On May 9, 2014, the IRS published final regulations regarding which costs incurred by trusts and estates are fully deductible under Internal Revenue Code (“IRC”) § 67(e).
Which Costs Are Fully Deductible?
Under IRC § 67(a), expenses known as miscellaneous itemized deductions (including investment advisory fees) are allowed only to the extent that they exceed 2% of an individual’s adjusted gross income (the “2% floor”). Under IRC § 67(e), the adjusted gross income of an estate or trust is computed in the same manner as an individual. However, IRC §67(e)(1) provides an exception to that rule: costs incurred by an estate or trust “which would not have been incurred if the property were not held in such estate or trust” are fully deductible.
There was a split among the U.S. Circuit Courts as to the interpretation of the language in IRC § 67(e)(1). Specifically, the split concerned whether investment advisory fees fell within the exception and were fully deductible on the basis that, although individuals do seek investment advice, trustees have specific fiduciary investment responsibilities.
In Knight v. Commissioner, 552 U.S. 181, 128 S. Ct. 782 (2008), the Supreme Court held that the language of IRC §67(e)(1) requires an inquiry into whether a hypothetical individual who held the same property outside a trust “commonly” or “customarily” would incur the expenses. Resolving a 15-year old circuit split, the Supreme Court ruled investment advisory fees incurred by trustees of non-grantor trusts will generally be subject to the 2% floor, absent an incremental cost or special additional charge or unusual investment objective, other than what is normally required by an ordinary taxpayer.
Proposed regulations issued in 2007 that predated and conflicted with the Supreme Court interpretation were ultimately withdrawn (after four years of interim guidance) and new proposed regulations were issued in 2011.
Final Regulations Retain Test of Whether Hypothetical Individual Would “Customarily” or “Commonly” Incur Expenses
According to the IRS, the final regulations generally retain the provisions of the 2011 proposed regulations with “minor modifications.” A cost will be subject to the 2% floor if it is:
- Included within the definition of miscellaneous itemized deductions under IRC § 67(b);
- Incurred by an estate or non-grantor trust; and
- Commonly or customarily would be incurred by a hypothetical individual holding the same property.
Which Costs are “Customarily” or “Commonly” Incurred?
According to the final regulations, in determining which costs commonly or customarily would be incurred by a hypothetical individual holding the same property, it is the type of product or service rendered that is determinative:
- Ownership Costs: Costs will be subject to the 2% floor if incurred by a property owner simply by reason of ownership, including condominium fees, insurance premiums and maintenance. However, ownership costs that are fully deductible under other provisions of the IRC are not miscellaneous itemized deductions and will not be subject to the 2% floor;
- Tax Preparation Fees: The final regulations provide an exclusive list of returns for which tax preparation costs are not subject to the 2% floor:
- estate and generation-skipping transfer tax returns;
- fiduciary income tax returns; and
- decedent’s final income tax return.
The costs of preparing all other returns are subject to the 2% floor.
- Investment Advisory Fees: Investment advisory fees are subject to the 2% floor, absent an incremental cost beyond the amount normally charged to an individual. An incremental cost is a special, additional charge that is added solely because:
- the investment advice is rendered to a trust or estate rather than to an individual; or
- is attributable to an unusual investment objective; or
- is attributable to the need for a specialized balancing of the interest of various parties (beyond the usual balancing of the varying interests of current beneficiaries and remaindermen).
Only the portion of the fee that exceeds the fee normally charged to an individual is not subject to the 2% floor.
- Appraisal Fees: Appraisal fees are not subject to the 2% floor if incurred by an estate or non-grantor trust:
- to determine value as of the decedent’s date of death; or
- to determine value for purposes of making distributions; or
- are otherwise required to properly prepare the estate’s or trust’s tax returns.
Appraisals for other purposes, like insurance, are subject to the 2% floor.
- Fiduciary Expenses: Certain fiduciary expenses are not customarily or commonly incurred by individuals and are not subject the 2% floor, including probate costs, fiduciary bond premiums and costs related to fiduciary accounts.
A bundled fee, as its name suggests, is typically a single comprehensive charge for a combination of services. A bundled fiduciary fee, for example, usually includes an umbrella of services such as custody, fiduciary income tax return preparation, communication with beneficiaries, investment advisory and other services.
Under the regulations, bundled fees must be unbundled to allocate costs between those subject to the 2% floor and those that are fully deductible. However, there is an exception provided: if the bundled fee is not computed on an hourly basis, only the investment management component of the fee is subject to the 2% floor. Any reasonable method may be used to allocate a bundled fee between costs subject to the 2% floor and costs that are not, including the portion of a bundled fee allocable to investment advice. In that regard, the regulations provide a non-exclusive list of factors to consider in determining whether an allocation is reasonable:
- Percentage of the corpus subject to investment advice;
- Whether a third-party advisor would have charged a comparable fee for similar services; and
- The amount of the fiduciary’s attention devoted to investment advice as compared to dealings with beneficiaries, distribution decisions and other fiduciary functions.
Note, however, that payments out of a bundled fee (1) to third parties for expenses subject to the 2% floor or (2) for any other separately assessed expense commonly or customarily incurred by an individual, are readily identifiable and must be treated separately from an otherwise bundled fee.
The final regulations apply to taxable years beginning on or after May 9, 2014.
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