Application of the 2-percent floor to trust and estate expenses
INSIGHT ARTICLE |
Though the IRS issued the final regulations for section 67 in May 2014 to require the unbundling of a fiduciary's integrated fee, corporate fiduciaries and tax planners continue to struggle with designing and implementing procedures to ensure that the directive is properly accounted for on returns during the upcoming tax filing season. While the unbundling directive has captured the headlines, other components of the regulations must be understood and adhered to as well. These regulations, which are essentially unchanged from the much maligned proposed regulations first issued in 2007, govern trust and estate costs subject to the 2-percent floor on miscellaneous itemized deductions. The regulations apply to tax years beginning on or after Jan. 1, 2015. While most corporate fiduciaries have moved on to the task of applying the regulations to their trusts and estates, some commentators still contend that the regulations misinterpret the U.S. Supreme Court decision in Knight v. CIR, 552 US 181, 128 S. Ct. 782 (2008), and should be challenged.
For high-net-worth individuals, estates and trusts, the stakes are high. Many of these trusts and estates are subject to the alternative minimum tax (AMT). The AMT regime consists of an alternative set of rules for calculating income tax that eliminates many deductions and credits, thus potentially increasing the tax liability. Miscellaneous itemized deductions are disallowed for purposes of computing an AMT liability (section 56(b)(1)(A)(i)). Trusts with an AMT liability are unable to deduct any investment advisory fees paid, regardless of whether the fees exceed the 2-percent floor. The regulations also impact the calculation of net investment income subject to the 3.8 percent Medicare surtax, which is assessed on the lesser of the trust or estate's undistributed net investment income and the trust or estate's adjusted gross income (AGI) in excess of $12,300 (for 2015).
The most contentious aspect of the final regulations is the requirement that investment advisory fees must be unbundled so as to segregate costs that are "commonly" or "customarily" incurred by an individual from the costs that are not commonly or customarily incurred by an individual and, thus, fully deductible. Reg. section 1.67-4(b)(4) tracks the further exception carved out by the Court in Knight and provides that additional fees attributable to "an unusual investment objective or the need for a specialized balancing of the interests of the various parties (beyond the usual balancing of the varying interests of the current beneficiaries and remaindermen) such that a reasonable comparison with individual investors would be improper" are not subject to the 2-percent floor. Applying this vague standard has proved difficult for fiduciaries, investment advisors and tax return preparers, who are eager to develop a methodology that would produce a generally applicable safe harbor.
Under section 67(a), miscellaneous itemized deductions may be deducted, but only to the extent the deductions exceed 2 percent of AGI. Subsection (e) applies the same rule to estates and trusts except that "the deductions for 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" are allowed in full. A two-part test evolved from Congress' language. Part one asks whether the expense was incurred during the administration of a trust or estate, and part two asks whether the expense would have been incurred if the property rights involved were not held in such trust or estate. The second prong triggered substantial litigation, and ultimately, the U.S. Supreme Court weighed in and ruled in Knight that "Section 67(e)(1) excepts from the 2-percent floor only those costs that it would be uncommon or unusual for such a hypothetical individual to incur." Since the Court's analysis employed malleable terms like "uncommon," the debate over the proper interpretation of the second prong has raged on. In 2011, the Treasury issued proposed regulations. Despite receiving caustic and detailed criticism from commentators, including the American College of Trust and Estate Counsel and the American Institute of Certified Public Accountants, these regulations were adopted largely intact on May 9, 2014.
As discussed above, the regulations provide that a cost is subject to the 2-percent floor to the extent that it is a cost commonly or customarily incurred by a hypothetical individual. The regulations offer specific guidance on how ownership costs, tax preparation fees, investment advisory fees, appraisal fees, fiduciary expenses and bundled fees should be treated.
The final regulations require companies that provide investment advisory fees to divide-or unbundle-their fees into an amount that an individual hiring an investment advisor would incur and the amount allocable to the performance of the fiduciary services other than the investment management component of the fee. The fees incurred as a result of probate proceedings, accounting for income and principal, processing receipts, evaluating tax elections, meetings with the executor and family members, dealing with beneficiaries in creating separate trusts or trust shares, calculating and making distributions, heirship and similar administrative expenses are fully deductible.
In the Knight opinion, the U.S. Supreme Court acknowledged the difficulty inherent in applying the statute. In explaining its interpretation, the Court acknowledged that a trust could have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison to individual investors would be improper. The Court recognized that there are trusts with such demanding administrative complexities and provisions that the bundled fee would be fully deductible. While this quote was incorporated into the final regulations, it is unclear at this point whether the IRS is prepared to embrace fully the sentiment behind the Court's analysis. It is also unclear what type of record or trust language would be needed to fall within this addendum to the general rule regarding investment advisory fees.
The regulations go on to provide that "any reasonable method may be used to allocate a bundled fee between those costs that are subject to the 2-percent floor and those costs that are not." The reasonable method can account for "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." This methodology looks to divide and track the fiduciary's time and effort-an undertaking that banks and trust companies are loathe to undertake. This misses the U.S. Supreme Court's point. Trusts quite often have beneficiaries in different generations and circumstances or complex family business assets that require an investment policy geared toward balancing the interests and tax attributes. It is incumbent on trustees under the duties of loyalty and impartiality to account for all of the moving parts involved in trust administration. By definition, this requires investment advice that is different than what an individual commonly needs. The bottom line of these regulations is that all time spent on trust and beneficiary matters will have to be accounted for-and justified-as distinct from time spent on services commonly offered to individuals.
Two additional examples of reasonable allocation methods are provided in the regulations. One method involves assessing the trust's assets and allocating the fiduciary investment advisor fees only to the percentage of assets subject to actual investment advice. Many trusts hold special assets, including real estate, farmland and family business assets. Since investment advice is not provided for special assets, the investment advice is attributable to a smaller percentage of the trust's total assets, and more of the fiduciary fee is fully deductible. The value of the special assets is essentially backed out of the value of the assets subject to the investment advisory fees. For example, assume 50 percent of the value of the trust corpus is farmland subject to a lease and additional investment real estate. Assuming that the fiduciary has done a cost analysis of how its fees generally divide between trust services and investment services and the data shows that 40 percent of its integrated fee is fully deductible, the fully deductible portion of the fiduciary fee would be 70 percent.
The final reasonable method articulated by the Treasury and the IRS centers on the bank or trust company's fee structure. In many states, including Illinois, Wisconsin, Nevada, Delaware and Florida, a trustee can be directed by an investment advisor. The directed trustee performs all the functions of a trustee, except investment management, and the fee structure reflects a reduction accordingly. Under this methodology, an amount equal to the directed trustee's fee should be fully deductible, and only the difference between the directed trustee's fee and the full trustee's fee (presumably representing the value of the investment management services) should be subject to the 2-percent floor.
The problem with this methodology is that the business model is such that many institutions charge nearly as much for investment advice as they do for acting as trustee. This may evolve as institutions begin to more closely align their cost structures with their fee structures in order to more easily implement the unbundling directive. Fee structures will likely change to more fully describe the component parts in order to justify safe harbor allocations established by the bank or trust company. Corporate fiduciaries are looking at job descriptions, staffing and internal tax and accounting personnel to understand their cost structures and unbundle fees.
Ultimately, it is likely that software to track the time and effort expended by trust officers will be developed and implemented. In the meantime, smaller trust companies are likely to adopt the IRS' recommendation and unbundle based on a comparison of fees and fully deduct only the differential between what the company charges to manage an individual's investment account and what it charges to act as trustee. For small trusts, the additional expense of precisely allocating the fiduciary fee as opposed to computing a safe harbor based on the institution's fee structure is probably not justified in many cases. But for larger trusts, and certainly for AMT trusts, using the fee differential will likely produce a smaller deduction than a methodology that fully accounts for the role of the trust officer in administering the trust. In the terms used in the regulation, the institution must internally account for the portion of the fees attributable to "dealings with beneficiaries and distribution decisions and other fiduciary functions," which are fully deductible.
Compliance with the new regulations is imperative for the preparers of Forms 1041. At this point, the IRS has not amended the instructions to Form 1041 to assist preparers. The starting point for preparers and tax advisors would be to consult with the fiduciary or investment advisor, and request documentation from the fiduciary of the time spent-or portion of a wrap fee-that is attributable to the trust administration activities other than those associated with the traditional investment advisory component.
Ideally, the methodology adopted by the corporate fiduciary would account for the different nature of the trusts under management. Indeed, the regulations provide that there is no duty of consistency for the methodology from trust to trust. For example, an insurance trust or a minor's trust, where administration is largely investment-related until the trigger event (death of the insured or the minor attaining age 21), consumes far less fiduciary time and effort than a trust with beneficiaries who disagree with the trustee over distribution policies or fiduciary accounting methodologies.
Clearly, fiduciary services relating to estate administration should be separately tracked by corporate fiduciaries because typically such services require intensive trustee work but only moderate investment advice. This is especially true where the corporate fiduciary is acting as the executor of the estate.
Other components of the regulations
Throughout the three versions of these regulations, the Treasury and the IRS have provided nonexclusive listings of expenses that fall on one side or the other of the 2-percent rule. When compared to the commonly or customarily incurred by an individual test, these demarcations appear arbitrary in some cases. Nonetheless, these are the guidelines to be used for preparing Forms 1041.
Litigation expenses-Under Reg. section 1.67-4(b)(1), costs incurred in defending a claim against the trust or estate would be fully deductible as long as the lawsuit involved the existence, validity or administration of the estate or trust. This presumably would include all lawsuits against all estates and trusts-whether in domestic relations, probate or chancery courts. It is hard to see what line the IRS is attempting to draw since administration is a very expansive term.
Ownership costs-These are the costs, such as insurance premiums, maintenance fees and property fees, incurred by an owner of property. Since these costs are customarily incurred by individuals, they are subject to the 2-percent limitation. However, these costs may be deductible under other Code sections. For example, real estate taxes are generally deductible by a trust or estate under section 164.
Tax preparation fees-The final regulations provide that the costs associated with preparing all estate tax returns, fiduciary income tax returns and the decedent's final income tax return are not subject to the 2-percent limitation, but the expense of preparing gift tax returns and FBARS, which are commonly prepared for individuals, would be subject to the 2-percent floor.
Appraisal fees-Appraisal fees incurred (1) to prepare the Form 706, (2) for any estate settlement reason, (3) for determining fair market value of an asset at date of death, or (4) for making trust distributions are fully deductible under the final regulations.
Probate expenses-Probate costs, including all court costs, are not subject to the 2-percent floor.
Some commentators who have followed the jurisprudence of section 67(e) believe that the final regulations are the end of the saga. However, it seems significant unanswered questions remain about how the regulations will be interpreted and applied. Given that the Knight case did not explicitly create a mandate to unbundle fees and that the internal cost structure of banks and trust companies is not based on charging for every trustee service from trust creation to termination, there are bound to be further disagreements between the IRS and corporate fiduciaries. There is also a lot of work to be done educating trust beneficiaries regarding the new regulations and the deductions they will lose once the regulations are implemented.