New Proposed Regulation § 1.67-4

The IRS has issued new proposed regulations governing the income tax deductibility of certain expenses and costs incurred by an estate or non-grantor trust.

Code Section 67(e):

Deductibility of Certain Costs and Expenses. Generally, costs and expenses that are characterized as “miscellaneous itemized deductions” under the Internal Revenue Code (the “Code”) are deductible on an income tax return only to the extent such costs and expenses exceed 2% of the taxpayer’s adjusted gross income. When the taxpayer is an estate or non-grantor trust, however, a special Code section (“Code Section 67(e)”) provides that costs and expenses are fully deductible, and thus not subject to the 2% floor, if such costs or expenses are paid or incurred in connection with the administration of an estate or non-grantor trust and would not have been incurred if the property with which such costs or expenses are associated were not held in such estate or trust.

Conflicting Interpretations of Code Section 67(e).

In 2007, the IRS issued proposed regulations interpreting Code Section 67(e) as rendering a cost or expense incurred by an estate or non-grantor trust fully deductible only if that cost or expense is unique to an estate or trust. The following year, the U.S. Supreme Court held that a proper interpretation of Code Section 67(e) would allow a cost or expense incurred by an estate or non-grantor trust to be fully deductible unless such cost or expense customarily or commonly would be incurred by a hypothetical individual holding the same property outside of an estate or trust. 

New Proposed Regulations.

In accordance with the Supreme Court’s interpretation of Code Section 67(e), on Sept. 6, 2011, the IRS withdrew the 2007 proposed regulations and issued new proposed regulations providing that a cost or expense incurred by an estate or non-grantor trust is subject to the 2% floor if such cost or expense is commonly or customarily incurred by a hypothetical individual holding the same property. The new proposed regulations provide the following examples of costs and expenses, which are and are not commonly or customarily incurred by a hypothetical individual:

• In General. Expenses that do not depend on the identity of the payor (in particular, whether the payor is an individual, estate or trust) are commonly or customarily incurred by a hypothetical individual.

Commonly or Customarily Incurred: costs incurred in defense of a claim against an estate, decedent or non-grantor trust that are unrelated to the existence, validity or administration of such estate or trust.

• Ownership Costs. Costs incurred by an owner of property simply by reason of being the owner are commonly or customarily incurred by a hypothetical individual.

Commonly or Customarily Incurred: condominium fees, real estate taxes, insurance premiums, maintenance and lawn services, automobile registration and insurance costs and partnership costs deemed passed-thru to a partner.

• Tax Preparation Fees. Costs incurred in connection with the preparation of a tax return may or may not be commonly or customarily incurred by a hypothetical individual.

Commonly or Customarily Incurred: fees associated with preparation of individual income tax returns, gift tax returns, tax returns for a sole proprietorship and tax returns for a retirement plan.

Not Commonly or Customarily Incurred: fees associated with preparation of estate tax returns, generation-skipping transfer tax returns, fiduciary income tax returns and decedent final individual income tax returns.

• Investment Advisory Fees. Investment advisory fees may or may not be commonly or customarily incurred by a hypothetical individual.

Commonly or Customarily Incurred: fees for investment advice that would be provided to an individual investor as part of an investment advisory fee.

Not Commonly or Customarily Incurred: certain “incremental costs” of investment advice beyond the amount that normally would be charged to an individual investor. An “incremental cost” is a special, additional charge added solely because the investment advice is rendered to a trust or estate instead of to an individual, and that is attributable to an unusual investment objective or the need for a specialized balancing of the interests of various parties (beyond the usual balancing of the varying interests of current beneficiaries and remaindermen).

Any bundled fee (a single fee, commission or expense (other than an out-of-pocket expense), such as a trustee’s fee, attorney’s fee or accountant’s fee) of more than a de minimus amount must be allocated between costs subject to and costs not subject to the 2% floor. The new proposed regulations provide the following guidance for allocating bundled fees:

• A payment made from a bundled fee to a third party is subject to the 2% floor if such payment would have been subject to the 2% floor had such payment been paid directly to such third party.

• If a bundled fee is not computed on an hourly basis (e.g., if computed as a percentage of the value of the trust income), then only that portion of that fee that is attributable to investment advice is subject to the 2% floor.

• In making allocations from bundled fees, any reasonable method may be used.

Tax advice disclosure:  Any tax advice contained in this publication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.