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The IRS has reissued proposed regulations that clarify when a nongrantor trust’s (NGT) or estate’s investment advisory services are fully deductible for income tax purposes. Most advisory expenses are subject to what can be a severe restriction that greatly reduces their deductibility.
Individuals are permitted to deduct “miscellaneous itemized deductions” only to the extent the deductions exceed 2% of the individual’s adjusted gross income [referred to as the 2% floor]. For example, if an individual taxpayer has an adjusted gross income of $1MM and $30k in miscellaneous itemized deductions, only $10k of the expenses is deductible [2% of $1MM is $20k and $30k-$20k =$10k].
Miscellaneous itemized deductions include investment advisory fees.
Until the Supreme Court case of Knight v. Commissioner was decided, executors and trustee were uncertain how the floor applied to estates and NGTs. Knight clarified which of an estate’s or NGT’s expenses are subject to the 2% floor for itemized deductions. Expenses that are “customarily” or “commonly” incurred when property is held by an individual are subject to the 2% floor when they are incurred by an estate or nongrantor trust. Expenses that are unique to estates and NGTs are not subject to the floor.
What Knight didn’t do was enunciate specific rules; it didn’t precisely define what are “common” and “customary” expenses. It left the Treasury and IRS to define the contours of the rule. And the IRS did just that. After Knight, the IRS issued a series of Notices that curtailed the deductibility of investment adviser’s fees for estates and nongrantor trusts.
On Sept. 6 the IRS and Treasury reissued proposed regulations defining which expenses of a nongrantor trust or estate are subject to the 2% floor. The regulations define which of an estate’s or trust’s expenses are commonly or customarily incurred when individual taxpayers hold the property.
Under the regs, the product or service’s type is determinative, not the amount of the expense. Because fees for investment advice are incurred commonly and customarily by individual investors, the deductibility of most advisory fees incurred by estates and nongrantor trusts will be subject to the 2% floor. However, incremental costs that are beyond those that would commonly and customarily be charged to individuals are not subject to the 2% floor when incurred by estates and NGTs.
The IRS notices issued before the proposed regs specified that executors and trustees were not required to “unbundle” unitary fiduciary fees to separate out the component that was subject to the 2% floor. In contrast, the proposed regs require executors to unbundle fees and specify which portion is subject to the 2% floor.
When the proposed regs are finalized it will be imperative for investment advisors to estates to clearly define which advisory fees are incremental costs that apply only as a result of the estate or trust holding the property instead of an individual. But that doesn’t mean that the entire fee can be classified as “incremental” or otherwise unique to an estate or trust. The type of service is determinative, and improper classification will backfire in the end.
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See also The Law Professor's blog at AdvisorFYI.