In July, the IRS issued proposed regulations (REG128224-06) providing guidance on whether costs incurred by estates or nongrantor trusts are subject to the 2% floor for miscellaneous itemized deductions. The new rules intend to clarify the deductibility of advisory fees paid by estates and trusts. This item outlines the major elements in the proposed rules and examines some existing controversial issues under the new standards.
The taxable income of estates and trusts is generally computed in the same manner as that of an individual under Sec. 641(b). An individual may deduct investment advisory fees as miscellaneous itemized deductions under Sec. 212, but Sec. 67(a) limits an individual’s mis-cellaneous itemized deductions to the amount in excess of 2% of adjusted gross income (AGI). However, Sec. 67(e)(1) provides exceptions that allow certain fiduciary costs to be fully deductible. These exceptions apply to “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.”
An arguable issue is whether investment advisory fees paid by an estate or trust to outside investment advisers fall within the exception of Sec. 67(e)(1). The Service has determined that these fees do not meet the exception. Nonetheless, the courts have split on this question. In O’Neill, 994 F2d 302 (6th Cir. 1993), the Sixth Circuit reversed a Tax Court decision and held that when the trustees lacked experience in managing large sums of money, investment advisory fees paid to outside professional advisers were not subject to the 2% floor. In its opinion, the Sixth Circuit noted that although individuals routinely incur investment advice, they are not required to act prudently and are not subject to penalties or liabilities for negligent acts. Therefore, the investment advisory fees were necessary. In contrast, the Second, Fourth, and Federal Circuits held in similar cases for the IRS on the 2% rule (Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006), cert. granted 6/25/07; Scott, 328 F3d 132 (4th Cir. 2003); Mellon Bank, N.A., 265 F3d 1275 (Fed. Cir. 2001)).
The inconsistent treatment of the deductibility of investment advisory fees in the case law leaves the resolution of any particular case dependent on the jurisdiction in which the executor or trustee is located. While the Supreme Court has granted certiorari in Rudkin and should settle the split among the circuits, the Service has proposed new regulations to provide a uniform standard for determining which types of costs are excepted from the 2% floor under Sec. 67(e)(1).
Prop. Regs. Sec. 1.67-4(a) provides that when a cost incurred by an estate or nongrantor trust is unique to such an entity, the cost is not subject to the 2% floor. A cost is considered unique only when an individual could not have incurred that cost if the property were not held in an estate or trust (Prop. Regs. Sec. 1.67-4(b)). In addition, the type of product or service rendered to the estate or trust, rather than the characterization of the cost of that product or service, is decisive for classification purposes.
The proposed regulations provide the following nonexclusive list of items as unique products or services: (1) those rendered in connection with fiduciary accountings; (2) judicial or quasi-judicial filings required as part of the administration of the estate or trust; (3) fiduciary income tax and estate tax returns; (4) the division or distribution of income or corpus to or among beneficiaries; (5) trust or will contest or construction; (6) fiduciary bond premiums; and (7) communications with beneficiaries regarding estate or trust matters.
On the other hand, the proposed regulations list the following products or services as not unique: (1) those rendered in connection with custody or management of property; (2) advice on investing for total return; (3) gift tax returns; (4) the defense of claims by creditors of the decedent or grantor; and (5) the purchase, sale, maintenance, repair, insurance, or management of non-trade or business property. Therefore, according to the proposed regulations, investment advisory fees paid by an estate or trust to outside professional investment advisers are not unique expenses. Even if an estate or trust bundles trustees’ fees and investment advisory fees into a single fee, the new rule requires the taxpayer to use any reasonable method to allocate the single fee between the unique and not-unique expenses (Prop. Regs. Sec. 1.67-4(c)).
Impact of New Rules
Several questions raised in recent cases illustrate the impact of the proposed rules.
1. Are investment advisory fees unique to the administration of an estate or trust?
The Tax Court in O’Neill, 98 TC 227 (1992), and Rudkin Testamentary Trust, 124 TC 304 (2005), the Second Circuit in Rudkin, the Fourth Circuit in Scott, and the Federal Circuit in Mellon Bank noted that investment advisory fees are not unique to the administration of estates or trusts. Furthermore, the Court of Federal Claims in Mellon Bank, 47 Fed. Cl. 186 (2000), stated that “in certain circumstances investment advisory fees may not have been incurred if the property were not held in trust, but it hardly supports the conclusion that in all situations investment advisory fees ‘would not have been incurred if the property were not held in such trust.’” Therefore, the court determined that investment advisory fees are not unique. In contrast, the Sixth Circuit in O’Neill concluded that investment advisory fees are unique when the trustees lack experience in managing a large lump sum of money.
The impact of the proposed regulations on these judicial decisions in general, and on the Sixth Circuit’s decision in O’Neill in particular, is unclear. It is unlikely that the Sixth Circuit will change its position because when the IRS argued that investment advisory fees are not unique in O’Neill, the court rejected the argument. Since Sec. 67(e)(1) is unchanged after the decision, there is no reason to expect that the Sixth Circuit will adjust its stance. The Supreme Court’s decision in Rudkin, when issued, will affect either the Sixth Circuit’s position or the position of the other circuits and the IRS. Nonetheless, until that time, the proposed regulations have raised the bar for taxpayers to challenge the 2% rule on investment advisory fees outside of the Sixth Circuit.
2. Can the prudent investor rule make the investment advisory fees unique to the administration of an estate or trust?
The Tax Court in O’Neill and the Fourth Circuit in Scott held that it did not, but the Sixth Circuit in O’Neill held that where trustees lacked experience in investing and managing assets, the investment advisory fees would not have been incurred if the property had not been held in trust and were therefore not subject to the 2% floor. For the reasons discussed in question 1, the IRS’s reiterating its position in the proposed regulations will not resolve this issue.
This question originates in the conflicting interpretations of the uniqueness requirement in Sec. 67(e)(1), which states that the exceptions to the 2% floor apply to “costs which are paid or incurred in connection with the admin-istration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate” (emphasis added). Based on this language, the Fourth and Federal Circuits interpret unique costs to be expenses that are not “commonly” or “customarily” incurred by an individual. Going further, the Second Circuit restricts unique costs to expenses that are “peculiar to trusts” and “could not” be incurred by an individual. On the other hand, the Sixth Circuit focuses on the necessity of the costs to fulfill the fiduciary duty and disregards the fact that an individual might incur such expenses as well.
Note that Sec. 67(e)(1) uses the words “would not” rather than “could not.” It seems that the IRS in the proposed regulations follows the Second Circuit and interprets the uniqueness requirement as if the section said “could not.”
3. Are investment advisory fees implicitly included in the trustee fees’ exceptions to the 2% rule?
The Court of Federal Claims in Mellon Bank noted that characterizing fees paid for trustees’ tasks and determining whether those fees would meet the uniqueness requirement were independent issues and not logically related. On appeal, the Federal Circuit stated, “It is undisputed that trustee fees are fully deductible.” However, because whether investment advisory fees implicitly included in trustee fees are fully deductible was not a present issue in the case, the opinion should not be overinterpreted.
Prop. Regs. Sec. 1.67-4(c) requires taxpayers to unbundle the trustee fees and reasonably allocate between the unique and not-unique costs. Therefore, a common tax planning strategy that includes the investment advisory fees in the trustee fees will not be viable after the proposed rules are finalized.
4. Do investment advisory fees mandated by a trust instrument meet the uniqueness requirement?
The Tax Court in O’Neill clearly stated that fees paid to the trustee and trust accounting fees mandated by law or the trust agreement meet the uniqueness requirement. In the proposed regulations, the Service does not directly address this issue. Nevertheless, under the proposed regulations, whether costs are subject to the 2% floor depends on the type of services provided rather than on the taxpayer’s characterization of such services. Since the essence of investment advice does not change, regardless of whether the fees are mandated by the trust agreement, a challenge on this issue from the IRS can be expected.
Under the proposed rules, taxpayers should incorporate the following into their tax planning.
1. Because the proposed regulations increase the difficulty for taxpayers to challenge the Service’s perspective on the deductibility of investment advisory fees, the probability of tax penalties being imposed on taxpayers whose payments are deficient increases. Therefore, to avoid penalties, taxpayers should consider paying their tax liabilities in advance and then suing for refunds.
2. Because of the split judicial opinions, taxpayers need to be aware of what case law applies in their particular jurisdictions. Currently, taxpayers have better odds of winning in the Sixth Circuit than in the Second Circuit, the Fourth Circuit, or the Federal Circuit. After the Supreme Court decides the appeal in Rudkin, the courts should all apply the same standard, but what that standard will be remains to be seen.
3. If a trust has high AGI, capitalizing investment advisory fees may be beneficial. (See the AICPA Tax Division’s Trust, Estate and Gift Tax Technical Resource Panel’s Sec. 67(e) Task Force, “Deducting Third-Party Investment Mgmt. Fees Under Sec. 67(e),” 33 The Tax Adviser (October 2002): 646.)
4. In litigation, taxpayers should focus their reasoning on the specific wording of Sec. 67(e)(1). That is, the words “would not” in the statute should be emphasized. The proposed regulations may conflict with the “plain” language of this statutory provision.
5. Taxpayers should carefully scrutinize their existing tax plans in response to the proposed rules. Specifically, tax strategies such as bundling investment advisory fees into trustees’ fees or using trust agreements to mandate the use of investment advisers might be confronted by the IRS under the proposed regulations. However, other strategies such as appropriately applying the prudent person rule could still be used, though taxpayers should note the increasing difficulty of challenging the proposed regulations when they are finalized.
The Service intends the proposed regulations on estate and trust costs to provide a uniform standard for identifying the types of costs that are not subject to the 2% floor under Sec. 67(e)(1). However, the IRS’s position on the uniqueness requirement in the proposed regulations is similar to its original position in the O’Neill case. Moreover, the uniqueness requirement in the proposed rules does not use the exact wording contained in the statute, leaving some room for taxpayers’ legal arguments. Accordingly, the objective of the proposed regulations may not be fully achieved. Taxpayers should also be aware of the potential impact of the unbundling requirement.