Tuesday, March 04, 2008

IRS Issues Interim Guidance for Fid Inc Tax Returns

On February 27, 2008, the Internal Revenue Service issued Notice 2008-32 (2008-11 IRB 1) providing "interim guidance" how fiduciaries (like executors & trustees) should handle issues under Section 67 of the Internal Revenue Code in filing federal fiduciary income tax returns for 2007.

Notice 2008-32
("Limitations on Estates or Trusts for Bundled Investment Management and Advisory Costs") was issued by the IRS for the following purpose:

This notice provides interim guidance on the treatment under § 67 of the Internal Revenue Code of investment advisory costs and other costs subject to the 2-percent floor under § 67(a) that are bundled as part of one commission or fee paid to the trustee or executor (“Bundled Fiduciary Fee”) and are incurred by a trust other than a grantor trust (nongrantor trust) or an estate. * * *

Note that the 2007 U.S. Income Tax Return for Estates & Trusts is available from the IRS here: 2007 Form 1041. PDF

I asked my friend, Robert B. Wolf, Esq., of Pittsburgh, PA, for his thoughts about this "interim guidance". Over the weekend, he provided an analysis in the form of an article, which he authorized me to post on this Blog (although he retains copyright privileges, not me.)

I thank Bob for his article, which follows:

Interim Guidance Issued on 2007 Fiduciary Income Tax Returns
Saves the Pain for Next Year

by Robert B. Wolf, Esq.

The Background

Miscellaneous itemized deductions are generally subject to a “floor” of 2% of the taxpayer’s adjusted gross income. So modest expenses are not deductible at all, and if they exceed the 2% floor, the excess is deductible for the calculation of the income tax but is added back into the calculation of the alternative minimum tax, potentially causing the imposition of the 26% alternative minimum tax if it is greater than the ordinary income tax calculation.

Trusts may also take such deductions, including trust administrative expenses, trustees’ fees, investment advisory fees, attorneys’ fees and the like. If the trust is a revocable trust or other “grantor” trust, all of such fees are subject to the 2% floor, and, potentially, the alternative minimum tax. But if the trust is a nongrantor irrevocable trust, and the relevant deductible expense is “paid or incurred in connection with the administration of the . . .trust” and “would not have been incurred if the property were not held in such trust,” the cost may be deducted without regard to the 2% floor under Section 67(e) of the Internal Revenue Code.

The Foreground

There has long been litigation and a split of authority over the treatment of investment advisory fees paid by the trustee of an irrevocable trust, some holding that they were deductible without reference to the 2% floor and some, and more recently, the majority, holding that they were subject to it. A conflict of decisions between Federal Circuit Courts of Appeals eventually brought the matter to our U.S. Supreme Court.

On January 16, 2008, the Supreme Court of the United States issued its decision in Michael J. Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner, 552 U.S. ___, 128 S. Ct. 782 (2008), holding that investment advisory fees incurred by a trustee are subject to the 2% floor. [Note: See PA EE&F Law Blog posting "IRS Wins Rudkin Case in U.S. Supreme Court" (01/17/08), including links therein to prior postings.]

The question presented to the Court was how to interpret the words "would not have been incurred if there property were not held in such trust." The IRS argued, and even issued Proposed Regulations during the pendency of this case, that for the deduction to be free of the 2% floor, it must be an expense that an individual could not have incurred unless there was a trust. Too tough, said the Court. The taxpayer argued a strict causation test that if the deduction were incurred because of the property being held in the trust, then it should be deductible in full. Too soft, said the Court.

Obviously, investment advisory fees can be incurred, and often are incurred, by individuals, though the trustee's fiduciary obligations under the Prudent Investor Act may cause a higher percentage of trustees to seek professional advice than they might for their own funds.

The Main Grounds

But the Supreme Court rejected both proffered interpretations, adopting the approach used in the 4th and Federal Circuit Decisions:

"This brings us to the test adopted by the Fourth and Federal Circuits: Costs incurred by trusts that escape the 2% floor are those that would not “commonly” or “customarily” be incurred by individuals. 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 (§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”). The Solicitor General also accepts this view as an alternative reading of the statute. See Brief for Respondent 20–21. We agree with this approach."

Since investment advisory fees are commonly incurred by individuals, they are subject to the 2% floor. If there had been a quantifiable cost for investment advisory fees as they dealt specifically with unique trust issues, the Court left the door open for a full deduction without the 2% floor. These will be unusual, however, given the Court's reasoning.

The IRS Target

So the IRS won the day in Knight, but they had and have in their sights bigger game than just the separate investment advisory fees. They clearly intend to publish Final Regulations which will require trustees to “unbundle” their trustees’ fees into the portion they think is justifiable as expenses which are special to the administration of the trust, and those which are ordinarily incurred in nontrust settings.

However, the Knight case is on the books, and the Final Regulations will not be available in time for completion and filing of 2007 fiduciary income tax returns, so the IRS issued, on February 27, 2008, Notice 2008-38 , providing interim guidance for tax years beginning before 2008.

The Next Big Thing

Here’s what they said about what they call a “Bundled Fiduciary Fee” and which you and I might call a “trustee’s fee:”

“The IRS and the Treasury Department expect to issue final regulations under § 1.67-4 of the Income Tax Regulations consistent with the Supreme Court’s holding in Knight. The final regulations also will address the issue raised when a nongrantor trust or estate pays a Bundled Fiduciary Fee for costs incurred in-house by the fiduciary, some of which are subject to the 2-percent floor and some of which are fully deductible without regard to the 2-percent floor.

The final regulations, however, will not be issued prior to the due date for filing 2007 income tax returns (determined without regard to extensions), and will apply only prospectively. Accordingly, in light of the Supreme Court’s decision in Knight, the IRS and the Treasury Department are providing interim guidance that specifically addresses the treatment of a Bundled Fiduciary Fee.”

The guidance provided is helpful in that a “Bundled Fiduciary Fee”/”Trustee’s Fee” can be deducted in full on 2007 U.S. Fiduciary Income Tax Returns, the last of which returns will be due on April 15, 2008. Taxpayers will not be required to “unbundle” their trustee’s fees this year. Fair enough, since the unbundling really isn’t the law yet, and no one knows how such unbundling would be determined at this point, including the IRS and Treasury, which is why they are seeking comments on just that point as they expect to include safe-harbors in their Final Regulations, which will be issued effective for tax years beginning in 2008.

Interested parties are invited to submit comments on this notice and § 1.67-4 of the proposed regulations published in the Federal Register of July 27, 2007 (2007-36 I.R.B. 551 [72 FR 41243-01]) by May 27, 2008. No doubt the American Bankers Association will want to make suggestions on the matter of what portion of the total expenses might be fairly categorized as those which ought to be subject to the 2% rule, such as, but not limited to, investment advisory fees, and those which ought not to be, as fairly reflecting that portion of trustee’s fees that “would not have been incurred if the property were not held in such trust.” The IRS particularly mentions that it would welcome comments as to whether the safe harbor rules should take into account the value and/or nature of the assets and the number of beneficiaries of the trust.

The comment period ends in May, and the Final Regulations are promised “without delay” thereafter, which I interpret to mean by the end of summer, 2008.


I quibble with the general wording of a “bundled fiduciary fee” when describing a trustee’s fee, in the sense that a trustee has certain duties which include safeguarding the property, prudently investing the assets, administering the trust in accordance with the governing instrument and applicable law and reporting and paying the applicable taxes. Those duties are not “bundled” by the trustee, they are part of the trustee’s job description. It has been more in recent years that trustees have in some cases and to some degree “unbundled” their fees with a more “open architecture” allowing outside investment advisors to manage portions of the trust assets and to charge separately for it. These fees paid to third parties are “bundled” by those trustees in their total fees, and the outside investment advisors are paid accordingly. But if the trustee performs all of the functions of the trustee in house, the fee is not “bundled” in the opinion of this writer, and one wonders whether the IRS has the authority to require them to be unbundled for this purpose. After all, a “trustee’s fee” is never charged unless there is a trust, though in the case of a revocable trust, there is no doubt that it is all subject to the 2% floor.

What does this all mean to attorneys and to professional trustees?

First, and most clearly, no unbundling will be required for 2007 returns. So in the ordinary case where a bank trustee charges its fees and performs its own investment advisory services, no unbundling will be needed.

Separate investment advisory fees on 2007 returns, are, however, subject to the 2% floor, and potentially, the alternative minimum tax. I think this would include the investment managers/advisors used in an open architecture arrangement even if the fees are all paid through the trustee.

For 2008, it is very likely that substantial portions of professional trustees’ fees will be subject to the 2% floor and potentially the alternative minimum tax. Unfortunately, because of the fact that most professional trustees charge the same or almost the same for full trustees’ duties as they do for investment management accounts, the factual background is not particularly favorable to the argument that a very small portion of the trustee’s fees are attributable to investment advisory services.

Effectively, if the IRS is able to require this unbundling, it will raise the effective cost of trustees’ services considerably, not so much because of the 2% floor, since 2% of the adjusted gross income of the trust is likely not to be so very much, unless there are a lot of capital gains, but for the fact that the 2% floor drags with it the addition of that portion of the expenses back into income for the alternative minimum tax. As a result, we will see tax letters for our clients where the alternative minimum tax adjustment is very substantial, perhaps the majority of the trust expenses, potentially increasing the net cost of such services up to 26% of those subject to the AMT, which increasingly includes more and more taxpayers every year, and certainly includes most of our best clients!

Note also, that this 2% rule also requires interrelated calculations to figure out distributable net income which takes into account the 2% deduction which takes into account the deduction for the distributable net income. So good luck figuring it out without a good software package!

Although the case and the interim guidance do not speak directly to it, one wonders and hopes that attorneys’ fees will not fall prey to the same scrutiny and potential “unbundling.” If so, we might be required to divide our attorneys’ fees into the tasks we perform for trustees and executors which are performed because the trust or estate is what it is, which in an estate or a trust as a result of the death of the client, and the services that might be commonly performed for clients outside the trust and estate arena.

That would be a less than pleasant ending to our story. Hopefully the Final Regulations will create some clear and fair rules that will bring the litigation and uncertainty to an end.

The Notice provides directions for anyone desiring to submit comments to the IRS.
Comments should be submitted to: Internal Revenue Service, CC:PA:LPD:PR (Notice [2008-32]), Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, DC 20224.

Alternatively, comments may be hand delivered Monday through Friday between the hours of 8:00 a.m. to 4:00 p.m. to: CC:PA:LPD:PR (Notice [2008-32]), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC.

Comments may also be submitted electronically via the following e-mail address:
Notice.Comments@irscounsel.treas.gov. Please include [Notice 2008-32] in the subject line of any electronic submissions.
Bob can be reached at his law firm, Tener, Van Kirk, Wolf & Moore, P.C., located at 920 Oliver Building, 535 Smithfield Street, Pittsburgh, PA 15222-2368 (Ofc: 412-281-5580; Email: RWolf50@aol.com).

Update: 03/10/08:

The American Institute of Certified Public Accountants maintains a web page with a discussion on these issues & the court rulings, along with links to pleadings filed in the Rudkin case. See:
Section 67(e) Rudkin Case.