The Internal Revenue Service issued final regulations under Internal Revenue Code Section 67 regarding the application of the 2 percent floor to miscellaneous itemized deductions for non-grantor trusts and estates. Here’s what you need to know to comply with the new rules.
Non-grantor trusts and estates may deduct certain miscellaneous itemized deductions only to the extent they exceed 2 percent of adjusted gross income (AGI). The stakes are high: If an expense is subject to the 2 percent floor, the benefit of the deduction will be reduced or eliminated entirely, resulting in a higher income tax bill. Determining which expenses are subject to the 2 percent floor, therefore, is critically important.
The long-awaited regulations1 may require professional fiduciaries to change their practices to comply with the new rules. A key issue that will require special attention is the treatment of “bundled” fees (that include both costs that are subject to the 2 percent floor and those that aren’t), which must now be allocated between the component parts.
Two Percent Floor
Generally, miscellaneous itemized deductions are allowed only to the extent that the aggregate of the deductions for any taxable year exceeds 2 percent of AGI.2 IRC Section 67(e) applies this rule to non-grantor trusts and estates with one key modification: Costs paid or incurred in connection with the administration of a trust or estate “which would not have been incurred if the property were not held in such trust or estate” are deductible without regard to the 2 percent floor.
Whether a cost is subject to the 2 percent floor depends on the nature of the expense. For instance, trustee fees are deductible in full because these fees are, by definition, incurred only when assets are held in trust. Other types of fiduciary expenses—most notably, investment advisory fees—may be subject to the 2 percent floor. Indeed, much of the litigation about the boundaries of the 2 percent floor rule, including the U.S. Supreme Court’s decision in Knight v. Commissioner,3 centers on the deductibility of investment expenses.
Prior to the Knight decision, the courts were divided on the legal standard for deducting investment expenses. In 1993, the U.S. Court of Appeals for the Sixth Circuit held that a non-grantor trust or estate could deduct investment advisory fees in full.4 In contrast, the Federal Circuit (in 2001) and the Fourth Circuit (in 2003) reasoned that Section 67 requires an inquiry as to whether an expense is customarily or commonly incurred outside of a trust or estate.5 Because investment advisory fees are frequently incurred by individuals, the courts held that investment fees incurred by a non-grantor trust or estate were subject to the 2 percent floor.
In 2006, the Second Circuit adopted yet another reading of the statute.6 It held that Section 67 allows a full deduction only for those costs that couldn’t have been incurred by an individual property owner, with the result that investment advisory fees were subject to the 2 percent floor.
In 2007, the IRS issued proposed regulations under Section 67 that followed the strict standard adopted by the Second Circuit and allowed a full deduction only for costs unique to an estate or trust—meaning costs that couldn’t have been incurred by an individual owner.
Importantly, the 2007 proposed regulations included an anti-avoidance rule designed to prevent taxpayers from bundling fees that are subject to the 2 percent floor with fees that aren’t into a single deductible charge. Under the proposed rule, fiduciaries would be required to allocate bundled fees between the component parts using any reasonable method. This unbundling concept has been retained and expanded in the final regulations.
The 2007 proposed regulations were quickly made obsolete by the Supreme Court’s decision in Knight (on appeal from the Second Circuit).
In Knight, the trustee of a trust paid about $22,000 in investment advisory fees and deducted this expense in full on the trust’s income tax return. On audit, the IRS took the position that the deduction was subject to the 2 percent floor.
The Supreme Court adopted the reasoning of the Fourth and Federal Circuits. Specifically, the court held that the key test for deductibility under Section 67 is whether it would be “uncommon (or unusual, or unlikely)” for a cost incurred by a trust or estate to be incurred by a hypothetical individual owner. A cost that wouldn’t be commonly incurred by an individual is fully deductible, while a cost that would be commonly or customarily incurred by an individual is subject to the 2 percent floor.
Based on this standard, the court held that investment advisory fees paid by a trust are subject to the 2 percent floor because it’s not unusual or uncommon for an individual owner to pay for investment advice.
The court emphasized, however, that some investment advisory fees incurred by a trust may be fully deductible if, for example, “an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts.” In addition, the court reasoned that it’s possible for a trust to have an unusual investment objective or that a trust may require a specialized balancing of the interests of various parties (beyond the usual balancing of income and remainder beneficiaries’ interests). In such cases, the incremental cost of such specialized investment advice wouldn’t be subject to the 2 percent floor.
In response to Knight, the IRS issued interim guidance announcing that it expected to publish final regulations that would be consistent with the Supreme Court’s analysis. Because the final regulations would be effective only prospectively, however, the IRS permitted fiduciaries to continue deducting bundled fees without regard to the 2 percent floor until the final regulations were issued.7
In 2011, the 2007 proposed regulations were withdrawn as inconsistent with Knight, and the IRS issued another round of proposed regulations. The 2011 proposed regulations provided that an expense would be subject to the 2 percent floor to the extent it commonly or customarily would be incurred by a hypothetical individual holding the same property.
2014 Final Regulations
In May 2014, the 2011 proposed regulations were issued in final form with relatively minor modifications. The key aspects include:
• General standard. The final regulations retain the “commonly or customarily” test for deductibility first put forth in the 2011 proposed regulations. Under this test, a miscellaneous itemized deduction of an estate or non-grantor trust is subject to the 2 percent floor if the expense commonly or customarily would be incurred by a hypothetical individual holding the same property.
The final regulations expressly provide that expenses subject to the 2 percent floor include certain ownership costs, tax preparation fees, investment advisory fees and appraisal fees.
• Ownership costs. Ownership costs subject to the 2 percent floor include expenses incurred simply by reason of being the owner of the property. For example, a custody fee charged for holding securities would likely be characterized as an ownership cost.
• Tax preparation fees. The final regulations supply an exclusive list of tax return preparation costs that aren’t subject to the 2 percent floor. Fully deductible expenses include the cost of preparing estate and generation-skipping transfer (GST) (but not gift) tax returns, fiduciary income tax returns and the decedent’s final individual income tax return. The cost of preparing all other tax returns is subject to the 2 percent floor.
• Investment advisory fees. Generally, investment advisory fees are subject to the 2 percent floor. However, consistent with Knight, the final regulations provide that certain incremental costs of investment advice beyond the amount typically charged to an individual investor aren’t subject to the 2 percent floor. Likewise, the cost of providing specialized advice relating to an unusual investment objective or the need for customized balancing of the interests of various parties is fully deductible, to the extent the cost of this specialized advice exceeds the cost charged to a hypothetical individual. In other words, the fact that investment advice is highly specialized doesn’t alone make the cost deductible; the fee must also exceed the fee charged to an individual client.
• Appraisal fees. The final regulations expressly provide that certain appraisal fees aren’t subject to the 2 percent floor. Specifically, the cost of appraisals for determining the value of assets as of the decedent’s date of death for purposes of making distributions from a trust or estate or to prepare the trust’s or estate’s tax returns (including GST tax returns) is fully deductible. The cost of all other appraisals is subject to the 2 percent floor.
• Fiduciary expenses. The final regulations contain a new provision intended to confirm that certain specific fiduciary expenses aren’t subject to the 2 percent floor. These include probate court fees and costs, fiduciary bond premiums, costs of providing legal notices and costs related to fiduciary accounts.
Treatment of Bundled Fees
Importantly, the final regulations retain the requirement to allocate bundled fees between costs that are subject to the 2 percent floor and those that aren’t. Although the rule is simple in concept, complying with it will be difficult in practice.
• Non-hourly fees. A key exception to the “unbundling” requirement is that bundled fees not computed on an hourly basis must be allocated only between investment advice and all other services. The investment portion is subject to the 2 percent floor, while the entire remaining balance is fully deductible.
This exception is favorable from an administrative point of view because it allows professional fiduciaries (whose fees are typically calculated as a percentage of assets under management) to avoid breaking out their charges into many separate components representing all the different types of services they provide. Indeed, several large corporate trustees have already taken advantage of this rule by adopting fee schedules with two separately stated fee components—one for investment management and one for all other fiduciary services.
• Separate payments. The final regulations contain two exceptions for payments that may not be allocated as part of a bundled fee and must be analyzed separately. First, any payments made from the bundled fee to third parties that would have been subject to the 2 percent floor if paid directly by the trust or estate are subject to the 2 percent floor. For example, if a trustee charges a single fee for administering a trust and hires an outside investment advisor whose fees are paid by the trustee out of its own compensation, the separate investment advisory fee will be subject to the 2 percent floor. The separate fee may, however, be deductible to the extent it includes specialized advice not required for individuals.
Second, any payments separately assessed by the fiduciary in addition to the usual bundled fee are subject to the 2 percent floor (again, to the extent the charges for the additional services are commonly or customarily incurred by an individual).
• Reasonable method of allocation. The final regulations retain the flexibility (from the 2007 proposed regulations) of allowing fiduciaries to allocate bundled fees among the component parts using any reasonable method. The IRS believes that this rule will help mitigate the administrative burden of complying with the unbundling requirement.
The final regulations contain a non-exclusive list of factors that may be considered in determining whether an allocation is reasonable. The factors are: (1) the percentage of the value of the trust subject to investment advice; (2) whether a third party advisor would have charged a comparable fee for similar advisory services; and (3) 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.
Note that the final regulations don’t provide any safe harbor method for allocating bundled fees. As a practical matter, this absence means that fiduciaries will need to exercise their judgment in developing a reasonable method of allocation. The IRS reserved the right, however, to provide safe harbors in future guidance.
Practical Implications for Fiduciaries
The final regulations will have a substantial impact on professional fiduciaries, who must evaluate whether their current practices (especially regarding fee allocation and unbundling) satisfy the new rules. Fiduciaries should focus on three key areas:
1. Develop a reasonable unbundling method. Guidance on what constitutes a reasonable method of allocating bundled fees is sparse. Here are several suggestions:
• Determine the amount of time dedicated to investment and non-investment tasks. Review prior time records or begin recording time going forward. If this approach isn’t practical, consider using sampling techniques to identify client relationships with a representative mix of services to develop a reasonable allocation that could be applied to similar clients.
• Benchmark how your fees compare to other professional fiduciaries and investment advisors in your market segment. If your bundled fees are higher than those charged by “pure” investment advisors, it may be possible to allocate a greater portion of them to non-investment (fully deductible) fiduciary advice. Likewise, if you provide substantial non-investment services as part of the overall client relationship, consider allocating a greater portion of the bundled fee to those value-added services.
• Identify investment and non-investment fees on your schedule of fees separately, to make it easier for clients and their accountants to prepare fiduciary income tax returns. Also, consider developing separate fee schedules for individual and trust clients. Finally, consider charging some trust clients an additional trust-only investment fee, which should be deductible in full.
2. Look for unique situations. From a practical perspective, it’s easier to implement a unified allocation method across all client relationships. Don’t forget, however, to keep an eye out for trusts with truly unique investment objectives, such as trusts that will last a very long time (for example, a dynasty trust or a perpetual charitable foundation). Arguably, an extremely long-term investment horizon is well beyond the investment objective of a hypothetical individual owner, and any additional charges (in excess of what’s charged to an individual investor) for implementing a special investment program shouldn’t be subject to the 2 percent floor.
3. Manage transition issues. The final regulations apply to taxable years beginning on or after May 9, 2014. Thus, calendar year trusts and estates and many fiscal year entities may continue to deduct bundled fees in full on the 2014 return and will have considerable time to react to the new regulations. Taxpayers whose fiscal years begin on or after May 9, however, will need to comply much sooner. This includes existing fiscal year estates and newly created non-grantor trusts and estates.
1. Treasury Regulations Section 1.67-4.
2. Internal Revenue Code Section 67(a).
3. Knight v. Commissioner, 552 U.S. 181 (2008).
4. O’Neill v. Comm’r, 994 F.2d 302 (6th Cir. 1993).
5. Mellon Bank, N.A. v. U.S., 265 F.3d 1275 (Fed. Cir. 2001); Scott v. U.S., 328 F.3d 132 (4th Cir. 2003).
6. Rudkin v. Comm’r, 467 F.3d 149 (2d Cir. 2006).
7. Notice 2008-32 (effective for tax years beginning before Jan. 1, 2008); Notice 2008-116 (extension through Jan. 1, 2009); Notice 2010-32 (extension through Jan. 1, 2010); Notice 2011-37 (extension through the publication of final regulations in the Federal Register).