At long last, the IRS finalized regulations that were initially proposed in 2007. Treas. Reg. §1.67-4 clarifies which estate and non-grantor trust costs are fully deductible for income tax purposes and which are only allowed to the extent that they exceed 2% of the estate’s or trust’s adjusted gross income as set out in §67(a). Section 67(a) “miscellaneous itemized deductions” are generally subject to this 2% floor for individuals, but §67(e)(1) provides an exception for costs paid or incurred by an estate or trust if an individual who held the property outright would not have paid them. In essence, costs incurred by an estate or non-grantor trust as a direct result of the form of ownership are fully deductible.
The standard under the regulations tracks the Supreme Court’s decision in Knight v. Commissioner, 552 U.S. 181 (2008). If an individual who held the same property outside of a trust would “customarily” or “commonly” incur the expense at issue, it is subject to the 2% floor. Using this inquiry, the Court determined that investment advisory fees would generally be subject to the 2% floor, and the finalized regulations reflect that holding. But if an investment advisory fee incurred by an estate or trust is higher than what would normally be charged to an individual investor, then the portion of the fee that exceeds a ‘normal’ charge is considered a special cost, particular to the estate or trust context and therefore not subject to the 2% floor. This also means that normal “ownership costs,” defined in §1.67-4(b)(2), such as condominium fees or insurance premiums, are subject to the 2% floor, but only if they are costs properly analyzed under §67. (Business costs, for example, would be fully deductible under §162.) On the other hand, some tax preparation fees and appraisal fees are not subject to the 2% floor because they arise out of the form of ownership. This includes estate and generation-skipping transfer tax returns and the appraisals required for preparation of those returns. Likewise, certain fiduciary expenses are fully deductible, a non-exhaustive list of which is provided in the regulations. This all seems fairly consistent with Knight and the Code.
The real head-scratcher appears in subsection (c). If an estate or non-grantor trust pays a single fee (for example, to an attorney or accountant or as a fiduciary commission) attributable to both kinds of costs, this so-called “bundled fee” must be allocated between the portion that is subject to the 2% floor and the portion that is not. Practitioners objected to this allocation requirement during notice and comment, arguing that it would drastically increase administration costs. The IRS disagreed, pointing out that the new regulations allow “any reasonable method” to be used in allocating bundled fees. However, a vague standard is no one’s friend, and this one is unlikely to comfort planners. In addition, unscrupulous professionals could choose to collude with their estate and trust clients by itemizing their “bundled fees” but allocating a minimal portion to costs subject to the 2% floor.
The Service’s position on bundled fees in the finalized regulations is a departure from the temporary guidance it issued in 2008, which had stated that the portion of a bundled fee subject to 2% floor costs did not have to be determined. Hence the bottom line is that estates and non-grantor trusts incurring these types of fees will no longer enjoy a complete deduction, and will have to develop a “reasonable” method of determining how they break them down. This means increased costs, both in taxes paid and in administration.