The Tax Cuts and Jobs Act suspends miscellaneous itemized deductions (i.e., those deductions subject to a 2% floor) from 2018 through 2025, creating an incentive for taxpayers to try and characterize their expenses as giving rise to itemized deductions rather than miscellaneous itemized deductions. General discussion of the new tax law has overlooked this repeal’s impact on estates and non-grantor trusts (i.e., most irrevocable trusts), including a time-sensitive planning opportunity.
Prior to the new legislation, an individual could claim miscellaneous itemized deductions for certain types of expenses that were not specifically enumerated in Internal Revenue Code Section 67. These expenses were not deductible until they exceeded 2% of an individual’s adjusted gross income. Expenses specifically enumerated in Section 67 were itemized deductions not subject to the same 2% floor, making them more attractive to taxpayers than miscellaneous itemized deductions. The new legislation suspends miscellaneous itemized deductions but keeps itemized deductions (subject to certain other restrictions not relevant here).
In the context of trusts and estates, expenses paid by a trust that could have been incurred by an individual are miscellaneous itemized deductions, while expenses that are unique to trust administration are itemized deductions not subject to the 2% floor. Examples of miscellaneous itemized deductions in the trusts and estates context include most investment advisory fees, the cost of preparing gift tax returns, and certain costs incurred to defend a claim against the trust or estate. Examples of itemized deductions not subject to the 2% floor include costs related to fiduciary income tax returns and estate tax returns, probate court costs, and certain appraisal fees.
Deductions in excess of income in the final year of a trust or estate pass through to beneficiaries as miscellaneous itemized deductions even if the expenses would otherwise be characterized as itemized deductions. Whereas in previous years all miscellaneous itemized deductions flowing through to beneficiaries were subject to the 2% floor on the beneficiaries’ individual income tax returns, they now are completely disallowed.
A fiduciary (i.e., trustee or executor) should carefully consider when to pay expenses in order to mitigate the impact of these “wasted deductions.” For example, a fiduciary may wish to pay the cost of preparing the estate tax return in a year prior to final distribution if the deduction for such expense would otherwise be lost.
In addition, if a trust or estate is going to make a final distribution in the first 65 days of 2018, it may be in the beneficiaries’ interest for the fiduciary to make a “Section 663(b) election” to treat the distribution as occurring on the last day of 2017. Any deductions in excess of income would pass to the beneficiaries, thereby enabling them to deduct the expenses on their 2017 individual income tax returns, subject to the 2% floor.