On November 14, 2007, at 10 a.m., a hearing was held by the Internal Revenue Service at its offices in Washington, D.C., to receive comments about the Notice of Proposed Rulemaking on Section 67 Limitations on Estates or Trusts (Internal Revenue Bulletin No. 2007-36), issued September 4, 2007.
That Notice was summarized as follows:
This Notice contains proposed regulations that provide guidance on which costs incurred by estates or non-grantor trusts are subject to the 2-percent floor for miscellaneous itemized deductions under section 67(a). The regulations will affect estates and non-grantor trusts. This document also provides notice of a public hearing on these proposed regulations.
The issue in each case has been whether the trust’s costs (specifically, investment advisory fees) “would not have been incurred if the property were not held in such trust or estate.”The IRS determined to issue proposed regulations to resolve the situation.
In O’Neill v. Commissioner, 994 F.2d 302 (6th Cir. 1993), the Court of Appeals for the Sixth Circuit held that investment advisory fees paid for professional investment services were fully deductible under section 67(e)(1) where the trustees lacked experience in managing large sums of money. The court found that, under state law, the trustee was required to engage an investment advisor to meet its fiduciary obligations and to incur fees that the trust would not have incurred if the property were not held in trust. The court held that estate or trust expenditures that are necessary to meet specific fiduciary obligations under state law are not subject to the 2-percent floor.
In contrast, in Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001), Scott v. United States, 328 F.3d 132 (4th Cir. 2003), and Rudkin v. Commissioner, 467 F.3d 149 (2d Cir. 2006), the courts held that investment advisory fees are subject to the 2-percent floor.
These courts read the language of section 67(e)(1) differently than the Sixth Circuit. Specifically, the courts in Scott and Mellon Bank concluded that a trust expense is subject to the 2-percent floor if it is an expense “commonly” or “customarily” incurred by individuals; and the court in Rudkin looked to whether such an expense was “peculiar to trusts” and “could not” be incurred by an individual. * * *
The result of this lack of consistency in the case law is that the deductions of similarly situated taxpayers may or may not be subject to the 2-percent floor, depending upon the jurisdiction in which the executor or the trustee is located. * * *
That was quite unusual -- and somewhat controversial -- because the Supreme Court of the United States already had granted a review of these conflicting federal circuit court decisions. For background about the dispute involving William L. Rudkin Testamentary Trust v. Commissioner (PDF, 19 pages), 467 F.3d 149, 98 AFTR2d 2006-7368 (2d Cir. 10/18/06), see PA EE&F Law Blog postings: "Rudkin" Regulations Proposed During Appeal (08/02/07); and Bankers Associations File Amicus Brief in Rudkin Case (09/24/07). Furthermore, the proposed regulations would create rules going beyond even supportive court decisions.
In anticipation of the October 24th deadline for submission of written comments about the proposed regulations, the American Bar Association sent a letter, dated October 23, 2007 (PDF, 1 page), relating to the "Proposed Regulations Relating to Limitation on Estates or Trusts Deductions (REG-128224-06)".
The comments, derived from its Tax Section and its Real Property, Trusts & Estate Law Section, were brief:
The interpretation of section 67(e) will be before the United States Supreme Court in the current term (Rudkin v. Commissioner, 467 F.3d 149 (2nd Cir. 2006), cert. granted sub nom. Knight v. Commissioner (S. Ct. Doc. No. 06-1286)).The American Bankers Association also submitted comments consistent with its general position on trust taxation issues:
Therefore, we respectfully request that the Treasury and the Service consider deferring 1) the submission date for the comments on the Proposed Regulations, 2) the hearing date for the comments on the Proposed Regulations, and 3) any action on the Proposed Regulations all until after the Court has issued its decision in the Knight case.
This will afford the public the opportunity to take into account the effect, if any, of the Court's conclusions when submitting comments on the Proposed Regulations.
In particular, the IRS calls for the unbundling of fees and a list of what fees are deductible and what fees are not. This requirement goes beyond the scope of the statute.However, the letter, dated October 24, 2007, sent by the American Bankers Association (PDF, 6 pages), provided far more detail in its substantive objections to the proposed regulations. That letter then concluded, similarly:
This issue was raised in the Rudkin case for which the Supreme Court recently granted certiorari and on which the ABA has filed an amicus brief.
At a minimum, the IRS should not move forward with this proposal until the Supreme Court has had an opportunity to rule on the merits of the case before it.On November 16, 2007, Susan D. Snyder, Esq., of Northern Trust Corporation, posted on the listserv of the American College of Trust & Estate Counsel (ACTEC) the following summary, which was circulated by the American Bankers Association post-hearing:
In addition, we would strongly urge the IRS to abandon this proposal, as it ignores the significant fiduciary duties of trustees and leads to far greater burdens than benefits.
The panel consisted of three attorneys in the IRS's Passthroughs and Special Industries section (Danielle Grimm; Brad Poston; and Jennifer Keeney) and one person from Treasury, Catherine Hughes, Attorney Advisor in the Office of Tax Policy.Susan also posted the testimony presented by her co-worker, tax attorney Grace Allison, Esq., on behalf of Northern Trust Corporation, at that hearing.
Seven people testified: Robert Balter, attorney; Joseph Mooney, representing the American Bankers Association; Richard Weber, representing the AICPA; Grace Allison, Northern Trust; Diana Zeydel, attorney; Barbara Sloan, attorney; and Randall Harris, attorney.
Generally, the speakers made these arguments: (1) extend the comment period until 90 days after the Supreme Court has issued a decision; (2) plain meaning of Sec. 67(e) allows a full deduction of the entire trust fee, including investment management fees; (3) the unbundling requirement will be very costly and burdensome to trustees; (4) trustees are held to fiduciary principles, individuals are not; (5) in drafting the proposed regulation, the IRS is engaging in linguistic manipulation of the statute.
Since I cannot find these comments on either the Northern Trust Corporation website or the American Bankers Association website, I requested to repost them. Susan graciously consented; and I do so, with thanks to her, Grace, & their employer.
Ladies and Gentlemen:Update: 12/05/07:
Thank you for the opportunity to make this presentation today.
I represent Northern Trust Corporation (“Northern Trust”), which has been in the business of administering trusts since its founding in 1889. Today, Northern is one of the largest trust companies in the world, with a network of 85 offices in 18 U.S. states, administering more than 15,000 irrevocable trusts nationwide.
In my position as Vice President in the Personal Financial Services Division of Northern Trust, I have worked closely with trust administrators, investment managers and ancillary personnel on a wide range of trust matters. I am a tax attorney, admitted to the Illinois bar and to practice before the Tax Court.
As a member of the Illinois Bankers Association, Northern Trust endorses the amicus brief filed on August 23, 2007, by The American Bankers Association in Knight v. Commissioner, U.S., No. 06-1286, as well as the comments submitted by The American Bankers Association in connection with this hearing.
It is our view that the proposed regulations should be replaced with regulations adopting the rationale articulated by the Sixth Circuit in O’Neil v. Commissioner, 994 F.2d 302 (6th Cir. 1993).
Additionally, we submit that the plain language of section 67(e) fails to provide any basis whatsoever for the requirement that trustees “unbundle” their fees and that the proposed regulations, to the extent they so require, are invalid as an abuse of administrative authority.
The Plain Meaning of Section 67(e)
Section 67 generally provides that an itemized deduction is allowed only to the extent that it exceeds 2% of a taxpayer’s adjusted gross income. Subsection (e) of that section, however, permits a full deduction (without application of the 2% floor) for “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 estate or trust . . ..”
This plain language, and the legislative history behind it, permit a full and undiminished deduction for all trust fees (including fees for custody and investment advice) to the extent that such costs are paid in connection with the administration of the trust and would not have been incurred if the property were not held in the trust. Indeed trustee fees can only be incurred in connection with property held in a trust. Regardless of whether we incur costs to achieve good business practice and reputation or to comply with strict requirements of local fiduciary law, there is no question that we incur them in order to administer our trusts.
We are not talking here about abusive pass-throughs of inappropriate expenses—such as stadium tickets or airfare to China. The fees that are the proper subject of this hearing relate to integral trust functions. There is no authority for excluding legitimate trustee fees from the coverage of section 67(e).
Disparate Treatment of Mutual Fund Fees.
It is also important to note that the proposed regulations, if made final, have the potential to disrupt the financial markets (and create another tax loophole) by providing a new incentive for all trusts to invest in mutual funds. This undoubtedly unintended consequence is caused by the asymmetry between the treatment of investment costs incurred by mutual funds and the treatment, under the proposed regulations, of trust investment fees.
The former are, pursuant to section 67(c)(2)(B), allowed as a direct offset to the fund’s investment income; the latter, by regulation, would now be allowed only to the extent they exceed a 2% floor. To put it plainly, Treasury lacks the authority to require trustees to “unbundle” their fees, just as it would lack the authority to require mutual funds to pass their unbundled fees through to trust investors.
In addition, the requirement to “unbundle” fees imposes an impractical burden on all trust companies, large and small, and would set a standard impossible to meet with any degree of precision. Put in an historical context, the proposed regulations rival the ill-fated carryover basis rules in the degree of administrative complexity they would entail if made final as proposed.
When providing trust services (whether as sole trustee or co-fiduciary), trustees must pay keen attention to the needs of beneficiaries. This means that services must be individualized—and the exact service mix will depend on a variety of factors, including the complexity of the family situation, the number of beneficiaries, the terms of the trust, and the type of assets under administration. For example, a trust administrator may spend many, many hours on a trust established for a disabled child or a distraught widow. In the same vein, a trust with 40 beneficiaries has different needs from a trust that benefits a single individual.
Some of our accounts are simple trusts, requiring that all income be paid annually, with no discretion to distribute principal. In other trusts, however, distributions of both income and principal are left to the discretion of the trustee, with complex distribution standards requiring hours of fact-finding and analysis.
In several of our large trust relationships, the predominant asset is closely-held stock of a family business; with this type of asset, discussions of family values are often as important—and far more difficult—than straight-forward investment briefings.
As a consequence, the percentage of time devoted to trust administration fluctuates widely from trust to trust and from year to year—and would be most difficult to quantify.
In pertinent part, the preamble to the proposed regulations states that: “whether costs are subject to the 2-percent floor . . . depends on the type of services provided, rather than on taxpayer characterizations or labels for such services.”
Read literally, this would require Northern to detail its services on a minute-by-minute account-by-account basis. This is an impossibility in a corporate trustee environment, where some services are rendered to hundreds of trusts at the same time—and other services are required for more than one purpose.
Is the cost of tax lot accounting, for example, most properly allocated to trust accounting (not subject to the 2% floor), to tax return preparation (not subject to the 2% floor) or to investment management (subject to the 2% floor)?
Proposed Safe Harbors.
The preamble to the proposed Regulations notes that the IRS and the Treasury Department “invite comments on whether any safe harbors or other guidance, concerning allocation methods or otherwise, would be helpful.”
In the unfortunate event that IRS and Treasury cannot be persuaded to withdraw the proposed regulations, we reluctantly suggest consideration of the two safe harbors described below.
For a few of its largest and most complex trust relationships, Northern Trust enters into highly individualized arm’s length written contracts detailing annual fees for specific services such as custody, investment management and trust administration. It would be helpful if the proposed regulations clarified that, in such situations, the terms of the actual written contract should form the basis for any fee allocation.
In addition, for the thousands of our accounts where there is no such individualized agreement, the addition of a bright-line safe harbor would provide necessary practicality in applying these proposed regulations. Given the diversity of our trusts, and the corresponding diversity of services needed to protect them, we have found it impossible to arrive at a single allocation percentage. Rather, our experience leads us to conclude that an allocation range would be most appropriate, with between 53 and 62.5 percent of total trustee fees allocated to trust administration services not subject to the 2 percent floor. This proposed safe harbor is based on our actual experience as a corporate trustee and, to the best of our ability, on the definitions of “unique” and “not unique” services found in the proposed Regulations at section 1.67-4(b).
We recognize that, in some trust situations, the safe harbors described above will not accurately reflect actual trust services rendered, and will, for that reason, not achieve a fair result for our clients. We would hope, however, that in the bulk of our situations, the safe harbors we suggest would further administrative efficiency—and would help ensure that all clients of all trustees are treated equally.
In conclusion, we strongly urge Treasury and the IRS to withdraw the proposed Regulations, which are neither contemplated nor sanctioned by section 67, as ill-advised, impractical and expensive—both to the taxpayer and to the IRS.
A weekly update email message sent by the American College of Trust & Estate Counsel (ACTEC) to its members provided a further useful resource on this issue: a link to the transcript of the oral argument held on November 27, 2007, before the U.S. Supreme Court, in the matter of Knight v. Commissioner (Rudkin).
The transcript is available here (PDF, 66 pages).
On January 16, 2008, the United States Supreme Court issued its decision in Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue Service. (No. 06–1286; PDF, 16 pages). In short, the IRS won. But the drama may not be over, either.
See: PA EE&F Law Blog posting "IRS Wins Rudkin Case in U.S. Supreme Court" (01/17/08).