IRC 642: Exemption, Charitable Deduction, and Termination Rules

Internal Revenue Code Section 642 sets the deduction and credit rules that apply to estates and non-grantor trusts, and they differ from the rules individuals follow on Form 1040. The section covers a small fixed exemption, an uncapped charitable deduction, an election over where to claim administration expenses, an allocation rule for depreciation, and the pass-through of unused losses when the entity ends. Several of these rules take on more weight in 2026 as Tax Cuts and Jobs Act provisions expire.

The Fixed Exemption Under 642(b)

Estates and trusts do not get a personal exemption under Section 151. They get a small fixed amount under Section 642(b): $600 for an estate, $300 for a simple trust (one required by its governing instrument to distribute all income currently), and $100 for a complex trust.¹

These figures are not indexed for inflation and haven’t changed in decades. They rarely drive planning, but they do figure into the final-year excess-deductions calculation described below.

The Charitable Deduction Under 642(c)

Section 642(c) is the most powerful deduction available to a fiduciary. An estate or trust can deduct the full amount of gross income paid to a qualifying charity, with no percentage-of-AGI cap of the sort that limits individuals.¹

Two conditions attach. First, the governing instrument (the will or the trust document) must authorize the charitable payment. If the document is silent, the deduction is unavailable even if the fiduciary actually makes the gift. Second, the payment must be traceable to gross income, not to principal or corpus. A gift funded by selling original estate property that never produced income won’t qualify. The tracing doesn’t have to match the current year’s earnings; courts have accepted that the source can be gross income from any year, as long as it isn’t corpus.

Paid Versus Permanently Set Aside

Section 642(c) distinguishes amounts “paid” from amounts “permanently set aside.” The paid rule applies broadly: if the entity pays a qualifying charity during the tax year, it takes the deduction. A fiduciary may also elect to treat a payment made by the following year’s filing deadline as paid in the earlier year.²

The set-aside rule is narrower. It reaches only estates and trusts created on or before October 9, 1969, that were required by their governing instruments to set aside amounts for charity.¹ Any trust created after that date must actually pay the money out to deduct it.

What This Enables

Because there is no AGI cap, an estate that realizes a large capital gain can, if the will authorizes charitable gifts, direct equivalent income to a qualified charity and offset the gain in full. No individual can do that in a single year. The deduction is reported on Schedule A of Form 1041 (a different Schedule A from the individual one) and is not subject to a floor or phase-out.

Deducting Administration Expenses: Form 706 or Form 1041

Section 642(g) prevents estates from deducting the same expense on both the estate tax return (Form 706) and the fiduciary income tax return (Form 1041). Executor commissions, attorney fees, appraisal fees, and casualty and theft losses during administration all fall inside this rule.³

The executor picks where each expense goes, item by item. Part of an attorney’s bill can be claimed on Form 706 and the rest on Form 1041. To claim the deduction on the income tax return, the executor files a waiver giving up the right to deduct that item on the estate tax return. The waiver becomes irrevocable once the estate tax deduction is “finally allowed.”³

How to Choose

The decision turns on rates. The top estate tax rate is 40% and the top fiduciary income tax rate is 37%, so if the estate owes estate tax, deducting on Form 706 usually saves more per dollar. If the estate falls under the exemption and owes no estate tax, the Form 706 deduction is worth nothing, and Form 1041 is the only place the expense does any good.

The mix of estates in that second group narrows in 2026. The TCJA temporarily raised the basic exclusion to $10 million adjusted for inflation, but that increase expires after 2025.⁴ The exemption reverts to a $5 million baseline adjusted for inflation, estimated at roughly $7 million. Many more estates will owe estate tax, and the 642(g) election will matter for a much larger group. Executors should also weigh the beneficiaries’ brackets, since income distributed out of the estate carries the deduction’s benefit with it.

Allocating Depreciation and Depletion Under 642(e)

When an estate or trust owns depreciable or depletable property, Section 642(e) splits the deduction between the fiduciary and the beneficiaries.⁵ The deduction follows the income.

The governing instrument controls. If it requires the fiduciary to maintain a depreciation reserve, the deduction is allocated to the fiduciary up to the amount set aside for that reserve, and the rest goes to the beneficiaries. If the document is silent, the split follows the income distribution. If 60% of the property’s income is distributed to beneficiaries, 60% of the depreciation deduction goes to them, and the fiduciary claims the other 40%. The allocation happens regardless of whether each party can actually use its share; beneficiaries pick up their portion on Schedule K-1.

Passing Unused Losses and Excess Deductions at Termination

When an estate or trust closes, Section 642(h) hands leftover tax benefits to the beneficiaries who receive the remaining property, so they don’t disappear.⁶

NOL and Capital Loss Carryovers

Any net operating loss carryover and any capital loss carryover the entity had at termination pass to the beneficiaries, keeping their character. Beneficiaries pick them up starting in their tax year in which the entity terminates, and they carry forward on the beneficiaries’ returns under the usual NOL and capital loss rules. They do not expire after a single year.

Excess Deductions on Termination

If deductions in the final year exceed gross income, the difference (excluding the charitable deduction and the personal exemption) passes to the beneficiaries as excess deductions on termination.⁶ Unlike NOL and capital loss carryovers, excess deductions can only be used in the beneficiary’s tax year in which the entity terminates. There is no carryforward. Anything the beneficiary can’t absorb that year is lost. That makes the timing of the final distribution a planning question, not just an administrative one.

Character in 2026

IRS regulations require excess deductions on termination to retain the character they had inside the entity, rather than being combined into a single miscellaneous item.⁷ Administration costs that would not have been incurred if the property were not held in an estate or trust, such as trustee fees or fiduciary-specific accounting, are not miscellaneous itemized deductions subject to the 2% floor.

From 2018 through 2025 the distinction was largely academic, because the TCJA suspended all miscellaneous itemized deductions subject to the 2% floor. That suspension expires after 2025.⁴ Starting in 2026, excess deductions that qualify as fiduciary-specific administration expenses remain deductible above the line, while any that are ordinary miscellaneous itemized deductions are again subject to the 2% AGI floor. Beneficiaries have to itemize to claim any of these amounts. Fiduciaries report the final-year figures on Schedule K-1 (Form 1041), and accurate categorization matters more in 2026 than it has in years.

Why the Rate Structure Makes All of This Matter

Estates and trusts reach the top 37% federal bracket at a very low income threshold. A single filer doesn’t hit 37% until taxable income runs well over $600,000; an estate or trust hits it in the low five figures. Every deduction under Section 642 carries more weight because of that compression. A $10,000 deduction that saves an individual $2,200 can save an estate or trust $3,700. The charitable deduction can wipe out capital gains. The 642(g) election chooses between offsetting estate tax at 40% and income tax at 37%. The 642(h) pass-through can move deductions from the entity’s compressed brackets to a beneficiary’s lower one. And the depreciation allocation prevents either side from getting a windfall. These are the mechanics fiduciaries are paid to get right.

1
Office of the Law Revision Counsel. 26 U.S. Code 642 – Special Rules for Credits and Deductions
2
GovInfo. 26 U.S.C. 642 – Special Rules for Credits and Deductions
3
eCFR. 26 CFR 1.642(g)-1 – Disallowance of Double Deductions; In General
4
Internal Revenue Service. Tax Cuts and Jobs Act – Individuals
5
eCFR. 26 CFR 1.642(e)-1 – Depreciation and Depletion
6
eCFR. 26 CFR 1.642(h)-2 – Excess Deductions on Termination of an Estate or Trust
7
Internal Revenue Service. Internal Revenue Bulletin 2020-22