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Trust and Estate Miscellaneous Deductions
This one sounds tedious, but it’s pretty significant for
many wealthy taxpayers and those who advise them. If you as an individual claim
certain miscellaneous itemized deductions you have to first reduce them by 2%
of your adjusted gross income (“AGI”). IRC Sec. 67(a). Your
adjusted gross income is the total of all your income, including wagers,
profits from businesses, rents, dividends, etc., less certain deductions, such
as trade or business expenses, or depreciation in rental property and so forth.
Uncertainty has plagued the application of this limitation to expenses incurred
by trusts. A key issue is whether trust investment management fees, which can
be substantial, were subject to this reduction. Expenses subject to the 2%
reduction are not only limited for purposes of the income tax, but they are
subject to the alternative minimum tax (AMT) which can eliminate any deduction.
Understanding these rules is important for trustees, beneficiaries, and those
advising trusts (money managers, accountants, attorneys). The history is a bit
sordid so we will wind you through it.
Statutory Background.
Code Section 67(a) provides that an individual can claim
miscellaneous itemized deductions for any tax year only to the extent that the
deductions exceed 2% of AGI. These deductions are
defined as any deduction other than certain enumerated deductions such as
interest (IRC Sec. 163), taxes (IRC Sec. 164), casualty and theft
losses (IRC Sec. 165), Contributions (IRC Sec. 170), medical and dental
expenses (IRC Sec. 213) and so on. Since trusts and estates are generally taxed
by applying the paradigm of individual income taxation, these rules have to be
applied to trusts and estates. IRC Sec. 67(e) addresses this by stating that
the AGI of an estate or trust shall be computed in the same manner as in the
case of an individual, except that “…the deductions for costs which are paid
or incurred in connection with the administration of the estate or trust and
which would not have been incurred if the property were not held in such trust
or estate…” This last phrase has spawned a lot of confusion and
controversy.
Court Cases.
This issue has been hotly contested by the IRS.
The 6th Circuit held investment advisory fees
deductible without the 2% reduction. O’Neill, 994 F2d. 302. The Federal and
4th Circuits held that the reduction applied. Mellon Bank,
265 F.3d 1275, Scott, 328 F3d 132, and Rudkin 467 F3d 149.
Proposed Regulation.
The Treasury department, while the Supreme Court case in
Knight (see below) was pending, issued proposed regulations. Prop. Reg.
§ 1.67-4. These classify costs which were not “unique” to a trust as being
subject to the 2% floor. “Unique” to a trust meant costs that
could not have been incurred by an individual property owner. If you do not see
the word “unique” in the law above, and you read the law as containing the
phrase “would not” instead of “could not” as the Regs provide, well you are
starting to understand the confusion and frustration. The Regs also require
Trustees to unbundle aggregated fees. If a trustee pays a lawyer or financial
planner for several services, including those that are unique, and those that
are not, analysis of those fees is required. The IRS posited that judicial
accountings, the cost of preparing a trust income tax return, the fee for a
trustee bond, etc. are unique and hence fully deductible. The costs incurred
regarding the custody or management of trust property, or investing trust
assets for total return, are not considered “unique”. These regulations will
have to be modified in light of the Supreme Court’s holding in
Knight.
Supreme Court Has the Last Word (not
really).
The Supreme Court recently ruled in the case Knight v.
Commissioner, 552 U.S. ___, 128 S. Ct 782 (Jan. 16, 2008), that trust
investment management fees are subject to this 2% reduction applicable to
itemized deductions. The Court interpreted the phrase “which would not have
been incurred if the property were not held in such trust” as requiring an
inquiry as to whether the particular cost “would customarily” be incurred by an
individual. Effectively the trustee must ask the following theoretical question
of every cost: “Would this cost have been commonly or customarily incurred had
the property been held by an individual and not in this trust?” In making this
theoretical determination the trustee should consider custom, habit, natural
disposition or probability. If the cost would be uncommon, or unusual for an
individual to incur, the trust could deduct it in full without regard to the 2%
floor. If the trustee can demonstrate that a particular cost was incremental to
the cost and the individual would have customarily incurred it, then that
excess can be deducted without regard to the 2% floor. For example, if an
investment adviser charged a supplemental fee to trust accounts, that would be
fully deductible. For many costs this would be the accounting equivalent of
splitting the dead sea. Similarly, if a trust had an unusual investment
objective, or requires the special balancing of the interests of various
parties, such that a reasonable comparison with individual investors would be
improper, it would be deducible in full. Fiduciaries will have to determine
which costs are subject to this restriction. This may require breaking certain
aggregate fees and costs into their components in order to make the appropriate
allocation to determine deductions. After all the paperwork, little may be
deductible without being subjected to the 2% floor, which will likely eliminate
any deductions. bundled costs after that date will have to be
divided based on the Supreme Court’s standard set forth in Knight.
IRS Notice.
The IRS recently issues Notice 2008-32 to provide guidance
on how trust deductions should be handled in light of the Regs and cases
discussed above. The IRS will issue new Regs consistent with the Knight
case. The revised Regs will eliminate the concept of “unique” and apply the
Supreme Court sanctioned paradigm discussed above. These Regs will also have to
guide trustees on how to parse aggregate or bundled fees which include in a
single amount costs which would be incurred by an individual and costs which
are uncommon or unusual for an individual to incur. For tax years prior to 2008
trustees will be permitted to deduct in their entirety bundled fees. Bundled
costs will be deductible for 2007 without allocation. Implicit in the ability
to claim this deduction is that the costs are bundled, i.e., that they include
deductible components which are uncommon for an individual to incur, as well as
non-deductible components, e.g., investment management fees. This means
investment management fees that do not include some amount for services would
not be deductible in 2007. If your trust return is on extension, you’ll still
need to figure this out. If you filed, you might want to review the position
your accountant took in this regard. (5) Fees paid to third parties, such as
advisory fees, are to be treated separately from bundled fees (that means that
if they don’t meet the Supreme Court test they are not deductible even in
2007.
Tax Practitioner Comments to the IRS.
Tax practitioners are submitting comments to the IRS
suggesting methods of addressing these issues in the new set of regulations.
Recommendations include specifying that certain types of costs, such as tax
return preparation, should not have to be parsed into costs commonly incurred
by individuals and those that are not; that as a safe-harbor taxpayers can
choose to elect a reduction in the 2% floor amount in lieu of engaging in more
complex accounting; safe-harbor amounts that can be deducted without having to
resort to more detailed analysis (e.g., any otherwise qualifying deduction
under $X can be deducted without regard to the 2% floor), etc. While most of
the proposals seek to create certainty and avoid costly and administratively
burdensome accounting, the sheer details of the issues involved leaves even the
most taxpayer favorable recommendations (and there is no assurance that the IRS
will even buy into those) pretty daunting for accountants and other
professionals.
Splitting Cost Hairs.
These rules may ultimately require investment managers,
accountants, attorneys and others providing services to trusts to allocate
their fees into the two categories. Separate charges may have to be made for
custody, investment management, trust distributions, communication with
beneficiaries, etc. For some institutional trustees, the fee they charge for a
directed trust for which they provide no investment management advice may be a
touchstone for determining the quantum of fees that are properly allocable to
non-investment services. Although this seems a logical calculation none of the
authorities or comments address it.
Conclusion.
The issue of trusts deducting various fees was seemingly
resolved by the Supreme Court in Knight, but the issues, planning and
administrative burdens have yet to be known.