Section 807(d) of the Code provides the method of computing life insurance reserves for purposes of determining the income of an insurance company subject to Federal income tax under subchapter L of chapter 1 of the Code (subchapter L). Section 807(d)(1)(A) provides generally that the amount of life insurance reserves for a life insurance contract (other than a variable contract subject to section 807(d)(1)(B)) is the greater of (i) the net surrender value of such contract, or (ii) 92.81 percent of the reserve determined under the tax-reserve method applicable to the contract under section 807(d)(3).

Section 1.807-1(a) of the proposed regulations (proposed § 1.807-1(a)) provides that no asset adequacy reserve may be included in the amount of life insurance reserves under section 807(d). Proposed § 1.807-1(a) describes an asset adequacy reserve as “includ[ing] any reserve that is established as an additional reserve based upon an analysis of the adequacy of reserves that would otherwise be established or any reserve that is not held with respect to a particular contract.” Further, proposed § 1.807-1(a) provides that an asset adequacy reserve is “any reserve or portion of a reserve that would have been established pursuant to an asset adequacy analysis required by the National Association of Insurance Commissioner’s Valuation Manual 30 as it existed on December 22, 2017, the date of enactment of Public Law 115-97 . . . .”

Two commenters requested that the first quoted provision be changed to provide that asset adequacy reserves are those reserves established pursuant to an analysis of the adequacy of reserves only if that analysis is pursuant to the requirements of the National Association of Insurance Commissioners’ (NAIC) Valuation Manual 30. Both commenters suggested the final regulations state what an asset adequacy reserve “is” as opposed to what it “includes.” Moreover, both commenters would remove the language that includes within the definition of “asset adequacy reserve” any reserve that is not held with respect to a particular contract.

The final regulations generally incorporate these comments. The final regulations, however, also incorporate in the definition of asset adequacy reserves any reserve that is similar to an asset adequacy reserve that is determined under the NAIC’s requirements as of the date the reserve is determined.

With respect to the second provision previously quoted, one commenter proposed removing the December 22, 2017, fixed date and replacing it with a reference to “the date the reserve is determined.” The commenter believed that such a change would make the provision more consistent with section 807(d)(3), which generally requires using the tax reserve method that is applicable as of the date the reserve is determined.

The final regulations do not adopt this suggestion. Section 807(d)(3) specifically provides that the tax reserve method (for example, the Commissioners’ Reserve Valuation Method (CRVM) or Commissioners’ Annuity Reserve Valuation Method (CARVM)) to be used in determining a reserve is the tax reserve method that is applicable when the reserve is determined. No such rule exists with respect to asset adequacy reserves.

The reserves determined based on the application of those parts of the NAIC Valuation Manual, as it existed when the TCJA was enacted, that implement and define CRVM and CARVM are not asset adequacy reserves. See Staff of the Joint Committee on Taxation, 115th Cong., General Explanation of Public Law 115-97, 235 (Comm. Print 2018) (Bluebook) (“Under NAIC-prescribed principle-based reserve methodology in effect at the time of the enactment of the provision, principle-base[d] reserves for any contract do not include any asset adequacy reserve component.”) (citation omitted). On the other hand, any additional reserve required to be set aside under Valuation Manual 30, as it existed when the TCJA was enacted, based on an analysis of the adequacy of the reserves otherwise determined, constitutes an asset adequacy reserve under § 1.807-1 of the final regulations.

One commenter proposed the addition of a general provision explaining the significance and selection of the tax reserve method for a contract. The final regulations include such a provision.

The commenter also proposed the addition of an example illustrating the determination of life insurance reserves under section 807(d)(1) and the exclusion of asset adequacy reserves from life insurance reserves. The Treasury Department and the IRS did not include the example in the final regulations, but the principles illustrated by the example are explained in this preamble.

Section 807(f)(1) of the Code provides that if the basis for determining any item referred to in section 807(c) as of the close of any taxable year differs from the basis for such determination as of the close of the preceding taxable year, then so much of the difference between (A) the amount of the item at the close of the taxable year, computed on the new basis, and (B) the amount of the item at the close of the taxable year, computed on the old basis, as is attributable to contracts issued before the taxable year must be taken into account under section 481 as adjustments attributable to a change in method of accounting initiated by the taxpayer and made with the consent of the Secretary.

Section 1.807-4 of the proposed regulations (proposed § 1.807-4) provides guidance relating to both the change in basis of computing reserves of a life insurance company and the change in basis of computing life insurance reserves of an insurance company other than a life insurance company (a nonlife insurance company). Under proposed § 1.807-4(a), a change in basis of computing an item referred to in section 807(c) is a change in method of accounting for purposes of § 1.446-1(e), unless § 1.446-1(e) provides otherwise. Accordingly, under proposed § 1.807-4(a), both a life insurance company changing the basis of computing an item referred to in section 807(c) and a nonlife insurance company changing the basis of computing life insurance reserves must follow the administrative procedures prescribed by the Commissioner of Internal Revenue or his delegate (Commissioner) to obtain the consent of the Commissioner to such a change.

A. Relationship between section 446 and subchapter L

One commenter suggested that § 1.807-4(a) state at the outset that section 807(f) treats a change in basis of computing reserves as a change in method of accounting. The commenter thought this would better establish why § 1.446-1(e) applies to the change in basis of computing reserves. The final regulations incorporate this suggestion. The amendment of section 807(f) by the TCJA led to the requirement in § 1.807-4(a) that changes in basis of computing an item referred to in section 807(c) must follow the same administrative procedures as other changes in method of accounting. Accordingly, this Treasury decision removes or obsoletes contrary guidance (for example, § 1.806-4 and Rev. Rul. 94-74, 1994-2 C.B. 157).

Another commenter took the position that a change in basis of computing an item referred to in section 807(c) is not a change in method of accounting that should require consent under section 446(e). The commenter believed that the IRS’s consent should be needed under section 481(c) only to reflect a multi-year spread of a section 481(a) adjustment that may result from a change in basis of computing reserves. The Treasury Department and the IRS do not agree with this position. The computation of reserves has always been a method of accounting. See Am. Gen. Life & Accident Ins. Co. v. United States, 90-1 USTC (CCH) ¶ 50,010 (M.D. Tenn. 1989) (“[W]hile the government is correct in classifying the change at issue as a change in method of accounting, it is also more specifically a change in the method of computing reserves.”); Rev. Rul. 94-74 (stating that “§ 807(f) is a more specific application of the general tax rules governing a change in method of accounting”). Under the specific provisions of former section 807(f), the general change in method of accounting procedures did not apply to a change in basis of computing reserves. With the TCJA’s amendment to section 807(f), the procedures generally applicable to a change in method of accounting apply to a change in basis of computing reserves under section 807(c). See Bluebook at 228 (stating that a company that changes its method of computing reserves must comply with applicable IRS procedures).

The same commenter recommended that if the final regulations do not remove the requirement that a change in basis of computing reserves under section 807(f) requires consent under section 446(e), then the preamble to the final regulations should clarify that section 446(b) does not apply to the determination of insurance reserves. This recommendation is similar to another commenter’s recommendation that the preamble should acknowledge that the application of the consent provisions of section 446(e) and § 1.446-1(e) does not affect the role of sections 811(a) and 807(d) with respect to the determination of section 807(c) reserves.

Except in extraordinary circumstances, section 446(b) does not affect the requirement that a life insurance company compute its reserves for Federal income tax purposes as required by subchapter L. Similarly, subchapter L does not affect the requirement under section 446(e) that an insurance company secure the consent of the Commissioner before changing its basis of computing reserves.

B. Examples in § 1.807-4(d)

Proposed § 1.807-4 contains four examples illustrating the principles of proposed § 1.807-4(a) through (c). One commenter suggested several clarifications to Example 1 and Example 2 in proposed § 1.807-4(d). Additionally, the commenter requested additional guidance on how the standard for what constitutes a change in basis of computing reserves applies to frequently-encountered fact patterns involving life insurance reserves, such as under principle-based reserve methodologies.

The final regulations do not include what had been Example 1 and Example 2 in proposed § 1.807-4(d). The principles illustrated in these examples are sufficiently illustrated in the remaining examples. Moreover, the Treasury Department and the IRS are providing additional guidance on the fact patterns that constitute a change in basis of computing life insurance reserves in Rev. Rul. 2020-19, 2020-40 I.R.B. 611, released contemporaneously with publication of these final regulations in the Federal Register.

C. Automatic consent procedures for reserves of nonlife insurance companies

Currently, section 26.04 of Rev. Proc. 2019-43, 2019-48 I.R.B. 1107, provides for automatic consent to a change in method of accounting if that change relates to section 807(c) items (which include life insurance reserves for a nonlife insurance company). One commenter requested that the same treatment be extended to changes in method of accounting for the unearned premium reserves and the unpaid loss reserves of nonlife insurance companies.

The final regulations do not incorporate this request, and the Treasury Department and the IRS do not anticipate that Rev. Proc. 2019-43 will be amended to allow for the requested automatic consent. The automatic consent procedures provided in section 26.04 of Rev. Proc. 2019-43 to life insurance companies for a change in basis of computing reserves and to nonlife insurance companies for a change in basis of computing life insurance reserves were a response to the specific change in section 807(f) made by the TCJA. No such change was made by the TCJA for unearned premium reserves or unpaid loss reserves of nonlife insurance companies.

D. Obsoleting of revenue rulings and notice

The preamble to the proposed regulations proposes obsoleting the following revenue rulings because they are inconsistent with section 807(f), as amended by the TCJA: Rev. Rul. 2002-6, 2002-1 C.B. 460, Rev. Rul. 94-74, 1994-2 C.B. 157, Rev. Rul. 80-117, 1980-1 C.B. 143, Rev. Rul. 80-116, 1980-1 C.B. 141, Rev. Rul. 78-354, 1978-2 C.B. 190, Rev. Rul. 77-198, 1977-1 C.B. 190, Rev. Rul. 75-308, 1975-2 C.B. 264, Rev. Rul. 74-57, 1974-1 C.B. 163, Rev. Rul. 70-568, 1970-2 C.B. 140, Rev. Rul. 70-192, 1970-1 C.B. 153, Rev. Rul. 69-444, 1969-2 C.B. 145, Rev. Rul. 65-240, 1965-2 C.B. 236, Rev. Rul. 65-233, 1965-2 C.B. 228, Rev. Rul. 65-143, 1965-1 C.B. 261.

One commenter believes Rev. Rul. 2002-6, Rev. Rul. 94-74, and Rev. Rul. 69-444 contain principles that provide guidance on what constitutes a change in basis of computing reserves and that additional guidance is needed if these revenue rulings are obsoleted. While this Treasury decision obsoletes those revenue rulings, the Treasury Department and the IRS are providing additional guidance on the fact patterns that constitute a change in basis of computing life insurance reserves contemporaneously with publication of the final regulations in the Federal Register. See Rev. Rul. 2020-19.

The preamble to the proposed regulations also proposes to obsolete Notice 2010-29, 2010-15 I.R.B. 547, which provided interim guidance relating to variable annuity contracts as a result of the adoption by the NAIC of Actuarial Guideline 43, which describes a principle-based reserve method. No comments were received regarding this proposed obsolescence, and this Treasury decision obsoletes Notice 2010-29.

E. Revising section 26.04 of Rev. Proc. 2019-43

The preamble to the proposed regulations describes revisions that the Treasury Department and the IRS intend to make to section 26.04 of Rev. Proc. 2019-43. First, section 26.04(2)(b)(ii) of Rev. Proc. 2019-43 provides that multiple changes during the same taxable year for the same type of contract are considered a single change in basis and the effects of such changes are netted and treated as a single section 481(a) adjustment. Section 807(f)(1), however, provides that the section 481(a) adjustment is the difference between the amount of any item referred to in section 807(c) computed on the new basis and the amount of such item computed on the old basis. Accordingly, the Treasury Department and the IRS intend to revise section 26.04 of Rev. Proc. 2019-43 to require netting of the section 481(a) adjustments at the level of each item referred to in section 807(c) so there is a single section 481(a) adjustment for each of the items referred to in section 807(c).

Second, section 26.04(1) of Rev. Proc. 2019-43 provides that the automatic change procedures apply to a nonlife insurance company. The Treasury Department and the IRS intend to revise section 26.04 of Rev. Proc. 2019-43 to clarify the manner in which nonlife insurance companies implement changes to the basis of computing life insurance reserves (as defined in section 816(b)) during a taxable year (year of change). Specifically, the clarification would provide that, if a nonlife insurance company changes the basis of computing its life insurance reserves, then for purposes of applying section 832(b)(4), (i) for the year of change, life insurance reserves at the end of the year of change with respect to contracts issued before the year of change are determined on the old basis and (ii) for the year following the year of change, life insurance reserves at the end of the preceding taxable year with respect to contracts issued before the year of change are determined on the new basis. Life insurance reserves attributable to contracts issued during the year of change and thereafter must be computed on the new basis.

One commenter agreed with the intended revisions.

Section 13517 of the TCJA added section 807(e)(6) to the Code, which provides that the Secretary of the Treasury or his delegate (Secretary) “shall require reporting (at such time and in such manner as the Secretary shall prescribe) with respect to the opening and closing balance of reserves and with respect to the method of computing reserves for purposes of determining income.” In accordance with section 807(e)(6), § 1.807-3 of the proposed regulations (proposed § 1.807-3) provides that the IRS may require reporting on Form 1120-L with respect to the opening and closing balances of the items described in section 807(c) and with respect to the method of computing such items for the purposes of determining income.

One commenter requested further consultation with the life insurance industry before any additional reserve reporting requirements are implemented. According to the commenter, this consultation will be necessary to ensure that the information provided is useful to the government and that providing the information is not unduly burdensome to taxpayers relative to the information’s utility.

The IRS understands the importance of obtaining the life insurance industry’s input before changing the reporting requirements. Proposed § 1.807-3 is adopted as final by this Treasury decision, and the IRS expects to consult with the life insurance industry before making any changes to reporting requirements. Further, as discussed in the Special Analysis section of this preamble, any future changes to tax return form requirements stemming from this provision would be subject to burden analysis and public notice and comment under the Paperwork Reduction Act, which requirements the IRS is committed to follow.

Section 1.816-1(a) of the proposed regulations (proposed § 1.816-1(a)) provides that a reserve (other than an asset adequacy reserve) that is computed using a tax reserve method as defined in section 807(d)(3) and that meets the requirements of section 816(b)(1) and (b)(2) will not be disqualified as a life insurance reserve solely because the method used to calculate the reserve takes into account factors other than those prescribed by section 816(b)(1) and (b)(2). Thus, for instance, reserves calculated using principle-based reserve methodologies will not fail to qualify as life insurance reserves solely because the reserves might be calculated using certain factors in addition to assumed rates of interest and recognized mortality or morbidity tables.

One commenter requested the preamble for the final regulations state that in some cases the use of additional factors in computing reserves for taxable years prior to the effective date of these final regulations is not prohibited. The commenter did not want any negative inference that proposed § 1.816-1 is making permissible what was before impermissible (namely using certain additional factors in computing reserves).

The Treasury Department and the IRS agree that certain factors other than those prescribed by section 816(b)(1) and (b)(2) may be taken into account in determining life insurance reserves for taxable years prior to the effective date of these final regulations if the use of such factors would make the calculation of the reserve more accurate. See, e.g., Mutual Benefit Life Insurance Co. v. Commissioner, 488 F.2d 1101, 1106 (3d Cir. 1974).

The Conference Report to the TCJA contemplates requiring the electronic filing of annual statements to improve reporting of insurance reserves, as necessary to carry out and enforce section 807. H.R. Rep. No. 115-466, at 478-79 (2017) (Conference Report). In response to the Conference Report, the proposed regulations propose to remove § 1.6012-2(c)(4), which prohibits an insurance company that files its Form 1120-L or Form 1120-PC electronically from attaching its annual statement (or pro forma annual statement) to its return.

One commenter stated that for some of the largest groups of companies, the size limits found in section 2.1.2 of IRS Publication 4164, Modernized e-File (MeF) Guide to Software Developers and Transmitters, Processing Year 2020, would likely be exceeded if the annual statement were to be filed electronically, and for other groups of companies, the size limit would likely be exceeded by the return and the annual statement when combined. The commenter suggested retaining the existing rule that electronic filers should not submit their annual statements with their returns, or alternatively, changing the requirement such that electronic filers must only submit limited parts of the annual statement.

The final regulations retain § 1.6012-2(c)(4), but it now provides that electronic filers must file their annual statement or a portion thereof in accordance with the applicable rules in the forms or instructions. The Treasury Department and the IRS anticipate that once the IRS has the capacity to accept the electronic filing of annual statements, the tax return forms and instructions will require electronic filing of all or portions of the annual statement. The IRS, however, expects to consult with the insurance industry before requiring such electronic filing.

The proposed regulations propose to remove parts of § 1.817A-1 that pertain to sections 807(d)(2)(B) and 812(b)(2)(A). Those sections were removed by the TCJA. The notice of proposed rulemaking requested comments on whether § 1.817A-1 should continue to provide a current market interest rate to be used in computing reserves under section 807(c)(3) during the temporary guarantee period of a modified guaranteed contract (MGC) given that the TCJA modified the flush language of section 807(c) to provide a specific interest rate to be used in making section 807(c)(3) computations.

One commenter recommended that § 1.817A-1 be removed in its entirety. The final regulations remove provisions relating to section 807(c)(3) but retain the provision (and related definitions) that waives section 811(d) for non-equity indexed MGCs during the temporary guarantee period, because these rules continue to remain relevant.

The proposed regulations also propose to remove or amend the following regulatory provisions: §§ 1.338-11, 1.381(c)(22)-1, 1.801-2, 1.801-5, 1.801-7, 1.801-8, 1.806-4, 1.809-2, 1.809-5, 1.810-3, 1.817A-0, 1.818-2, 1.818-4, 1.848-1, and 301.9100-6T. These provisions were proposed to be removed or amended because they related to repealed or amended law or to regulations that were proposed to be removed or amended or they had no future application.

One commenter suggested that parts of paragraph (a) of § 1.801-7, a provision proposed to be removed in its entirety, continue to remain relevant under section 817. By its terms, § 1.801-7 is not applicable to any taxable year beginning after 1962. See § 1.801-7(d). Because § 1.801-7 is not applicable to any taxable year after 1962, the commenter’s suggestion is not adopted.

More generally, the commenter requested removal of more “deadwood” provisions than provided for in the notice of proposed rulemaking. The removal of additional “deadwood” provisions is beyond the scope of this rulemaking. No other specific comments were received with respect to these proposed conforming changes.

The Code contains a statutory definition of a life insurance contract under section 7702, rules applicable to certain flexible premium contracts under section 101(f), distribution on death requirements under section 72(s), and diversification requirements under section 817(h). These statutory requirements, which reflect Congress’s concern that the tax-favored treatment generally accorded life insurance and annuity contracts was available to contracts that were too investment oriented or provided for undue tax deferral, are relevant to the tax treatment of a policyholder, annuitant, or beneficiary as well as the entity that issues or reinsures a life insurance or annuity contract.

In response to a request to promulgate regulations that exempt certain contracts from the statutory requirements of sections 72(s), 101(f), 817(h), and 7702, the preamble to the proposed regulations asks for comments on whether such regulations should be promulgated. As described in the preamble to the proposed regulations, the requested exemption would apply to contracts issued by a non-U.S. insurance company and reinsured by a U.S. insurance company if (i) no policyholder, insured, annuitant, or beneficiary with respect to the contract is a U.S. person and (ii) such contract is regulated as a life insurance or annuity contract by a foreign regulator. The preamble to the proposed regulations states that the Treasury Department and the IRS are evaluating the request, including whether to address it as part of this rulemaking, and requests comments including in respect of statutory interpretation and implications in various contexts and provisions outside of subchapter L.

Three comments were received. One commenter (whose comment was endorsed by another commenter) generally repeated the original request (but narrowed the requested exemptions to only sections 7702 and 72(s)) and stated that such regulations would assist U.S. reinsurers of exempted contracts to qualify as life insurance companies under section 816. The commenter asserted that the proposal would (i) align with domestic and U.S. international tax policy considerations because they would be applicable only to contracts owned by and benefitting persons not subject to Federal income tax and (ii) support policy goals of the TCJA to bring profitable business operations into the United States. The commenter further asserted that such regulations would not (i) affect the character, source, or separate category basket in which income derived from the reinsurance is included for U.S. withholding tax or foreign tax credit purposes, (ii) alter the application of any applicable U.S. withholding tax on income from sources within the United States paid by a domestic insurance company to any foreign corporation, or (iii) affect the treatment under section 59A of any claims and benefits or any other amounts paid by a domestic insurance company to a foreign related party under a reinsurance contract. The commenter acknowledged that it may not be possible for a U.S. insurance company to know the identity of a contract’s underlying beneficial owners unless the beneficial owner and the policyholder were the same person and requested that U.S. insurance companies be able to rely upon the Foreign Account Tax Compliance Act beneficial ownership rules to determine if a contract has a U.S. person as a beneficial owner.

Another commenter stated that tax reserve deductions are already available for failed life insurance contracts under other provisions of section 807(c), just in a different amount than would be the case with life insurance reserve treatment. The commenter stated that there could nevertheless be benefits of conformity and suggested an alternative proposal. The commenter recommended that the Treasury Department and the IRS use their authority under sections 811(a) and 7805(a) to issue regulations that provide that reserves held by a U.S. reinsurer relating to indemnity reinsurance of contracts issued by a foreign insurance company be treated as life insurance reserves for purposes of subchapter L if: (i) the underlying contracts are issued by a foreign insurer, (ii) such contracts are regulated as life insurance or annuity contracts both under the applicable law in the foreign jurisdiction and by the regulator of the reinsuring domestic insurance company, (iii) the NAIC prescribes reserves for such contracts that are computed as reserves applicable to life insurance or annuity contracts, and (iv) the initial issuance of the insurance contract to the policyholder was not through the conduct of a trade or business within the United States.

The considerations surrounding the issuance of the requested regulations are complex and require further study. Accordingly, the Treasury Department and the IRS have decided not to issue the requested regulations as part of this rulemaking and will continue to carefully consider these comments.

The collection of information relating to the final regulations was submitted to the Office of Management and Budget for review under OMB Control Number 1545-0123 in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)).

In response to the Conference Report and comments on the proposed regulations, § 1.6012-2(c)(4), as revised by the final regulations, provides that an insurance company should include the insurance company’s annual statement (as defined in § 1.6012-2(c)(5)), or a portion thereof, with an electronically filed Federal income tax return (Form 1120-L for a life insurance company and Form 1120-PC for a nonlife insurance company) as required by the applicable forms or instructions. Federal income tax items of an insurance company are determined in part based upon the insurance company’s annual statement. Providing the annual statement, or a portion thereof, to the IRS with an electronically filed Federal income tax return will allow the IRS to better and more efficiently examine an insurance company’s Federal income tax return. However, until the applicable forms or instructions are revised, the current rules for including the annual statement with an electronically filed Federal income tax return continue to apply.

For purposes of the Paperwork Reduction Act, the burden for the collection of information associated with § 1.6012-2 of the final regulations will be reflected in the burden on the Form 1120-L and in the burden on the Form 1120-PC (OMB Control Number 1545-0123) when the burden for each is revised to reflect the collection of information associated with § 1.6012-2 of the final regulations. The respondents to the collection of information are life insurance companies that file the Form 1120-L electronically and nonlife insurance companies that file the Form 1120-PC electronically. The Treasury Department and the IRS expect to consult with the life insurance industry before making any changes to these reporting requirements.

In accordance with section 807(e)(6), as added by the TCJA, § 1.807-3 of the final regulations provides that the IRS may require reporting on Form 1120-L of the opening balance and closing balance of items described in section 807(c) (for example, life insurance reserves) and the method of computing such items for purposes of determining income. Providing this information will allow the IRS to better examine an insurance company’s Federal income tax return. However, under § 1.807-3 of the final regulations, this information is not required to be provided on any prescribed forms, such as the Form 1120-L, until the relevant prescribed forms or instructions are revised to require the reporting of such information.

For purposes of the Paperwork Reduction Act, the burden for the collection of information associated with § 1.807-3 of the final regulations will be reflected in the burden on the Form 1120-L (OMB Control Number 1545-0123) when the burden is revised to reflect the collection of information associated with § 1.807-3 of the final regulations. The respondents to the collection of information are life insurance companies that file a Form 1120-L. The Treasury Department and the IRS expect to consult with the life insurance industry before making any changes to these reporting requirements.

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.

It is hereby certified that the final regulations will not have a significant economic impact on a substantial number of small entities pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6).

Section 13517 of the TCJA added section 807(e)(6) to the Code. Under section 807(e)(6), the Secretary may require reporting (at such time and in such manner as the Secretary shall prescribe) with respect to the opening balances and the closing balances of reserves and with respect to the method of computing reserves for purposes of determining income. Section 1.807-3 of the final regulations allows the IRS to require the reporting of this information on any prescribed forms, such as the Form 1120-L.

The Conference Report provides that, under existing authority, the Secretary may require an insurance company to provide its annual statement via a link, electronic copy, or other similar means. See Conference Report at 478-79. Section 1.6012-2(c)(4) of the final regulations provides that an insurance company should include the insurance company’s annual statement, or a portion thereof, with an electronically filed Federal income tax return (Form 1120-L for a life insurance company and Form 1120-PC for a nonlife insurance company) as required by the applicable forms or instructions. Under current procedures, an insurance company can only electronically file a Form 1120-L or Form 1120-PC if the insurance company is part of an affiliated group filing a consolidated return, the parent of which files a Form 1120. Although data are not readily available, the Treasury Department and the IRS expect that any reporting burden associated with § 1.6012-2(c) will fall primarily on financial and insurance firms with annual receipts greater than $41.5 million and, therefore, will not affect a substantial number of small entities. See 13 CFR 121.201, sector 52 (finance and insurance).

As stated in the preceding paragraph, the rule is not expected to affect a substantial number of small entities; however, even if a substantial number of small entities were affected, the economic impact of the regulation is not likely to be significant. Section 1.807-3 of the final regulations is limited in scope to time and manner of information reporting, and any economic impact associated with this regulation is expected to be minimal. Further, the information reported to the IRS is information that the insurance company has readily available and the Treasury Department and the IRS expect to consult with the life insurance industry before making any changes to the reporting requirements. Accordingly, the Secretary certifies that the final regulations 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 preceding the Final Regulations was submitted to the Chief Counsel for the Office of Advocacy of the Small Business Administration for comment on its impact on small business, and no comments were received from the Chief Counsel for the Office of Advocacy of the Small Business Administration.

Generally, section 151 allows a taxpayer to claim a deduction equal to the exemption amount for each of the taxpayer and his or her spouse, and for any dependents. Prior to the TCJA, section 151(d) provided for an exemption amount of $2,000 that was adjusted annually for inflation beginning with calendar year 1990. Before the enactment of the TCJA, the IRS had determined that the exemption amount for taxable year 2018 was $4,150. Rev. Proc. 2017-58, 2017-45 I.R.B. 489, modified and superseded by Rev. Proc. 2018-18, 2018-10 I.R.B. 392.

Section 11041(a)(2) of the TCJA added section 151(d)(5) to provide special rules for taxable years 2018 through 2025 regarding the exemption amount. Section 151(d)(5)(A) provides that, for a taxable year beginning after December 31, 2017, and before January 1, 2026, the exemption amount is zero, thereby suspending the deductions for personal exemptions and the dependency exemption. H.R. Rep. No. 115-466, at 202-204 (2017) (Conference Report). However, section 151(d)(5)(B) provides that the reduction of the exemption amount to zero is not taken into account in determining whether a deduction under section 151 is allowed or allowable to a taxpayer, or whether a taxpayer is entitled to a deduction under section 151, for purposes of any other provision of the Code. The Conference Report states that this provision clarifies that the reduction of the personal exemption to zero “should not alter the operation of those provisions of the Code which refer to a taxpayer allowed a deduction . . . under section 151,” including the child tax credit in section 24(a). Id. at 203 n.16. For example, the definition of head of household in section 2(b)(1)(A) includes the requirement that the taxpayer maintain as his or her home a household for a qualifying individual for a specified period of time. A qualifying individual under section 2(b)(1)(A)(ii) includes a person who is a qualifying relative under section 152(d) if the taxpayer is entitled to a deduction under section 151 for the person for the taxable year.

The section 152(d)(1)(C) support test requires that an individual receive more than one-half of his or her support from the taxpayer to be claimed as a qualifying relative of that taxpayer. Prior to the TCJA, payments of alimony or separate maintenance paid to a spouse or former spouse were not treated as support of a dependent provided by the payor spouse. Additionally, alimony and separate maintenance payments were deductible by the payor spouse and includible in income by the recipient spouse under sections 61(a)(8), 71(a), and 215(a) of the Code. Under section 71(c), child support payments were not treated as alimony includible in income.

Section 11051 of the TCJA repealed sections 61(a)(8), 71 and 215, and, in a conforming change, also repealed section 682 of the Code for any divorce or separation instrument executed after 2018, and for any instrument executed before 2019 and later modified to apply the provisions of the TCJA. Consistent with prior law, the TCJA provides that payments of alimony or separate maintenance paid to a spouse or former spouse are not treated as support of a dependent provided by the payor spouse. To conform with the repeal of sections 71 and 682 by the TCJA, section 11051(b)(3)(B) of the TCJA amended section 152(d)(5) of the Code regarding the source of a qualifying relative’s support by revising the language of section 152(d)(5) to eliminate references to former sections 71 and 682.

Section 11022(a) of the TCJA amended section 24 of the Code to create a $500 credit for certain dependents of a taxpayer other than a qualifying child described in section 24(c) for whom the child tax credit is allowed. The $500 credit applies to two categories of dependents: (1) Qualifying children for whom a child tax credit is not allowed, and (2) qualifying relatives as defined in section 152(d). Section 24(h)(4)(A) and (C). Like the amendment to section 151(d) reducing the exemption amount to zero, this new credit applies for taxable years 2018 through 2025. The Conference Report explains that “[t]he credit is further modified to temporarily provide for a $500 nonrefundable credit for qualifying dependents other than qualifying children. The provision generally retains the present-law definition of dependent.” H.R. Rep. No. 115-466, at 227.

On August 28, 2018, the Treasury Department and the IRS issued Notice 2018-70. This notice announced the intent to issue proposed regulations providing that the reduction of the exemption amount to zero under section 151(d)(5)(A) for taxable years 2018 through 2025 will not be taken into account in determining whether an individual meets the requirement of section 152(d)(1)(B) to be a qualifying relative. Notice 2018-70 also stated that, before the issuance of the proposed regulations described in the notice, a taxpayer may rely on the rules described in the notice.

On June 9, 2020, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-118997-19) in the Federal Register (85 FR 35233) proposing regulations under sections 24 and 152 (proposed regulations). Consistent with Notice 2018-70, the proposed regulations provide that, in determining whether an individual is a qualifying relative for purposes of various provisions of the Code that refer to section 152 in taxable years in which the exemption amount is zero, the section 151(d) exemption amount will be the inflation-adjusted section 152(d)(1)(B) exemption amount in the annual revenue procedure setting forth inflation-adjusted items that is published in the Internal Revenue Bulletin. Thus, the exemption amount to be used for this purpose is $4,150 for taxable year 2018 (section 3.24 of Rev. Proc. 2017-58, 2017-45 I.R.B. 489, modified and superseded by Rev. Proc. 2018-18, 2018-10 I.R.B. 392); $4,200 for taxable year 2019 (section 3.25 of Rev. Proc. 2018-57, 2018-49 I.R.B. 827); and $4,300 for taxable year 2020 (section 3.25 of Rev. Proc. 2019-44, 2019-47 I.R.B. 1093).

Section 1.152-3(c)(3) and (d)(2) of the proposed regulations were proposed as changes to an earlier notice of proposed rulemaking (REG-137604-07) also providing rules regarding the definition of a dependent under section 152, which was published in the Federal Register (82 FR 6370) on January 19, 2017 (January 2017 Proposed Regulations). Section 1.152-3(d)(2) of the January 2017 Proposed Regulations, which have not yet been finalized, originally included references to sections 71 and 682. Accordingly, the proposed regulations withdrew §1.152-3(d)(2) of the January 2017 Proposed Regulations and replaced it with a proposed rule to reflect the amendments to section 152(d)(5) discussed in part II of this Background.

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).

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 § 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 § 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 expenses. 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 § 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 § 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 § 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 for 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.

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 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 § 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 estate or trust

Section 1.642(h)-2(b)(2) of the proposed regulations provides that the provisions of § 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 § 1.652(b)–3 comprises 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, § 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 an estate or 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, § 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 § 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.

5. 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 estate 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, § 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 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 § 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.

6. Example 2

Section § 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 § 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 § 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 § 1.652(b)-3(b) and (d).

The proposed regulations provide that the changes to §§ 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 § 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 or trust 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 § 1.67-4 and §§ 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.