IRS Publishes Final Regulations Under Section 67 On Deductibility Of Fiduciary Expenses; Postpones Effective Date

On May 8, 2014, the IRS issued final regulations regarding which costs or expenses incurred by estates and non-grantor trusts are subject to the 2-percent floor for miscellaneous itemized deductions under section 67. These regulations can be found at Reg. § 1.67-4.

Generally, the final regulations are substantively similar to the 2011 proposed regulations and provide that an expense is subject to the 2-percent floor if "it is included in the definition of miscellaneous itemized deductions under section 67(b), is incurred by an estate or non-grantor trust, and commonly or customarily would be incurred by a hypothetical individual holding the same property."

The regulations provide guiding principles and examples, but they leave a number of questions unanswered regarding the applicability of these principles. In particular, the regulations leave fiduciaries with further questions about the deductibility of what the regulations call "investment advisory fees," whether or not those fees are bundled with other fiduciary expenses.

On July 17, 2014, the IRS postponed the effective date of these regulations and provided that the regulations will apply to all estates and non-grantor trusts with tax years beginning on or after January 1, 2015. This postponement gives fiduciaries and their advisors more time to develop procedures to properly implement the requirements of these regulations.

Postponement and Uniformity of Effective Date

By an amendment dated July 17, the effective date of these regulations is now January 1, 2015; this means that the regulations will apply only to a taxable year of any trust or estate that begins on or after January 1, 2015.

Initially, the regulations would have applied to taxable years beginning on or after May 9, 2014. That is, the regulations would have immediately applied to an irrevocable non-grantor trust created on or after May 9, 2014, and to the estate of an individual who died on or after May 9, 2014. In addition, the regulations would have applied prior to January 1, 2015, to an existing fiscal-year estate with a taxable year beginning between May 9, 2014, and January 1, 2015. But as for existing trusts with calendar years, the typical case the writers of the regulations may have had in mind, the regulations would have taken effect exactly on January 1, 2015.

Upon publication of the final regulations, the American Bankers Association and 14 state bankers associations requested a delay in the enforcement of the regulations so their members could properly develop procedures to comply with the regulations, particularly procedures to unbundle their fiduciary fees in compliance with the regulations in a fair, consistent and accurate manner.

The regulations now will not apply to any trust or estate prior to January 1, 2015, giving all fiduciaries and their advisors more time to digest and respond to these regulations.

Applicability of the 2-Percent Floor

According to section 67(a), individual miscellaneous itemized deductions are allowed "only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income." Under section 67(e), in the case of a trust or estate these deductions are treated in the same manner as in the case of an individual, except that "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 trust or estate ... shall be treated as allowable in arriving at adjusted gross income" and thus are not subject to the 2-percent floor.

The final regulations under section 67(e) provide generally that a cost incurred by a trust or estate is subject to the 2-percent floor if the cost "commonly or customarily would be incurred by a hypothetical individual holding the same property."

This test of "commonly or customarily" incurred costs was endorsed by the Supreme Supreme Court in Knight v. Commissioner, 552 U.S. 181 (2008). In that case, the Supreme Court, in interpreting section 67, adopted the test of the Federal and Fourth Circuit Courts of Appeals that an expense "would not have been incurred" by the estate or trust if it was a cost "commonly or customarily" incurred by an individual holding the same property. The Supreme Court rejected the test used by the Second Circuit that would have allowed a cost to be exempt from the 2-percent...