How will final Regs. apply the Knight "commonly incurred" test?

• Author: Cantrell, Carol
• Position: Estates, Trusts & Gifts

EXECUTIVE SUMMARY

* The exact meaning of Sec. 67(e) is not clear on its face and the legislative history of the provision sheds little light on Congress's intent. Before the Knight decision, there was a split in opinion among the appellate circuits over the correct interpretation of the provision.

* In Knight, the Supreme Court held that under Sec. 67(e), a trust expense otherwise subject to the 2% of AGI floor is fully deductible under the exception in Sec. 67(e) only flit would be uncommon for an individual holding the same property to incur the expenses.

* The IRS is poised to issue final regulations under Sec. 67(e) in the near future. The proposed regulations, which were issued before the Knight decision, allowed a full deduction for expenses under Sec. 67(e) only if they could not have been incurred by an individual. They also included a highly controversial requirement to unbundle trustee fees in determining whether they are fully deductible.

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Whether investment advisory fees and other expenses incurred by estates and trusts are subject to the 2% floor on miscellaneous itemized deductions has been a continual controversy since the enactment of Sec. 67(e) as part of the Tax Reform Act of 1986. This article explains the Supreme Court's interpretation of Sec. 67(e) in Knight and discusses its possible impact on the forthcoming final Sec. 67(e) regulations.

It has been 22 years since Congress added the phrase "which would not have been incurred if the property were not held in such mast or estate" to the Code (Sec. 67(e)) in the final hours of a heated closed-door Joint Conference Committee session on the Tax Reform Act of 1986. (1) Since then its meaning has been a mystery, spawning eight costly court battles, resulting in a three-way circuit split, and culminating in the U.S. Supreme Court's Knight decision on January 16, 2008. (2)

All this energy has been spent trying to determine the boundaries set by a 17-word phrase that aims to exempt certain administrative costs of an estate or trust from the Sec. 67(a) 2% floor on miscellaneous itemized deductions. Although the announced purpose of the 2% floor in Sec. 67(a) was to simplify recordkeeping and prevent individuals from deducting personal expenses, the exact purpose of Sec. 67(e) is not so clear. (3) Sec. 67(e) allows an estate or trust a full deduction for administrative costs "which would not have been incurred if the property were not held in such trust or estate." But what does that mean?

The only explanation of Sec. 67(e) in the legislative history appears in the Conference Committee Report in a four-sentence paragraph describing when costs of passthrough entities owned by individuals, estates, and trusts are subject to the 2% floor. (4) Read in context, it appears that Congress intended the phrase to subject only administrative costs flowing from passthrough entities owned by the estate or trust. The various courts that have been confronted with the issue have offered differing explanations of the section. The Sixth Circuit in O'Neill held that it allows a full deduction for costs that are necessary to fulfill the trustee's duties. (5) The Federal and Fourth Circuits in Mellon Bank and Scott held that it allows a flail deduction only for costs not commonly incurred by individuals. (6) And most recently, in 2006 in Rudkin Testamentary Trust, the Second Circuit held that it allows a full deduction only for costs that individuals are incapable of incurring. (7)

Given the multiple interpretations of Sec. 67(e), Chief Justice Roberts chose the middle road in interpreting the provision's meaning in order to achieve his confessed goal (8) of unanimity among the justices. Indeed, the Roberts Court has achieved unanimity in nearly 50% of its cases compared with about 38% over the last 50 years. (9) Knight holds that "costs incurred by trusts that escape the 2% floor are those that would not 'commonly' or 'customarily' be incurred by individuals." (10) It essentially adopts the Mellon/Scott approach:

See Scott, 328 F.3d at 140 ("Put simply, trust-related administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by individual taxpayers"); Mellon Bank, 265 F. 3d at 1281 ([section] 67(e)) "treats as fully deductible only those trust-related administrative expenses that are unique to the administration of a trust and not customarily incurred outside of trusts"). ... We agree with this approach. (11)

After endorsing the Mellon/Scott approach, Chief Justice Roberts added his own explanation, which he framed as a prediction: "[T]he question of whether a trust-related expense is fully deductible turns on a prediction about what would happen ... if the property were held by an individual rather than by a trust." The "direct import of the language in context" is to ask "whether expenses are 'customarily' incurred outside of trusts." This, he said, "necessarily entails a prediction; and predictions are based on what would customarily or commonly occur. Thus, in asking whether a particular type of cost 'would not have been incurred' if the property were held by an individual, Sec. 67(e)(1) excepts from the 2% floor only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur." (12)

Taxpayers must now live with that narrowly constructed compromise, despite the fact that both the taxpayer and the government described the test as "inadministrable" in briefs and oral argument before the Court.

AICPA Issues Interim Guidance for 2007 Tax Returns

As soon as the Court issued its opinion, it became clear that Prop. Kegs. Sec. 1.67-4 had to be .withdrawn or amended. The proposed regulations (REG-128224-06) adopted the Second Circuit's view (expressed in Rudkin) that a full deduction is allowed only for costs an individual cannot incur. The Court described this interpretation of Sec. 67(e) as "fly[ins] in the face of the statutory language." (13)

The issuance of the Court's decision at the beginning of the 2008 tax filing season required quick action on everyone's part. The AICPA led the way by issuing guidance to its members on February 4, 2008, in a Tax Section e-alert addressing how to treat outside investment advisory fees, trustee fees, fiduciary income tax preparation fees, and other costs in preparing 2007 Forms 1041, U.S. Income Tax Return for Estates and Trusts. (14) The AICPA offered the following advice on these subjects:

Investment advisory fees: Based on the Supreme Court's reading of Sec. 67(e)(1), investment advisory fees paid by the trust to an investment adviser are subject to the 2% floor unless the trustee can show that there is an "incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer" or that the investment adviser "impos[ed] a special, additional charge applicable only to its fiduciary accounts" or that the trust has "an unusual investment objective, or ... require[s] a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2 percent floor" (15)

To exempt any part of the investment advisory fee from the 2% floor, the trustee must substantiate that it would be unusual for an individual who owned the same property to have incurred the same cost. Such substantiation could include, for example, the trust agreement investment directives, the special needs of the trust beneficiaries, fee schedules, descriptions of the services provided, or surveys and statistics about common investor traits to the extent they are obtainable.

Trustee fees and unbundling: Because the Supreme Court did not specifically address trustee fees and agreed with the Mellon/Scott approach, which allowed a full deduction for them, trustee fees should be exempt from the 2% floor. Moreover, it "would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur" trustee fees. Thus, unbundling is not required until and unless the final regulations require such treatment.

Fiduciary tax return preparation fees: Based on the Supreme Court's agreement with Mellon/Scott and the Service's long-standing position, fiduciary income tax return preparation and judicial accounting fees should be exempt from the 2% floor. Moreover, it would be uncommon (or unusual or unlikely) for a hypothetical individual to incur these costs.

Other costs: Tax return preparers should inquire about the nature of other costs and determine on a case-by-case basis whether it would be unusual or uncommon for an individual with the same property to incur the cost. In some cases it will be easy to decide whether a cost is uncommon to individuals, such as disputes over income and principal. However, most types of fees, such as consulting fees, appraisal fees, and family office expenses, will require a high level of judgment and adequate substantiation to claim a flail deduction.

AICPA Comments to Treasury

Four days after sending its e-alert to members, the AICPA also sent comments to Treasury and the IRS asking them to withdraw Prop. Kegs. Sec. 1.67-4 and to open a new comment period so the public can explain the complex issues that trustees face when comparing their costs with those of an ordinary individual with the same property. (16) The AICPA comments include 15 examples of unique situations that trustees face in managing property under the Prudent Investor Act for the benefit of others. It also proposed solutions to the examples, hoping to learn where the IRS will draw the "commonly" line, whether in terms of percentages, portfolio size, unique circumstances involved, or some combination.

Example 1: A trust owns $2 million of U.S. Treasury bonds, which the decedent, D, owned and managed during his lifetime. D's spouse...