On September 6, 2011, the Internal Revenue Service withdrew four-year-old proposed regulations and released new proposed regulations to address the treatment of expenses of estates and non-grantor trusts under the “2% floor” applicable to “miscellaneous itemized deductions” under section 67 of the Internal Revenue Code.
Section 67 was enacted 25 years ago to limit an individual’s miscellaneous itemized deductions to 2% of the individual’s adjusted gross income. Section 67(e) provides that for this purpose “the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual” and that the 2% floor does not apply to “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.” This exception has been the subject of several litigated cases, including Michael J. Knight, Trustee v. Commissioner, 552 U.S. 181 (2008), in which a unanimous Supreme Court held that trust investment advisory fees are generally subject to the 2% floor.
While the Knight case was pending in the Supreme Court, the IRS published tough proposed regulations, providing, among other things, that when a trust pays a single or unitary fee that includes both services that are subject to the 2% floor and services that are not, the trustee must “unbundle” that fee to determine the portion that is subject to the 2% floor and the portion that is fully deductible. From year to year, the IRS published notices relieving trustees of the unbundling requirement, culminating in Notice 2011-37, which extended the no-unbundling pronouncements to fiduciary income tax returns for all taxable years beginning before the date on which final regulations on the subject are published.
New Proposed Regulations
The September 6, 2011, Notice of Proposed Rulemaking summarizes the relevant history, including the periods of public comment, and concludes: “Many of the comments recommended that the proposed regulations be withdrawn and that new proposed regulations be issued to allow the public to comment on the impact of the Knight, 76 Fed.Reg. 55322 (Sept. 7, 2011), decision on the regulations to be issued under section 67(e). After consideration of all of the comments received since the issuance of the proposed regulations, the proposed regulations published on July 27, 2007, are withdrawn and this document contains new proposed regulations.”
Certain Largely Bright-Line Categories of Expenses
The new proposed regulations, in Proposed Reg. § 1.67-4(a), would provide that a miscellaneous itemized deduction of an estate or non-grantor trust is subject to the 2% floor if it “commonly or customarily would be incurred by a hypothetical individual holding the same property.” Examples, in Proposed Reg. § 1.67-4(b)(1), are “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.” Other examples, in Proposed Reg. § 1.67-4(b)(2), are “ownership costs” that attach to a particular asset, 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.”
Under Proposed Reg. § 1.67-4(b)(3), the costs of preparing tax returns would be characterized with reference to the type of return. The costs of individual income tax and gift tax returns, as well as tax returns for a sole proprietorship or a retirement plan, are generally viewed as “costs commonly and customarily incurred by individuals and thus … subject to the 2-percent floor.” But the costs of returns that by their nature are filed only by executors or trustees are not subject to the 2% floor, including estate and GST tax returns and fiduciary income tax returns, of course, but also including, sensibly, a decedent’s final income tax return.
Lingering Focus on Investment Advice
While the foregoing examples draw fairly objective lines and should be relatively noncontroversial, the proposed regulations become more vague and potentially more burdensome when they address investment advisory fees and unbundling of unitary fees. In an assertion likely to draw criticism, Proposed Reg. § 1.67-4(b)(4) states that “[f]ees for investment advice … are incurred commonly or customarily by a hypothetical individual investor.” Thus, the cost of investment advice would continue to be subject to the 2% floor, just as courts have recently held.
There is an exception for “special” investment advice “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).” This represents an enterprising adaptation of a similar acknowledgment in the last paragraph of the Supreme Court’s Knight opinion, in which the formulation was “the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer.” The 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. Nevertheless, if these proposed regulations move toward final approval, fiduciaries will be well advised to review both the ordinary and extraordinary contexts they encounter for balancing the interests of their beneficiaries and to develop protocols for distinguishing between trusts with “usual” successive interests and those with more sophisticated balancing needs.
Unbundling Single Fiduciary Fees
In a bad-news-good-news result, Proposed Reg. § 1.67-4(c)(1) would also retain the requirement for single fees to be “unbundled” into components that are subject to the 2% floor and components that are not; that is the bad news. The good news is that, under Proposed Reg. § 1.67-4(c)(2), if the fee “is not computed on an hourly basis,” only the investment advice component would have to be unbundled, by “[a]ny reasonable method.” Payments made out of the bundled fee to third parties, or fees assessed on top of the bundled fee, for services subject to the 2% floor would also have to be accounted for separately, but presumably such amounts would be determined by the bright-line tests described above and would not have to be subjectively apportioned.
Public Comment and Hearing and Effective Date
The Notice of Proposed Rulemaking invites public comments by early December and announces a public hearing scheduled for December 19, 2011. Proposed Reg. § 1.67-4(d) provides that the regulations will apply to taxable years beginning on or after the date that the final regulations are published in the Federal Register. Because that means that there is no practical prospect of final regulations before 2012, trustees of calendar-year trusts should not be required to unbundle their fees before 2013 or to reflect that unbundling earlier than the income tax returns filed in 2014.
In sum, although the regulations still have a way to go to be final, fiduciaries should begin to anticipate the following:
- Except for investment advisory costs, the costs incurred by an estate or trust that are subject to the 2% floor should be objectively determined in a largely common-sense manner. There is no apparent search for new types of subjective costs comparable to investment advisory costs.
- If not already in use, conversion to unitary fees and flat fees may increase the income-tax efficiency of some trusts. This may be true of individual fiduciaries, not just institutional fiduciaries, and of other professionals who advise fiduciaries.
- While absorption of some costs in-house might support larger income tax deductions than payments to subcontractors and other third-party vendors, overall fairness to clients and customers might suggest a greater bundled fiduciary fee in such a case, and the increment is likely to be treated as a special assessment subject to the 2% floor anyway. Thus, decisions about obtaining services outside or providing those services in-house are likely to continue to be based largely on business judgments rather than tax considerations.
- In a trust where the competing interests of beneficiaries are uncommonly complex, but the bundled fee is the same, a smaller portion of that fee may be allocated to the costs of investment advice subject to the 2% floor. If the fee increases for that reason, the increment should not be subject to the 2% floor.
- For calendar-year trusts, unbundling is very unlikely to be required before 2013 in any event, because the final regulations are likely to be issued in 2012 at the earliest.