The IRS issued new proposed regulations September 6 (REG-128224-06) intended to reflect the U.S. Supreme Court’s 2008 holding in Knight, 552 U.S. 181 (2008), on income tax deductibility by estates and nongrantor trusts of investment advisory and other fees.
The IRS simultaneously withdrew July 2007 proposed regulations with the same project number.
The Supreme Court held in Knight that fees paid to an investment adviser by a nongrantor trust or estate are generally miscellaneous itemized deductions subject to a floor of 2% of adjusted gross income (AGI) under the general rule of Sec. 67(a), rather than fully deductible as an expense of administering an estate or trust under Sec. 67(e)(1). The latter provision limits such treatment to expenses that would not have been incurred if property were not held in a trust or estate.
Under the new proposed regulations, a fee is fully deductible to the extent it exceeds that generally charged to an individual investor, where the excess is “attributable to an unusual investment objective” of the trust or estate or to “the need for a specialized balancing of the interests of various parties . . . such that a reasonable comparison with individual investors would be improper” (Prop. Regs. Sec. 1.67-4(b)(4)).
The new proposed regulations also provide guidance on “bundled” fees, with a portion fully deductible and another portion subject to the 2%-of-AGI floor. Generally, the portion of a bundled fiduciary fee attributable to investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) will be subject to the 2% floor. Any fiduciary fee not allocated to investment advice and not calculated on an hourly basis may be fully deductible without regard to the 2% floor, except for (1) payments made to a third party out of the bundled fee that would have been subject to the 2% floor if paid directly by the trust or estate, and (2) separately assessed expenses (in addition to usual or basic fees or commissions) that are commonly or customarily incurred by an individual.
The 2007 proposed regulations sought to prevent a practice of circumventing the 2% floor by bundling investment fees with administrative costs. They provided generally that fiduciaries must allocate fees between those fully deductible and those subject to the 2%-of-AGI floor. They also provided further guidance on the application of Sec. 67(e)(1) to fully deductible expenses.
Acknowledging complaints of the administrative difficulty of “unbundling,” the IRS in 2008 provided interim guidance (Notice 2008-32) providing that fiduciaries were not required to determine the portion of bundled expenses subject to the 2%-of-AGI floor for tax years beginning before 2008. That relief was subsequently continued in a succession of notices and recently was extended until the proposed regulations are finalized (Notice 2011-37).
The new proposed regulations will be effective for tax years beginning on or after their publication as final regulations. Comments are requested within 90 days after the new proposed regulations’ publication in the Federal Register, and a public hearing is scheduled for December19. The IRS requests comments particularly on a reasonable method of allocating expenses and their substantiation, especially on methods for reasonably estimating the portion of a bundled fee that is attributable to investment advice.
The AICPA has sent several comment letters to the IRS and Congress on this topic since the 2007 proposed regulations were issued.