The Internal Revenue Service has published final regulations to provide guidance on which costs incurred by estates or trusts other than grantor trusts are subject to a 2 percent floor for miscellaneous itemized deductions.
The final regulations in TD 9664 affect estates and non-grantor trusts. Section 67(a) of the Tax Code provides that, for an individual taxpayer, miscellaneous itemized deductions are allowed only to the extent that the aggregate of those deductions exceeds 2 percent of the adjusted gross income. Section 67(b) excludes certain itemized deductions from the definition of “miscellaneous itemized deductions,” while Section 67(e) provides that the adjusted gross income of an estate or trust should be computed the same way it would be for an individual.
However, Section 67(e)(1) adds that the deductions for costs paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in the estate or trust should be treated as allowable in arriving at the adjusted gross income. Therefore, the deductions described in Section 67(e)(1) are not subject to the 2 percent floor for miscellaneous itemized deductions under Section 67(a).
The IRS proposed regulations back in July 2007 saying that a cost would be fully deductible to the extent that it’s unique to an estate or trust, but if the cost was not unique so that an individual could have incurred it, then the cost would be subject to the 2 percent floor. The 2007 proposed regulations also addressed costs subject to the 2 percent floor that are included as part of a comprehensive fee paid to the trustee or executor, known as bundled fees. The IRS received a number of written comments and held a hearing in November 2007.
But the final regulations were also influenced by a Supreme Court ruling in 2008, in the case of Michael Knight, trustee of the William L. Rudkin Testamentary Trust. The Supreme Court rules that fees paid to an investment advisor by an estate or non-grantor trust generally are subject to the 2 percent floor for miscellaneous itemized deductions under Section 67(a). The court reached the decision based upon an interpretation of Section 67(e) that differed from the 2007 proposed regulations. The 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. Expenses that are “customarily” or “commonly” incurred by individuals are subject to the 2 percent floor.
After considering the Supreme Court ruling in the Knight case, the Treasury Department and the IRS issued Notice 2008-32 in March 2008 to provide interim guidance on the treatment of bundled fees, and subsequent notices extended the interim guidance.
In September 2011, the IRS issued another set of proposed regulations and received a new batch of comments. The final regulations that were issued last week generally retain the provisions of the 2011 proposed regulations with some minor modifications.