On May 8, 2014, the IRS issued final regulations regarding which costs or expenses incurred by estates and non-grantor trusts are subject to the 2-percent floor for miscellaneous itemized deductions under section 67. These regulations can be found at Reg. § 1.67-4.
Generally, the final regulations are substantively similar to the 2011 proposed regulations and provide that an expense is subject to the 2-percent floor if “it is 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 by a hypothetical individual holding the same property.”
The regulations provide guiding principles and examples, but they leave a number of questions unanswered regarding the applicability of these principles. In particular, the regulations leave fiduciaries with further questions about the deductibility of what the regulations call “investment advisory fees,” whether or not those fees are bundled with other fiduciary expenses.
On July 17, 2014, the IRS postponed the effective date of these regulations and provided that the regulations will apply to all estates and non-grantor trusts with tax years beginning on or after January 1, 2015. This postponement gives fiduciaries and their advisors more time to develop procedures to properly implement the requirements of these regulations.
Postponement and Uniformity of Effective Date
By an amendment dated July 17, the effective date of these regulations is now January 1, 2015; this means that the regulations will apply only to a taxable year of any trust or estate that begins on or after January 1, 2015.
Initially, the regulations would have applied to taxable years beginning on or after May 9, 2014. That is, the regulations would have immediately applied to an irrevocable non-grantor trust created on or after May 9, 2014, and to the estate of an individual who died on or after May 9, 2014. In addition, the regulations would have applied prior to January 1, 2015, to an existing fiscal-year estate with a taxable year beginning between May 9, 2014, and January 1, 2015. But as for existing trusts with calendar years, the typical case the writers of the regulations may have had in mind, the regulations would have taken effect exactly on January 1, 2015.
Upon publication of the final regulations, the American Bankers Association and 14 state bankers associations requested a delay in the enforcement of the regulations so their members could properly develop procedures to comply with the regulations, particularly procedures to unbundle their fiduciary fees in compliance with the regulations in a fair, consistent and accurate manner.
The regulations now will not apply to any trust or estate prior to January 1, 2015, giving all fiduciaries and their advisors more time to digest and respond to these regulations.
Applicability of the 2-Percent Floor
According to section 67(a), individual miscellaneous itemized deductions are allowed “only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.” Under section 67(e), in the case of a trust or estate these deductions are treated in the same manner as in the case of an individual, except that “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 … shall be treated as allowable in arriving at adjusted gross income” and thus are not subject to the 2-percent floor.
The final regulations under section 67(e) provide generally that a cost incurred by a trust or estate is subject to the 2-percent floor if the cost “commonly or customarily would be incurred by a hypothetical individual holding the same property.”
This test of “commonly or customarily” incurred costs was endorsed by the Supreme Supreme Court in Knight v. Commissioner, 552 U.S. 181 (2008). In that case, the Supreme Court, in interpreting section 67, adopted the test of the Federal and Fourth Circuit Courts of Appeals that an expense “would not have been incurred” by the estate or trust if it was a cost “commonly or customarily” incurred by an individual holding the same property. The Supreme Court rejected the test used by the Second Circuit that would have allowed a cost to be exempt from the 2-percent floor only if the cost “could not have been incurred” by an individual.
Building on this general test of costs that are “commonly or customarily” incurred by individuals, the regulations provide a number of examples of such costs.
Ownership Costs. In Reg. § 1.67-4(b)(2), the regulations provide that costs that are incurred “simply by reason of being the owner of the property” are subject to the 2-percent floor. These costs “include, but are not limited to,” certain fees that would be incurred by any owner, including condominium fees, insurance premiums, and maintenance and lawn service costs.
One might first note that these categories do not distinguish between subcategories of expenses that might be more typical of ownership by a fiduciary. For example, a fiduciary might feel a greater incentive to secure ample insurance for a given property, and a fiduciary also typically would need to pay for maintenance and lawn services, whereas individual owners might be able to perform such tasks themselves. However, these broad categories are consistent with the holding in Knight; in that case, the Supreme Court expressly rejected the trustee’s argument that costs should be deducted based on “causation” and fully deductible if required by the trustee’s fiduciary duties. Instead, and consistent with the Supreme Court’s holding in Knight, because these are costs that are commonly incurred by individuals, the regulations provide that they are all subject to the 2-percent floor.
Tax Preparation Fees. The regulations further provide in Reg. § 1.67-4(b)(3) that tax preparation fees included in an exclusive list are not subject to the 2-percent floor. The regulations provide that 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, whereas the costs of preparing “all other tax returns (for example, gift tax returns)” are subject to the 2-percent floor.
The regulations’ taxonomy of these categories is, on its face, clear, and at least simple and straightforward in application.
However, these categories may not hew closely to the rules articulated by Knight and by the statute.
As the American Bankers Association noted in its May 30, 2014, letter to the Commissioner of Internal Revenue, this expressly exhaustive list of returns that are not subject to the 2-percent floor appears to leave out at least two examples of tax-related expenses that would not be incurred if the property were not held in a trust or estate. First, the ABA notes that the list does not exempt the fiduciary’s work relating to tax payments or information reporting to a foreign government that imposes wealth and income taxes on foreign tax-resident beneficiaries of domestic trusts. Unless such costs related to foreign taxes would fit into the category of “all … estate tax returns,” then such costs would fall under “other tax returns” that do not fit into any specific category in the regulations, and such costs would apparently be subject to the 2-percent floor.
Second, the ABA also notes that the regulations expressly do not exempt from the 2-percent floor the preparation of gift tax returns, even though an executor’s duties may require the preparation and filing of past unfiled gift tax returns. It is true that an executor may also be required to file past, unfiled individual income tax returns as part of the executor’s duties, and yet those returns certainly would have been (or, perhaps, should have been) prepared by a hypothetical individual. Unlike most income tax returns, however, the failure to file gift tax returns that only use the donor’s unified credit and do not require the payment of gift tax usually does not result in penalties or interest, and the unique continuity of gift tax returns with the estate tax return makes it hard to understand different treatment for those returns.
Similarly, the list of returns that are not subject to the 2-percent floor may also be inconsistent with the principles underlying the statute. For example, a decedent’s final income tax return is expressly included in the regulation as a cost that is not subject to the 2-perceent floor. Still, such a return relates to an individual and presumably would be due for all individuals, even if no executor is appointed. It is not self-evident why all such returns would be exempt from the 2-percent floor, without some threshold determination of whether the preparation of that return related to the decedent’s estate or trust, even though final individual income tax returns typically involve splitting a calendar year and making one-time allocations between the decedent’s final return and the estate’s initial return. Indeed, a harsh view of this exception might have considered the fact that even a fiduciary income tax return often involves much of the same collection and presentation of information as an individual income tax return. Nevertheless, the rule that all fiduciary income tax returns and all final individual income tax returns are exempt from the 2-percent floor is appropriately favorable to taxpayers.
Investment Advisory Fees. Reg § 1.67-4(b)(4) provides guidance and examples related to “investment advisory fees” incurred by the estate or trust, and is already the subject of much discussion.
This subparagraph provides that fees for investment advice are typically subject to the 2-percent floor, but the regulations note that “certain incremental costs of investment advice beyond the amount that normally would be charged to an individual investor” are not subject to the 2-percent floor. The regulations provide that the amount of the fee that would be charged to the individual is subject to the 2-percent floor, while only the additional fee is not subject to the 2-percent floor.
The regulations give the following two scenarios in which such a “special, additional charge” would not be subject to the 2-percent floor: (i) a special, additional charge “added solely because the investment advice is rendered to a trust or estate,” or (ii) a special, additional charge “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.”
Taking the second category first, this requirement that the fees require “specialized” balancing has already sparked controversy. It is not clear why the regulations would refuse to recognize a trust or estate’s need for the “usual balancing” of interests between current and remainder beneficiaries. In a prior Alert regarding this language, we noted that “[t]he fact that the ‘ordinary taxpayer’ has no need for ‘balancing of the interests of various parties’ will not be lost on fiduciaries and commentators, who will notice that the bar has been subtly raised.”
Whatever its merits, this language in the regulations appears to be driven by the language of the Knight opinion. In that case, the trustee had engaged an investment advisor to comply with his fiduciary duties under Connecticut’s Uniform Prudent Investor Act, which required a trustee to follow the “prudent investor rule.” The Supreme Court first noted that the statute did not apply a different standard to trustees, in that it did not require a trustee to follow a “prudent trustee” rule. The Supreme Court further noted that in other cases, it is “conceivable” that a trust might “require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper” (emphasis added). Because the trust in Knight apparently required such balancing between different beneficial interests, as do most trusts with more than one beneficiary, the Supreme Court therefore implied that such balancing was not sufficiently “specialized” to cause the 2-percent floor to not apply.
One might justify this provision of the regulations by noting that a trustee’s need to invest to protect the interests of both current beneficiaries and remainder beneficiaries may be similar to the balancing of income generation and principal conservation. An investment strategy that balances income and principal is regularly recommended by an investment advisor, and thus it may not warrant any special treatment when undertaken for the express purpose of balancing the needs of two classes of beneficiaries.
This reference to “unusual” investment objectives and “specialized” balancing will therefore require substantial further consideration by fiduciaries and investment advisors.
As for the first category of this clause regarding investment advisory fees, which apparently allows for a full deduction if the charge is “added solely because the investment advice is rendered to a trust or estate,” it is unclear the extent to which the IRS would allow a full deduction of a fee merely because an investment advisory firm included such a fee on its itemized fee schedule for trusts and estates, and not for individuals. As noted above, the Supreme Court in Knight rejected a simple “causation” test, which would have exempted expenses from the 2-percent floor merely if they were incurred by a trustee in the course of the trustee’s duties. One imagines that the IRS would also be skeptical of a trustee’s attempt to serve its fiduciary clients by classifying a portion of its fee as required for trusts and estates.
Again, whatever its merits, this language was taken from the opinion in Knight. In that case, the Supreme Court noted that some trust-related investment advisory fees may be fully deductible “if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts,” but that in the case of Knight there was nothing to suggest that the advisor “charged the Trustee anything extra, or treated the Trust any differently than it would have treated an individual with similar objectives, because of the Trustee’s fiduciary obligations.”
It is conceivable, then, that the regulations would allow an investment firm’s automatic charge to a trust or estate to be not subject to the 2-percent floor. In fact, such a charge could be a stand-in for the need of the investment firm to balance the needs of income and remainder beneficiaries, even though a fee would not be fully deductible if it were cast in those terms, rather than as an automatic increase in the fee.
In any event, we will likely see fiduciaries develop a series of protocols for distinguishing between trusts with “usual” successive interests, and those with more sophisticated balancing needs that would be exempt from the 2-percent floor.
Appraisal Fees. Reg. § 1.67-4(b)(5), regarding the deductibility of expenses related to certain appraisals, again sets out an apparently exhaustive list of appraisals that would not be subject to the 2-percent floor, while any other appraisals are not exempted.
This clause provides that fees are not subject to the 2-percent floor if incurred to determine date of death values, to determine values for purposes of making distributions, or as otherwise required to prepare the estate or trust’s tax returns or generation-skipping transfer tax return.
Certain Fiduciary Fees. The regulations also exempt from the 2-percent floor certain minor fiduciary fees and costs, such as probate fees, fiduciary bond premiums and legal publication costs. These are found in Reg. § 1.67-4(b)(6).
Reg. § 1.67-4(c) provides a separate set of rules for estates and trusts that pay a single fee, commission or other expense that includes costs that would be subject to the 2-percent floor and costs that would not. This rule would apply not only to a fiduciary’s single commission for fiduciary services, but also to an attorney’s or accountant’s single fee for advice rendered to such fiduciary.
In the case of such a single fee, commission or other expense, such fee “must be allocated” between costs that are subject to the 2-percent floor and those that are not. The regulations allow any “reasonable” method for such allocation and include the following set of non-exclusive factors that “may” be considered in making such a reasonable allocation: (i) the percentage of the value of the corpus subject to investment advice; (ii) whether a third party advisor would have charged a comparable fee for similar advisory services; and (iii) the amount of the fiduciary’s attention to the trust or estate that is devoted to investment advice versus other fiduciary functions.
Notably, if a bundled fee is not computed on an hourly basis, then the regulations provide that only the portion of the fee that is “attributable to investment advice” is subject to the 2-percent floor, and the remaining portion is not. Curiously, because “out-of-pocket” payments to third parties for investment advice are strictly subject to the 2-percent floor under the regulations, the investment advice component the regulations appear to target is in effect advice that a trustee, presumably a corporate trustee, would give to itself. Although this anomaly in the proposed regulations was pointed out in specific public comments, the Treasury Department chose to stick with this idiom, and it would be hard to argue that its intent is not clear.
Reg. § 1.67-4(c)(2) states that in the case of a non-hourly bundled fee, investment advice is “subject” to the 2-percent floor, and the remainder is “not subject” to the 2-percent floor.
However, this unbundling of non-hourly fees probably also involves a second step. This reference to investment advice being “subject” to the 2-percent floor may only mean that the investment advice portion is “subject” to the rules in subsection (b) regarding applicability of the 2-percent floor. Thus, the fiduciary would unbundle the non-hourly fee in two steps: first, the fiduciary would separate investment from non-investment services, under Reg. § 1.67-4(c)(2), and would treat the non-investment services as not subject to the 2-percent floor; and second, the fiduciary would separate out that portion of the investment services that is “commonly or customarily” incurred by an individual, from that portion that is particular to a trust or estate, under Reg. § 1.67-4(b)(4), and would treat the portion that is particular to a trust or estate as also not subject to the 2-percent floor.
As has been stated by McGuireWoods LLP partner Ronald D. Aucutt to the IRS in Public Comments on Proposed 67(e) Regulations, subjecting estates and non-grantor trusts at all to the 2-percent floor is so contrary to the simplification Congress explicitly intended when it enacted section 67 that it seems misguided and imprudent. The final regulations remain detached from the statutory objectives and are disappointing. Yet, particularly with regard to the unbundling requirement, the writers of the regulations do not appear to have been oblivious to the vexing administrative burdens. Reg. § 1.67-4(c)(1) requires unbundling “except to the extent provided otherwise by guidance published in the Internal Revenue Bulletin.” This leaves the door open to the provision of expanded exceptions, safe harbors, or other relief that the writers might have sensed is needed but were not able to complete in time to give fiduciaries the almost eight months of time for implementation that the adjusted effective date provides, and it allows that relief to be published without the formality and delay of an amendment of the regulations.
The postponement of the applicability of these final regulations under section 67(e) will allow fiduciaries to begin to apply a single set of rules to deductions for trusts and estates on January 1, 2015. As noted above, it is no easy task to develop the best protocols for determining which costs will be subject to the 2-percent floor and which costs will not, and for determining how to unbundle and allocate fees between the two. In particular, fiduciaries will continue to spend the latter half of 2014 developing procedures to determine how best to address investment-related expenses, whether or not those expenses are bundled into unitary fees.