To understand this change, I’ll give a little background. When a person dies, their income tax year ends on the day of their death, and a new taxpayer called an “estate” comes into being. For federal income tax purposes, the estate files a Form 1041. On Form 1041, the estate has to report any income it receives, such as interest and dividends as well as gains and losses on the sales of any estate assets. The estate also gets to claim various deductions on Form 1041, and these deductions include certain expenses that an individual cannot typically claim, such as attorney fees and executor’s commissions. When the estate ends, the estate files a final Form 1041, and if the expenses on that final return exceed the estate’s income, those so-called “excess deductions” can be claimed by the estate beneficiaries on their individual personal returns (Form 1040). The excess deductions are listed on a Schedule K-1 that is part of the estate’s Form 1041. A copy of the Schedule K-1 is sent to each beneficiary and gives them the tax information they are to report on their Form 1040. When our office handles an estate settlement, we prepare the estate’s income tax return and issue the Schedule K-1, and we time the payment of various expenses to minimize taxes and maximize these deductions. This is often the most valuable service we offer when settling an estate. Many law offices have no experience with these issues and do not prepare the Form 1041 or consider the proper timing of income and expenses.
Unfortunately, under the prior rules, these excess deductions generally provided little benefit to the beneficiaries because everyone thought the excess deductions were miscellaneous itemized deductions that were deductible only to the extent they exceeded 2% of the taxpayer’s adjusted gross income and then only if they otherwise itemized their deductions. HOWEVER, AS A RESULT OF PROPOSED REGULATIONS ISSUED MAY 11, 2020, THESE SECTION 67(e) EXCESS DEDUCTIONS ARE NOW MUCH MORE VALUABLE FOR ALL ESTATE BENEFICIARIES. UNDER THE NEW RULES, THE IRS NOWS SAYS THAT THESE SECTION 67 (e) EXCESS DEDUCTIONS ARE DEDUCTIBLE AS AN “ABOVE-THE -LINE” DEDUCTION. THIS MEANS ALL TAXPAYERS CAN CLAIM THE DEDUCTION! BETTER YET, THE CHANGE IS RETROACTIVE SO THOSE WHO RECEIVED EXCESS DEDUCTIONS IN 2018 or 2019 TAX YEARS MAY WANT TO CONSIDER FILING AMENDING RETURNS TO TAKE ADVANTAGE OF THE NEW RULE.
You can read the technical details and how to report these deductions for tax years 2018 and 2019 at this link: https://www.irs.gov/forms-pubs/reporting-excess-deductions-on-termination-of-an-estate-or-trust-on-forms-1040-1040-sr-and-1040-nr-for-tax-year-2018-and-tax-year-2019
