Estates, Trusts & Gifts
In September 2011, the IRS issued Prop. Regs. Sec. 1.67-4 (REG-128224-06) that superseded proposed regulations from 2007 regarding the treatment of certain trust deductions. The new proposed regulations provide that a cost incurred by a trust that is “commonly or customarily” incurred by a hypothetical individual holding the same property is subject to the 2% floor on miscellaneous itemized deductions as applied under Sec. 67(e). The proposed regulations also state that, if a trust pays a single fee or other expense for both costs that are subject to the 2% floor and costs that are not subject to it (a “bundled fee”), then the amount “must be allocated . . . between the costs subject to the 2% floor and those that are not.”
The IRS issued Notice 2011-37, however, to provide that the requirement of unbundling fees will not apply to tax years that begin before final regulations are issued. As of February 2012, the IRS had not released final regulations. Thus, preparers of fiduciary tax returns for tax years 2011 and 2012 will not be required to unbundle fiduciary fees, but they still must treat payments readily identifiable as subject to the 2% floor separately from a bundled fiduciary fee.
Under Sec. 67(a), for an individual, miscellaneous deductions “shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.” According to Sec. 641(b), the taxable income of an estate or trust is computed in the same manner as for an individual, with certain exceptions not relevant to this discussion. Sec. 67(e) makes an exception to the general rule of Sec. 67 for trusts and estates, stating that “the deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate . . . shall be treated as allowable in arriving at adjusted gross income.”
In William L. Rudkin Testamentary Trust, 467 F.3d 149 (2d Cir. 2006), the court held that investment advisory fees of a trust were subject to the 2% floor, as they were similar to costs incurred by individuals that are subject to the 2% floor. Only trust expenses that individuals are incapable of incurring are not subject to the 2% floor, the court held. Examples of such costs discussed in the decision include “fees paid to trustees, expenses associated with judicial accountings, and the costs of preparing and filing fiduciary income tax returns.”
In July 2007, the IRS released proposed regulations that followed the reasoning of the Rudkin decision by saying that only expenses “unique” to trusts or estates qualify. The proposed regulations went a step further, however, by introducing the concept of unbundling trustee fees to separate costs that are unique to trusts (which would not be subject to the 2% floor) and those that were not unique to trusts (and hence would be subject to the 2% floor).
Although the Supreme Court affirmed the Rudkin decision in Knight, 552 U.S. 181 (2008), the Court held that only expenses considered “uncommon or unusual” for a hypothetical individual to incur would qualify for the Sec. 67(e) exception. Since investment advisory fees generally are incurred by individuals, they are miscellaneous itemized deductions for the trust, subject to the 2% floor. The opinion did not discuss the proposed regulations’ unbundling requirement.
Following the Knight decision, the IRS requested comments in Notice 2008-32 regarding the position the regulations should take regarding Sec. 67(e), particularly concerning suggestions for safe harbors. This notice also provided guidance that fiduciary fees would not have to be unbundled for any tax years before 2008 (subsequently extended through 2009 and 2010 and then further extended by Notice 2011-37 to all tax periods beginning before the final regulations are issued).
Prop. Regs. Sec. 1.67-4
Prop. Regs. Sec. 1.67-4(a) as reissued states that “[a] cost is subject to the 2-percent floor to the extent that it is included in the definition of miscellaneous itemized deductions under section 67(b), is incurred by an estate or non-grantor trust, and commonly or customarily would be incurred by a hypothetical individual holding the same property,” which reflects the Court’s holding in Knight. The standard for “commonly” or “customarily” is driven by the type of product or service provided to the trust, rather than the description of the cost of the product or service.
The proposed regulations then discuss some examples of typical costs incurred by trusts. Ownership costs (such as condominium fees, real estate taxes, insurance premiums, etc.) are subject to the 2% floor, as these types of costs are incidental to ownership and would be commonly and customarily incurred by a hypothetical individual owner of such property. Tax preparation fees, however, are not subject to the 2% floor if they are for preparation of estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent’s final individual income tax return. Tax preparation costs typically incurred by individuals, such as for individual income tax (other than the decedent’s final return) and gift tax returns, are subject to the 2% floor.
Prop. Regs. Sec. 1.67-4(b)(4) also specifically addresses investment advisory fees. Fees for investment advice that is similar to that received by individuals are subject to the 2% floor. Any other cost that is normally not incurred by an individual because it is specific to a trust or involves an “unusual investment objective or the need for a specialized balancing of the interests of various parties” is not subject to the 2% floor.
Prop. Regs. Sec. 1.67-4(c) discusses the treatment of a bundled fee charged by fiduciaries, attorneys, and accountants. Where a single fee contains both costs that are and that are not (in more than a de minimis amount) subject to the 2% floor, trusts must apply a reasonable method to allocate the single fee. Where the fee is not computed on an hourly basis, only the portion of the single fee that is allocable to investment advice will be considered subject to the 2% floor. Unlike attorneys and accountants, most trustees do not determine a fee on an hourly basis. Thus, a trustee will need to determine only the portion of a single fee allocable to investment advice, since the remaining portion of the fee will be deductible by the trust in arriving at adjusted gross income.
If, however, the fiduciary, attorney, or accountant receives an additional payment or pays a third party for services that customarily would have been paid by an individual, those costs would be subject to the 2% floor. This rule is better explained by an example in Prop. Regs. Sec. 1.67-4(c)(2):
A corporate trustee charges a percentage of the value of the trust income and corpus as its annual commission. In addition, the trustee bills a separate amount to the trust each year as compensation for leasing and managing the trust’s rental real estate. The separate real estate management fee is subject to the 2-percent floor because it is a fee commonly or customarily incurred by an individual owner of rental real estate.
The proposed regulations provide useful guidance on the IRS’s current intentions toward the final regulations. Until those regulations are issued, the tax adviser must apply the law in effect, which is Sec. 67(e) as interpreted by the Supreme Court in Knight and summarized in Prop. Regs. Sec. 1.67-4(a), as quoted above. Combined with the transition relief for bundled fees, it suggests the following treatment of trust expenses:
Subject to the 2% floor: General investment advisory fees, ownership costs, and other trust expenses that would commonly and customarily be incurred by a hypothetical individual.
Not subject to the 2% floor: Fees for preparation of fiduciary income tax returns, estate tax returns, generation-skipping tax returns, and a decedent’s final income tax return; additional investment advisory fees attributable to services specific to trusts (beyond what would normally be required for the ordinary individual taxpayer); bundled fiduciary fees (until the year after final regulations are released); court-ordered accountings and filing fees; professional fees associated with trust issues such as trust interpretation; and fees related to distributions of income or principal among beneficiaries.
While some specific costs may be difficult to allocate now, preparers should generally apply a reasonable standard to determine the proper deductibility of trust expenses. The IRS has received numerous comments on the proposed regulations and notices released to date, and preparers are optimistic that some simplified guidance will be found in the final regulations.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or firstname.lastname@example.org.
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