Prop. regs. address deductibility of trust and estate costs.

• Author: Englebrecht, Ted D.

In July, the IRS issued proposed regulations (REG-128224-06) providing guidance on whether costs incurred by estates or nongrantor trusts are subject to the 2% floor for miscellaneous itemized deductions. The new rules intend to clarify the deductibility of advisory fees paid by estates and trusts. This item outlines the major elements in the proposed hales and examines some existing controversial issues under the new standards.

Background

The taxable income of estates and trusts is generally computed in the same manner as that of an individual under Sec. 641(b). An individual may deduct investment advisory fees as miscellaneous itemized deductions under Sec. 212, but Sec. 67(a) limits an individual's miscellaneous itemized deductions to the amount in excess of 2% of adjusted gross income (AGI). However, Sec. 67(e)(1) provides exceptions that allow certain fiduciary costs to be fully deductible. These exceptions apply to "costs which are 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 trust or estate."

An arguable issue is whether investment advisory fees paid by an estate or trust to outside investment advisers fall within the exception of Sec. 67(e)(1). The Service has determined that these fees do not meet the exception. Nonetheless, the courts have split on this question. In O'Neill, 994 F2d 302 (6th Cir. 1993), the Sixth Circuit reversed a Tax Court decision and held that when the trustees lacked experience in managing large sums of money, investment advisory fees paid to outside professional advisers were not subject to the 2% floor. In its opinion, the Sixth Circuit noted that although individuals routinely incur investment advice, they are not required to act prudently and are not subject to penalties or liabilities for negligent acts. Therefore, the investment advisory fees were necessary. In contrast, the Second, Fourth, and Federal Circuits held in similar cases for the IP,.S on the 2% rule (Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006), cert. granted 6/25/07; Scott, 328 F3d 132 (4th Cir. 2003); Mellon Bank, N.A., 265 F3d 1275 (Fed. Cir. 2001)).

Proposed Rules

The inconsistent treatment of the deductibility of investment advisory fees in the case law leaves the resolution of any particular case dependent on the jurisdiction in which the executor or trustee is located. While the Supreme Court has granted certiorari in Rudkin and should settle the split among the circuits, the Service has proposed new regulations to provide a uniform standard for determining which types of costs are excepted from the 2% floor under Sec. 67(e)(1).

Prop. Regs. Sec. 1.67-4(a)...