The treatment of tax-exempt income on Form
1041 depends on the type of tax-exempt income earned.
Tax-Exempt Interest: Includes
interest on state and local bonds as well as tax exempt-interest dividends
received from a mutual fund or other regulated investment company.
• Interest paid on debt used to purchase
or carry tax-exempt obligations is not deductible.
• Administrative expenses under IRC §212 directly attributable to
tax-exempt interest are not deductible. Administrative expenses directly
attributable to taxable income are fully deductible.
• A portion of indirect administrative expenses deductible under IRC
§212 must be allocated to tax-exempt interest; and that portion is not
deductible [IRC §265]. Indirect expenses are those not directly related
to either taxable income or tax-exempt income.
• Tax-exempt interest is reported on Line 2 of Schedule B and on Line 1
of Other Information.
Other Tax-Exempt Income: Examples:
Life insurance proceeds, compensation for injuries or sickness, etc.
• No deductions are allowed for expenses directly attributable to
tax-exempt income.
• Tax-exempt income and related expenses may be included in the amounts
reported on Lines 9 and 10 of Schedule B. The income and deductions
related to other tax-exempt income must be deducted on Line 12 of Schedule
B.
• Other tax-exempt income is not reported on Line 2 of Schedule B or on
Line 1 of Other Information. Administrative expenses are not apportioned
to other tax-exempt income.
