Trust’s Investment Advisory Fees • National Research Program • S Corps. under Scrutiny • GST Exemption Allocation

Lesli S. Laffie, J.D., LL.M.

Court Decisions

Trust’s Investment Advisory Fees

In William L. Rudkin Testamentary Trust, 124 TC No. 19 (2005), the Tax Court held that investment advisory fees that a trust paid were deductible only to the extent they exceeded 2% of the trust’s adjusted gross income (AGI) under Sec. 67(a). For purposes of this floor, under Sec. 67(e), a trust’s AGI is computed the same way as for an individual, except that costs paid or incurred in connection with trust administration that would not have been incurred had the property not been held in the trust, can be deducted in arriving at AGI.

Background: In William J. O’Neill, Jr. Irrevocable Trust, 994 F2d 302 (6th Cir. 1993), nonacq., 1994-2 CB 1, rev’g 98 TC 227 (1992), the Sixth Circuit reversed the Tax Court and held that investment counseling fees paid by a trust to aid the trustees in discharging their fiduciary duty to the trust beneficiaries were not subject to the 2% floor. Later, the Sixth Circuit’s approach was rejected by the IRS, the Federal and Fourth Circuits, and the Court of Federal Claims; for a discussion, see Satchit, “Trusts, Investment Advisory Fees and the 2% Floor,” TTA, February 2004, p. 87.

2% floor applies: In Rudkin Trust, the Tax Court was called on to revisit the issue and concluded that its original reasoning was sound. Thus, the fees were subject to the 2% floor. The case is appealable to the Second Circuit.

From the IRS

National Research Program

IRS examiners selected nearly 90% of 46,007 cases for face-to-face audits in the first phase of its National Research Program (NRP), despite hopes that it could handle more cases less intrusively.

Background: The NRP was instituted to help the Service isolate problem compliance areas, so that it could better target its enforcement efforts. It replaces the highly controversial Taxpayer Compliance Measurement Program (TCMP), which eventually was terminated amid cost overruns and taxpayer complaints of intrusiveness.

The IRS chose 1,817 tax returns (3.9%) for correspondence audits, while only 2,535 returns (5.5%) were accepted as accurate. Of the remaining returns, 0.9% (402) were accepted with an adjustment, while 0.4% (186) had been previously audited.

Audit reasons: The Service initially estimated that a larger number of returns would be accepted without change or selected for correspondence audits.

There are several possible reasons for the outcome. One is that the final design of the sample to be examined required the selection of more complex, higher-income returns. Another is that the classification procedures had not been fully developed when the initial estimates were released. A third is that the IRS was “overly optimistic” as to the types and numbers of compliance issues that it could handle via correspondence audit.

Future plans: The agency will be implementing new audit selection formulas in early 2006 and expects a fairly decent improvement in the no-change rate.

Despite higher-than-expected numbers of face-to-face audits, the process is still less burdensome than TCMP’s rigorous examinations; taxpayers generally have given the NRP positive feedback.

Although the first round of NRP audits yielded large amounts of data and preliminary numbers on the tax gap, the Service is still defining what the numbers mean. Overall, it is too soon to say how the information will affect the agency’s long-term compliance initiatives.

S Corps. under Scrutiny

According to IRS Associate Chief Counsel (Income Tax and Accounting) Robert Brown, the Service is intensifying scrutiny of S corporations as part of its program to measure tax compliance in various economic sectors. The agency’s National Research Program is already partway through a pilot study measuring reporting compliance among partnerships and S corporations. A full-scale study of income reported by S corporations is expected to start in October 2005.

Statistics show that, apparently, business income is the largest portion of underreported income contributing to the tax gap. Because flowthrough entities are the second largest entity type, the IRS is likely to continue its focus in this area.

According to Brown, S corporations are now the largest business entity type in the U.S. Congress has suggested that the agency take a closer look at compliance in this growing area.

Size and scope: As part of the forthcoming study, the IRS’s Small Business and Self-Employed Division will examine 4,700 S corporation returns, while the Large and Mid-Size Business Division will audit 300. The study will include two tax years; its proposed start date is October 2005. According to Brown, the entire examination process will likely take three years. Each tax year would have an examination cycle of approximately 24 months.

Skills assessment: The S corporation study is an outgrowth of an existing pilot project that began in October 2004 and encompasses review of filed S and partnership returns. In addition to yielding compliance data, it is intended to provide experiential data on the methodology and logistics of conducting such studies. The pilot includes 130 returns split evenly between the two types of forms, in an effort to test the IRS’s data capture systems and to assess examination skills and training needs.

Regulations

GST Exemption Allocation

The IRS issued final regulations (TD 9208) clarifying how taxpayers may (1) avoid application of the automatic generation-skipping transfer (GST) tax exemption allocation rules applicable to transfers to a GST trust and (2) terminate such an election. The regulations also address how taxpayers may elect GST treatment for a trust.

Comments considered: The Service said it accepted a number of recommendations made in comments on the proposed regulations (REG-153841-02). The proposed regulations had permitted only two options for electing out of the automatic allocation rules—transferors could elect out as to a current transfer only, or as to a current-year transfer and all future transfers to the same trust.

Commentators asked for more options; in response, the Service said the final rules add the option of electing out for only certain designated future transfers to a trust, or all future transfers made by the transferor to any trust, regardless of whether the trust exists at the time of the election.

The IRS also noted that, under the final regulations, the transferor may elect out on future transfers even if no current-year transfer is made and the transferor is not otherwise required to file a Federal gift tax return.

Further, the final regulations have been clarified to confirm that an election out of the automatic allocation rules for future years is limited to allocations to indirect skips made during the transferor’s life and has no effect on the allocation rules that apply after the transferor’s death.

The Service also clarified that the automatic allocation to an indirect skip is effective as of the date of the transfer, and becomes irrevocable on the due date for filing Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, regardless of whether a return is filed to report the transfer. A late-filed gift tax return will not change the allocation.

The IRS also accepted a recommendation that an affirmative partial allocation of GST exemption be treated as an election out of the automatic allocation rules for the balance of that specific transfer.

The final regulations on automatic allocation to an indirect skip subject to an estate tax inclusion period (ETIP) have been revised to match rules for a direct skip, so that the allocation to a direct or an indirect skip is deemed to be made at the ETIP’s close.

Thus, a transferor may elect out of the automatic allocation rules for transfers subject to an ETIP at any time before the due date of the Federal gift tax return for the calendar year in which the ETIP closes. Transferors may elect out of the allocation rules on the gift tax return reporting the transfer to the trust or on a gift tax return filed for any calendar year after the year of the transfer, up to and including the calendar year in which the ETIP closes.

An election out of the automatic allocation for all current transfers or for all transfers in the current year includes an election out for a transfer subject to an ETIP that was made during that year, but an election out of the automatic allocation rules for all future transfers to a trust will not apply to any previous transfers to a trust subject to an ETIP that is to close in the future.