A View from the Audience at Heckerling: Part III

Income tax was a hot topic at this year’s 49^th Annual Heckerling Institute on Estate Planning, and considerable attention was devoted to recent Internal Revenue Service guidance on an income tax issue specific to trusts and estates.

On May 9, 2014, the IRS issued final regulations under Treasury Regulations Section 1.67-4 that provide guidance on which costs incurred by estates or trusts other than grantor trusts (non-grantor trusts) are subject to the 2 percent of adjusted gross income floor (AGI) for miscellaneous itemized deductions under IRC Section 67(e) (the 2-percent floor).These final regulations apply to taxable years beginning on or after Jan. 1, 2015 and have created enormous concern among corporate fiduciaries in particular.Chief among these concerns is how a fiduciary should go about subdividing (or unbundling) a single fiduciary fee that represents a composite of various functions that the fiduciary has performed, including the providing of investment advice (which is generally subject to the 2 percent floor) and managing other aspects of its relationship with beneficiaries including distribution decisions (which aren’t subject to the 2 percent floor).

The stakes involved here are much higher than one might otherwise expect. Miscellaneous itemized deductions that are subject to the 2 percent floor are disallowed entirely for purposes of the alternative minimum tax (AMT).¹ So for those trusts and estates in an AMT posture, this is not simply a matter involving a small potential reduction in the after-tax cost of particular expenses.Rather, it may well be an “all or nothing” proposition as to whether significant expenses are effectively deductible at all.

 

The Basic Rules

Section 67(e) provides an exception to the 2 percent floor on miscellaneous itemized deductions for costs that are paid or incurred in connection with the administration of an estate or a non-grantor trust “that would not have been incurred if the property were not held in such estate or trust.”² A cost is subject to the 2 percent floor to the extent that it’s included in the definition of miscellaneous itemized deductions under Section 67(b), is incurred by an estate or non-grantor trust and “commonly or customarily would be incurred”³by a hypothetical individual holding the same property.

This standard raises the question of what it means for a cost to be “commonly or customarily incurred” by a hypothetical individual holding the same property.  The regulations instruct that “[i]n analyzing a cost to determine whether it commonly or customarily would be incurred by a hypothetical individual owning the same property, it is the type of product or service rendered to the estate or non-grantor trust in exchange for the cost, rather than the description of the cost of that product or service, that is determinative.”⁴Such costs that are incurred commonly or customarily by individuals (which would be subject to the 2 percent floor) include, for example, costs incurred in defense of a claim against the estate, the decedent or the non-grantor trust that are unrelated to the existence, validity or administration of the estate or trust, 5and ownership costs (including those that pass through to the trust or estate from a partnership).⁶

In addition, the final regulations provide guidance concerning the following specific categories of costs:

Tax preparation fees.  Costs relating to all estate and generation-skipping transfer (GST) tax returns, fiduciary income tax returns and the decedent’s final individual income tax returns aren’t subject to the 2 percent floor.  The costs of preparing all other tax returns (for example, gift tax returns) are costs commonly and customarily incurred by individuals and, thus, are subject to the 2 percent floor.⁷

Appraisal fees.  Appraisal fees incurred by an estate or a non-grantor trust to determine the FMV of assets as of the decedent’s date of death (or the alternate valuation date), to determine value for purposes of making distributions, or as otherwise required to properly prepare the estate’s or trust’s tax returns, or a GST tax return, aren’t incurred commonly or customarily by an individual and, thus, aren’t subject to the 2 percent floor.  The cost of appraisals for other purposes (for example, insurance) is commonly or customarily incurred by individuals and is subject to the 2 percent floor. ⁸

Certain fiduciary expenses.  Certain other fiduciary expenses aren’t commonly or customarily incurred by individuals, and thus aren’t subject to the 2 percent floor.  Such expenses include: 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. ⁹

 

Investment Advisory Fees

The final regulations provide that fees for investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) are incurred commonly or customarily by a hypothetical individual investor and, therefore, are subject to the 2 percent floor.  This basic rule gets complicated, however, as a result of the final regulations’ attempt to follow the imprimatur of the U.S.  Supreme Court’s 2008 decision in Knight v. Comm’r,¹⁰   The court held that fees paid to an investment advisor by an estate or non-grantor trust generally are subject to the 2 percent floor, subject to certain potential exceptions.  These potential exceptions are where “the rubber hits the road,” so to speak.  Following the court’s instructions in Knight, the final regulations provide that certain incremental costs of investment advice beyond the amount that typically would be charged to an individual investor aren’t subject to the 2 percent floor.  For this purpose, such an incremental cost is a special, additional charge that’s added solely because the investment advice is rendered to a trust or estate rather than to an individual or attributable to an unusual investment objective or the need for a specialized balancing of the interests of various parties (beyond the usual balancing of the varying interests of current beneficiaries and remaindermen), such that a reasonable comparison with individual investors would be improper.  The portion of the investment advisory fees not subject to the 2 percent floor is limited to the amount of those fees, if any, that exceeds the fees normally charged to an individual investor.¹¹

 

Bundled Fees

Another area of considerable uncertainty under the final regulations results from its requirement that bundled fees be unbundled into a portion that’s subject to the 2 percent floor and a portion that’s not subject to the 2 percent floor. The final regulations provide that: “[i]f an estate or a non-grantor trust pays a single fee, commission, or other expense (such as a fiduciary’s commission, attorney's fee, or accountant's fee) for both costs that are subject to the 2 percent floor and costs (in more than a de minimis amount) that aren’t, then, except to the extent provided otherwise by guidance published in the Internal Revenue Bulletin, the single fee, commission, or other expense (bundled fee) must be allocated, for purposes of computing the adjusted gross income of the estate or non-grantor trust in compliance with section 67(e), between the costs that are subject to the 2-percent floor and those that are not.”1²

The Final Regulations provide an important exception to having to unbundle fees when a bundled fee isn’t computed on an hourly basis.  In that case, only the portion of that fee that’s attributable to investment advice is subject to the 2 percent floor; the remaining portion isn’t.¹³  Although the final regulations are unclear on this point, presumably the Final their guidance (in accordance with the Supreme Court’s instructions in Knight) that certain incremental costs of investment advice beyond the amount that typically would be charged to an individual investor aren’t subject to the 2percent floor would also apply here. 

In addition, out-of-pocket expenses billed to the estate or non-grantor trust are treated as separate from the bundled fee.  In a similar vein, payments made from the bundled fee to third parties that would have been subject to the 2 percent floor if they’d been paid directly by the estate or non-grantor trust are subject to the 2 percent floor, as are any fees or expenses separately assessed by the fiduciary or other payee of the bundled fee (in addition to the usual or basic bundled fee) for services rendered to the estate or non-grantor trust that are commonly or customarily incurred by an individual.¹⁴

According to the Final Regulations, any reasonable method may be used to allocate a bundled fee between those costs that are subject to the 2 percent floor and those costs that aren’t.  Facts that may be considered in determining whether an allocation is reasonable include, but are not limited to, the percentage of the value of the corpus subject to investment advice, whether a third party advisor would have charged a comparable fee for similar advisory services and the amount of the fiduciary’s attention to the trust or estate that’s devoted to investment advice as compared to dealings with beneficiaries and distribution decisions and other fiduciary functions.  The reasonable method standard doesn’t apply to determine the portion of the bundled fee attributable to payments made to third parties for expenses subject to the 2 percent floor or to any other separately assessed expense commonly or customarily incurred by an individual, because those payments and expenses are readily identifiable without any discretion on the part of the fiduciary or return preparer.¹⁵

How then are corporate fiduciaries handling the allocation of a bundled fiduciary fee between the portion that’s subject to the 2 percent floor (such as for “basic” investment advice) and the portion that’s not (potentially everything else)?  This question was posed to the esteemed Recent Developments Panel consisting of Dennis Belcher, Carlyn McCaffrey and Samuel Donaldson, who in turn took a very informal straw poll of corporate fiduciaries attending Heckerling.  The following two responses were reported: 

• one corporate fiduciary has formed a committee to look into this issue, and
• another corporate fiduciary has taken the following approach: 

for trusts – 60 percent of the bundled fiduciary fee is allocated to investment advice, with 40 percent not subject to the 2 percent floor; and

for estates – 20 percent of the bundled fiduciary fee is allocated to investment advice, with 80 percent not subject to the 2 percent floor.

Endnotes

1. Internal Revenue Code Section 56(b)(1)(A)(i).

2.  Treasury Regulations Section 1.67-4(a) (emphasis added).

3. Treas. Regs. Section 1.67-4(a).
4. Treas. Regs. Section 1.67-4(b)(1).
5. Treas. Regs. Section 1.67-4(b)(1).
6. Treas. Regs. Section 1.67-4(b)(2).
7. Treas. Regs. Section 1.67-4(b)(3).
8. Treas. Regs. Section 1.67-4(b)(5).
9. Treas. Regs. Section 1.67-4(b)(6).
10. Knight v. Commissioner, 552 U.S. 181, 128 S. Ct. 782 (2008).
11. Treas. Regs. Section 1.67-4(b)(4).
12. Treas. Regs. Section 1.67-4(c)(1).
13. Treas. Regs. Section 1.67-4(c)(2).
14. Treas. Regs. Section 1.67-4(c)(3).
15. Treas. Regs. Section 1.67-4(c)(3).