Final rules on fiduciary fees keep “unbundling” requirement

BY SALLY P. SCHREIBER, J.D.

Controversial rules prompted by the Knight decision parse certain income tax deductions of estates and trusts.

The IRS issued final regulations on the controversial question of which costs incurred by trusts and estates are subject to the 2% floor on miscellaneous itemized deductions under Sec. 67(a). The regulations apply to tax years beginning on or after May 9, 2014. They retain from the proposed rules a requirement that certain “bundled” fees be unbundled.

The regulations finalize proposed rules issued in September 2011 (REG-128224-06) in response to the U.S. Supreme Court’s decision in Knight, 552 U.S. 181 (2008), on the deductibility by estates and nongrantor trusts of investment advisory and other fees. Under Knight, fees paid to an investment adviser by a nongrantor trust or estate are generally miscellaneous itemized deductions subject to a floor of 2% of adjusted gross income (AGI), rather than fully deductible as an expense of administering an estate or trust under Sec. 67(e)(1). The Supreme Court held that the latter provision is limited to expenses that would not “commonly” or “customarily” be incurred if the property were held by an individual.

The regulations implement the Court’s “commonly or customarily incurred” requirement for investment advisory fees by stating that a fee is not subject to the 2%-of-AGI floor to the extent it exceeds the fee generally charged to an individual investor, where the additional charge is added solely because the investment advice is rendered to a trust or estate rather than to an individual or is attributable “to an unusual investment objective” of the trust or estate or to “the need for a specialized balancing of the interests of various parties … such that a reasonable comparison with individual investors would be improper” (Regs. Sec. 1.67-4(b)(4)).

The final rules adopt the proposed regulations with a few modifications in response to comments. The proposed regulations provided that costs that do not depend on whether the payer is an individual or an estate or trust count as costs that are commonly or customarily incurred by an individual. One commentator said that this treatment was overly broad and was a disguised attempt to reassert the IRS’s effort, rejected in Knight, to subject any costs that could be incurred by an individual to the 2% floor. The IRS agreed and removed the reference to costs that do not depend on the payer’s identity.

Another change was the removal of real estate taxes as an example of an ownership cost because they are not miscellaneous itemized deductions but are fully deductible under Sec. 62(a)(4) or 164(a). The final regulations also clarify that costs incurred in connection with a trade or business or for the production of rents or royalties are not miscellaneous itemized deductions, and that partnership costs reportable by a partner are subject to the 2% floor only if those costs are miscellaneous itemized deductions under Sec. 67(b). In addition, to resolve ambiguities in a proposed rule regarding tax return preparation costs, the IRS provided in the final regulations an exclusive list of return preparation costs that are not subject to the 2% floor.

The IRS also added certain appraisal fees to the category of costs that are fully deductible: those needed to determine the value of property as of the decedent’s date of death (or the alternate valuation date), to determine value for purposes of making distributions, or to properly prepare the estate or trust’s tax returns. The final regulations further add a nonexclusive list of other fiduciary expenses that are not commonly or customarily incurred by individuals: probate court fees and costs, fiduciary bond premiums, legal publication costs of notices to creditors or heirs, the cost of certified copies of the decedent’s death certificate, and costs related to fiduciary accounts.

Bundled fees. Bundled fees are fees that are billed together, where a portion is fully deductible and another is subject to the 2%-of-AGI floor. In the preamble to the final regulations, the IRS noted that it received many comments on the treatment of bundled fees in the proposed regulations (see, e.g., AICPA comments at tinyurl.com/og9bkyh). Commentators objected to the administrative difficulty of unbundling fiduciary fees, and the IRS did not enforce unbundling pending the issuance of final regulations (Notice 2011-37). However, despite the objections of these commentators, the final regulations do include the unbundling requirement.

The final regulations, like the proposed regulations, require the deductible and nondeductible portions to be unbundled—that is, allocated between costs that are subject to the 2% floor and those that are not. The proposed regulations contain one exception to the allocation requirement: If a bundled fee is not computed on an hourly basis, only the portion attributable to investment advice (including any related services that would be provided to any individual investor as part of the investment advisory fee) is subject to the 2% floor. However, despite this exception, payments made to a third party out of the bundled fee that would have been subject to the 2% floor if paid directly by the trust or estate and separately assessed expenses (in addition to usual or basic fees or commissions) that are commonly or customarily incurred by an individual will be subject to the 2% floor. If amounts are allocable to investment advice but are not traceable to separate payments, the final regulations, consistent with the proposed regulations, allow the use of “any reasonable method” to make the allocation to investment advice. However, the final regulations expand on the proposed regulations by including a list of the facts that may be considered in determining whether an allocation is reasonable.

- T.D. 9664

By Sally P. Schreiber, J.D., a JofA senior editor.

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