The proper treatment of administrative expenses: the debate rages on.

• Author: Strobel, George L., II

Ever since the enactment of the unlimited marital deduction, the proper treatment of administrative expenses has been a fertile area of debate between taxpayers and the IRS. This article analyzes three recent cases, Martin,(1) Est. of Richardson(2) and Est. of Street,(3) that highlight the intensity of this debate. In situations in which a will provides for an unlimited estate tax marital or charitable deduction, executors have routinely deducted administrative expenses on the estate's income tax returns rather than on the estate tax return. During an IRS examination, a determination is made as to the return on which such administrative expenses have been deducted; if they have been deducted on the estate's income tax return, the IRS typically reduces the residual marital or charitable deduction by a corresponding amount. If the marginal estate tax rate is already 55%, the effective tax rate on the taxable portion of the estate due to reduction of the marital or charitable deduction could be as high as 122%.(4) If reduction of the marital or charitable deduction causes the taxable estate to exceed the unified credit equivalent, interest will be assessed on the deficiency.(5)

Understanding the Interplay of

Fiduciary and Tax Accounting

There is general misunderstanding by both fiduciaries and the IRS about the correct fiduciary accounting treatment for administrative expenses. This misunderstanding stems from a failure to distinguish between the treatment of such expenses for fiduciary accounting purposes, as opposed to their tax consequences. Treatment of an item for fiduciary accounting purposes is relevant (but not determinative) of its effect on the estate tax return.(6)

The primary obligation of an executor or fiduciary responsible for an estate is collecting and consolidating the decedent's assets, satisfying any valid debts of the decedent (including estate taxes) and making distributions as provided for under the will after payment of all claims. Unfortunately, this process often spans several years.

On the death of the first spouse, most wills provide for a credit trust, to the extent there is any remaining unified credit, with the rest of the estate passing to a residual trust qualifying for the marital deduction. During this period of administration, an estate typically incurs significant administrative expenses, including executor's fees, investment banking fees or other investment counseling expenses, estate tax and estate income tax return preparation fees, and legal and accounting fees. Other administrative expenses include appraisers' fees and costs of storing and maintaining property.

An executor must determine the assets and liabilities in the probate estate. Based on this information, the following issues must be resolved: (1) the total value of the assets passing under the marital trust and (2) how much income should be distributed to the surviving spouse. This process is further complicated by the fact that, while the estate's assets and liabilities are fixed as of the date of death, administrative expenses are incurred by the estate for several years thereafter.

In determining the proper treatment of administrative expenses, an executor must first look to the will to determine whether the decedent provided any guidance as to how to allocate these costs. A typical will normally provides an executor with the maximum degree of discretion allowed under state law in allocating items between income and corpus. In many jurisdictions, state law provides complete latitude in exercising discretion in allocating items between income and corpus. The only limiting standard seems to be one of reasonableness and fairness; this is often only found by reference to common law, not statute. In some states (e.g., Florida), certain administrative expenses must be allocated either to corpus or income.(7) Oklahoma provides that, absent instructions to the contrary, administrative expenses are allocated to income.(8)

From a fiduciary accounting perspective, there are three types of administrative expenses. The first type is items that, in all fairness, should be charged only to corpus. For example, the cost of preparing the estate tax return: it is a cost that was known to be needed as of the date of death, was anticipated by the decedent, is nonrecurring in nature, and its primary function is the preservation of estate assets. This category of administrative expense includes expenses that are inherent to winding up an estate and determining the terms of the will. Certainly, a portion of the executor's fee and attorney's fee falls into this category. Clearly, the costs of probating the estate should be borne by corpus.

The second category of administrative expenses are those that should be charged solely against estate income. For example, investment fees incurred in managing the estate's assets to maximize income or fees incurred to prepare the estate's income tax returns benefit only the income beneficiary. These costs relate solely to the postdeath management of the estate to maximize income rather than to resolve which assets are a part of the estate or to whom they will ultimately be distributed. Using a fairness standard, it would be inequitable to allocate these expenses against corpus.

The last category, by far the largest, is administrative expenses that can be allocated against either estate corpus or income (i.e., from an equitable perspective, there is no compelling argument to charge estate income or corpus). Typically, these expenses have either a direct or indirect benefit to both estate income and corpus. In allocating this last category of administrative expense, a fiduciary looks for direction from the will and determines whether the item is chargeable against the estate's income or corpus. Other than state law (which is typically silent), there is no standard against which the executor's allocation can be challenged. Traditionally, most administrative expenses were charged against the estate's corpus. However, the modern legislative trend is to grant the executor discretion in allocating these expenses against corpus or income.(9)

Determination of the Taxable Estate

Once administrative expenses have been allocated against either corpus or income for fiduciary accounting purposes, the executor can determine the estate and income tax consequences of such items.(10) Secs. 2056 (the marital deduction) and 642(g)(which precludes the double deduction of administrative expenses under Sec. 2053 or 2054 on both the estate tax and estate income tax returns) are at the core of the debate concerning treatment of administrative expenses. In general, Sec. 2056 provides a marital deduction determined by deducting from the gross estate the value of any interest in property that passes or is passed from the decedent to a surviving spouse, but only to the extent that such interest is included in determining the value of the gross estate. Sec. 2056(b)(4)(B) provides that, in determining the marital deduction, the value of any interest in property passing to the surviving spouse must be reduced by any encumbrance or tax imposed on it.

Under Regs. Sec. 20.2056(b)-4(a), in valuing an interest passing to the surviving spouse, account must be taken of the effect of any material limitations on the spouse's right to income from the property. The regulation illustrates this principle with an example ("Regulation Example") of a bequest of property in trust for the benefit of the decedent's spouse, the income from which (from the date of the decedent's death until distribution of the property to the trustee) is to be used to pay administration expenses.(11)

These regulations have remained virtually unchanged since their 1974 enactment. In fact, provisions in Sec. 2056(b)(4) are found in Section 812(e) of the Revenue Act of 1948. Congress originally provided that in considering the value of the marital deduction, "where such interest on property is encumbered in any manner, or where the surviving spouse incurs any obligation imposed by the decedent with respect to passing of such interest, such encumbrances or obligation shall be taken into account in the same manner as if the amount of a gift to such...