“Bundled Fiduciary Fees” Are Fully Deductible Until Final Regs Are Issued

Notice 2011-37, 2011-20 IRB

In a Notice, IRS has issued interim guidance on the treatment of investment advisory and other costs subject to the 2% floor under Code Sec. 67(a). Specifically, for tax years beginning before the date that final regs under Reg. §1.67-4 are published, nongrantor trusts and estates do not have to “unbundle” a fiduciary fee into parts consisting of costs that are fully deductible and costs that are subject to the 2% floor.

Observation: Initially, IRS had provided this relief only for tax years beginning before Jan. 1, 2008. In late 2008, IRS extended the relief to apply to tax years beginning before Jan. 1, 2009. In 2010, IRS granted yet another extension of this relief for tax years beginning before Jan. 1, 2010. The extension now provided—pegged as it is to the issuance of final regs—is undoubtedly the final extension of this relief.

Background. Miscellaneous itemized deductions are allowed only to the extent they exceed 2% of adjusted gross income (AGI). (Code Sec. 67(a)) For purposes of this floor, the AGI of an estate or trust is computed the same way as for an individual, subject to certain exceptions. (Code Sec. 67(e)) Under one exception, costs paid or incurred in connection with the administration of an estate or trust that wouldn't have been incurred if the property weren't held in the estate or trust are allowed as deductions in arriving at AGI. (Code Sec. 67(e)(1))

In January of 2008, resolving a conflict in the circuits courts, the Supreme Court held that investment advisory fees paid by a trust are deductible only to the extent that they exceed 2% of the trust's AGI. The Supreme Court reasoned that in determining whether a particular type of cost incurred by a trust “would not have been incurred” if the property were held by an individual, Code Sec. 67(e)(1) excepts from the 2% floor only those costs that would be uncommon (or unusual, or unlikely) for an individual to incur. The Court found that the trustee, who had the burden of establishing entitlement to the deduction, failed to demonstrate that it was uncommon or unusual for individuals to hire an investment adviser. (Knight v. Comm (S Ct 1/16/2008), 101 AFTR 2d 2008-544)

In late July of 2007, IRS had issued proposed regs providing that investment advice costs incurred by an estate or non-grantor trust would be subject to the 2%-of-AGI floor for miscellaneous itemized deductions under Code Sec. 67(a). Under the proposed regs, an estate or non-grantor trust that pays a single fee that includes both costs that are unique to estates and trusts, and costs that are not, would have to use a reasonable method to allocate the single fee between the two types of costs. (Prop Reg §1.67-4(c)) Thus, the 2% floor couldn't be circumvented by combining investment advisory fees and trustees' fees into a single fee.

Observation: The proposed regs—under which costs incurred by a trust would have to be unique to a trust in order to be excepted from the 2% floor—are more restrictive than the Supreme Court's decision in Knight, under which costs incurred by a trust are excepted from the 2% floor if the costs would not commonly or customarily be incurred by individuals.

IRS is planning to issue final regs consistent with the Supreme Court's holding in Knight. Those regs will also address the issue raised when a nongrantor trust or estate pays a “bundled fiduciary fee” for costs incurred in-house by the fiduciary, some of which are subject to the 2% floor and some of which are fully deductible without regard to the 2% floor. Because the final regs, which will only apply prospectively, were not issued before the due date for filing 2007 income tax returns (determined without regard to extensions), IRS provided interim guidance in Notice 2008-32, 2008-11 IRB 593, for tax years beginning before Jan. 1, 2008. It provided that taxpayers would not be required to determine the portion of a bundled fiduciary fee that is subject to the 2% floor for any tax year beginning before Jan. 1, 2008. Notice 2008-116, 2008-52 IRB 1372, extended the interim guidance provided in Notice 2008-32 to any tax years beginning before Jan. 1, 2009. Notice 2010-32, 2010-16 IRB 594, further extended the interim guidance to tax years beginning before Jan. 1, 2010.

Reprieve extended again. In Notice 2011-37, IRS says that taxpayers are not required to determine the portion of a bundled fiduciary fee that is subject to the 2% floor under Code Sec. 67 for any tax year beginning before the date that final regs are published. Instead, for each such tax year, taxpayers may deduct the full amount of the bundled fiduciary fee without regard to the 2% floor. But, payments by the fiduciary to third parties for expenses subject to the 2% floor are readily identifiable and must be treated separately from the otherwise bundled fiduciary fee.

References: For how the 2% floor applies to trusts, see FTC 2d/FIN ¶C-2202; United States Tax Reporter ¶674; TaxDesk ¶653,001; TG ¶2664.