The Ongoing Sec. 67(e) Controversy and the New Preparer Penalties

By Craig L. Janes, CPA, Washington, DC

Editor: Jeff Kummer, MBA

The correct way to handle trust administrative costs and the 2% floor on their deductibility has been a long-standing controversy. This item discusses how the 2% floor affects a trust’s regular tax and alternative minimum tax (AMT), the effect of the recent Supreme Court decision in Knight on the continuing controversy, and the efficacy of the proposed regulations in the wake of the Knight decision. It also discusses the effect of the Knight decision and the proposed regulations on both tax preparers and taxpayers under the current penalty structure.

Sec. 67—An Introduction

Under Sec. 67(a), miscellaneous itemized deductions are limited to the amount that exceeds 2% of the trust’s adjusted gross income (AGI). Trust administrative costs are deductible under the terms of Sec. 212 and are treated as miscellaneous itemized deductions under Sec. 67(b). Under this general rule, absent an express exception, all administrative deductions claimed by a trust would be subject to the 2% floor.

Sec. 67(e)(1) contains an exception for trusts and estates: It allows certain administrative costs to be deducted above the line in computing AGI. The exception contains two requirements: (1) the costs must have been “paid or incurred in connection with the administration of the . . . trust” (the necessity test); and (2) the costs must have been expenses “which would not have been incurred if the property were not held in such trust” (the exclusivity test).

A trust’s AGI is generally computed like an individual’s, but Sec. 67(e) allows “above the line” deductions for income distributed by the trust and for the annual exclusion amount under Sec. 642(b). A trust that distributes all or the majority of its taxable income in any given year will likely have a low 2% floor and will lose few deductions. But a trust that accumulates income and pays regular tax may lose deductions, depending on the size of its AGI relative to its administrative costs (i.e., a high AGI together with high administrative costs will lead to a loss in deductions).

The 2% floor will also affect the trust’s AMT calculation. Expenses subject to the 2% floor are considered an adjustment and are added back in order to calculate alternative minimum taxable income (AMTI) under Sec. 56(b)(1)(A). Under the rules of Sec. 59(c), all AMT adjustments are trapped at the trust level, except in the rare case in which trust distributions exceed regular tax distributable net income (DNI). Only in that case will the excess of AMT DNI over regular tax DNI be distributed to the beneficiary, leaving less AMTI subject to tax in the trust.

Because AMT adjustments are generally trapped at the fiduciary level, a distributing trust or estate runs a greater risk that it will be subject to AMT in any given year. When this happens, the combined tax burden (for the trust and the beneficiary) will be greater than if the trust had made no distributions at all. However, the AMT effect of the 2% floor on an accumulating trust or estate is unlikely to be significant because, by itself, the amount of disallowed expenses would generally not be enough to trigger the AMT for the trust.

The Historical Controversy

Several federal courts have ruled on the Sec. 67(e) exclusivity requirement. (See Scott, 328 F3d 132 (4th Cir. 2003), aff’g 186 FSupp2d 664 (E.D. Va. 2002); Mellon Bank, N.A., 265 F3d 1275 (Fed. Cir. 2001), aff’g 47 Fed. Cl. 186 (2000); O’Neill, 994 F2d 302 (6th Cir. 1993), rev’g 98 TC 227 (1992); and Rudkin Testamentary Trust,467 F3d 149 (2d Cir. 2006), aff’g 124 TC 304 (2005).) Specifically at issue in each case was the deduction of investment advisory fees. No two of these courts have come up with a consistent position. However, almost all the courts have sided with the government’s position that investment advisory fees are subject to the 2% floor; only the Sixth Circuit (reversing the Tax Court in O’Neill) sided with the taxpayer.

Unlike all the other cases, Mellon Bank involved the deductibility not just of investment fees but of expenses related to investment strategies advice, accounting and tax preparation fees, and management services. In denying a government motion for summary judgment, the Court of Federal Claims, later sustained by the Federal Circuit, noted that trust administrative costs would not be subject to the 2% floor if “such services when provided for a trust are ‘more onerous’ than those provided for individuals.” The government ended up winning the case because the taxpayer would not present evidence as to whether any portion of the costs at issue would not have been incurred if the property were not held in trust. Consequently, left unanswered was the extent to which any of the costs, in addition to the investment advisory fees, might otherwise have been found deductible.

On January 16, 2008, the Supreme Court issued a decision in the Rud kin case (now identified as Knight, S. Ct. Dkt. 06-1286 (U.S. 1/16/08)). The Court held that investment advisory fees are generally subject to the 2% floor (thus overruling O’Neill) but refused to go as far as the Second Circuit in saying that the exclusivity test requires that the fees could not have been incurred by an individual. Instead, the Supreme Court agreed with the test adopted by the Fourth and Federal Circuits that trust administrative costs that are not subject to the 2% floor are those that would not “commonly” or “customarily” be incurred by individuals. Chief Justice Roberts wrote:

The question whether a trust-related expense is fully deductible turns on a prediction about what would happen if a fact were changed—specifically, if the property were held by an individual rather than by a trust. . . . such an exercise necessarily entails a prediction; and predictions are based on what would customarily or commonly occur. Thus, in asking whether a particular type of cost “would not have been incurred” if the property were held by an individual, §67(e)(1) excepts from the 2% floor only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur.

The Court noted that because of the lack of regulatory guidance, it might be difficult to determine in other cases whether a cost is one that is common. In describing the application of the standards, the Court stated:

As the Solicitor General concedes, some trust-related investment advisory fees may be fully deductible “if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts.” . . . It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor.

Administrative Developments: The Proposed Regulations

On July 27, 2007, Treasury released Prop. Regs. Sec. 1.67-4 (REG-128224-06) in order to provide a “uniform standard for identifying the types of costs that are not subject to the 2-percent floor under section 67(e)(1).” The proposed regulations clearly adopted the Second Circuit’s view that only expenses that are “peculiar to trusts” and “could not” be incurred by an individual are not subject to the 2% floor. As a consequence, the regulations’ continuing viability is now suspect, given the Supreme Court’s repudiation of the Second Circuit’s rationale as too narrow.

A Discussion of the 2% Floor for Fees Other than Investment Advisory Fees

To their credit, the proposed regulations do what no court has attempted: They put forth a noncomprehensive list of services and product purchases that are unique to trusts and estates. Expenses or product purchases that are specifically identified as unique in the proposed regulations include

those rendered in connection with: Fiduciary accountings; judicial or quasi-judicial filings required as part of the administration of the estate or trust; fiduciary income tax and estate tax returns; the division or distribution of income or corpus to or among beneficiaries; trust or will contest or construction; fiduciary bond premiums; and communications with beneficiaries regarding estate or trust matters.

Although the Supreme Court identified the underlying premise of the proposed regulations as too narrow, this affirmative list is unlikely to be diminished in any subsequent development. The list does, however, raise a few issues. It is difficult to extrapolate from the list what characteristics would qualify a discretionary expense as unique. The specifically identified items have nothing in common except that they are costs typically “imposed” on the trustee by the trust agreement or state law. Interestingly, it was the “required” nature of the investment advice that moved the Sixth Circuit in O’Neill to allow the deduction, in full, of third-party investment advisory fees. Also, the services and products on the list are the type that are usually included in the trustee’s fee. Other service providers such as attorneys or accountants are typically engaged only when the service is nonroutine.

In one of their more controversial provisions, the proposed regulations require trusts to allocate single-fee payments between unique and non-unique services and product purchases. This makes the proposed regulations more restrictive than the decisions of the Fourth, Second, and Federal Circuits, which identified the trustee’s fee as being unique to trusts and estates and therefore fully deductible. Now that the Supreme Court has endorsed the rationale of the Fourth and Federal Circuits, it is likely that this provision will be revisited.

If this requirement is ultimately adopted in its current form, there are certain practical problems imposed upon a fiduciary. Specifically, this allocation may be relatively simple for service providers that bill on an hourly basis, but how is it to be accomplished for those that bill based on asset value? The proposed regulations say the fiduciary can “use any reasonable method”—but it may be a long time before fiduciaries know what the Service (and eventually the courts) will determine to be “reasonable.”

Also left undefined is how to determine whether a particular fee or product purchase is unique. For example, contained in the proposed regulations’ list of nonunique items is “advice on investing for total return,” which implies that not all forms of investment advice are subject to limitation. How does one differentiate between “total return” advice and other advice?

Similarly, the proposed regulations’ affirmative list of unique items, discussed above, also seems difficult to justify. Income tax preparation fees are on this list, but are these fees really unique just because a trust must file Form 1041?

Given the Supreme Court’s lack of direction on this point, our only guidance is that provided by the Court of Federal Claims in Mellon Bank that all administrative costs, other than those for investment advice, paid by the trustee or executor must be the subject of an objective analysis of the type and nature of the services and “whether a reasonable person exercising domain over the funds would have incurred the costs in a nontrust context” and, where that analysis yields a negative determination, whether such costs are “more onerous” than those incurred by persons in a nontrust context. Unfortunately, how to implement such a subjective analysis is a point on which current guidance is wholly inadequate.

Taxpayers and the Accuracy-Related Penalties

When dealing with the fluidity of the current state of the law in this area, both taxpayers and tax preparers must carefully consider their determinations against the backdrop of potential penalties that may be imposed should the IRS prevail in a challenge for failure to subject administrative expenses to the 2% floor. To further inform the decision making in this area, a cursory review of the current penalty landscape is in order.

When a taxpayer substantially understates his or her income tax liability (i.e., by more than the greater of 10% of the tax required to be shown on the return for the tax year or $5,000), an accuracy-related penalty will be assessed (Regs. Sec. 1.6662-4(b)(1)). It is important to note that the substantial understatement is determined on an aggregate basis (i.e., all adjustments to the tax return as filed), not on a per-issue basis (e.g., the 2% floor issue). However, there are exceptions to the understatement penalty.

Where a substantial understatement of liability occurs, the penalty will be reduced by any part that is attributable to an item for which there was substantial authority (Regs. Sec. 1.6662-4(d)). There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. The weight accorded an authority depends on its relevance, its persuasiveness, the type of authority, and how recent the authority is.

A taxpayer that lacks substantial authority can still avoid the accuracy-related penalty if there is a reasonable basis for the position and the position is adequately disclosed (Regs. Sec. 1.6662-4(a)). A “reasonable basis” means the position taken is reasonably based on one of the authorities that can be used under the substantial authority standard (Regs. Sec. 1.6662-3(b)(3)). Finally, if the taxpayer’s position is determined not to have substantial authority and the position is not disclosed, the penalty may be abated if the taxpayer can show that there was reasonable cause for its position and the taxpayer acted in good faith with respect to the item in question (Regs. Sec. 1.6664-4(a)).

The New Tax Preparer Standards

The Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), amended the Sec. 6694 tax return preparer penalty. SBWOTA expanded the scope of Sec. 6694 to include all federal tax returns (not just income tax returns), altered the standard of conduct required to be met in order to avoid the imposition of a preparer penalty, and significantly increased the amount of the penalty. These provisions generally apply to all returns, amended returns, and refund claims filed after December 31, 2007 (Notices 2007-54 and 2008-11).

On December 31, 2007, the government released Notice 2008-13, wherein it announced its intent in 2008 to “revise the regulatory scheme governing tax return preparer penalties,” to provide “interim guidance on the application of the tax return preparer penalties,” and to solicit “public comments regarding the revision of the regulatory scheme.” It further provided the following caveat: “Tax return preparers may rely on the interim guidance in this notice until further guidance is issued. It is important to note that the regulations expected to be finalized in 2008 may be substantially different from the rules described in this notice, and in some cases more stringent.”

The notice confirms what has generally been expected:

[f]or purposes of determining whether the tax return preparer has a reasonable basis for a position, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, as provided in [Regs.] §1.6694-1(e). In addition, a tax return preparer may rely in good faith and without verification upon information furnished by another tax return preparer or other third party. . . . The tax return preparer, however, may not ignore the implications of information furnished to the tax return preparer or actually known to the tax return preparer. The tax preparer also must make reasonable inquiries if the information furnished by another tax return preparer or a third party appears to be incorrect or incomplete.

What happens if the trustee tells the tax return preparer that 100% of an investment advisor’s fee is unique and deductible without regard to the 2% floor? While the tax return preparer’s reliance on such a statement should be beyond reproach, both Knight and Prop. Regs. Sec. 1.67-4 clearly indicate that at a minimum, except in extraordinary circumstances, some allocation of the fee between above-the-line and 2% floor deductions is required. Notice 2008-13 says that those implications cannot be categorically ignored. This is a scenario in which the tax preparer is clearly at an impasse. Taxpayers and tax preparers should proceed with caution and may need to employ the heightened disclosure discussed below.

Responding to the Increased Standard of Conduct

SBWOTA requires that a tax return position be disclosed unless there is “a reasonable belief that the [filing] position would more likely than not be sustained on its merits.” Notice 2008-13 elaborates by stating that, until additional guidance is issued, this standard will be deemed met “if the tax preparer analyzes the pertinent facts and authorities in the manner described in [Regs.] §1.6662-4(d)(3)(ii) and, in reliance upon that analysis, reasonably concludes in good faith that there is a greater than fifty percent likelihood that the tax treatment of the item will be upheld if challenged by the IRS.” It then goes on to point out that for purposes of the interim guidance, the standard just described would supersede that imposed by existing Regs. Sec. 1.6694-2(b). The general considerations of Regs. Sec. 1.6662-4(d) were discussed above in relationship to the taxpayer penalty.

Until the impending regulations are released, uncertainty about the standard will remain, but in all events making such a determination, while requiring considerable due diligence, is still an inherently subjective undertaking where the available authority is characterized by its inconsistency—as is the case with Sec. 67(e). If the more likely than not (MLTN) standard is not met and the item is not disclosed, a penalty may be imposed.

Notice 2008-13 sets forth certain “interim penalty compliance rules” that provide tax return preparers with alternative methods of satisfying their disclosure obligations under Sec. 6694. For example, in a situation in which substantial authority exists for a position, but for which a signing tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on its merits, the tax return preparer may meet its Sec. 6694 obligations by advising the client of the difference between the tax preparer standards under new Sec. 6694 and the taxpayer penalty standards under Sec. 6662, and contemporaneously documenting that advice, rather than by preparing a Form 8275, Disclosure Statement, with respect to the position.

Dealing with the New Standards

Based on the discussion above, how can practitioners attempt to deal with the subjectivity of determining whether an administrative cost is deductible “above the line” without incurring a risk of penalty?

For investment advisory fees paid by a trustee to a third-party provider, the MLTN requirement favors the government’s position. Thus, even under the circumstances identified by the Supreme Court where the facts support the deduction above the line of some or all of the fees, in the event of an IRS challenge of a practitioner’s interpretation of the facts, the only security against a preparer penalty is disclosure (or compliance with the interim penalty compliance rules of Notice 2008-13). Should the Service finalize Regs. Sec. 1.67-4, disclosure will probably be required on Form 8275-R, Regulation Disclosure Statement, in nearly all circumstances in order to defend against both taxpayer and preparer penalties. (See Regs. Secs. 1.6694-2(c)(3) and 1.6662-4(f).)

Under the proposed regulations, a taxpayer is required to allocate trustees’ fees between deductible unique and nondeductible nonunique fees. As previously indicated, with the Supreme Court’s endorsement of the Federal and Fourth Circuit decisions, both of which expressly found that trustee fees are always deductible above the line, the unbundling requirement would appear to lack support. Consequently, until the proposed regulations are finalized, it is more likely than not that a taxpayer’s failure to make an allocation will be sustained. If the proposed regulations are finalized with the unbundling requirement intact, a trust that does not allocate trustee fees would then be taking a position contrary to final regulations and therefore would be required to disclose in order to avoid both taxpayer and preparer penalties.

It is uncertain whether other administrative expenses can be deducted without any representations (or other supporting evidence) about the expenses’ uniqueness from the trustee. While the Supreme Court decision undermines the more conservative analysis endorsed by the proposed regulations, a subjective analysis of some sort is still required. Consequently, deducting such expenses without support as to their uniqueness would, in light of Knight, arguably lack reasonable basis as a filing position. Thus, in such circumstances even disclosure will provide no defense against a taxpayer penalty.

With respect to the preparer penalty in such situations, it is as yet unclear to what extent a preparer can rely on the trustee’s representations as to uniqueness (or on other support provided by the trustee) to ensure that an item’s fully deductible status will be sustained. Because identifying an expense as analogous to expenses paid by an individual precludes a finding of uniqueness, if the preparer finds such an analogue, the ability of the preparer to avoid a penalty on grounds of reliance in good faith on the taxpayer/trustee’s representations in the face of that analogue clearly, absent disclosure, places the tax preparer in some jeopardy of a preparer penalty. As discussed above, there seems to be no controlling characteristic that clearly delineates the uniqueness of any expense; this makes it difficult to identify unique expenses without more specific guidance from either the courts or the IRS.

Conclusion

In the face of such uncertainty about the application of the 2% floor to fiduciary taxpayers, it is becoming increasingly difficult to get comfortable with a position that does not subject all expenses other than those identified in the proposed regulations to the 2% floor without disclosing that position on a Form 8275 or otherwise complying with the alternative methods of satisfying their disclosure obligations under Sec. 6694 as provided in Notice 2008-13. What flexibility might exist now will be wholly eliminated if the proposed regulations are finalized in their current form. Hopefully, Treasury will issue the final regulations in a form that fully reflects the outcome of the Knight case. For now, one can only advise heightened due diligence in determining the level of authority available to support a position that an administrative expense is not subject to the 2% floor and caution in considering whether to disclose that position.


EditorNotes

Jeff Kummer, MBA, is Director of Tax Policy at Deloitte Tax LLP, Washington, DC.

If you would like additional information about these items, contact Mr. Kummer at (202) 220-2148 or jkummer@deloitte.com.

This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.

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