The IRS issued final regulations on the controversial question of which costs incurred by trust and estates are subject to the 2% floor on miscellaneous deductions under Sec. 67(a) (T.D. 9664). The regulations will apply to tax years beginning on or after May 9, 2014. The final regulations retain from the proposed rules a requirement that certain fees be unbundled.
The regulations finalize proposed rules issued in September 2011 (REG-128224-06) in response to the U.S. Supreme Court’s decision in Knight, 552 U.S. 181 (2008), on the income tax deductibility by estates and nongrantor trusts of investment advisory and other fees. Under Knight, 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), rather than fully deductible as an expense of administering an estate or trust under Sec. 67(e)(1). The Supreme Court held that the latter provision limits its treatment to expenses that would not “commonly” or “customarily” be incurred if the property were held by an individual.
The regulations implement the Court’s “commonly or customarily incurred” requirement by stating that a fee is deductible to the extent it exceeds the fee 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” (Regs. Sec. 1.67-4(b)(4)).
The final rules adopt the proposed regulations with a few modifications in response to comments. The proposed regulations provided that costs that do not depend on the whether payer is an individual or an estate or trust count as costs that are commonly or incurred by an individual. One commentator said that this treatment was overly broad and was a disguised attempt to reassert the IRS’s effort, rejected in Knight, to subject any costs that could be incurred by an individual to the 2% floor. The IRS agreed with this and removed the reference to costs that do not depend on the payer’s identity.
The second change made technical corrections to several examples of ownership costs that are not usually deductible. One, in particular, was to remove an example that included real estate taxes in ownership costs that would not be fully deductible because, as was pointed out, they are not an itemized deduction but are fully deductible under Sec. 62(a)(4) or Sec. 164(a).
A more significant change was the addition of appraisal fees to the category of costs that are fully deductible if they are needed to determine the value of property as of the decedent’s date of death (or the alternate valuation date), to determine value for purposes of making distributions, or to properly prepare the estate or trust’s tax returns. The final rules also add a nonexclusive list of other fiduciary expenses that are not commonly or customarily incurred by individuals: 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.
In the preamble to the final regulations, the IRS explains that it received many comments on the treatment of “bundled” fees in the proposed regulations. Bundled fees are fees that are billed together, where a portion is fully deductible and another is subject to the 2%-of-AGI floor. The proposed regulations would require the deductible and nondeductible portions to be “unbundled”—that is, allocated between costs that are subject to the 2% floor and those that are not. The proposed regulations contain one exception to the allocation requirement: If a bundled fee is not computed on an hourly basis, only the portion attributable to investment advice (including any related services that would be provided to any individual investor as part of the investment advisory fee) is subject to the 2% floor.
Commentators objected to the administrative difficulty of unbundling fiduciary fees, and the IRS did not enforce unbundling pending the issuance of final regulations (Notice 2011-37). However, despite the objections of these commentators, the final regulations do include the unbundling requirement.
Generally, under the final regulations, 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.
If amounts are allocable to investment advice but are not traceable to separate payments, the final regulations allow the use of “any reasonable method” to make the allocation to investment advice. The regulations include a listing of the facts that may be considered in determining whether an allocation is reasonable.