After many years of litigation and uncertainty—which resulted in a split among the U.S. circuit courts of appeal and culminated in the U.S. Supreme Court’s decision in Knight v. Comm’r [128 S.Ct. 782 (2008)]—the IRS published final regulations in 2014 [T.D. 9664, May 8, 2014, as amended Jul. 16, 2014 (to change effective date); Treasury Regulations section 1.67-4] that provide guidance on which costs incurred by estates and nongrantor trusts are subject to the 2% floor for miscellaneous itemized deductions under Internal Revenue Code (IRC) section 67(a). These regulations are effective for tax years beginning after December 31, 2014. Tax professionals preparing estate and nongrantor trust income tax returns need to be familiar with these rules.
Background and History
Pursuant to IRC section 67(a), miscellaneous itemized deductions for an individual taxpayer are allowed only to the extent that the aggregate of those deductions exceeds 2% of adjusted gross income (AGI). Under section 67(b), “miscellaneous itemized deductions” are any itemized deductions other than the 12 deductions listed therein (e.g., interest, taxes, charitable contributions, medical expenses, estate tax paid on income in respect of a decedent).
Under IRC section 67(e), the AGI of an estate or trust for purposes of section 67 is computed in the same manner as that of an individual, except that under section 67(e)(1), the deductions for administrative costs paid or incurred by an estate or trust that would not have been incurred if the property were not held in such estate or trust are treated as allowable in arriving at AGI. The interpretation of this language led to much uncertainty and court challenges, given that such deductions described in section 67(e)(1) are not subject to the abovementioned 2% floor.
The IRS issued proposed regulations in 2007 providing that administrative costs would be fully deductible only to the extent that such costs were unique to an estate or trust; that is, if an individual could have incurred the expense, then that expense would be subject to the 2% floor. Taxpayers generally argued that the IRS’s interpretation of section 67(e)(1) was overly restrictive vis-à-vis deductibility, and many took the position that certain administrative costs, even if not unique to an estate or trust, could nevertheless constitute costs that would not have otherwise been incurred but for the holding of such property in an estate or trust and, accordingly, should be deductible. For example, some taxpayers and commentators argued that the fiduciary duties of an executor or trustee under state law could require the fiduciary to retain professional investment advisors, and therefore investment advisory fees should not be subject to the 2% floor.
The Supreme Court ultimately decided the issue in Knight, which involved the deductibility of investment advisory fees by a trust. The Court held that fees paid to an investment advisor by an estate or nongrantor trust generally are subject to the 2% floor for miscellaneous itemized deductions under IRC section 67(a), but reached its conclusion under different reasoning than the IRS’s interpretation in the 2007 proposed regulations. It also took a more balanced approach, along the lines of certain prior circuit court decisions [see Scott v. U.S., 328 F.3d 132 (CA4 2003); Mellon Bank, N. A. v. U.S., 265 F.3d 1275 (CA Fed. 2001)]. The Court held that the proper reading of the language with respect to whether the expense “would not have been incurred if the property were not held in such trust or estate” requires an inquiry into whether a hypothetical individual who held the same property outside of a trust would customarily or commonly incur such expenses, and it found that expenses customarily or commonly incurred by individuals are subject to the 2% floor.
Subsequent to the Court’s holding in Knight, the IRS issued various notices to provide interim guidance on the treatment of a bundled fee [i.e., costs subject to the 2% floor under section 67(a) that are bundled as part of a single comprehensive fee paid to the trustee or executor] [Notice 2008-32 (2006-11 IRB 593) (Mar. 17, 2008); Notice 2008-116 (2008-52 IRB 1372) (Dec. 29, 2008); Notice 2010-32 (2010-16 IRB 594) (Apr. 19, 2010); Notice 2011-37 (2011-20 IRB 785) (May 16, 2011)], and then in 2011 issued new proposed regulations and withdrew the 2007 proposed regulations. The 2011 proposed regulations, with minor revisions, were then adopted as final regulations effective May 9, 2014. The IRS subsequently amended these regulations on July 16, 2014, to extend the effective date of the final regulations to tax years beginning after December 31, 2014.
The Final Regulations
The final regulations provide that a cost included in the definition of miscellaneous itemized deductions that is incurred by an estate or nongrantor trust is subject to the 2% floor to the extent it would be commonly or customarily incurred by a hypothetical individual holding the same property. In determining whether the cost would be commonly or customarily incurred by a hypothetical individual owning the same property, the type of product or service rendered to the estate or nongrantor trust is determinative [Treasury Regulations section 1.67-4(a), (b)(1)].
The final regulations also address the following specific types of costs: ownership costs, tax return preparation costs, investment advisory fees, appraisal fees and certain other fiduciary expenses, and bundled fees. In addition to analyzing those costs, the regulations provide that costs incurred in defense of a claim against the estate, the decedent, or the nongrantor trust that are unrelated to the existence, validity, or administration of the estate or trust are considered costs incurred commonly or customarily by individuals and therefore subject to the 2% floor [Treasury Regulations section 1.67-4(b)(1)].
The final regulations provide that, for purposes of IRC section 67(e), ownership costs constitute costs that are commonly or customarily incurred by a hypothetical individual owner of such property and, accordingly, are subject to the 2% floor. Ownership costs are defined as costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property. Examples given in the regulations are condominium fees, insurance premiums, maintenance and lawn services, automobile registration, and insurance costs [Treasury Regulations section 1.67-4(b)(2)].
In this regard, the final regulations clarify that certain other expenses incurred merely by reason of owning the property may be fully deductible under other IRC sections and are not a miscellaneous itemized deduction in such case. Such expenses include real estate taxes and costs incurred in connection with a trade or business or for the production of rents or royalties.
The final regulations specifically exclude the following tax return preparation costs from the 2% floor: costs relating to estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent’s final individual income tax returns. Any other tax return preparation costs (such as preparation costs for gift tax returns) are deemed to be costs commonly and customarily incurred by individuals and thus subject to the 2% floor [Treasury Regulations section 1.67-4(b)(3)].
The final regulations generally provide that fees for investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) are incurred commonly or customarily by a hypothetical individual investor and, therefore, are subject to the 2% floor. To address a special type of investment advice discussed by the Supreme Court in Knight, however, the regulations also provide that, to the extent that any portion of an investment advisory fee exceeds the fee generally charged to an individual investor, and such excess is solely due to the investment advice being rendered to a trust or estate instead of to an individual, or is attributable to an unusual investment objective of the trust or estate or to a specialized balancing of the interests of various parties (other than the customary balancing of the varying interests of the income beneficiaries and remaindermen), a reasonable comparison with individual investors is improper, and the excess is not subject to the 2% floor. No specific examples of this type of special fees are provided in the regulations [Treasury Regulations section 1.67-4(b)(4)].
The final regulations provide that the following appraisal fees incurred by an estate or nongrantor trust are not subject to the 2% floor: appraisals needed to determine value as of the decedent’s date of death (or the alternate valuation date), appraisals to determine value for purposes of making distributions, or appraisals otherwise required to properly prepare the estate’s or trust’s tax returns. Appraisal fees for other purposes, such as insurance, would be subject to the 2% floor [Treasury Regulations section 1.67-4(b)(5)].
The regulations also provide that certain other fiduciary expenses are not commonly or customarily incurred by individuals and thus are not subject to the 2% floor, including (without limitation) the following: probate court fees and costs, fiduciary bond premiums, legal publication costs of notices to creditors or heirs, the cost of certified copies of the decedent’s death certificate, and costs related to fiduciary accounts [Treasury Regulations section 1.67-4(b)(6)].
The Court found that expenses customarily or commonly incurred by individuals are subject to the 2% floor.
The regulations provide that a bundled fee must generally be unbundled and allocated between those two categories of costs [Treasury Regulations section 1.67-4(c)(1)]. A bundled fee is a single fee, such as a fiduciary’s commission or fee, attorney’s fee, or accountant’s fee, that encompasses both costs that are subject to the 2% floor and costs that are not. To reduce the administrative burdens in the unbundling of such fees, however, an important exception was provided to the unbundling requirement, which provides that a bundled fee that is not computed on an hourly basis is required to be allocated for purposes of the 2% floor only with respect to the portion attributable to investment advice [Treasury Regulations section 1.67-4(c)(2)].
The IRS’s rationale was that taxpayers who pay investment fees to a third-party investment advisor and those who pay investment fees as part of a bundled fiduciary fee should be given similar tax treatment. This is a significant exception, given that most corporate fiduciaries’ fees are customarily based on the fair market value of the assets and not on an hourly basis. Accordingly, such a fiduciary would only be required to make an allocation of its bundled fiduciary fee to those costs attributable to investment advice. On the other hand, legal and accounting fees are generally computed on an hourly basis and would thus need to be unbundled for all costs based on the underlying detailed hourly service cost.
The regulations further provide that any reasonable method may be used to allocate a bundled fee, including, without limitation, the allocation of a portion of a bundled fiduciary fee to investment advice. In this regard, the regulations provide the following nonexclusive factors to offer guidance with regard to determining whether an allocation is reasonable: 1) the percentage of the value of the corpus subject to investment advice, 2) whether a third-party advisor would have charged a comparable fee for similar advisory services, and 3) the amount of the fiduciary’s attention to the trust or estate that is devoted to investment advice vis-à-vis dealings with beneficiaries, distribution decisions, and other fiduciary functions [Treasury Regulations section 1.67-4(c)(4)]. The final regulations also permit the Treasury Department and IRS to provide percentage safe harbors in future guidance.
Out-of-pocket expenses charged to the estate or nongrantor trust are treated as separate from the bundled fee. Additionally, payments made from the bundled fee to third parties that would have been subject to the 2% floor—if they had been paid directly by the estate or nongrantor trust—are subject to the 2% floor, as are any fees or expenses separately assessed by the fiduciary or other payee of the bundled fee (in addition to the customary or basic bundled fee) for services rendered to the estate or nongrantor trust that are commonly or customarily incurred by an individual [Treasury Regulations section 1.67-4(c)(3)].
Therefore, under the final regulations, fiduciary, attorney, and accounting fees not computed on an hourly basis are fully deductible (apart from any portion allocable to tax-exempt income), except for 1) amounts allocable to investment advice (using any reasonable allocation method); 2) amounts paid out of the bundled fee by the fiduciary to third parties, if those amounts would have been subject to the 2% floor if they had been paid directly by the estate or nongrantor trust; and 3) amounts that are separately assessed (in addition to the customary or basic fiduciary fee or commission) by the fiduciary or other service provider that would be commonly or customarily incurred by an individual owning such property. The regulations state that the latter two categories are payments and expenses that are readily identifiable without any discretion on the part of the fiduciary or return preparer.
Alternative Minimum Tax Considerations
In addition to frequently being subject to the 2% floor for regular tax purposes, miscellaneous itemized deductions also affect calculation of the alternative minimum tax (AMT), which can sometimes be a more significant concern to fiduciaries and individual beneficiaries. Miscellaneous itemized deductions are disallowed in their entirety for purposes of computing AMT liability [IRC section 56 (b)(1)(A)(i)]. In contrast, under the regular tax regime, once the 2% floor has been reached, all such deductions exceeding that floor are generally fully deductible (except for any portion allocable to tax-exempt income).
For estates and nongrantor trusts for tax year 2016, the AMT tax rate is 26% on alternative minimum taxable income (AMTI), other than long-term capital gains and qualified dividends, not exceeding $186,300, and 28% on such AMTI exceeding $186,300. There is an AMT exemption available in the amount of $23,900, which is subject to phaseout at AMTI amounts over $79,850 and completely phased out at $175,450. (The AMT regime also applies to individuals; however, the AMT exemption is significantly higher for individuals than for estates and nongrantor trusts.) The top marginal tax rate applicable to estates and nongrantor trusts for regular tax purposes is 39.6%, which applies to taxable income (other than long-term capital gains and qualified dividends) exceeding $12,400. Lower rates on long-term capital gains and qualified dividends apply for both regular tax and AMT purposes.
The IRS’s rationale was that taxpayers who pay investment fees to a third-party investment advisor and those who pay investment fees as part of a bundled fiduciary fee should be given similar tax treatment.
Although a fiduciary can mitigate the AMT by making distributions to beneficiaries (if permissible under the trust instrument), the resulting AMT distribution deduction and reduction of AMTI would not remove the overall AMT concern. The disallowed AMT deduction would in that case be passed out to the beneficiary as an AMT adjustment item as a result of the distribution, and the individual beneficiary would then be required to add it to her own AMTI, and potentially pay AMT as a consequence.
A Critical Matter
Tax professionals must understand the rules in the final regulations when dealing with miscellaneous itemized deductions in their preparation of estate and non-grantor trust income tax returns (Federal Form 1041). The regulations provide helpful guidance and examples with respect to determining whether or not an expense is commonly or customarily incurred by an individual, which in turn controls whether it is treated as a miscellaneous itemized deduction subject to the 2% floor or is fully deductible. The AMT is also potentially impacted as well.
The regulations may also provide tax planning opportunities in certain cases, especially with regard to bundled fees, since any reasonable method can generally be used to allocate bundled fees. The portion allocated between 2% and non-2% costs can be derived and analyzed, with documentation of the analysis kept to support the allocation. In addition, as discussed above, bundled fees not computed on an hourly basis are not subject to the 2% floor, except with regard to the portion allocable to investment advice.
