This is the second in a two-part article examining developments in estate, gift, and generation-skipping transfer tax and trust income tax between June 2013 and May 2014. Part 1, which appeared in the September issue, discussed gift, estate, and generation-skipping transfer tax developments. Part 2 covers trust developments, the taxation of trusts under the new 3.8% net investment income tax, President Barack Obama's estate and gift tax proposals, and inflation adjustments for 2014.
Expenses Subject to 2%-of-AGI Limitation
On May 9, 2014, final regulations(1) were issued on which costs incurred by estates or nongrantor trusts are subject to the 2%-of-adjusted-gross-income (AGI) floor for miscellaneous itemized deductions under Sec. 67(a). The regulations require a bundled fee to be unbundled by allocating the fee between costs that are subject to the 2%-of-AGI floor and those that are not. The regulations, which are effective for tax years beginning after Dec. 31,2014, (2) adopt, with minor modifications, the repro-posed regulations(3) published in 2011. The regulations also supersede interim guidance in Notice 2008-32, Notice 2008-116, Notice 2010-32, and Notice 2011-37, which generally provided that until the final regulations were published, the unbundling of fees was not required.
Under Sec. 67(a), miscellaneous itemized deductions incurred by an individual are deductible only to the extent that the aggregate of those deductions exceeds 2% of AGI. Sec. 67(b) exdudes certain itemized deductions from the definition of "miscellaneous itemized deductions." Sec. 67(e) requires the AGI of an estate or trust to be computed in the same manner as an individual's AGI, but Sec. 67(e)(1) allows an above-the-line deduction for costs paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in an estate or trust. Therefore, the deductions described in Sec. 67(e)(1) are not subject to the 2%-of-AGI floor.
In Knight, (4) the Supreme Court settled a split among the circuit courts of appeals and put to rest the issue of whether investment advisory fees are fully deductible under Sec. 67(e) or are deductible under Sec. 67(a), making them subject to the 2%-of-AGI floor. The Supreme Court ruled that investment advisory fees were not "uncommon (or unusual, or unlikely)" for a hypothetical individual to incur and, therefore, the second requirement of Sec. 67(e)(1) (requiring that the expense "would not have been incurred if the property were not held in [the] trust") had not been met.
Before the Supreme Court's decision in Knight, proposed regulations(5) that were published in 2007 addressed for the first time the issue of "bundled trustee fees." The IRS and Treasury were concerned that fiduciaries were combining into one fee certain fees that were not deductible under Sec. 67(e)(1). Those proposed regulations would have required fiduciaries to "unbundle" these fees.
In 2011, the IRS withdrew the 2007 proposed regulations and issued new ones.(6) The new proposed regulations provided that a cost is subject to the 2%-of-AGI floor if it would be commonly or customarily incurred by a hypothetical individual owning the same property. These costs included ones that do not depend on the payer's identity and specifically included 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 trust or estate. The final regulations retain these rules but removed the reference to costs that do not depend on the payer's identity.
Ownership costs that are commonly or customarily incurred by individual property owners continue to be subject to the 2%-of-AGI floor under the final regulations. However, the final regulations clarify examples in the proposed regulations used to illustrate ownership costs. In addition, in the final regulations, the IRS added to the list of costs incurred by a trust or estate that are not subject to the floor appraisal fees for appraisals needed to determine value as of the date of a decedent's death, value for purposes of making distributions, or value as otherwise required to properly prepare a trust's or estate's tax returns.
The 2011 proposed regulations provided that, for tax preparation fees, the costs for all estate and generation-skipping transfer (GST) tax returns, fiduciary income tax returns, and the decedent's final individual income tax return are not subject to the 2%-of-AGI floor. In response to comments, the final regulations retain this rule but clarify it by including an exclusive list of tax return preparation costs that are not subject to the 2%-of-AGI floor. The final regulations also retain unchanged the rule that investment advisory fees are generally subject to the 2%-of-AGI floor. But incremental costs of investment advice are fully deductible if charged solely because the investment advice is rendered to a trust or estate instead of to an individual and is attributable to an unusual investment objective or the need for a specialized balancing of interests of the various parties (beyond the usual balancing between current beneficiaries and remaindermen).
In certain situations, a single fee (such as a fiduciary's commission, attorney's fee, or accountant's fee) must be unbundled and treated in accordance with its component parts. Under the final regulations, a taxpayer may use any reasonable method to allocate a bundled fee between costs that are subject to the 2%-of-AGI floor and those that are not. However, any portion of a bundled fee attributable to payments made from the bundled fee to third parties for expenses subject to the 2%-of-AGI floor that is readily identifiable must be pulled out of the bundled fee.
Unbundling is not required for fees computed on an hourly basis. In that situation, the portion of the fee that is attributable to investment advice must be pulled out as well as any payments made from the bundled fee to third parties for expenses that would have been subject to the 2%-of-AGI floor if they had been paid directly by the estate or trust, and any separately assessed fees that are commonly or customarily incurred by an individual owner of such property. This portion is then subject to the 2%-of-AGI floor while the remainder of the fee is fully deductible.
The unbundling requirement in the final regulations applies only to tax years beginning after Dec. 31, 2014. Therefore, Notice 2011-37, which provides that trusts and estates are not required to unbundle fees, remains in force for 2013 and 2014 fiduciary income tax returns. As a result, fiduciaries should consider charging bundled fees for services they will provide in 2015 in December 2014 to maximize the deductibility for the estate or trust. When considering the trust's overall tax liability between 2014 and 2015, this strategy may also lessen an estate's or trust's overall net investment income tax and alternative minimum tax liabilities.
Once these final regulations are fully in effect, trustees and executors will need to keep more detailed records regarding the expenses of the trust or estate--sep-arating those expenses that are subject to the 2%-of-AGI floor from those that are not. Trustees and executors will further have to address how they will apportion their fees (as well as other professionals' fees) between those fees subject to the floor and those that are not, and be aware that they will need to be able to justify the "reasonableness" of their apportionment method.
In Frank Aragona Trust, (7) the Tax Court held that a trust qualified as a "real estate professional" under Sec. 469(c)(7) and materially participated in the real estate activity for purposes of the passive loss rules under Sec. 469. This decision is important for nongrantor trusts that own interests in passthrough entities that conduct a trade or business for both the passive activity rules and the determination of the Sec. 1411 net investment income tax.
The trust owned rental real estate properties and also engaged in other real estate activities. After the grantor died, his five children and an independent trustee became the new trustees. The trustees managed and made all major trust decisions, and each trustee received trustee fees. Three trustees worked full time and received wages from an LLC owned by the trust that was a disregarded entity The LLC managed most of the trust's real estate properties and employed several other people. Two trustees held minority interests in some of the real estate entities the trust also owned. The trust conducted its rental real estate activities directly, through wholly owned entities, and through entities in which the two trustees/sons also owned minority interests. In the 2005 and 2006 tax years, the trust treated its losses from its rental real estate properties as losses from nonpassive activities. The IRS issued a notice of deficiency in which it determined the trust's rental real estate activities were passive activities.
Sec. 469(a) disallows passive activity losses in excess of passive activity income. Sec. 469(c)(1)(A) provides that the term "passive activity" means any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. Secs. 469(c)(2) and (c)(4) together provide that any rental activity is considered a passive activity, even if the taxpayer materially participates in the activity. However, under Sec. 469(c)(7), the rental activities of a taxpayer that qualifies as a real estate professional are not automatically considered passive.
Sec. 469(c)(7)(B) provides two tests, both of which a taxpayer must meet, to be classified as a real estate professional. The first test is met if more than one-half of the "personal services" the taxpayer performed in trades or businesses during the tax year are...