Final sec. 67(e) regulations: the end of a long journey.

• Author: Cantrell, Carol A.

PREVIEW

* Final regulations give practitioners some guidance on exactly which costs a trust may claim as above-the-line deductions and which costs are miscellaneous itemized deductions.

* Advisers must be aware of the treatment of the various categories of expenses included in the regulations and the rule requiring the unbundling of bundled fees.

* The increase in the amount of expenses treated as miscellaneous itemized deductions may have AMT implications for a trust or its beneficiaries.

Sec. 67(e) reached the end of a long and tortured journey on May 9, 2014, when the IRS issued final regulations defining, once and for all, which expenses of an estate or trust are classified as miscellaneous itemized deductions subject to the 2% floor and the alternative minimum tax (AMT). The meaning of Sec. 67(e)(1), which exempts from classification as miscellaneous itemized deductions costs that "would not have been incurred if the property were not held in such trust or estate," has perplexed trustees and their advisers since 1986 when the statute was enacted. No regulations were issued for 21 years, but plenty of litigation has occurred, and practitioners have sent numerous comments to the IRS and Congress over the past 28 years.

Background

The first court to clarify the meaning of Sec. 67(e) was the Sixth Circuit Court of Appeals, which held, in a 1991 case, O'Nei11, (1) that Sec. 67(e) exempts all costs incurred "because the property was held in trust," which is essentially a "but for" test. This holding did not solve the problem for long because, soon after, three other appellate courts reached different results. In 2001 and 2003, the Fourth and Federal Circuits held that Sec. 67(e) exempts only costs that are "not customarily incurred outside of trusts."(2) And in 2006, the Second Circuit divined yet another meaning of the exemption in Rudkin Testamentary Trust, which held that costs are exempt from the floor only if they "could not have been incurred if the property were held by an individual."(3)

On July 27, 2007, in the midst of the judicial fray, the IRS published its first set of regulations under Sec. 67(e).(4) Regs. Sec. 1.67-4 adopted the Second Circuit's interpretation of Sec. 67(e) and exempted only costs that would be "unique" to an estate or trust. It also required trustees to "unbundle" any legal, accounting, investment advisory, appraisal, or other fee, commission, or expense, separating costs that would be unique from those that would not. The proposed regulations permitted allocation of the expenses using any reasonable method. They defined "unique costs" as those "that an individual could not have incurred, (5) as the Second Circuit held.

However, those regulations were short-lived. Five months later, in Knight, the U.S. Supreme Court rejected that interpretation as "fl[ying] in the face of the statutory language." Instead, the Supreme Court adopted the Fourth and Federal Circuits' view that "only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur" are exempt from the floor.(6)

The IRS withdrew the 2007 proposed regulations and replaced them with a second set in 2011, which were intended to "reflect the reasoning and holding in Knight."(7) The 2011 proposed regulations eliminated the requirement that costs be unique, but retained the requirement to unbundle fees using any reasonable method. They also introduced several new categories of costs that would either be subject to or exempt from the floor.

Since 2008, the IRS has received countless comments from members of the AICPA, American Bar Association, American Bankers Association, state societies, and others suggesting ways to improve on the Sec. 67(e) regulations.(8) By far, the most controversial aspect of the regulations has been the requirement to unbundle trustee fees.(9) Although the preamble to the 2014 final regulations hints that perhaps only one person supported the requirement, the final regulations nonetheless retain the unbundling requirement virtually unchanged. (10)

Final Regulations

There are very few differences between the 2011 proposed regulations and the regulations as finally adopted in May 2014. The IRS removed some glaring errors and added some minor (and obvious) clarifications. This article discusses the final regulations in detail, suggests some planning opportunities, and comments on the AMT implications of the rules for trustees and beneficiaries.

"Commonly" or "Customarily" Incurred

Like the proposed regulations, the final regulations broadly define costs subject to the floor as costs that "commonly or customarily would be incurred by a hypothetical individual holding the same property."(11) In making that determination, they focus on the type of product or service rendered to the estate or trust and not the label. The final regulations, however, dropped the provision that costs that do not depend on the payer's identity are subject to the floor. The IRS received some justifiable criticism on this provision because "costs that do not depend on the identity of the payer" is just another way of saying "costs that could be incurred by an individual," which the Supreme Court rejected in Knight. (12) No one will really notice that this provision was removed, however, because it is nearly the same as ownership costs, which are costs incurred "simply by reason of being the owner of the property," and which the final regulations retained. (13)

The final regulations provide five categories of costs compared to three in the proposed regulations. These categories include ownership costs, tax preparation fees, investment advisory fees, appraisal fees, and "certain fiduciary expenses." The last two categories are new. In addition to these five categories, the final regulations provide that costs incurred in defense of a claim against the estate, the decedent, or the nongrantor trust that are unrelated to the existence, validity, or administration of the estate or trust would be subject to the floor. Because nearly every claim initiated against an estate or trust would relate to its existence, validity, or administration, this provision seems to target claims arising during the decedent's life that an executor has continued to defend. For example, if a lawyer died while defending a lawsuit against him by his neighbor for encroachment, the costs incurred by his estate in defending that suit would be miscellaneous itemized deductions subject to the floor. However, defense costs may be otherwise...