Sec. 67(e) reached the end of a long and tortured journey on May 9, 2014, when the IRS issued final regulations defining, once and for all, which expenses of an estate or trust are classified as miscellaneous itemized deductions subject to the 2% floor and the alternative minimum tax (AMT). The meaning of Sec. 67(e)(1), which exempts from classification as miscellaneous itemized deductions costs that "would not have been incurred if the property were not held in such trust or estate," has perplexed trustees and their advisers since 1986 when the statute was enacted. No regulations were issued for 21 years, but plenty of litigation has occurred, and practitioners have sent numerous comments to the IRS and Congress over the past 28 years.
The first court to clarify the meaning of Sec. 67(e) was the Sixth Circuit Court of Appeals, which held, in a 1991 case, O'Neill,1 that Sec. 67(e) exempts all costs incurred "because the property was held in trust," which is essentially a "but for" test. This holding did not solve the problem for long because, soon after, three other appellate courts reached different results. In 2001 and 2003, the Fourth and Federal Circuits held that Sec. 67(e) exempts only costs that are "not customarily incurred outside of trusts."2 And in 2006, the Second Circuit divined yet another meaning of the exemption in Rudkin Testamentary Trust, which held that costs are exempt from the floor only if they "could not have been incurred if the property were held by an individual."3
On July 27, 2007, in the midst of the judicial fray, the IRS published its first set of regulations under Sec. 67(e).4 Regs. Sec. 1.67-4 adopted the Second Circuit's interpretation of Sec. 67(e) and exempted only costs that would be "unique" to an estate or trust. It also required trustees to "unbundle" any legal, accounting, investment advisory, appraisal, or other fee, commission, or expense, separating costs that would be unique from those that would not. The proposed regulations permitted allocation of the expenses using any reasonable method. They defined "unique costs" as those "that an individual could not have incurred,"5 as the Second Circuit held.
However, those regulations were short-lived. Five months later, in Knight,the U.S. Supreme Court rejected that interpretation as "fl[ying] in the face of the statutory language." Instead, the Supreme Court adopted the Fourth and Federal Circuits' view that "only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur" are exempt from the floor.6
The IRS withdrew the 2007 proposed regulations and replaced them with a second set in 2011, which were intended to "reflect the reasoning and holding in Knight."7 The 2011 proposed regulations eliminated the requirement that costs be unique, but retained the requirement to unbundle fees using any reasonable method. They also introduced several new categories of costs that would either be subject to or exempt from the floor.
Since 2008, the IRS has received countless comments from members of the AICPA, American Bar Association, American Bankers Association, state societies, and others suggesting ways to improve on the Sec. 67(e) regulations.8 By far, the most controversial aspect of the regulations has been the requirement to unbundle trustee fees.9 Although the preamble to the 2014 final regulations hints that perhaps only one person supported the requirement, the final regulations nonetheless retain the unbundling requirement virtually unchanged.10
There are very few differences between the 2011 proposed regulations and the regulations as finally adopted in May 2014. The IRS removed some glaring errors and added some minor (and obvious) clarifications. This article discusses the final regulations in detail, suggests some planning opportunities, and comments on the AMT implications of the rules for trustees and beneficiaries.
"Commonly" or "Customarily" Incurred
Like the proposed regulations, the final regulations broadly define costs subject to the floor as costs that "commonly or customarily would be incurred by a hypothetical individual holding the same property."11 In making that determination, they focus on the type of product or service rendered to the estate or trust and not the label. The final regulations, however, dropped the provision that costs that do not depend on the payer's identity are subject to the floor. The IRS received some justifiable criticism on this provision because "costs that do not depend on the identity of the payer" is just another way of saying "costs that could be incurred by an individual," which the Supreme Court rejected in Knight.12 No one will really notice that this provision was removed, however, because it is nearly the same as ownership costs, which are costs incurred "simply by reason of being the owner of the property," and which the final regulations retained.13
The final regulations provide five categories of costs compared to three in the proposed regulations. These categories include ownership costs, tax preparation fees, investment advisory fees, appraisal fees, and "certain fiduciary expenses." The last two categories are new. In addition to these five categories, the final 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 would be subject to the floor. Because nearly every claim initiated against an estate or trust would relate to its existence, validity, or administration, this provision seems to target claims arising during the decedent's life that an executor has continued to defend. For example, if a lawyer died while defending a lawsuit against him by his neighbor for encroachment, the costs incurred by his estate in defending that suit would be miscellaneous itemized deductions subject to the floor. However, defense costs may be otherwise fully deductible. For example, if the lawyer died while defending a malpractice suit against him, these expenses should be business expenses deductible under Sec. 162.
The final regulations retained the provision that "ownership costs" are commonly incurred by individuals and therefore are considered miscellaneous itemized deductions subject to the floor and the AMT. Ownership costs are defined as costs that are incurred by an owner simply because he or she is the owner. The final regulations also retained the laundry list of expenses that would meet the description of ownership costs, including condominium fees, insurance premiums, maintenance and lawn services, automobile registration and insurance costs, and partnership costs passed through to a partner if the costs are defined as miscellaneous itemized deductions by Sec. 67(b).14
Noticeably absent from the final laundry list is real estate taxes. The IRS received a great deal of well-deserved criticism for including real estate taxes on the laundry list in the last set of proposed regulations because real estate taxes are expressly excluded under Sec. 67(b)(2). The final regulations include "other expenses incurred merely by reason of the ownership of property may be fully deductible under other provisions of the Code such as sections 62(a)(4), 162, or 164(a), which would not be miscellaneous itemized deductions subject to section 67(e)."15 Oddly, this safety net for fully deductible expenses fails to mention those expenses expressly excluded under Sec. 62(b) for qualified performing artists.
The final regulations also clarify that passthrough costs from a partnership are subject to the floor only if they are miscellaneous itemized deductions under Sec. 67(b).16 It was not entirely clear in the proposed regulations whether all partnership costs would be considered miscellaneous itemized deductions or only those that would otherwise be if incurred by an individual. Although clarification was requested, it was not altogether necessary because Temp. Regs. Sec. 1.67-2T(b) already provides that separately stated items from a partnership are subject to the floor only if they would be subject to the floor if the individual partner directly incurred the items. Moreover, Sec. 6031(a) and its regulations already require a partnership to separately report items to a partner that would require separate computation at the partner level. So this clarification was nice but not necessary.
Tax Preparation Fees
The final regulations also clean up some loose ends on the types of tax preparation fees that are fully deductible. Both the proposed and the final regulations allow a full deduction for costs relating to estate and generation-skipping tax (GST) returns (Form 706 series), fiduciary income tax returns (Form 1041 series), and the decedent's final individual income tax return (Form 1040 series). But unlike the proposed regulations, the final regulations stop there. They do not allow a full deduction for any other type of return, including the decedent's final gift tax return (Form 709), final FBAR (FinCEN Form 114, Report of Foreign Bank and Financial Accounts), or any other type of return.17 Nor do they mention any other type of return. The proposed regulations included a denial of a full deduction for fees to prepare "other individual income tax returns" or returns for retirement plans, but in response to comments that a trust would rarely incur these fees, this language was removed.
It seems a little arbitrary to allow a full deduction for the decedent's final Form 1040 but not for his or her final gift tax return or FBAR. The preamble to the final regulations explains that gift tax returns are subject to the floor because individuals commonly make gifts and commonly incur costs to prepare gift tax returns.18 But the same could be said for Form 1040 or the FBAR. Whether it makes any sense or not, that is the final rule.
Neither the proposed nor the final regulations discuss tax planning fees. This appears to be a conscious omission because it would have been simple to include them. Therefore, tax planning fees are probably bundled fees that need to be allocated between costs subject to the floor and those not subject to the floor. For example, fees for planning a Sec. 1031 tax-free exchange would likely be subject to the floor because individuals commonly engage in tax-free exchanges, while fees for determining whether to make a 65-day election (which permits trusts or estates to elect to treat a distribution made within the first 65 days of the entity's tax year as made the prior year)19 or electing small business trust (ESBT) election20 would not be subject to the floor. Consequently, accountants and lawyers should make sure their invoices to fiduciaries are clear and detailed. There is no de minimis rule for costs that are subject to the floor.
Yielding to numerous public comments, the final regulations reluctantly concede that appraisal fees will be fully deductible by an estate or trust if they are incurred to determine the fair market value of assets at the decedent's death (or alternate valuation date), to determine value for purposes of making a distribution (i.e., a unitrust payment), or as otherwise required to properly prepare the fiduciary's tax returns. Otherwise, appraisal fees are generally miscellaneous itemized deductions subject to the floor.21 The one example the regulations provide is appraisals incurred for insurance purposes.22 So fees incurred to appraise a trust's Picasso for insurance purposes are subject to the floor. That result makes perfect sense, assuming that individuals commonly incur fees for art appraisals.
"Certain Fiduciary Expenses"
The original 2007 regulations provided a list of costs that were unique to an estate or trust: fiduciary accountings, judicial or quasi-judicial filings required as part of the administration of the estate or trust, fiduciary income tax and estate tax returns, the division or distribution of income or corpus to or among beneficiaries, trust or will contests or construction, fiduciary bond premiums, and communications with beneficiaries regarding estate or trust matters.23 However, the laundry list disappeared from the 2011 proposed regulations.
But, back by popular demand, the final regulations resurrect a list of fully deductible expenses, including 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 certificates, and costs related to fiduciary accounts.24 One cannot help noticing that, with the possible exception of fiduciary accounts, these costs are rather minuscule.
Presumably, "fiduciary accounts" means any type of fiduciary accounting, whether prepared for a court proceeding or in the ordinary course of informing the beneficiary. Some of these accountings can be quite pricey, especially if done in connection with litigation. Accountings are usually billed on an hourly basis. As such, they would meet the definition of a "bundled fee" in Regs. Sec. 1.67-4(c). Therefore, it is not clear whether fiduciary accountings are automatically exempt from the floor because they appear on the laundry list or whether they would be required to be unbundled.
Fiduciary accountings can entail a number of different services that individuals commonly incur, such as tax planning, and meetings with lawyers, appraisers, bankers, and other advisers, to name a few. One could argue that fiduciary accounts are per se exempt from the floor because individuals do not usually incur fees for fiduciary accountings. On the other hand, consider the number of revocable living trusts that individuals use for estate planning purposes that need accountings. In this author's opinion, the IRS probably does not intend to go after fiduciary accountings when the big money is in the investment advisory fees.
Investment Advisory Fees
Following the Supreme Court's rationale that individuals commonly incur investment advisory fees, both the proposed and final regulations provide that those fees are subject to the floor, with one narrow and illusory exception. Any "incremental cost" of investment advice beyond the amount that would "normally" be charged an individual investor is not subject to the floor.25 Thus, if a trustee outsources the investment duties to a third-party investment adviser, the fees paid to that adviser are generally all subject to the floor.
In this author's experience, it would be rare for an adviser to charge a trustee an incremental fee for some special or unusual investment objective related to the trust beyond what the adviser would charge an individual. In fact, due to business competition among advisers, it is more likely that an adviser would charge less to get the trust's business. The IRS had asked for comments on the types of incremental costs that advisers might charge their estate and trust clients, and no one responded.26 Thus, to exempt any part of the adviser's fee from the floor, the adviser must either reduce the fees charged to nontrust clients or increase the fees charged to trust clients, neither of which he or she is likely to do.
"Investment advice" and "investment advisory fees" are mentioned numerous times in the preamble27 and in the text of the final regulations.28 Yet, the regulations do not define either of these terms. They simply piggyback on the Supreme Court's Knight decision in using the terms "investment advice" and "investment advisory fees" instead of "investment management" or "investment services." The distinction is important because the plain meaning of "advice" requires at least two people-the adviser and the advisee.
The Investment Advisers Act of 1940 defines an investment adviser as any natural person or company "who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities."29 The trustee who performs the investment duties for the trust is not advising others. Thus, it is hard to say that the trustee is an investment adviser or that the trustee is advising others.
All three sets of regulations required unbundling fees that contain both costs subject to and those exempt from the floor. Thus, if an estate or trust pays a single fee or commission that covers both types of costs, the single fee must be allocated between the two categories of costs. Out-of-pocket expenses billed to the trust and payments made out of a bundled fee to a third party are not treated as part of a bundled fee. Those expenses are easy to track and are subject to the floor if they are commonly or customarily incurred by an individual. All costs, no matter how small, need to be unbundled, except for de minimis costs that are exempt from the floor.30
Bundled fees include fiduciaries' commissions, attorneys' fees, and accountants' fees. Bundled fees computed on an hourly basis must be unbundled. That generally includes fees for lawyers and accountants. But fees that are not computed hourly, such as trustees' fees, need only be unbundled for the portion attributable to "investment advice." Any reasonable method can be used to determine what portion of a bundled fee is attributable to investment advice. This reasonable method can be applied to hourly as well as nonhourly fees. The final regulations provide some guidance for the first time on what might be considered a reasonable method. The trustee might consider the portion of the trust corpus that is subject to investment advice, what a third-party adviser would have charged, or how much of the trustee's time is devoted to investment advice.31
Although the regulations do not suggest this, it might also be reasonable to assign a value to all the noninvestment services the trustee performs throughout the year, such as reviewing documents, considering where to site the trust or estate, conducting fiduciary accountings, valuing unitrusts, deliberating over distributions, calculating income and principal, reviewing estate and GST consequences, considering tax elections, and determining whether to make cash vs. in-kind trust distributions, and more. Bessemer Trust published an exhaustive list of trustee services from creation to termination.32 Assigning a value to these services may reveal that the trustee is actually charging nothing for the investment advice, if he or she ever was giving advice to anyone.
There is a compelling reason to allocate no portion of a trustee's fee to investment advice. Given that a trustee is the legal owner of the trust corpus, the trustee does not advise the trust corpus, which then takes action pursuant to the trustee's advice. Rather, the trustee acts himself or herself as the principal. While it may be natural to think of a trustee who deals in securities for the trust as an investment adviser, in Selzer, a New York district court held that neither the common sense meaning of the word "adviser" nor the provisions of the Investment Advisers Act of 1940 would treat a trustee as an investment adviser.33 Moreover, state and federally chartered trust companies are expressly exempt from the definition of investment adviser under the Investment Advisers Act of 1940.34 Therefore, no part of their fees should be investment advisory fees.
That is not to say that a trustee cannot give investment advice under certain circumstances. Because trustee services are so broad, one can imagine situations where a trustee could be considered to be giving investment advice. One such circumstance involved an SEC no-action letter. In 1983, Joseph J. Nameth's attorney wrote the SEC requesting advice on whether Nameth would be considered an investment adviser under the following scenario. Nameth would gather together several wealthy friends and acquaintances, who would create revocable living trusts and name him as trustee. He would be given actual legal title to all the trust properties and have all the duties and functions of a common law trustee, including broad investment powers, except that he was required to follow the settlors' instructions for distributions and the settlor could specify what types of investments he would be permitted to invest in. Under those circumstances, the SEC determined that he was an investment adviser under the 1940 Act.35
Nameth probably did resemble an investment adviser more than a trustee because of the degree of control the settlors had over him and the revocable nature of the trusts. But aside from unusual cases like Nameth's, most trustees are not providing investment advice to the trust corpus. Rather, they are investing and managing their own property, like the trustees in Selzer and Loring. However, to the extent that the trustee decides to delegate all or part of the investment duties to an investment adviser, the adviser's fees are clearly subject to the 2% floor and the AMT. Trustees who delegate should keep in mind that the Prudent Investor Act requires the trustee to protect the beneficiary from "double dipping." "If for example, the trustee's regular compensation schedule presupposes that the trustee will conduct the investment management function, it should ordinarily follow that the trustee will lower its fee when delegating the investment function to an outside manager."36 If the trustee has followed this advice and delegated the entire investment function, no part of the fee should be attributable to investment advice, if any ever was.
Even though miscellaneous itemized deductions implicate both the 2% floor and the AMT, the AMT is a far bigger concern to trustees and their beneficiaries. Unless the trust has an extraordinarily large capital gain that it cannot distribute, it will generally only lose a small fraction of its miscellaneous itemized deductions to the extent that it accumulates income. Once the trust has exceeded that floor, all excess expenses are fully deductible. But, for AMT purposes, none of those expenses are deductible from the trust's alternative minimum taxable income (AMTI), which may cause the trust to incur AMT. The trust can reduce or avoid the AMT by making distributions to beneficiaries because it receives a deduction for these distributions from its AMTI. But that does not make the problem go away. It just forces the disallowed AMT deduction to pass out to the beneficiary, who must add it to his or her AMTI. Either way, someone will pay the AMT in most cases.
In essence, the AMT adjustment creates "phantom income" for the beneficiary because the beneficiary reports income for AMT purposes that the beneficiary did not receive. This phantom income problem prompted Congress to amend Sec. 67(c) in 1988 to exempt millions of middle-income mutual fund investors from the 2% floor. Like mutual fund investors, the vast majority of trust beneficiaries are individuals of modest means. Although the higher regular tax rates of 39.6% have somewhat reduced the impact of the AMT, they have not eliminated it.
Is it really the end of the journey for Sec. 67(e)? This author believes so. While the preamble notes that the IRS may issue future guidance on unbundling, the regulations did not adopt a percentage safe harbor for unbundling fees, and the only comment received on reasonable allocations of fees to investment advice noted that there was "no single standard that could be applied to multiple trusts or even to the same trust in different years."37 Therefore, it seems that this is as good as it gets.
Trustees need to ask themselves whether they are really giving investment advice and to whom. Trustees that outsource some or all of their investment duties will cause the trust to be subject to the 2% floor and the AMT. Trustees of small trusts should invest in mutual funds to avoid the floor altogether. Lawyers and accountants will need to provide more detailed invoices. And tax preparers will need to take more care in identifying which costs go above or below the line. Overall, the final regulations are not a disappointment.
Editor's note: A version of this article also appeared in the Probate Practice Reporter, a monthly newsletter dedicated to probate practice and edited by Howard M. Zaritsky, S. Alan Medlin, and F. Ladson Boyle.
1 O'Neill, 994 F.2d 302 (6th Cir. 1993).
2 Mellon Bank, N.A., 265 F.3d 1275 (Fed. Cir. 2001); Scott, 328 F.3d 132 (4th Cir. 2003).
3 Rudkin Testamentary Trust, 467 F.3d 149 (2d Cir. 2006).
4 REG-128224-06, 72 Fed. Reg. 41243 (7/27/07).
5 Preamble to REG-128224-06, emphasis added.
6 Knight, 552 U.S. 181 (2008), aff'g 467 F.3d 149 (2d Cir. 2006), aff'g 124 T.C. 304 (2005).
7 REG-128224-06, 76 Fed. Reg. 55322 (9/7/11).
8 See, e.g., "AICPA Asks Treasury to Withdraw Proposed 2 Percent Floor Regs in Light of Recent Supreme Court Decision," 2008 TNT 29-17 (Feb. 8, 2008); "AICPA Comments on Proposed Regs on Estates', Non-Grantor Trusts' Costs Subject to 2 Percent Floor," 2011 TNT 237-17 (Dec. 9, 2011).
9 See, e.g., AICPA and American Bankers Ass'n, "IRS Proposed Regulation 26 CFR 1.67-4 Regarding Fees of Trusts and Estates" (4/17/09), available at www.aicpa.org.
10 Preamble to T.D. 9664.
11 Regs. Sec. 1.67-4(b).
12 Preamble to T.D. 9664.
14 Regs. Sec. 1.67-4(b)(2).
17 Regs. Sec. 1.67-4(b)(3).
18 Preamble to T.D. 9664.
19 Sec. 663(b).
20 Sec. 1361(e).
21 Preamble to T.D. 9664.
22 Regs. Sec. 1.67-4(b)(5).
23 Prop. Regs. Sec. 1.67-4(a) (2007).
24 Regs. Sec. 1.67-4(b)(6).
25 Regs. Sec. 1.67-4(b)(4).
26 Preamble to T.D. 9664.
28 Regs. Sec. 1.67-4.
29 15 U.S.C. §§80b-2(a)(11), (16).
30 Regs. Sec. 1.67-4(c)(1).
31 Regs. Sec. 1.67-4(c).
32 Bessemer Trust, "Re: Notice 2008-32: Proposed Deduction Limitations for Trusts Under Section 67(e)," 2008 TNT 115-29 (May 30, 2008).
33 Selzer v. Bank of Bermuda, Ltd., 385 F. Supp. 415 (S.D.N.Y. 1974). See also In re Loring,11 S.E.C. 885 (1942).
34 15 U.S.C. §80b-2(a)(11)(A); §80b-2(a)(2).
35 Joseph J. Nameth, SEC No-Action Letter (Jan. 31, 1983).
36 Uniform Prudent Investor Act §9, comment.
37 Preamble to T.D. 9664.
|Carol A. Cantrell is managing member of Cantrell & Cantrell PLLC, a Texas law firm specializing in tax, and is an active member of the American Bar Association and the AICPA. For more information about this article, contact Ms. Cantrell at firstname.lastname@example.org.