IRS Guidance on the Two Percent of AGI Floor for Trusts and Estates

By:
Kevin Matz, JD, LLM, CPA
Published Date:
Sep 1, 2014

On May 9, 2014, the IRS issued final regulations under Treasury Regulations section 1.67-4 that provide guidance on which costs incurred by estates or trusts, other than grantor trusts (nongrantor trusts), are subject to the two percent of adjusted gross income (AGI) floor for miscellaneous itemized deductions under Internal Revenue Code (IRC) section 67(e). Although the IRS has deferred the effective date of these final regulations so that they now apply to taxable years beginning on or after Jan. 1, 2015, it has nevertheless created enormous concern among corporate fiduciaries in particular. Chief among these concerns is how a fiduciary should go about subdividing (or “unbundling”) a single fiduciary fee that represents a composite of various functions that the fiduciary has performed, including providing investment advice (which is generally subject to the two percent floor) and managing other aspects of its relationship with beneficiaries including distribution decisions (which is not subject to the two percent floor).

The stakes involved here are much higher than one might otherwise expect. Miscellaneous itemized deductions subject to the two percent floor are disallowed entirely for purposes of the alternative minimum tax (AMT) [IRC section 56(b)(1)(A)(i)]. For those trusts and estates in an AMT posture, this is not simply a matter involving a small potential reduction in the after-tax cost of particular expenses; rather, it may well be an “all-or-nothing” proposition as to whether significant expenses are effectively deductible at all.

The Basic Rules

IRC section 67(e) provides an exception to the two percent floor on miscellaneous itemized deductions for costs that are paid or incurred in connection with the administration of an estate or a nongrantor trust “that would not have been incurred if the property were not held in such estate or trust” [Treasury Regulations section 1.67-4(a)]. A cost is subject to the two percent floor to the extent that—

  • it is included in the definition of miscellaneous itemized deductions under IRC section 67(b),
  • it is incurred by an estate or nongrantor trust, and
  • it “commonly or customarily would be incurred” by a hypothetical individual holding the same property [Treasury Regulations. section 1.67-4(a)].

This standard raises the question of what it means for a cost to be “commonly or customarily incurred” by a hypothetical individual holding the same property. The Treasury Regulations instruct that “[i]n analyzing a cost to determine whether it commonly or customarily would be incurred by a hypothetical individual owning the same property, it is the type of product or service rendered to the estate or nongrantor trust in exchange for the cost, rather than the description of the cost of that product or service, that is determinative” [Treasury Regulations section 1.67-4(b)(1)]. Such costs that are incurred commonly or customarily by individuals (which would be subject to the two percent floor) include costs incurred in defense of a claim against the estate, the decedent, or the nongrantor trust that are unrelated to the existence, validity, or administration of the estate or trust [Treasury Regulations section 1.67-4(b)(1)], as well as ownership costs (including those that pass through to the trust or estate from a partnership) [Treasury Regulations section 1.67-4(b)(2)].

In addition, the final regulations provide guidance concerning the following specific categories of costs:

  • Tax preparation fees. Costs relating to all estate and generation-skipping transfer (GST) tax returns, fiduciary income tax returns, and the decedent’s final individual income tax returns are not subject to the two percent floor. The costs of preparing all other tax returns (for example, gift tax returns) are costs commonly and customarily incurred by individuals and thus are subject to the two percent floor [Treasury Regulations. section 1.67-4(b)(3)].
  • Appraisal fees. Appraisal fees incurred by an estate or a nongrantor trust to determine the fair market value of assets 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 or a GST tax return are not incurred commonly or customarily by an individual and thus are not subject to the two percent floor. The cost of appraisals for other purposes (e.g., insurance) is commonly or customarily incurred by individuals and is subject to the two percent floor [Treasury Regulations section 1.67(b)(5)].
  • Certain fiduciary expenses. Certain other fiduciary expenses are not commonly or customarily incurred by individuals and thus are not subject to the two percent floor. Such expenses include, without limitation, the following: 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 [Treasury Regulations. 1.67-4(b)(6)].

The Special Case of Investment Advisory Fees

The final regulations provide that fees for investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) are incurred commonly or customarily by a hypothetical individual investor and, therefore, are subject to the two percent floor. This basic rule gets complicated, however, as a result of the final regulations’ attempt to follow the imprimatur of the U.S. Supreme Court’s 2008 decision in Knight v. Commissioner. The Court held that fees paid to an investment advisor by an estate or nongrantor trust generally are subject to the two percent floor, with certain potential exceptions.

Following the Supreme Court’s instructions in Knight, the final regulations provide that certain incremental costs of investment advice beyond the amount that normally would be charged to an individual investor are not subject to the two percent floor. For this purpose, such an incremental cost is a special, additional charge that is added solely because the investment advice is rendered to a trust or estate rather than to an individual or attributable to an unusual investment objective or the need for a specialized balancing of the interests of various parties (beyond the usual balancing of the varying interests of current beneficiaries and remaindermen), such that a reasonable comparison with individual investors would be improper. The portion of the investment advisory fees not subject to the two percent floor by reason of the preceding sentence is limited to the amount of those fees, if any, that exceeds the fees normally charged to an individual investor [Treasury Regulations. section 1.67-4(b)(4)].

How this all plays out as a practical matter will likely be the subject of continued uncertainty and litigation in the years to come.

Bundled Fees

Another area of considerable uncertainty under the final regulations results from its requirement that “bundled fees” be unbundled into a portion that is subject to the two percent floor and a portion that is not. They also provide that “[i]f an estate or a non-grantor trust pays a single fee, commission, or other expense (such as a fiduciary's commission, attorney's fee, or accountant's fee) for both costs that are subject to the two percent floor and costs (in more than a de minimis amount) that are not, then, except to the extent provided otherwise by guidance published in the Internal Revenue Bulletin, the single fee, commission, or other expense (bundled fee) must be allocated, for purposes of computing the adjusted gross income of the estate or non-grantor trust in compliance with section 67(e), between the costs that are subject to the 2-percent floor and those that are not” [Treasury Regulations section 1.67-4(c)(1)].

The final regulations provide an important exception to having to unbundle fees where a bundled fee is not computed on an hourly basis. In that case, only the portion of that fee that is attributable to investment advice is subject to the two percent floor; the remaining portion is not subject to the two percent floor [Treasury Regulations section 1.67-4(c)(2)]. Although the final regulations are unclear on this point, presumably their guidance (in accordance with the Supreme Court’s instructions in Knight) that certain incremental costs of investment advice beyond the amount that normally would be charged to an individual investor are not subject to the two percent floor would also apply here.

In addition, out-of-pocket expenses billed to the estate or nongrantor trust are treated as separate from the bundled fee. In a similar vein, payments made from the bundled fee to third parties that would have been subject to the two percent floor if they had been paid directly by the estate or nongrantor trust are subject to the two percent floor, as are any fees or expenses separately assessed by the fiduciary or other payee of the bundled fee (in addition to the usual or basic bundled fee) for services rendered to the estate or nongrantor trust that are commonly or customarily incurred by an individual [Treasury Regulations section 1.67-4(c)(3)].

According to the final regulations, any reasonable method may be used to allocate a bundled fee between those costs that are subject to the two percent floor and those costs that are not (such as for investment advice). 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. The reasonable method standard does not apply to determine the portion of the bundled fee attributable to payments made to third parties for expenses subject to the two percent floor or to any other separately assessed expense commonly or customarily incurred by an individual, because those payments and expenses are readily identifiable without any discretion on the part of the fiduciary or return preparer [Treasury Regulations section 1.67-4(c)(3)].

The quandary posed by unbundling raises the following question: which methods will the IRS consider “reasonable” in allocating a bundled fee between those costs that are subject to the two percent floor (such as for basic investment advice) and those costs that are not (potentially everything else)?

One method might involve comparing the amount of the corporate fiduciary’s commissions against the amount of commissions that an individual fiduciary would be entitled to receive under the applicable state fiduciary commissions statute. Where the applicable state fiduciary commissions statute (such as section 2309 of the New York Surrogate’s Court Procedure Act in the case of New York) specifies the amount of commissions that an individual fiduciary would be entitled to receive and the corporate fiduciary does not outsource its investment advisory function, the amount of the “spread” in the fiduciary commissions amounts could potentially be attributed to the corporate fiduciary’s investment advisory function (and therefore potentially subject to the two percent floor), with the remaining portion not subject to the two percent floor.

Another approach could involve comparing the amount that a trustee (including its corporate affiliate) would charge for a “directed trust” (i.e., a trust in which the trustee is not responsible for the investment advisory function) to a trust in which the trustee is responsible for the investment advisory function. In such event, a strong case can be made that the “spread” in trustee commissions’ amounts reflects the value of the investment advisory function (which would be potentially subject to the two percent floor), with the remaining portion not subject to the floor.

Significantly, the final regulations only require that the method of allocating a bundled fee between those costs that are subject to the two percent floor and those costs that are not be “reasonable.” The approaches suggested above would appear to lend themselves to such a determination. Presumably, other principled methods of allocation will satisfy the reasonableness requirement as well.


Kevin Matz, JD, LLM, CPAKevin Matz, JD, LLM, CPA, is the managing attorney of the law firm of Kevin Matz & Associates PLLC, with offices in New York City and White Plains, New York. His practice is devoted principally to domestic and international estate and tax planning. Mr. Matz is also the chair of the NYSSCPA’s Estate Planning Committee, and frequently writes and lectures on estate and tax planning topics. He can be reached by email at kmatz@kmatzlaw.com, or by phone at 914-682-6884.

 
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