Press Room: Tax Release

May 27, 2014

IRS Guidance on Trust and Estate 2% Floor on Itemized Deductions

Trustees and executors have received much-anticipated guidance concerning the determination of costs that are deductible without limitation by an estate or non-grantor trust, versus those that are subject to disallowance by the 2% floor on miscellaneous itemized deductions. Of particular importance, the recently finalized regulations address two very significant issues — investment advisory costs and requirements for unbundling fees — along with some other clarifications of the previously proposed regulation.

Although individuals, estates and non-grantor trusts have been subject to the disallowance of miscellaneous itemized deductions to the extent of 2% of their adjusted gross income since Congress enacted Sec. 67 in 1986, there has been uncertainty about which estate and trust expenses are covered by that limitation. For those entities, the statutory language permits deduction without limitation, 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.

The regulations clarify this language by subjecting to the limitation costs that are commonly or customarily incurred by a hypothetical individual owning the same property, but that are not allowable under other statutory provisions (e.g., rent and royalty expenses, trade or business expenses, state and local property taxes).

Examples of miscellaneous deductions that are subject to the limitation include:

  • Costs incurred in defense of a claim against the estate, decedent or trust that are unrelated to the existence, validity or administration of the estate or trust
  • Property ownership costs (including those passed through from a partnership or other entity), such as condominium fees, insurance premiums, maintenance and lawn services, and automobile registration and insurance costs
  • Tax return preparation fees other than for estate and generation-skipping tax returns, fiduciary income tax returns and the decedent’s final individual return

Examples of costs that are not subject to the 2% floor include:

  • Appraisal fees to determine date of death values or for purposes of making distributions (but not for insurance or other purposes that individuals commonly or customarily obtain appraisals)
  • Probate court costs, fiduciary bond premiums, costs to publish notices to creditors or heirs, death certificates and fiduciary accountings

Settling a major point of contention between taxpayers and the government, the regulations state that investment advisory fees are subject to the 2% floor, but with a very narrow exception. The exception is for incremental costs of investment advice beyond the amount normally charged to an individual investor. The cost must be a special, additional charge that is added solely because the advice is to an estate or trust or is attributable to an unusual investment objective or the need for a specialized balancing of interests of various parties (beyond the usual balancing of the varying interests of current beneficiaries and remaindermen).

So-called bundled fees (e.g., those billed by the trustee, executor, attorney or accountant) that cover costs that both are and are not subject to the floor generally must be allocated if they contain more than a de minimis amount that is subject to the floor. However, if the bundled fee is not computed on an hourly basis, only the portion that is attributable to investment advice must be carved out and subjected to the floor.

The regulations then provide guidance on how fiduciaries should unbundle fees, but first carve out portions of those fees for separate determination as to whether they are subject to the 2% floor:

  • Out of pocket expenses are considered separately from the bundled fee
  • The portion of bundled fees that is paid to third parties (e.g., investment managers)
  • Any fees or expenses that are assessed separately from the bundled fee

Any reasonable method may be used to allocate the rest of the bundled fee. Facts that may be considered in a reasonable allocation include, but are not limited to, the percentage of the corpus subject to investment advice, comparable fees for similar advisory services, and the amount of the fiduciary’s attention to the estate or trust that is devoted to investment advice as compared to dealings with beneficiaries, distribution decisions and other fiduciary functions.

The regulation is effective for taxable years beginning on or after May 9, 2014.