such ... estate." Examples of costs that fall within the scope of IRC § 67(e)(1) include attorney's expenses, filing fees, and commissions.

IRC § 67 may be more well known, however, for its provisions regarding miscellaneous itemized deductions, which have been eliminated for tax years between 2018 and 2025 by new IRC § 67(g). Because of that elimination, there has been some confusion as to whether the IRC § 67(e)(1) deduction remains available to estates.

Recently, in Notice 2018-61, the Department of Treasury and Internal Revenue Service ("IRS") clarified that the expenses described in IRC § 67(e)(1) remain available because they are not miscellaneous itemized deductions in the hands of an estate. Instead, as above-the-line deductions used to arrive at an estate's adjusted gross income, the IRS and Treasury Department opined that the elimination of miscellaneous itemized deductions for tax years 2018 through 2025 did not affect the availability of IRC § 67(e)(1) deductions. This means that costs such as probate court fees, fiduciary expenses and attorney's fees remain deductible by estates, while costs that would be "commonly or customarily ? incurred by a hypothetical individual owning the same property," such as insurance premiums and investment advisory fees, are no longer allowable.

With respect to an estate's final taxable year, the result of the elimination of miscellaneous itemized deductions has proven to be even less favorable to estate beneficiaries. IRC § 642(h)(2) provides that where an estate has excess income tax deductions in its final year (i.e., its deductible expenses exceeded its income), those excess deductions are allowed as a deduction to the estate's ultimate beneficiary.

Although no part of the Tax Cuts and Jobs Act of 2017 specifically mentioned the section 642(h)(2) excess deduction, or appeared to contemplate its elimination, the section 642(h)(2) excess deduction was effectively eliminated under the new tax law. This elimination was confirmed in Notice 2018-61, in which the Department of Treasury and IRS opined that, unlike IRC § 67(e)(1) deductions, the section 642(h)(2) excess deduction is treated as a miscellaneous itemized deduction to the beneficiary and the disallowance of miscellaneous itemized deductions under new IRC § 67(g) "appears to include the section 642(h)(2) excess deduction."

In summary, as a result of the Tax Cuts and Jobs Act of 2017 an estate, like an individual, can no longer take miscellaneous itemized deductions on its income tax return (Form 1041), but still will retain the ability to deduct expenses like attorney's fees, filing fees and commissions that fall within the scope of IRC § 67(e)(1). However, in the final year of an estate's administration, those expenses that would otherwise be deductible under IRC § 67(e)(1) can no longer be passed through as a deduction to an estate's beneficiaries under IRC § 642(h)(2) because they will be treated as miscellaneous itemized deductions which are disallowed under IRC § 67(g).

Consequently, executors should consider incurring deductible expenses earlier in an estate's administration so as to secure any available IRC § 67(e)(1) deductions against an estate's income. Additionally, consideration should be given as to whether a final income tax return needs to be filed if there is no income in the final year of an estate's administration and the only reason to have filed previously was to take advantage of the excess deduction, as it is no longer available to estate beneficiaries.

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Diane Donnelly is an associate in Boylan Code's Wealth Protection and Transfer Practice Group. She focuses her practice on elder law, estate planning, asset protection, and estate and trust administration.

Published: Fri, Nov 23, 2018

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