Regulations Released for Estate and Trust Deductions

The IRS has issued final regulations as to which costs incurred by non-grantor trusts and estates are subject to the 2% floor on miscellaneous itemized deductions. These regulations retain most of the proposed regulations from the IRS’s September 2011 proposal, including the rule that certain fees be unbundled.

The final regulations were, in part, a response to the 2008 Supreme Court ruling in Knight v. Commissioner, where the court ruled that only costs and expenses that are not typically incurred by an individual are fully deductible, and other costs and expenses would be treated as miscellaneous deductions, and thereby subject to the 2% floor. The 2% floor means that the miscellaneous itemized deductions can only be deducted if they exceed 2% of the estate’s or trust’s adjusted gross income.

One of the issues addressed in the final regulations is whether or not investment advisory fees are fully deductible by the estate or trust, or whether they are subject to the 2% floor on miscellaneous itemized deductions. It was determined that fees for investment advisory services are subject to the 2% floor; however, it is possible that additional fees are incurred above the normal amount charged to an individual. These additional costs are not subject to the 2% floor.

With respect to bundled fees, the final regulations require that deductible and non-deductible fees be unbundled. Examples of deductible fees for an estate or trust are special, additional charges added solely because the investment advice is rendered to an estate or trust (rather than to an individual). In addition, deductible fees can also apply 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 and remainder beneficiaries).

For these deductible incremental investment charges, the trustee must substantiate that it would be unusual for an individual who owned the same property to have incurred the same cost. Such substantiation could include, for example, the trust agreement investment directives, the special needs of the trust beneficiaries, fee schedules, descriptions of the services provided, or surveys and statistics about common investor traits to the extent they are obtainable. The regulations also require that they be allocated between costs that are subject to the 2% floor and those that are not. Additional items that are subject to the 2% floor are ownership costs and costs due to the trust or estate being an owner of an asset (e.g., condominium fees, real estate taxes, insurance premiums, automobile registration and insurance costs).

The final regulations also addressed costs that are not subject to the 2% floor, including:

• Appraisal costs which are needed to determine value for distribution or are needed to prepare the estate’s or trust’s tax return, or generation-skipping transfer return.
• Tax preparation costs for the estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the final income tax return for the descendent.
• Certain fiduciary expenses, such as probate court fees, cost of certified copies of the descendant’s death certificate, and legal publication costs to notify heirs and creditors.

The final regulations apply to taxable years beginning on or after May 9, 2014. Should you have any questions about how the final regulations will affect your strategy and your current estate plan, please feel free to contact me at (805) 963-7811 or dlewis@bpw.com.