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Trust Deductions Reduced by 2% of Income
Summary:
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). Uncertainty has plagued
the application of this limitation to expenses incurred by trusts. A key issue
was 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’ll 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 don’t 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’re 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 aren’t,
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 individual would have customarily incurred, 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, 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.