Today’s final regulations [PDF 212 KB] adopt regulations that were proposed in September 2011 “with minor modifications” made in response to comments. They are applicable to tax years beginning on or after the date of publication (scheduled for May 9, 2014).
Summary of changes included in final regulations
Specifically, the changes made by the final regulations:
- Require unbundling of bundled fees using any reasonable method, and provide additional guidance in the form of non-exclusive factors to be considered in making the allocation
- Provide an exclusive list of tax return preparation costs that are not subject to the 2% floor (i.e., any other tax return preparation cost is subject to the 2% floor)
- Provide that certain appraisal fees incurred by an estate or non-grantor trust are not subject to the 2% floor—i.e., appraisals needed to determine value as of the decedent’s date of death (or the alternate valuation date), to determine value for purposes of making distributions, or as otherwise required to properly prepare the estate’s or trust’s tax returns
- Include a statement with regard to some examples of fiduciary expenses that are not commonly or customarily incurred by individuals
- Remove a reference to costs that do not depend on the identity of the payor
- Revise examples to clarify that real estate taxes, costs incurred in connection with a trade or business or for the production of rents or royalties, and certain partnership costs are fully deductible and are not subject to the 2% floor
- Delete 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 non-grantor trust because such a fee is fully deductible
In July 2007, regulations were proposed under section 67(e) to clarify which costs are unique to an estate or a non-grantor trust and are therefore not subject to the 2% floor for miscellaneous itemized deductions. The 2007 proposed regulations included a nonexclusive list of services or products for which the costs would be unique (and therefore fully deductible) and, conversely, a nonexclusive list of services or products (including investment advisory fees) that would be subject to the 2% floor.
In early 2008, the U.S. Supreme Court held that fees paid to an investment advisor by a non-grantor trust or estate generally are subject to the 2% floor for miscellaneous itemized deductions under section 67(a)—thus, reaching a position that differed from that set forth in the 2007 proposed regulations. Michael J. Knight, Trustee of the William L. Rudkin Testamentary Trust v. Commissioner, 552 U.S. 181 (2008).
The Supreme Court held that the proper reading of the language in section 67(e)—which asks whether the expense “would not have been incurred if the property were not held in such trust or estate”—requires an inquiry into whether a hypothetical individual who held the same property outside of a trust “customarily” or “commonly” would incur such expenses. Thus, expenses that are “customarily” or “commonly” incurred by individuals would be subject to the 2% floor.
Following the Supreme Court’s decision in Knight, the IRS issued Notice 2008-32 as interim guidance on the treatment of “bundled fiduciary fees.” Notice 2008-32 and then subsequent notices eventually provided that taxpayers are not required to determine the portion of a bundled fiduciary fee that is subject to the 2% floor under section 67 for any tax year beginning before before the publication of final regulations in the Federal Register.
IRS, Treasury interpretation of Supreme Court’s decision
In September 2011, Treasury and the IRS released proposed regulations. In those regulations, the IRS and Treasury found that the Supreme Court in Knight had held that the deductibility of an expense under section 67(e)(1) depends upon whether the cost is “commonly” or “customarily” incurred when the property is held instead by an individual. In other words, as the Court restated its holding, section 67(e)(1) excepts from the 2% floor “…only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual...” holding the same property to incur (emphasis in original).
In applying this interpretation to investment advisory fees incurred by a trust, the 2011 proposed regulations explained that the Supreme Court found that such fees generally are not uncommonly incurred by individual investors and thus are subject to the 2% floor.
The final regulations adopt the proposed regulations with only minor modifications.
Under the final regulations, the following costs would be subject to the 2% floor:
- Costs that are commonly or customarily incurred by a hypothetical individual owning the same property
- Costs incurred merely because the trust or estate is the owner of an asset (including partnership costs passed through on a Schedule K-1)
- Investment advisory fees are generally subject to the 2% floor except to the extent the fee exceeds the fee generally charged to an individual investor and such excess is attributable to some identifiable aspect of the service unique to the trust or estate
Conversely, the following costs would not be 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, but all other tax returns including gift tax returns are subject to the 2% floor
- Appraisal costs for determining date of death value, for valuation of distributions, or as otherwise required for preparing the estate’s or trust’s tax returns
- Certain fiduciary expenses such as probate fees, fiduciary bond premiums, legal publication costs, costs of certified copies of death certificates, and costs related to fiduciary accounts
Bundled fees that are charged by a trustee or executor on an hourly basis must be allocated between those services subject to the 2% floor and those that are not. For bundled fees that are charged other than on an hourly basis, “only that portion of that 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 such a bundled fee. Facts that may be considered in determining whether an allocation is reasonable include, but are not limited to: the percentage of the value of the corpus subject to investment advice; whether a third-party advisor would have charged a comparable fee for similar advisory services; and 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.
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. And, finally, separate fees levied by the executor or trustee in addition to the normal bundled fee are treated as separate costs subject to their own analysis.