Excess Deductions on Termination: How to Claim Them

When an estate or trust concludes its affairs, it may have more deductions than income in its final year. These unused deductions, known as “excess deductions on termination,” can be passed to the beneficiaries. This transfer allows beneficiaries to use the estate’s or trust’s leftover deductions to lower their own income tax liability, ensuring the value of these final expenses is not lost.

Understanding How Excess Deductions Arise

Excess deductions are generated during the final tax year of an estate or trust. In this concluding period, the fiduciary, such as an executor or trustee, is responsible for paying all remaining administrative expenses and settling the entity’s financial obligations. These final costs can include fiduciary fees, legal and accounting services required for the final settlement, and any outstanding state or local taxes.

If the total of these deductible expenses exceeds the income the estate or trust earned during that same final year, an “excess” amount is created. For example, if a trust earned $5,000 in its final year but incurred $12,000 in attorney and fiduciary fees to finalize distributions and file its last return, it would have $7,000 in excess deductions. This amount is then made available to the beneficiaries.

The deductions originate from the operational necessities of terminating the entity, as the expenses are part of the administrative process. The tax code allows these unused deductions to flow through to the beneficiaries, preventing their value from being lost. A beneficiary who receives these deductions cannot carry them forward to a future tax year if they cannot be fully used in the year they are received.

The Impact of Tax Law Changes

The tax treatment of excess deductions on termination has undergone significant changes. Historically, these deductions were classified as miscellaneous itemized deductions for the beneficiary. This meant they could only be claimed on Schedule A of Form 1040 and were subject to a limitation, only being deductible to the extent they exceeded 2% of the beneficiary’s adjusted gross income (AGI). This floor often limited or eliminated the tax benefit.

The Tax Cuts and Jobs Act of 2017 (TCJA) created a period of uncertainty. The TCJA suspended the deduction for miscellaneous itemized deductions subject to the 2% AGI floor for tax years 2018 through 2025. This change led to concerns that these deductions were no longer available to beneficiaries, as their primary classification had been suspended.

The IRS and the Department of the Treasury issued final regulations, Treasury Decision 9918, in October 2020. This guidance clarified that certain excess deductions are not miscellaneous itemized deductions. These are costs for administering the estate or trust that would not have been incurred if the property were not held in such an entity, often referred to as Section 67(e) expenses.

Under these regulations, these specific administrative expenses are treated as an “above-the-line” deduction. A beneficiary can deduct them directly from their gross income on Schedule 1 of Form 1040, without needing to itemize and without being subject to the 2% AGI limitation. This change preserves the value of these deductions, making them more accessible than under pre-TCJA rules.

Receiving and Reporting Excess Deductions

Beneficiaries receive notification of their share of excess deductions from the estate or trust on a Schedule K-1 (Form 1041). This form reports the beneficiary’s share of items from the entity’s final year. The specific information regarding excess deductions is found in Box 11 of the Schedule K-1.

The amount designated with code A in Box 11 represents the “Excess Deductions on Termination – Section 67(e) Expenses.” These are the administrative costs that are now deductible above-the-line. The amount listed is the total figure the beneficiary is entitled to claim as an adjustment to their income.

The amount from Box 11, Code A, is transferred to Schedule 1 (Form 1040), “Additional Income and Adjustments to Income.” It is reported in Part II, Adjustments to Income, on the line for other adjustments. This action directly reduces the beneficiary’s adjusted gross income, allowing them to realize the tax benefit of the deduction.

Distinguishing Between Deduction Types

When an estate or trust terminates, a beneficiary may receive different pass-through items on their final Schedule K-1, and it is important to understand their distinct tax treatments. Not everything passed through is an excess deduction under Section 642(h). Each type of loss or deduction has its own rules and is reported on a different part of the beneficiary’s tax return.

The first type is the excess deductions from administrative costs. As previously discussed, these are deductible “above-the-line” on Schedule 1 (Form 1040), reducing a beneficiary’s AGI without the need to itemize. This treatment applies to expenses like fiduciary and attorney fees unique to the administration of an estate or trust.

A separate category is a net operating loss (NOL). If the estate or trust incurred an NOL in its final year, this loss can also pass through to the beneficiary. Unlike excess administrative deductions, an NOL is treated differently and has its own carryforward rules. The beneficiary claims this loss separately, and it follows different regulations for its use.

Unused capital losses from the estate or trust are another distinct item passed to beneficiaries. These losses retain their character as either short-term or long-term. The beneficiary reports these on their Schedule D (Form 1040), where they can be used to offset the beneficiary’s own capital gains. If the losses exceed gains, up to $3,000 per year can be used to offset ordinary income, with any remaining amount carried forward.