The ongoing sec. 67(e) controversy and the new preparer penalties.

• Author: Janes, Craig L.
• Position: ESTATES, TRUSTS & GIFTS

The correct way to handle trust administrative costs and the 2% floor on their deductibility has been a long-standing controversy. This item discusses how the 2% floor affects a trust's regular tax and alternative minimum tax (AMT), the effect of the recent Supreme Court decision in Knight on the continuing controversy, and the efficacy of the proposed regulations in the wake of the Knight decision. It also discusses the effect of the Knight decision and the proposed regulations on both tax preparers and taxpayers under the current penalty structure.

Sec. 67--An Introduction

Under Sec. 67(a), miscellaneous itemized deductions are limited to the amount that exceeds 2% of the trust's adjusted gross income (AGI). Trust administrative costs are deductible under the terms of Sec. 212 and are treated as miscellaneous itemized deductions under Sec. 67(b). Under this general rule, absent an express exception, all administrative deductions claimed by a trust would be subject to the 2% floor.

Sec. 67(e)(1) contains an exception for trusts and estates: It allows certain administrative costs to be deducted above the line in computing AGI. The exception contains two requirements: (1) the costs must have been "paid or incurred in connection with the administration of the ... trust" (the necessity test); and (2) the costs must have been expenses "which would not have been incurred if the property were not held in such trust" (the exclusivity test).

A trust's AGI is generally computed like an individual's, but Sec. 67(e) allows "above the line" deductions for income distributed by the trust and for the annual exclusion amount under Sec. 642(b). A trust that distributes all or the majority of its taxable income in any given year will likely have a low 2% floor and will lose few deductions. But a trust that accumulates income and pays regular tax may lose deductions, depending on the size of its AGI relative to its administrative costs (i.e., a high AGI together with high administrative costs will lead to a loss in deductions).

The 2% floor will also affect the trust's AMT calculation. Expenses subject to the 2% floor are considered an adjustment and are added back in order to calculate alternative minimum taxable income (AMTI) under Sec. 56(b)(1)(A). Under the rules of Sec. 59(c), all AMT adjustments are trapped at the trust level, except in the rare case in which trust distributions exceed regular tax distributable net income (DNI). Only in that case will the excess of AMT DNI over regular tax DNI be distributed to the beneficiary, leaving less AMTI subject to tax in the trust.

Because AMT adjustments are generally trapped at the fiduciary level, a distributing trust or estate runs a greater risk that it will be subject to AMT in any given year. When this happens, the combined tax burden (for the trust and the beneficiary) will be greater than if the trust had made no distributions at all. However, the AMT effect of the 2% floor on an accumulating trust or estate is unlikely to be significant because, by itself, the amount of disallowed expenses would generally not be enough to trigger the AMT for the trust.

The Historical Controversy

Several federal courts have ruled on the Sec. 67(e) exclusivity requirement. (See Scott, 328 F3d 132 (4th Cir. 2003), aff'g 186 FSupp2d 664 (E.D. Va. 2002); Mellon Bank, N.A., 265 F3d 1275 (Fed. Cir. 2001), aff'g 47 Fed. C1. 186 (2000); O'Neill, 994 F2d 302 (6th Cir. 1993), rev'g 98 TC 227 (1992); and Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006), aff'g 124 TC 304 (2005).) Specifically at issue in each case was the deduction of investment advisory fees. No two of these courts have come up with a consistent position. However, almost all the courts have sided with the government's position that investment advisory fees are subject to the 2% floor; only the Sixth Circuit (reversing the Tax Court in O'Neill) sided with the taxpayer.

Unlike all the other cases, Mellon Bank involved the deductibility not just of investment fees but of expenses related to investment strategies advice, accounting and tax preparation fees, and management services. In denying a government motion for summary judgment, the Court of Federal Claims, later sustained by the Federal Circuit, noted that trust administrative costs would not be subject to the 2% floor if "such services when provided for a trust are 'more onerous' than those provided for individuals." The government ended up winning the case because the taxpayer would not present evidence as to whether any portion of the costs at issue would not have been incurred if the property were not held in trust. Consequently, left unanswered was the extent to which any of the costs, in addition to the investment advisory fees, might otherwise have been found deductible.

On January 16, 2008, the Supreme Court issued a decision in the Rudkin case (now identified as Knight, S...