The final year of a trust or estate administration is unlike any other year. Certain deductions that accumulated during administration — and could not be used because the entity had insufficient income — do not simply disappear. Under IRC §642(h), they pass through to the beneficiaries on the final Schedule K-1 and can be claimed on the beneficiaries' individual returns.

This passthrough is one of the most underutilized provisions in fiduciary taxation. Executors and trustees who do not understand it leave real tax savings on the table.

When a trust or estate terminates, it files a final Form 1041. The final year has several unique characteristics:

1. All income is distributed — the entity distributes all remaining assets to beneficiaries, so DNI equals the total income for the year;
2. Excess deductions pass through — deductions in excess of gross income are allocated to beneficiaries under IRC §642(h)(2);
3. Net operating losses pass through — any unused NOL carryover passes to beneficiaries under IRC §642(h)(1);
4. Capital loss carryovers pass through — unused capital loss carryovers pass to beneficiaries under IRC §642(h)(1); and
5. The personal exemption is $0 — the entity's personal exemption is not available in the final year.

If the trust or estate's deductions for the final year exceed its gross income, the excess deductions pass through to the beneficiaries in proportion to their share of the entity's assets.

The excess deductions that pass through include:

• Administrative expenses — executor fees, trustee fees, attorney fees, accountant fees, court costs, and other costs of administration;
• Investment expenses — expenses incurred in connection with the production of income;
• Interest expense — deductible interest paid by the entity; and
• Other deductions — any deduction allowable to the entity under the IRC that exceeds gross income.

Important: The character of the excess deductions matters. Under regulations finalized in 2020 (T.D. 9918), excess deductions are allocated to specific categories:

• Deductions described in IRC §67(e) — costs paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in such estate or trust. These are not subject to the 2% floor and are deductible by beneficiaries as above-the-line adjustments.
• Non-miscellaneous itemized deductions — deductions such as state and local taxes (subject to the $10,000 SALT cap) and charitable contributions. These are deductible as itemized deductions without the 2% floor.
• Miscellaneous itemized deductions — deductions subject to the 2% floor under IRC §67(a). Under current law (through 2025, and extended under OBBBA), these deductions are suspended and provide no benefit to beneficiaries.

The executor or trustee must separately state each category of excess deduction on the final Schedule K-1 (Box 11, Code A, B, or C).

Excess deductions are allocated among beneficiaries in proportion to their share of the entity's assets as of the date of termination. A beneficiary who receives 50% of the estate's assets receives 50% of the excess deductions.

If the trust or estate has an unused net operating loss (NOL) carryover at the time of termination, the NOL passes through to the beneficiaries on the final K-1.

Each beneficiary receives a share of the NOL proportionate to their share of the entity's assets. The beneficiary can then carry the NOL forward on their individual return under the rules of IRC §172 — generally, an 80% limitation on taxable income in carryforward years.

NOL carryovers from the entity retain their character as NOLs on the beneficiary's return. They do not become excess deductions.

Similarly, unused capital loss carryovers pass through to beneficiaries on the final K-1. Each beneficiary receives a proportionate share of the capital loss carryover, which they can use on their individual returns subject to the normal capital loss rules — $3,000 per year against ordinary income, with the remainder carried forward.

Capital loss carryovers from the entity retain their character (short-term or long-term) when they pass to beneficiaries.

The 65-day election under IRC §663(b) — which allows a trustee to treat distributions made in the first 65 days of the following year as made in the prior year — does not apply to the final year of a trust or estate. Once the entity terminates, there is no following year to which distributions can be related back.

Accelerate deductible expenses into the final year. Administrative expenses paid in the final year generate excess deductions that pass through to beneficiaries. Expenses paid in earlier years are deducted against the entity's income (which may be taxed at compressed trust rates). If the entity has low income in the final year, accelerating expenses maximizes the passthrough benefit.

Coordinate with beneficiaries' tax situations. Excess deductions are most valuable to beneficiaries in high tax brackets. If the beneficiaries are in low brackets, the passthrough benefit is reduced. Understanding the beneficiaries' tax situations before the final year helps optimize the timing of expenses and distributions.

Separately state each category of excess deduction. The 2020 regulations require the executor or trustee to separately state §67(e) deductions, non-miscellaneous itemized deductions, and miscellaneous itemized deductions on the final K-1. Failure to separately state these categories prevents beneficiaries from correctly claiming the deductions.

File the final return promptly. Beneficiaries cannot claim excess deductions until the final K-1 is issued. Delays in filing the final Form 1041 delay the beneficiaries' ability to use the deductions.

Failing to identify excess deductions. Many executors and trustees do not realize that excess deductions pass through to beneficiaries. The final K-1 is prepared without Box 11 entries, and the beneficiaries lose the deduction.

Incorrect categorization. Lumping all excess deductions into a single category — rather than separately stating §67(e) deductions, non-miscellaneous itemized deductions, and miscellaneous itemized deductions — produces incorrect K-1s and may result in beneficiaries claiming deductions they are not entitled to.

Ignoring NOL and capital loss carryovers. Unused carryovers from prior years are frequently overlooked in the final year. The executor or trustee should review the entity's prior returns to identify any carryovers that should pass through on the final K-1.

Failing to coordinate with beneficiaries. Beneficiaries need to know about excess deductions and carryovers before they file their own returns. Late K-1s force beneficiaries to file extensions or amended returns.

The final year of a trust or estate administration is an opportunity to maximize the tax benefit of accumulated deductions, NOL carryovers, and capital loss carryovers by passing them through to beneficiaries. Executors and trustees who understand these rules can produce meaningful tax savings for the people they serve.

If you are administering a trust or estate approaching termination, contact us to ensure the final Form 1041 is prepared correctly and all available deductions are captured.

Governing authority: IRC §§642(h), 172, 1212; Treas. Reg. §1.642(h)-1 through 1.642(h)-4; T.D. 9918 (2020); IRS Publication 559.

Related: Distributable Net Income: How Trust and Estate Distributions Are Taxed · Form 1041 vs. Form 706 · Estate vs. Trust: What the Tax Difference Actually Means