Practitioners have been waiting patiently, and with some
trepidation, for the IRS to issue final regulations on which costs,
incurred by estates or nongrantor trusts, are subject to the 2%
floor for miscellaneous itemized deductions.
Here is a summary of changes included in final regulations,
issued May 9, 2014:
• Unbundling of fiduciary fees using any reasonable method.
The IRS also provided additional guidance through
nonexclusive factors that should be considered in making the
• An exclusive list of tax return preparation costs not
subject to the 2% floor (meaning that any other tax return
preparation cost is subject to the 2% floor);
• Certain appraisal fees incurred by an estate or nongrantor
trust are not subject to the 2% floor. These include appraisals
needed to determine value as of the decedent's date of death (or
the alternate valuation date), to determine value for making
distributions, or as otherwise required to properly prepare the
estate's or trust's tax returns;
• Includes nonexclusive examples of fiduciary expenses that
are not commonly or customarily incurred by individuals;
• Removed the reference to costs that do not depend on the
"identity of the payor";
• Revised the examples to clarify which items are fully
deductible and are not subject to the 2% floor. These included real
estate taxes, costs incurred in connection with a trade or business
or for the production of rents or royalties, and certain
partnership costs; and
• Removed an example illustrating a type of expense that is
separately assessed as an additional fee charged by the fiduciary
for managing rental real estate owned by the estate or nongrantor
trust because the example fee is fully deductible under other tax
Before the Supreme Court's decision in Knight, the question of
whether investment advice given to a trust was considered to be a
"miscellaneous itemized deduction" subject to the 2% floor depended
on which circuit the taxpayer was in. The Tax Court had held that
the 2% floor did apply but was reversed by the Sixth Circuit.
O'Neill Irrevocable Trust v. Commissioner
, 98 T.C. 227
rev'd, 994 F.2d 302
(6th Cir. 1993), nonacq., 1994-2 C.B. 1. Other
circuit courts disagreed with the Sixth Circuit, including the
Fourth Circuit in Scott v. United States
, 328 F.3d 132
2003), the Federal Circuit in Mellon Bank, N.A. v. United States
265 F.3d 1275
(Fed. Cir. 2001), and the Second Circuit in the previous Knight
(William L. Rudkin Testamentary Trust v. Commissioner
, 467 F.3d 149
(2d Cir. 2006), which all held that the 2% floor did apply.
Although affirming the Second Circuit's decision in Knight
the Supreme Court applied a different test than the one created by
the Second Circuit, which held that §67(e)(1)
, in no uncertain
terms, only exempted from the §67(a)
2% floor those costs incurred
by a trust that could not have been incurred if an individual held
the property. The Supreme Court held that the correct
interpretation of the language found in §67(e)
requires making a
prediction based on what would customarily or commonly occur if an
individual held the trust or estate property. Those expenses
customarily or commonly incurred by individuals would be subject to
the 2% floor; those expenses not customarily or commonly incurred
by individuals would be fully deductible.
Before the Supreme Court's decision in 2008, the IRS used the
Second Circuit's more stringent test in proposed regulations. See
, 72 Fed. Reg. 41243 (7/27/07). The IRS issued
interim guidance through Notice 2008-32
for bundled fiduciary fees
after Knight. Notice 2008-32 and its progeny of superseding
notices allowed taxpayers to avoid unbundling fiduciaries until
final regulations were issued.
In 2011, the IRS withdrew the 2007 proposed regulations and
issued revised proposed regulations that would conform to Knight
and provide guidance on which estate or nongrantor trust costs are
subject to the 2% floor. See Prop. Regs. §1.67-4; REG-128224-06
Fed. Reg. 55322 (9/7/11). The substituted proposed regulations
would specify that investment advisory fees incurred by estates and
nongrantor trusts are costs commonly or customarily incurred by
individuals and, thus, are subject to the 2% floor. Prop. Regs.
. Investment advisory fees subject to the 2% floor
would include fees for related services that would be provided to
an individual investor as part of an investment advisory fee but
would exclude certain incremental costs of investment advice beyond
the amount normally charged to an individual investor. Id. The
proposed regulations would also explain the treatment of bundled
fiduciary fees that include investment advisory fees. Prop. Regs.
. (For further discussion of the proposed regulations, see Tax Practice Series ¶6120
: Estate and Trust Income Taxation — General Rules.)
The IRS adopted the proposed regulations with only minor modifications.
Under the final regulations, the following costs are subject to the 2% floor:
• Costs that are commonly or customarily incurred by a hypothetical individual owning the same property as that owned by the estate or nongrantor trust;
• Costs incurred solely because the trust or estate is the owner of an asset (this does not include partnership costs passed through to the partners); and
• Investment advisory fees are generally subject to the 2% floor. However, fees exceeding the fees generally charged to an individual investor and the excess attributable to an identifiable feature or part of the service that unique to the estate or nongrantor trust.
The following costs are not subject to the 2% floor:
• Tax return preparation costs for estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent’s final individual income tax return. However, all other tax returns (including gift tax returns) are subject to the 2% floor;
• Appraisal costs for determining date of death value (or the alternate valuation date value), for valuation of distributions, or if a valuation is required for preparing the estate’s or nongrantor trust’s tax returns;
• Certain fiduciary expenses such as probate fees, fiduciary bond premiums, legal publication and notification costs, costs of certified copies of death certificates, and costs related to fiduciary accounts;
• Bundled fees that are charged on an hourly basis must be allocated between the services subject to the 2% floor and those that are not. For bundled fees that are charged on other than on an hourly basis, only the part of the fee that is attributable to investment advice is subject to the 2% floor. The final regulations provide that any reasonable method may be used to allocate a bundled fee. Facts that may be considered in determining whether an allocation is reasonable include, but are not limited to: (1) the percentage of the value of the corpus subject to investment advice; (2) whether a third-party advisor would have charged a comparable fee for similar advisory services; and (3) the amount of the fiduciary’s attention to the trust or estate that is devoted to investment advice as compared to other fiduciary functions.
• Out-of-pocket expenses billed separately from the bundled fee are considered a separate cost subject to its own analysis. Charges paid to third parties from the bundled fee that would have been subject to the 2% floor had they been paid directly from trust or estate funds must be separated from the bundled fee and are subject to the 2% floor. Fees that are separately charged by the executor or trustee in addition to the normal bundled fee are treated as separate costs. These charges will need to be analyzed on their own merits using the criteria outlined in the final regulations.
• One item that was not covered in the preamble to the final regulations was the addition of the final sentence in (b)(4). The new sentence specifically limits the amount of the investment advisory fees not subject to the 2% floor. This amount represents an incremental cost that is a special, additional charge added solely because the investment advice given to a nongrantor trust or estate, or attributable to an unusual investment objective or need for specialized balancing of interests unique to a nongrantor trust or estate. It does this by stating that such a fee is limited to the difference between the fees normally charged to an individual investor and the actual fee charged to the nongrantor trust or estate, normally a percentage of the corpus value. Thus, a trust company that might consider creating two separate fee schedules, one for individuals and one for estates and nongrantor trusts, may find that charging different fees for the same work will not result in recharacterization of the fees as solely because the advice is for an estate or trust. The executor or trustee may instead have to either explain the difference in the charges for similar services, or justify those differences.
• The regulations provide an exception for bundled fees not calculated on an hourly basis, subjecting only the fees attributable to investment advice to the 2% floor. However, there is nothing further to indicate that the nongrantor trust or estate unique expenses, which should be exempt from the 2% floor, will be fully deductible, as required by the Knight decision.
This ‘take back’ of full exemption for nongrantor trust and estate specific charges is bolstered by the preamble’s discussion, noting that the unbundling except will be limited to (i) amounts allocable to investment advice, (ii) amounts of bundled fees paid to third parties already subject to the 2% floor, and (iii) separately billed amounts that are common and customary for individuals.
Thus, the IRS is offering a financial incentive for fiduciaries to unbundle their fees while at the same time charging a ‘convenience fee’ for not fully accounting for charges. It remains to be seen if the courts will accept this application of the Knight decision.
• Finally, there is nothing in the regulations indicating what the IRS might do with fees that change radically from year to year because of market changes, asset changes, changes in phases of the trust itself, or using different methods to separate the investment advisory fees. While the change may be justifiable in light of changed circumstances, the IRS has not indicated when such a change may become troublesome.
The allocation of bundled fees will present the most difficulty to practitioners, especially corporate trustees. While the IRS attempted to provide some guidance through ‘any reasonable method’ of allocation, unique assets, advice on the change of the trust asset composition and opaque, flat-fee billing could present special problems for trustees attempting to properly unbundle fees.
Full service, corporate trustees bear the brunt of the burden under the final regulations. Since their fees are often a percentage of the corpus assets, unbundling those fees will focus attention on what work created those fees, and how to describe those services.
A corporate trustee holds various business partnership interests and securities in trust. The trust instrument states detailed goals for the trust, including a specific level of income for the beneficiaries with an inflation adjustment that allows retaining income or corpus distribution as necessary to meet those beneficiary income amounts, as well as a directive to preserve the trust corpus if possible for later income generation. There are also spendthrift provisions in the trust that apply to several of the beneficiaries, and others requesting deferral or disclaimer of their quarterly distributions. In addition, there are corpus distributions allocated in the future for minor beneficiaries. The corporate trustee has limited, but active, input in the partnerships, and provides all investment advice and decisions for its security holdings. The trustee provides all distribution services and prepares the tax returns for the trust. The trust is subject to a flat fee to the trustee for the services rendered, based on a combination of the corpus value and the total distributions.
Issues Facing Trustee:
The best approach would appear to be to focus on the trees, and not the forest.
This example is obviously a bundles fee. The facts provided do not have any charges either separate from the bundled fee or paid from the bundled fee, so that these are not deducted from the bundled fees and subjected to the 2% floor. The only tree left standing is the investment advisory fee. However, what are the services provided for which the fee was charged? There are actually two-the advice on the securities investment and, potentially, a portion of the advice or activity in the partnerships. (See, e.g., Silver v. Commissioner
, T.C. Memo 1982-326
(advice on interests in several partnerships regarded as investment advice)). Regs. §1.67-1T(a)(1)(ii)
is broad in its reach into expenses for the production of income, under which investment advisory fees fall. These are the fees applicable to individuals, and which, because they are applicable to individuals, are also subject to the 2% floor for nongrantor trusts and estates. Thus, the charges for working within the partnership (this does not include the business deductions that pass through from the partnerships) would also be subject to the 2% floor.
The 2% floor could also apply if the fees were bundled, but charged on an hourly basis. While the trust could argue that the investment advisory fees are unique to trusts and estates in addressing balancing the needs for income, an individual with a growing family may also have the same specific goals with her investments if she plans to meet both the growing current household expenses and send her children to college. In addition, the administrative fees buried in the bundled fees might actually be able to justify extending the exemption for the services provided to the beneficiaries, if they are extensive.
The IRS provided for a nongrantor trust or estate to use any reasonable means in order to separate these investment advisory fees subject to the 2% floor. Returning to the example above, what are the options for determining what portion of the fees should be allocated to investment advisory fees? Basically, this is a question about how to best measure the services provided: by impact (looking at the corpus value for which advice was given), by comparison with the competition (using third party charges as a basis for charges), time and effort (wait, isn’t that hourly billing?), or whatever method accurately reflects the economic reality of the services provided. Bear in mind that deductions are always a matter of legislative grace to be proven by the taxpayer, and that the case standards for ‘reasonable method’ under §446(b)
for accounting methods could service as a guideline to the I.R.S. to ‘reasonable method’ under Regs. §1.67-4(b)
. The most reasonable method would appear to be to disclose as much of the mechanics for determining the basis of the fees as possible, which is what the IRS wants, regardless of what system for measuring those services the taxpayer uses. One option here would be to separate the charges between work on the partnership(s), the securities advice and the beneficiary services, and evaluate each separately. This would reap some of the financial reward of separate billing. If the trust company is determined that, in the best interests of the trust, it would be advantageous to retain a bundled fee, it should specifically separate all investment advisory advice by asset and possibly tie it to the income (the investments and the partnership(s)).
* * * * * *
While much of the concern is centered on corporate trustees who may charge a single fee for their services, the smaller individual trustee or private trust company may also face challenges with unbundling fees.
Soon after the grantor’s death, a private trust company was formed to manage trust assets, including real estate, various securities and income from oil and gas leases. The real estate is owned through two separate LLCs, of which the trustee is the sole member. The investments were previously all mutual funds, but the trustee has begun replacing these funds with individual investments. The trustee is receiving advice from a professional advisor. The income from the individual investments service a variety of needs, including funds to renovate the properties and an income stream for the beneficiaries. The receipts from the oil and gas leases have been slowly declining. The trustee charges fees based on the value of the assets in the trust.
Issues Facing Trustee:
First, which costs are commonly and customarily incurred, regardless of the trustee’s ownership? The costs for the real estate are not dependent on being trust property. They would be subject to the 2% floor no matter who owned them. However, depending on whether the trustee actively participates in the management with such items as building maintenance, contracting with tenants, renovation of the buildings, etc., and the costs for such items as taxes, repair materials, and tenant services may be fully deductible under §162
. See Frank Aragona Trust v. Commissioner
, 142 T.C. No. 9
Second, any probate fees that are assigned and paid by the trust are not subject to the 2% floor. This includes the probate fees due to the supervising court, the fiduciary bond premiums for the estate’s administration, costs for legal publication and notification of heirs and creditors, costs of certified copies of death certificates and probate or letters of administration, and costs related to fiduciary accounts as required by the supervising court. It also appears that attorney fees for advice during probate may be fully deductible. However, costs such as deeds transferring property to the trust or fees for retitling or consolidating accounts may not be fully deductible, since they are customary and ordinary for transferring property regardless of whether they are owned by a trust or an individual.
Third, appraisal fees for the real property would be fully deductible if they were necessary for estate valuation purposes or preparing the estate tax return for the estate. However, they would subject to the 2% floor if the trustee were applying for a loan in order to renovate the property. The first would be a cost solely attributable to ownership by a trust, but the second would be a cost customary to obtaining financing regardless of the property’s ownership.
Fourth, investment advice fees would likely be subject to the 2% floor. If the advice is given and billed on an hourly basis, these costs are clearly identifiable, and are customary and ordinarily charged regardless of the ownership of the securities. If there is a flat fee charged, usually based on the total value of the account, then the trustee must allocate the charges attributable to investment advice. While the final regulations allow the trustee to use any reasonable method to allocate the costs of investment advice, the facts of this trust indicate that these would all be outside of the trustee fees, identifiable whether they are hourly or at a flat rate, and would be reported as subject to the 2% floor since they are usual and customary for any account that is changing its investment profile.
One sub issue of investment advice is that many brokerage firms and investment houses will offer a discount for multiple accounts. In this case, if the beneficiaries also maintained accounts with the firm to make distributions convenient, such discounts may be allocable among the trust and beneficiaries. In addition, trust companies organized to manage trusts benefitting particular charities may offer discounts based on the amount designated in the trust for charitable purposes. Depending on the asset mix in the trust, these fee discounts may also have to be allocated.
Fifth, the fees charged by the trust company must be allocated between those services and costs customary and ordinary to individuals, and those that are unique to trusts. In this example, after having eliminated the probate expenses, some of the appraisal costs, and the advisory fees, the trustee/trust company must first determine which services and charges are customary and ordinary, and whether any further charges are specifically for a trust. This particular trust operates more as a management company than to address issues specific to trusts. The only allocation issue would be whether the beneficiary and distribution decisions claim an identifiable amount of the trustee’s time. While this simple set of facts does not indicate any particular special requirements for a trust, a beneficiary’s specific needs for income, distribution form or deferral could qualify as costs exempt from the 2% floor.
As many readers may notice, there are also issues about passive income, and the net investment income tax applicable to that income. These issues are beyond the focus of this discussion, but trustees should be aware that they may also have to account for that tax.
* * * * * *
What is a fiduciary to do? First, he or she should demand that there is a clear statement of all charges. In this regard, bills should detail what services are provided, when the services were provided, how much each service cost, and the allocation of those charges to fully deductible or subject to 2% floor status. This could include separate descriptions for advisory fees, accounting fees, valuation fees, and to which assets they apply. This starts to look much like hourly billing. In addition, services provided by outside vendors might become a good way to preserve the fees allocated to the trust specific services when balancing the trust’s best interests (fewer total costs) against a trust company’s needs (greater profits).
Trust companies must now be able to justify their fees not only to their clients, but to the IRS. This might drive larger trusts to demand a different fee structure, or to ask for indemnification if the fees are challenged by the IRS. Trust companies might, in turn, push back with a charge to cover such a contingency. Such a charge would, indeed, be unique to trusts and estates.
While flat fees can adjust to meet the costs in advising trusts, at least from the trust’s perspective, there are limits. Flat fees also have an advantage in creating predictability for the costs in a trust. The advantages of flat fees also work for the trust advisor in creating the same predictability. However, this may also mean that trust companies in particular may have to absorb some of those costs in-house. With the limitation imposed by Regs. §1.67-4(b)(4)
, specialized trust services under a flat fee might actually justify a larger fully deductible portion of the fees than payments to outside service providers, particularly if the trust instrument specifies unusual requirements or the trust requires extensive beneficiary service.
At the end of the path, while the final regulations provide that a trust can use any reasonable method of allocating these fees, it should be kept in mind that the taxpayer will bear the burden of proof in substantiating any deduction. Clearly, the trust’s burden may be too onerous to overcome where all the trust receives is nondetailed and nondeliniated bills. Therefore, trustees should begin insisting that its service providers detail its bills as much as practicable if it wishes to avoid the 2% floor on itemized deductions.