This one sounds tedious, but it's pretty significant for many wealthy taxpayers and those who advise them. If you as an individual claim certain miscellaneous itemized deductions you have to first reduce them by 2% of your adjusted gross income ("AGI"). IRC Sec. 67(a). Uncertainty has plagued the application of this limitation to expenses incurred by trusts. A key issue was whether trust investment management fees, which can be substantial, were subject to this reduction. Expenses subject to the 2% reduction are not only limited for purposes of the income tax, but they are subject to the alternative minimum tax (AMT) which can eliminate any deduction. Understanding these rules is important for trustees, beneficiaries, and those advising trusts (money managers, accountants, attorneys). The history is a bit sordid so we'll wind you through it.
Code Section 67(a) provides that an individual can claim miscellaneous itemized deductions for any tax year only to the extent that the deductions exceed 2% of AGI. These deductions are defined as any deduction other than certain enumerated deductions such as interest (IRC Sec. 163), taxes (IRC Sec. 164), casualty and theft losses (IRC Sec. 165), Contributions (IRC Sec. 170), medical and dental expenses (IRC Sec. 213) and so on. Since trusts and estates are generally taxed by applying the paradigm of individual income taxation, these rules have to be applied to trusts and estates. IRC Sec. 67(e) addresses this by stating that the AGI of an estate or trust shall be computed in the same manner as in the case of an individual, 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…" This last phrase has spawned a lot of confusion and controversy.
This issue has been hotly contested by the IRS. The 6th Circuit held investment advisory fees deductible without the 2% reduction. O'Neill, 994 F2d. 302. The Federal and 4th Circuits held that the reduction applied. Mellon Bank, 265 F.3d 1275, Scott, 328 F3d 132, and Rudkin 467 F3d 149.
The Treasury department, while the Supreme Court case in Knight (see below) was pending, issued proposed regulations. Prop. Reg. § 1.67-4. These classify costs which were not "unique" to a trust as being subject to the 2% floor. "Unique" to a trust meant costs that could not have been incurred by an individual property owner. If you don't see the word "unique" in the law above, and you read the law as containing the phrase "would not" instead of "could not" as the Regs provide, well you're starting to understand the confusion and frustration. The Regs also require Trustees to unbundle aggregated fees. If a trustee pays a lawyer or financial planner for several services, including those that are unique, and those that aren't, analysis of those fees is required. The IRS posited that judicial accountings, the cost of preparing a trust income tax return, the fee for a trustee bond, etc. are unique and hence fully deductible. The costs incurred regarding the custody or management of trust property, or investing trust assets for total return, are not considered "unique". These regulations will have to be modified in light of the Supreme Court's holding in Knight.
Supreme Court Has the Last Word (not really).
The Supreme Court recently ruled in the case Knight v. Commissioner, 552 U.S. ___, 128 S. Ct 782 (Jan. 16, 2008), that trust investment management fees are subject to this 2% reduction applicable to itemized deductions. The Court interpreted the phrase "which would not have been incurred if the property were not held in such trust" as requiring an inquiry as to whether the particular cost "would customarily" be incurred by an individual. Effectively the trustee must ask the following theoretical question of every cost: "Would this cost have been commonly or customarily incurred had the property been held by an individual and not in this trust?" In making this theoretical determination the trustee should consider custom, habit, natural disposition or probability. If the cost would be uncommon, or unusual for an individual to incur, the trust could deduct it in full without regard to the 2% floor. If the trustee can demonstrate that a particular cost was incremental to the cost and individual would have customarily incurred, then that excess can be deducted without regard to the 2% floor. For example, if an investment adviser charged a supplemental fee to trust accounts, that would be fully deductible. For many costs this would be the accounting equivalent of splitting the dead sea. Similarly, if a trust had an unusual investment objective, or requires the special balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper, it would be deducible in full. Fiduciaries will have to determine which costs are subject to this restriction. This may require breaking certain aggregate fees and costs into their components in order to make the appropriate allocation to determine deductions. After all the paperwork, little may be deductible without being subjected to the 2% floor, which will likely eliminate any deductions. bundled costs after that date will have to be divided based on the Supreme Court's standard set forth in Knight.
The IRS recently issues Notice 2008-32 to provide guidance on how trust deductions should be handled in light of the Regs and cases discussed above. The IRS will issue new Regs consistent with the Knight case. The revised Regs will eliminate the concept of "unique" and apply the Supreme Court sanctioned paradigm discussed above. These Regs will also have to guide trustees on how to parse aggregate or bundled fees which include in a single amount costs which would be incurred by an individual and costs which are uncommon or unusual for an individual to incur. For tax years prior to 2008 trustees will be permitted to deduct in their entirety bundled fees. Bundled costs will be deductible for 2007 without allocation. Implicit in the ability to claim this deduction is that the costs are bundled, i.e., that they include deductible components which are uncommon for an individual to incur, as well as non-deductible components, e.g., investment management fees. This means investment management fees that do not include some amount for services would not be deductible in 2007. If your trust return is on extension, you'll still need to figure this out. If you filed, you might want to review the position your accountant took in this regard. (5) Fees paid to third parties, such as advisory fees, are to be treated separately from bundled fees (that means that if they don't meet the Supreme Court test they are not deductible even in 2007.
Tax Practitioner Comments to the IRS.
Tax practitioners are submitting comments to the IRS suggesting methods of addressing these issues in the new set of regulations. Recommendations include specifying that certain types of costs, such as tax return preparation, not have to be parsed into costs commonly incurred by individuals and those that are not; that as a safe-harbor taxpayers can choose to elect a reduction in the 2% floor amount in lieu of engaging in more complex accounting; safe-harbor amounts that can be deducted without having to resort to more detailed analysis (e.g., any otherwise qualifying deduction under $X can be deducted without regard to the 2% floor), etc. While most of the proposals seek to create certainty and avoid costly and administratively burdensome accounting, the sheer details of the issues involved leaves even the most taxpayer favorable recommendations (and there is no assurance that the IRS will even buy into those) pretty daunting for accountants and other professionals.
Splitting Cost Hairs.
These rules may ultimately require investment managers, accountants, attorneys and others providing services to trusts to allocate their fees into the two categories. Separate charges may have to be made for custody, investment management, trust distributions, communication with beneficiaries, etc. For some institutional trustees, the fee they charge for a directed trust for which they provide no investment management advice, may be a touchstone for determining the quantum of fees that are properly allocable to non-investment services. Although this seems a logical calculation none of the authorities or comments address it.
The issue of trusts deducting various fees was seemingly resolved by the Supreme Court in Knight, but the issues, planning and administrative burdens have yet to be known.
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