When preparing Form 1041, after Deductions have been entered but before the Income Distribution Deduction and any Deduction for Estate Taxes have been calculated, complete the Allocation of Deductions for Tax Exempt Income if the entity has any tax-exempt income.
The Internal Revenue Code provides that generally no deduction that would otherwise be allowable can be allowed for any expense that is allocable to tax-exempt income. For this reason, a return with tax-exempt income must make an allocation of any deductions on the return between the tax-exempt income and taxable income. If an expense is directly related to tax-exempt income, then it is allocated to tax-exempt income. Otherwise, expenses that relate indirectly to tax-exempt income are allocated in a "reasonable proportion".
Allocating expenses between taxable and tax-exempt income must not be overlooked, as failure to make the allocation on a return that includes tax-exempt income will result the return rejecting if it is filed electronically.
If the return includes tax-exempt interest or tax-exempt dividends, after exiting the interest or dividends income lines the expense allocation table will be displayed as a reminder to ensure that it is completed correctly. Otherwise, to access the tax exempt income allocation statement, from the Main Menu of the tax return (Form 1041) select
- Other Information
- Tax-Exempt Expense Allocation
- Select New and enter a description of the deduction and the amounts to allocate to taxable and tax-exempt income. Enter an explanation if desired.
The allocation statement prints separately from the return, and its data is transmitted to the IRS when the return is electronically filed.