Nikki Marie Oliveira, Esq., LL.M.
Kerry L. Spindler, Esq., Goulston & Storrs, PC
On September 7, 2011, the IRS withdrew the 2007 proposed regulations and released new proposed regulations providing guidance as to when expenses incurred by estates or non-grantor trusts are subject to the two percent floor for miscellaneous itemized deductions under I.R.C. § 67(a). When final, the regulations will be published at Treas. Reg. § 1.67-4.
I.R.C § 67(a) provides that, with respect to an individual taxpayer, miscellaneous itemized deductions are allowed only to the extent that the aggregate of the deductions exceeds two percent of adjusted gross income (“AGI”). I.R.C. § 67(e) provides that estates and trusts compute AGI in the same manner as an individual except that deductions for costs “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” are deductible without regard to the two percent floor.
The law around this exception has been evolving, and in 2007 the IRS published proposed regulationsproviding that a cost is deductible without regard to the two percent floor to the extent that it is “unique” to the estate or trust. The 2007 proposed regulations also provided that where an estate or trust pays a single investment advisory fee that includes costs subject to the two percent floor and costs not subject to the two percent floor, the fee must be “unbundled”.
In 2008, the United States Supreme Court decided the case of Knight v. Commissioner, 55 U.S. 181 (2008), holding that while trust investment advisory fees are generally subject to the two percent floor, they are not subject to the floor if they are “uncommon (or unusual or unlikely) for a[n] . . . individual to incur”. Knight’s focus on “uncommon” expenses was considered to be less restrictive than the requirement in the 2007 proposed regulations that the expenses be “unique”.
Since 2008, the IRS has issued annual guidance stating that fees did not have to be unbundled until final regulations were promulgated. In September 2011, the IRS withdrew the 2007 regulations and published new proposed regulations more aligned with Knight. Noteworthy provisions of the new proposed regulations are as follows.
Test for When Expenses are Subject to the Two Percent Floor
The new proposed regulations provide a three-prong test for determining when an expense is subject to or excepted from the two percent floor. A cost is subject to the two percent floor to the extent that it is: (1) included in the definition of miscellaneous itemized deductions under section 67(b), (2) incurred by an estate or non-grantor trust, and (3) commonly or customarily incurred by a hypothetical individual holding the same property.
Expenses Commonly or Customarily Incurred by Individuals
Whether an expense is commonly or customarily incurred by a hypothetical individual holding the same property depends on “the type of product or service rendered…, rather than the description of the cost of that product or service.” Costs that are commonly or customarily incurred by individuals include:
- Costs incurred in defense of a claim against the estate, the decedent, or trust that are unrelated to the existence, validity, or administration of the estate or trust.
- Ownership costs, such as condominium fees, real estate taxes, insurance premiums, maintenance and lawn services, automobile registration and insurance costs, and partnership costs deemed to be passed through to and reportable by a partner.
- Certain tax preparation fees. Deductibility is dependent upon the type of tax return. For instance, tax preparation fees for an estate tax return, generation-skipping transfer tax return, fiduciary income tax return, or a decedent’s final individual income tax return are not subject to the two percent floor. On the other hand, other individual income tax returns, gift tax returns, and tax returns for a retirement plan or sole proprietorship are commonly incurred by individuals and would be subject to the two percent floor.
- Investment advisory fees are generally subject to the two percent floor, however, the new proposed regulations provide an exception to the extent that any portion of the investment advisory fee exceeds the fee normally charged to an individual investor, and the excess is attributable to (a) an unusual investment objective of the trust or estate or (b) a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper.
Unbundling of Fiduciary Fees
There has been much controversy over when and how fiduciary fees must be “unbundled” for the purpose of calculating the AGI of the trust or estate under I.R.C. § 67(e). While the new proposed regulations permit more expenses to avoid the two percent floor, looming is still the issue of how to allocate investment advisory fees.
The new proposed regulations provide that costs that are subject to the two percent floor and those that are not must be separately accounted for in computing AGI. However, if the fee charged is not based on an hourly rate, then only the portion for investment advice is characterized as subject to the two percent floor and any excess is deductible without regard to the floor. In response to concerns raised over high anticipated administrative costs associated with unbundling fees, the new proposed regulations allow “any reasonable method” to be used to unbundle. Nevertheless, this is a broad and vague standard requiring further clarification.
Estates and non-grantor trusts with tax years beginning on or after final regulations are published in the Federal Register must comply with the new rules. Since the public hearing is scheduled for December 19, 2011, it is unlikely that the final regulations will be published before 2012. Therefore, where a trust has a calendar-year accounting period, trustees should not need to unbundle fees until at least 2013, and unbundled fees should not need to be reflected on income tax returns until those filed in 2014, at the earliest.
 72 Fed. Reg. 144, 41,243 (July 27, 2007).
 Prop. Reg. § 1.67-4(a) (2007).
 Prop. Reg. § 1.67-4(c) (2007).
 Knight v. Comm’r, 55. U.S. 181 (2008) (emphasis deleted from original).
 I.R.S. Notice 2011-37, 2010-32, 2008-116 & 2008-32.
 Prop. Reg. § 1.67-4(a).
 Prop. Reg. § 1.67-4(b)(1).
 Prop. Reg. §1.67-4(b)(1).
 Id. at § 1.67-4(b)(2).
 Id. at § 1.67-4(b)(3).
 Id. at § 1.67-4(b)(3).
 76 Fed. Reg. 173, 55,323 (Sept. 7, 2011)