Small Business Taxes & Management^TM--Copyright 2007, A/N Group, Inc.

Background and Proposed Rules

Some miscellaneous expenses are fully deductible on Schedule A of your individual tax return (e.g., gambling losses). However, the most frequently encountered ones, such as investment expenses, are subject to a 2% floor. That means only the amount in excess of 2 percent of your adjusted gross income (AGI) are deductible. Section 67(e) provides that the adjusted gross income of an estate or trust must be computed in the same manner as that of an individual. However, Section 67(e)(1) provides that the deductions for costs paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such estate or trust shall be treated as allowable in arriving at adjusted gross income. Therefore, these deductions are not subject to the 2-percent floor.

Example--The Fred Flood Testamentary Trust has interest from interest, dividends, and capital gains of $310,000 for 2007. It's only expense consist of investment management fees of $30,000. The expenses are subject to the 2-percent floor, $6,200. Thus, only the expenses in excess of that amount, $23,800 ($30,000 less $6,200) are deductible. Or, looking at it another way, the first $6,200 of expenses aren't deductible.

Different courts have interpreted the rule differently in determining which costs are subject to the 2-percent floor. In one case the court found that, under state law, the trustee was required to engage an investment advisor to meet its fiduciary obligations and to incur fees that the trust would not have incurred if the property were not held in trust. The court held that estate or trust expenditures that are necessary to meet specific fiduciary obligations under state law are not subject to the 2-percent floor. In a different circuit, the court concluded that a trust expense is subject to the 2-percent floor if it is an expense commonly or customarily incurred by individuals; another court looked to whether such an expense was "peculiar to trusts" and "could not" be incurred by an individual.

In an effort to clarify and make uniform the rule, the IRS is issuing proposed regulations (REG-128244-06). The proposed regulations provide that costs incurred by estates or non-grantor trusts that are unique to an estate or trust are not subject to the 2-percent floor. For this purpose, a cost is unique to an estate or trust if an individual could not have incurred that cost in connection with property not held in an estate or trust. To the extent that expenses paid or incurred by an estate or non-grantor trust do not meet this standard, they are subject to the 2-percent floor of Section 67(a). (Neither Section 67 nor this rule applies to expenses that are excluded under Section 67(b) from the definition of miscellaneous itemized deductions, or to expenses related to a trade or business.)

Under the proposed regulations, whether costs are subject to the 2-percent floor on miscellaneous itemized deductions depends on the type of services provided, rather than on taxpayer characterizations or labels for such services. Thus, taxpayers may not circumvent the 2-percent floor by "bundling" investment advisory fees and trustees' fees into a single fee. The regulations provide that, if an estate or non-grantor trust pays a single fee that includes both costs that are unique to estates and trusts and costs that are not, then the estate or non-grantor trust must use a reasonable method to allocate the single fee between the two types of costs. The regulations also provide a non-exclusive list of services for which the cost is either exempt from or subject to the 2-percent floor. The IRS is inviting comments on whether any safe harbors or other guidance, concerning allocation methods or otherwise, would be helpful.

The issue is important for many taxpayers who have set up trusts that are taxed separately. (A grantor trust, where the person who contributed the property to the trust is still in control of the property and, therefore, for tax purposes still the owner aren't affected.) And the use of trusts for estate planning and tax purposes have expanded sharply in recent years. The issue is so significant that the U.S. Supreme Court has agreed to hear a case (Rudkin) where the court sided with the IRS in ruling the 2-percent floor applied.

Despite the publication of proposed regulations, the issue is still in flux. The Supreme Court decision may modify the proposed regulation as could public comments.

Full Text of Proposed Regulations

Sec. 1.67-4 Costs paid or incurred by estates or non-grantor trusts.

(a) In general. Section 67(e) provides an exception to the 2-percent floor on miscellaneous itemized deductions for costs that are paid or incurred in connection with the administration of an estate or a trust not described in Sec. 1.67-2T(g)(1)(i) (a non-grantor trust) and which would not have been incurred if the property were not held in such estate or trust. To the extent that a cost incurred by an estate or non-grantor trust is unique to such an entity, that cost is not subject to the 2-percent floor on miscellaneous itemized deductions. To the extent that a cost included in the definition of miscellaneous itemized deductions and incurred by an estate or non-grantor trust is not unique to such an entity, that cost is subject to the 2-percent floor.

(b) Unique. For purposes of this section, a cost is unique to an estate or a non-grantor trust if an individual could not have incurred that cost in connection with property not held in an estate or trust. In making this determination, it is the type of product or service rendered to the estate or trust, rather than the characterization of the cost of that product or service, that is relevant. A non-exclusive list of products or services that are unique to an estate or trust includes those rendered in connection with: fiduciary accountings; judicial or quasi-judicial filings required as part of the administration of the estate or trust; fiduciary income tax and estate tax returns; the division or distribution of income or corpus to or among beneficiaries; trust or will contest or construction; fiduciary bond premiums; and communications with beneficiaries regarding estate or trust matters. A non-exclusive list of products or services that are not unique to an estate or trust, and therefore are subject to the 2-percent floor, includes those rendered in connection with: custody or management of property; advice on investing for total return; gift tax returns; the defense of claims by creditors of the decedent or grantor; and the purchase, sale, maintenance, repair, insurance or management of non-trade or business property.

(c) "Bundled fees". If an estate or a non-grantor trust pays a single fee, commission or other expense for both costs that are unique to estates and trusts and costs that are not, then the estate or non-grantor trust must identify the portion (if any) of the legal, accounting, investment advisory, appraisal or other fee, commission or expense that is unique to estates and trusts and is thus not subject to the 2-percent floor. The taxpayer must use any reasonable method to allocate the single fee, commission or expense between the costs unique to estates and trusts and other costs.

(d) Effective/applicability date. These regulations are proposed to be effective for payments made after the date final regulations are published in Federal Register.

--Last Update 08/02/07