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Final regs list additional trust/estate expenses that escape the 2% AGI floor

May 9, 2014

T.D. 9664, 05/08/2014; Reg. § 1.67-4

IRS has issued final regs on which costs incurred by estates and non-grantor trusts (trusts) are subject to Code Sec. 67(a)’s 2% floor for miscellaneous itemized deductions. The final regs largely follow, but also expand upon, proposed regs that were issued in 2011.

Background. Miscellaneous itemized deductions are allowed only to the extent they exceed 2% of adjusted gross income (AGI). (Code Sec. 67(a)) For purposes of this floor, the AGI of an estate or trust is computed the same way as for an individual, subject to certain exceptions. (Code Sec. 67(e)) Under one exception, costs paid or incurred in connection with the administration of an estate or trust that wouldn’t have been incurred if the property weren’t held in the estate or trust are allowed as deductions in arriving at AGI. (Code Sec. 67(e)(1))

In 2007, IRS issued proposed regs that provided, among other things, that a cost is fully deductible in computing AGI to the extent that the cost is unique to an estate or trust. If a cost is not unique to an estate or trust, such that an individual could have incurred the expense, then that cost was subject to the 2%-of-AGI floor for miscellaneous itemized deductions under Code Sec. 67(a). (Prop Reg § 1.67-4(c); see Weekly Alert ¶  9  08/02/2007)

In January of 2008, resolving a conflict in the circuits, the Supreme Court held that investment advisory fees paid by a trust are generally deductible only to the extent that they exceed 2% of the trust’s AGI. The Supreme Court reasoned that in determining whether a particular type of cost incurred by a trust “would not have been incurred” if the property were held by an individual, Code Sec. 67(e)(1) excepts from the 2% floor only those costs that an individual would not “customarily” or “commonly” incur. (Knight v. Comm (S Ct 1/16/2008), 101 AFTR 2d 2008-544101 AFTR 2d 2008-544; see Weekly Alert ¶  13  01/24/2008)

Thereafter, IRS issued interim guidance in a series of Notices which stated that trusts and estates don’t have to determine the portion of a bundled fiduciary fee that is subject to the 2% floor under Code Sec. 67. Bundled fees are single fees, etc. that cover both costs that are subject to the 2% floor and costs that are not. The last of these Notices, Notice 2011-37, 2011-20 IRB 785, provided that it applied for tax years that begin before the date that final regs are published. (See Weekly Alert ¶  12  04/21/2011.)

In 2011, IRS withdrew the 2007 proposed regs and issued new proposed regs that reflected the holding in Knight. (Prop Reg § 1.67-4, see Weekly Alert ¶  14a  9/08/2011) The proposed regs provided that a cost is subject to the 2% floor to the extent that it is included in the definition of miscellaneous itemized deductions under Code Sec. 67(b), is incurred by an estate or trust, and commonly or customarily would be incurred by a hypothetical individual holding the same property. They also defined “customarily or commonly incurred,” defined the term “ownership costs,” set out that ownership costs are customarily or incurred by all property owners including individual owners, and set out rules for determining whether particular tax preparation fees and investment advisory fees are customarily or commonly incurred by individual taxpayers. They also provided rules for bundled fees paid by trusts and estates.

Final regs make several changes and additions. IRS has now issued final regs. While largely following the proposed regs, the final regs contain several changes and additions to the proposed regs. Specifically:

… Ownership costs. The proposed regs provided that “ownership costs” are costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property. They also set out that such costs are customarily or commonly incurred by all property owners, including individual owners.

The final regs don’t change the proposed regs, but, after listing examples of ownership costs that are customarily or commonly incurred by all property owners, they note that other expenses incurred merely by reason of the ownership of property may be fully deductible under other provisions of the Code, such as Code Sec. 62(a)(4), Code Sec. 162 and Code Sec. 164(a), and thus would not be miscellaneous itemized deductions subject to Code Sec. 67(e). (Reg. § 1.67-4(b)(2))

… Tax preparation fees. The proposed regs set out a list of tax returns the costs relating to which are not subject to the 2% floor. Those returns are estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent’s final individual income tax returns.

The final regs clarify that the above list is an exclusive list; the costs of preparing all other tax returns are subject to the 2% floor. (Reg. § 1.67-4(b)(3))

… Investment advisory fees. The proposed regs provided 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 subject to the 2% floor. They also provide that, to the extent that a portion (if any) of an investment advisory fee exceeds the fee generally charged to an individual investor, and that excess is attributable to an unusual investment objective of the trust or estate or to a specialized balancing of the interests of various parties such that a reasonable comparison with individual investors would be improper, that excess is not subject to the 2% floor.

The final regs make no change to these provisions. (Reg. § 1.67-4(b)(4))

… Appraisal fees. Unlike the proposed regs, the final regs address appraisal fees. The final regs provide that appraisal fees incurred by an estate or a trust to determine the fair market value of assets as of the decedent’s date of death (or the alternate valuation date), to determine value for purposes of making distributions, or as otherwise required to properly prepare the estate’s or trust’s tax returns, or a generation-skipping transfer tax return, are not subject to the 2% floor. The cost of appraisals for other purposes (for example, appraisals to determine the proper amount of insurance needed on property) is subject to the 2% floor. (Reg. § 1.67-4(b)(5))

…Other fiduciary expenses. Unlike the proposed regs, the final regs address other fiduciary expenses. The final regs provide that certain other fiduciary expenses are not subject to the 2% floor. Such expenses include, without limitation: 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. (Reg. § 1.67-4(b)(6))

… Bundled fees. Under the proposed regs, if an estate or trust pays a bundled fee (as defined above), that fee must be allocated, for purposes of computing the adjusted gross income of the estate or trust in compliance with Code Sec. 67(e), between the costs that are subject to the 2% floor and those that are not. The proposed regs provided an exception to this rule for certain bundled fees. They also provided that any reasonable method may be used to allocate the bundled fee between the two types of costs.

The final regs make no changes to the proposed regs, but they add the following:

 

1. IRS creates the possibility of additional exceptions to the bundling rule by adding “except to the extent provided otherwise by guidance published in the Internal Revenue Bulletin” to the bundling rule. (Reg. § 1.67-4(c)(1))
2. Facts that may be considered in determining whether an allocation is reasonable include, but are not limited to, the percentage of the value of the corpus subject to investment advice, whether a third party advisor would have charged a comparable fee for similar advisory services, and the amount of the fiduciary’s attention to the trust or estate that is devoted to investment advice as compared to dealings with beneficiaries and distribution decisions and other fiduciary functions. (Reg. § 1.67-4(c)(4))

 

Effective date. The regs are effective for tax years that begin on or after May 9, 2014. (Reg. § 1.67-4(d))

RIA recommendation: Because the reg’s bundling provision applies to amounts that a trust or estate “pays” (as opposed to “incurs”), taxpayers who incur bundled costs, and who want to take advantage of the “safe harbor” provided by Notice 2011-37, must pay their bundled costs before the end of their last tax year that begins before May 9, 2014. Thus, for example, calendar year trusts and estates must make such payments by Dec. 31, 2014.