Under IRC Section 67, miscellaneous itemized deductions are allowed only to the extent that they exceed 2% of a taxpayer’s adjusted gross income. In general, an estate or trust is subject to these rules in the same manner as an individual taxpayer. However, IRC § 67(e)(1) contains an exception for costs paid or incurred in connection with the administration of an estate or trust that would not have been incurred if the property was not held in an estate or trust. Such amounts are not subject to the 2% floor of IRC § 67.
In 1992, the Tax Court held in O’Neill v. Commissioner that investment counseling fees paid by an estate or trust were subject to the 2% floor because individuals can incur these same costs in the same manner as an estate or trust. The following year, the Sixth Circuit reversed the Tax Court's decision, holding that the fiduciary duties of an executor or trustee distinguished him or her from other individuals. In subsequent litigation, a number of other circuits adopted the Tax Court’s approach. We previously reported (Vol. I, No. 3, December, 2006) on the Rudkin case, where the Second Circuit held that fees for investment management are subject to the 2% floor. The Rudkin case is now pending before the United States Supreme Court and should be resolved during this term.
In July, the IRS issued proposed regulations to address the matter. The regulations provide that in order for a cost to be eligible for the exception of IRC § 67(e)(1), it must be unique to an estate or trust, which means it must be the type of cost that an individual could not have incurred if the same property was held outside of an estate or trust. The most common of these costs is trustee’s fees. One strategy that was being used to avoid the 2% floor problem was the bundling of investment advisory fees and trustee’s fees into a single fee and claiming it was a trustee’s fee eligible for the IRC § 67(e)(l) exception. The proposed regulations require that where a single trustees’ fee is paid that includes services for investment advice, a reasonable allocation of the bundled fee must be made and the portion of the fee attributable to investment advice subject to the 2% of AGI Floor.
The proposed regulations also provide specific examples of services that either do or do not qualify for the exemption. Qualifying services include costs of fiduciary accountings, judicial or quasi-judicial filings required as part of the administration of the estate or trust, preparation of fiduciary income tax and estate tax returns, the division or distribution of income or corpus to or among the beneficiaries, fees incurred for trust or will contests or constructions, fiduciary bond premiums and communications with beneficiaries regarding estate or trust matters. Services that do not qualify for the exception include fees for the custody or management of property, advice on investing, preparation of gift tax returns, defense of claims by creditors of the decedent or trust grantor and the purchase, sale, maintenance, repair, insurance or management of non-trade or business property. The proposed regulations are not effective until they are finalized by the IRS, although the treatment of investment management fees will likely be resolved by the Supreme Court before that occurs.