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Final Regs Require Estates and Trusts to Unbundle Fees; Beneficiaries Could See Tax Increases. (Parker Tax Publishing June 3, 2014)

Final regulations provide guidance on which costs incurred by estates or nongrantor trusts are subject to the 2-percent floor on miscellaneous itemized deductions. T.D. 9664 (5/9/14).

Summary

There has been considerable controversy over which costs incurred by estates and nongrantor trusts are subject to the 2-percent floor on miscellaneous itemized deductions. Under Code Sec. 67(e), costs that would not have been incurred if the property to which the costs relate were not held in such trusts or estates are deductible in full. Otherwise, the costs follow the normal rule under Code Sec. 67(a) and are deductible only to the extent all aggregated costs exceed 2 percent of the estate or trust's adjusted gross income (AGI).

The recently finalized regulations could mean higher taxes for the beneficiaries of estates and trusts due to changes in the taxing of bundled fees. The regulations now require that bundled fees - i.e., fiduciary fees paid by an estate or nongrantor trust that include both costs subject to the 2-percent of AGI limitation and those that are not - must be unbundled. This requirement is effective for tax years beginning after May 9, 2014. Previously, the entire bundle was deductible in full. As a result, beneficiaries may now see the pass-through of expenses that are not deductible for alternative minimum tax (AMT) purposes.

Practice Tip: Practitioners and fiduciaries should consider proactively warning beneficiaries of the possible negative AMT consequences resulting from the pass-through of miscellaneous itemized deductions that are not deductible for AMT purposes.

Additionally, the unbundling of investment advisory fees may impact the estate or trust's net investment income tax. This is because the 3.8 percent tax imposed on such entities under Code Sec. 1411 is calculated on net investment income; that is, investment income reduced by investment expenses. To the extent previously bundled fees were deductible from investment income in full and are now only partially deductible, the estate or trust may see an increase in its net investment income tax.

Background

Generally, under Code Sec. 67(a), miscellaneous itemized deductions incurred by an individual are deductible only to the extent the aggregate of those deductions exceeds 2 percent of AGI. Under Code Sec. 67(b), certain itemized deductions are excluded from the definition of miscellaneous itemized deductions. Code Sec. 67(e) provides that the AGI of an estate or nongrantor trust is computed in the same manner as an individual. However, the deduction for costs paid or incurred in connection with the administration of the estate or nongrantor trust that would not have been incurred if the property were not held in such estate or trust are deductible in arriving at AGI. Therefore, such deductions are not subject to the 2-percent-of-AGI floor.

OBSERVATION: The rule in Code Sec. 67(e) does not apply to expenses of grantor trusts because, under Reg. Sec. 1.67-2T(b)(1), such expenses are treated as miscellaneous itemized deductions of the grantor or other person treated as the owner of the trust. They are not treated as expenses of the trust itself.

The precursor proposed regulations, issued in 2007, implemented a "unique to an estate or trust" test for determining if a cost is subject to the 2-percent-of-AGI floor requirement. If a cost was not unique to an estate or trust, meaning that an individual could have incurred the cost, then that cost was subject to the 2-percent floor.

However, in Knight v. Comm'r, 2008 PTC 1 (2008), the Supreme Court rejected the IRS's "unique" interpretation of Code Sec. 67(e) in favor of exempting from the 2-percent floor costs that an individual "could not have incurred." The Court held that when Sec. 67(e) asks whether the expense "would not have been incurred if the property were not held in such trust", there must be an inquiry into whether a hypothetical individual who held the same property outside of a trust would "customarily"' or "commonly" incur such expenses. This, the Court noted, requires determining what would happen if a fact was changed. Such an exercise necessarily entails a prediction, the Court stated, and predictions are based on what would customarily or commonly occur. Thus, the Court concluded, in asking whether a particular type of cost would not have been incurred if the property were held by an individual, Code Sec. 67(e)(1) excepts from the 2-percent floor only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur.

The 2007 proposed regulations also addressed costs subject to the 2-percent floor that were part of a comprehensive fee paid by the trustee or executor (i.e., bundled fees). The proposed regulations provided that the estate or trust had to identify the portion (if any) of the fee that was unique to estates and trusts and was thus not subject to the 2-percent floor. Taxpayers were allowed to use any reasonable method to allocate the bundled expense between the costs unique to estates and trusts and costs that were not unique. The Court in Knight did not address bundled fees, as they were not at issue in the case. Nonetheless, considering the Court's holding, the IRS issued Notice 2008-32 to provide interim guidance on the treatment of bundled fees. Notice 2008-32, and subsequent extensions of that notice, provided that, until the effective date of final regulations, fiduciaries did not have to allocate bundled fees.

In 2011, IRS withdrew the 2007 proposed regulations and issued new proposed regulations (REG-128224-06 (9/7/11)). Those regulations adopted the Knight holding providing that costs incurred commonly or customarily by individuals include expenses that do not depend on the identity of the payor. Additionally, the 2011 proposed regulations kept the requirement to unbundle fees and allocate them between those subject to the 2-percent limitation and those not subject to the limitation. In response through the comment process, practitioners challenged the regulatory authority to require this unbundling and argued that the administrative and recordkeeping expense required to break down specific expenses would be overly burdensome. A practitioner also accused the IRS of trying to expand costs subject to the 2-percent floor by having the regulations focus on the identity of the payor rather than an inquiry as to what costs an individual would customarily or commonly occur.

Final Regulations

On May 9, 2014, the IRS withdrew the 2011 proposed regulations and issued final regulations in T.D. 9664. The regulations eliminated some of the requirements in the proposed regulations, clarified other provisions, added new provisions, and, unfortunately for taxpayers, kept the requirement to unbundle certain fees (but afforded some flexibility).

Commonly or Customarily Incurred Expenses - In General One of the complaints practitioners had with the 2011 proposed regulations was that they did not contain an inquiry into what expenses a hypothetical individual who held the same property outside of an estate or trust would "customarily" or "commonly" incur. Instead, the proposed regulations provided that costs were considered commonly incurred by individuals if they did not depend on the identity of the payor. Some practitioners found this interpretation overly broad and inconsistent with the Knight decision.

In response to this comment, the final regulations eliminated the reference to costs that do not depend on the identity of the payor.

Ownership Costs

The proposed regulations provided that, for purposes of Code Sec. 67(e), ownership costs were costs commonly or customarily incurred by a hypothetical individual owner of such property. Therefore, the proposed regulations said, ownership costs are subject to the 2-percent floor. The proposed regulations defined ownership costs as costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property, 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.

Practitioners took issue with some of the examples used to illustrate ownership costs in the proposed regulations. First, they pointed out that real estate taxes used in one of the examples are not a miscellaneous itemized deduction because they are fully deductible under Code Sec. 62(a)(4) or Code Sec. 164(a). Second, practitioners asked that the final regulations clarify that costs incurred in connection with a trade or business or for the production of rents or royalties are fully deductible under Code Sec. 162 or Code Sec. 62(a)(4) and thus are not miscellaneous deductions. Third, practitioners requested that the final regulations clarify that the partnership costs reportable by a partner are subject to the 2-percent floor only if those costs are miscellaneous itemized deductions under Code Sec. 67(b). Thus, for example, a partnership cost that is fully deductible is not subject to the 2-percent floor.

The IRS adopted these suggestions in the final regulations.

Tax Return Preparation Costs

The proposed regulations provided that the application of the 2-percent floor to the cost of preparing tax returns on behalf of the estate, decedent, or nongrantor trust would depend on the particular tax return. The proposed regulations provided that all costs of preparing estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent's final individual income tax returns were not subject to the 2-percent floor. However, the proposed regulations also provided that costs of preparing other individual income tax returns, gift tax returns, and tax returns for a sole proprietorship or a retirement plan, for example, were costs commonly and customarily incurred by individuals and thus were subject to the 2-percent floor. Several commentators pointed out that it would be very rare for a trust to pay for the preparation of the tax return of an individual other than the decedent. In the unlikely event that it did, such a cost would either be a deemed beneficiary distribution or would represent a breach of fiduciary duty. Further, practitioners noted, tax preparation fees for sole proprietorships and retirement plans would be fully deductible as business expenses under Code Sec. 162.

To resolve these ambiguities in the proposed regulations, the final regulations provide that the costs relating to all estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent's final individual income tax returns are not 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.

OBSERVATION: Some practitioners had suggested that the final regulations provide that the cost of preparing all gift tax returns are exempt from the application of the 2-percent floor. However, the IRS noted that gifts are made by individuals, and the gift tax returns required to report those gifts are commonly and customarily required to be prepared and filed by or on behalf of individuals. Therefore, it did not agree that gift tax returns should be included in the category of returns whose preparation costs are exempt from the 2-percent floor.

Investment Advisory Fees

The proposed regulations provided 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. However, the proposed regulations also provided flexibility regarding a special type of investment advice discussed by the Supreme Court in Knight.

In Knight, the Supreme Court noted that it was conceivable that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such cases, the Court said, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer is not subject to the 2-percent floor.

As a result, the final regulations provide that, to the extent a portion (if any) of an investment advisory fee exceeds the fee generally charged to an individual investor, and that excess is attributable to an unusual investment objective of the trust or estate or to a specialized balancing of the interests of various parties such that a reasonable comparison with individual investors would be improper, that excess is not subject to the 2-percent floor.

Appraisal Fees

In response to the proposed regulations, practitioners suggested that the final regulations include appraisal fees incurred by an estate or trust as a category of expense that is not subject to the 2-percent floor. Although individuals commonly or customarily would have assets appraised, estates and nongrantor trusts are required to undertake valuations for the maintenance and administration of these entities that an individual would not undertake. For example, Form 5227, Split-Interest Trust Information Return, requires taxpayers to determine the fair market value of the trust's assets for each tax year.

The IRS agreed with this suggestion, and the final regulations expressly provide that certain appraisal fees incurred by an estate or nongrantor trust are not subject to the 2-percent floor. Specifically, the regulation exempts appraisals needed to determine value as of the decedent's date of death (or the alternate valuation date), to determine the value of assets for purposes of making distributions, or as otherwise required to properly prepare the estate's or trust's tax returns. Appraisals for these purposes are not customarily obtained by individuals (unlike, for example, appraisals to determine the proper amount of insurance needed on certain property) and thus meet the requirements for exemption from the 2-percent floor under Code Sec. 67(e).

Certain Fiduciary Expenses

In response to practitioner requests, the final regulations added a provision that certain other fiduciary expenses are not commonly or customarily incurred by individuals, and thus are not subject to the 2-percent limitation. 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.

Bundled Fees

A bundled fee is 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 are not. The final regulations kept the requirement in the proposed regulations that a bundled fee must be allocated between costs that are subject to the 2-percent floor and costs that are not.

OBSERVATION: After the Knight decision, the IRS issued Notice 2008-32, which stated that taxpayers were not required to determine the portion of a bundled fee subject to the 2-percent floor for any tax year beginning before January 1, 2008. Subsequently, Notice 2008-116 extended the interim guidance provided in Notice 2008-32 to tax years beginning before 2009, Notice 2010-32 extended the interim guidance provided in Notice 2008-116 and Notice 2008-32 to tax years beginning before 2010, and Notice 2011-37 extended the existing interim guidance to tax years beginning before the effective date of final regulations. The effective date of the final regulations is May 9, 2014. Thus, the unbundling requirement applies for tax years beginning on or after May 9, 2014.

Practice Tip: In the preamble to the final regulations, the IRS suggested that future safe harbor rules regarding the unbundling of fees may be issued.

Under the final regulations, there is an exception to the allocation requirement for a bundled fee that was not computed on an hourly basis. For such a fee, only the portion attributable to investment advice (including any related services that would be provided to any individual investor as part of the investment advisory fee) is subject to the 2-percent floor.

Out-of-pocket expenses billed to the estate or nongrantor trust are treated as separate from the bundled fee. In addition, payments made from the bundled fee to third parties that would have been subject to the 2-percent floor if they had been paid directly by the estate or nongrantor trust are subject to the 2-percent floor. Similarly, the floor applies to 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 nongrantor trust that are commonly or customarily incurred by an individual.

The final regulations permit any reasonable method to determine allocation of a bundled fee between those costs that are subject to the 2-percent floor and those costs that are not, including without limitation the allocation of a portion of a fiduciary commission that is a bundled fee to investment advice. In response to the concerns raised about the difficulty of unbundling, the final regulation provides some guiding factors that may be considered in determining whether an allocation is reasonable include, but are not limited to: (1) the percentage of the value of the corpus 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 is devoted to investment advice as compared to dealings with beneficiaries and distribution decisions and other fiduciary functions. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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