Judicial & Administrative Actions Affect Estate & Trust Deductions

California CPA magazine: October 2007

Unique Costs

Under IRC Sec. 67(a), individuals’ miscellaneous itemized deductions are allowed only to the extent they exceed 2 percent of adjusted gross income (AGI), i.e., the “floor.” Sec. 67(e) states that, for this purpose, an estate’s or trust’s AGI should be computed as for an individual.
  However, under Sec. 67(e)(1), deductions for costs paid or incurred in administering the estate or trust, which would not have been incurred if the property were not held in such estate or trust shall be treated as allowable in arriving at AGI. Therefore, deductions described in Sec. 67(e)(1) are not subject to this floor.

Appeals Courts Split

Several appeals courts have interpreted Sec. 67(e)(1) differently. The issue in each case was whether the trust’s investment advisory fees “would not have been incurred if the property were not held in such trust or estate.”
  In William J. O’Neill, Jr., Irrevocable Trust v. Commissioner (994 F. 2d 302, 6th Cir. 1993) the court decided that these fees were fully deductible 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 floor.
  In contrast, in Mellon Bank, N.A. v. United States (265 F. 3d 1275, Fed. Cir. 2001), J.H. Scott v. United States (328 F. 3d 132, 4th Cir. 2003) and William L. Rudkin Testamentary Trust v. Commissioner (467 F. 3d 149, 2d Cir. 2006) the courts held that these fees are subject to this floor.
  Specifically, the Mellon Bank and Scott courts concluded that a trust expense is subject to the floor if it is an expense “commonly” or “customarily” incurred by individuals. The Rudkin court looked to whether such an expense was “peculiar to trusts” and “could not” be incurred by individuals.

Supreme Court Review

The Supreme Court granted certiorari on June 25, 2007 in an appeal by Rudkin, now called Knight (a trustee). Possibly, arguments may be heard in December and a decision may be rendered by June 2008.

Proposed Regulations

Proposed regulations were published July 27, 2007 and would apply to payments made after the date final regulations are published in the Federal Register. Under these proposals, costs incurred by estates or non-grantor trusts that are unique to an estate or trust are not subject to the floor. A cost is unique if an individual could not have incurred that cost in connection with property not held in an estate or trust.
  The proposed regulations provide that, if an estate or non-grantor trust pays a single fee that includes both costs that are unique to estates and trusts and costs that are not, the estate or non-grantor trust must use any reasonable method to allocate the single fee between these two costs.
  These proposals contain a non-exclusive list of services that are unique to an estate or trust, such as:
1. Fiduciary income and estate tax returns;
2. Fiduciary accountings;
3. Judicial or quasi-judicial filings required as part of an estate’s or trust’s administration; and
4. The division or distribution of income or corpus to or among beneficiaries.
  These proposals also contain a non-exclusive list of services that are not unique to an estate or trust, such as:
1. Gift tax returns;
2. Custody or management of property;
3. Advice on investing for total return; and
4. The defense of claims by the decedent’s or grantor’s creditors.

Planning Considerations

In preparing 2007 fiduciary and beneficiary income tax returns to be filed in 2008, preparers should consider the effect of the Supreme Court’s decision on the proposed regulations and any final regulations.
  Pending the Supreme Court’s decision, preparers also must deal with the new requirement that there be a “reasonable belief” that the treatment of the estate’s or non-grantor trust’s costs is more likely than not the proper treatment. (See the August 2007 issue of California CPA, Page 25.)
  Comment: The Ninth Circuit Court of Appeals has not decided this issue.
  Because of this uncertainty, preparers should consider disclosure on Forms 8275 (Disclosure Statement) or 8275-R (Regulation Disclosure Statement)—as appropriate—if “non-unique” costs are treated as not subject to this floor.
  Note: Further discussion of which disclosure form should be used in this situation is beyond this column’s scope.
  However, if disclosure is undesirable, consider extending returns due before the Supreme Court’s decision is known. Compute 2007 estimated tax and extension payments, and 2008 estimated taxes due before the Supreme Court’s decision is rendered, by applying the floor to non-unique deductions.
  Under this approach, if the Supreme Court rules favorably for taxpayers, their income taxes will be overpaid. If the Supreme Court upholds the IRS’ position, tax underpayment penalties will be avoided.