The Cost of Trust(s), an IRS Perspective
Unlike partnerships, trusts (other than grantor trusts) are treated as actual taxpayers for U.S. tax purposes, and do not (automatically) allocate taxable income to beneficiaries. Unlike corporations, trusts do not interpose a second level of tax between entity level income and the “beneficial” owner. Also unlike corporations, trusts are potentially able to benefit from preferential US capital gains rates.
This is because trusts are generally taxed in the same manner as individuals for income tax purposes.
Recent IRS regulations offer an opportunity to examine an interesting deduction available to trusts and estates under US tax law.
For individuals and trusts, the Internal Revenue Code divides deductions into “above the line” deductions and “below the line” deductions”. A full discussion of the differences would be, well, over the line. Important for this discussion is that “below the line deductions”, also called “miscellaneous itemized deductions,” are only allowed to the extent that they exceed (in the aggregate) 2% of AGI.
In plain English, this means that the value of these deductions is severely restricted for most taxpayers.
The 2% floor is a bitter pill even when applied to expenses that don’t generate taxable income (such as losses of non-business property in a shipwreck) – but is particularly frustrating when applied to costs of generating taxable income. Understandably, taxpayers get very frustrated that many wealth management expenses, such as investment advisory fees, tax return preparation, legal and accounting fees and other professional and management fees, can all be subject to this “itemized deduction” treatment when paid by individuals.
As noted above, trusts generally calculate their tax in the same manner as individuals. However, as with many tax laws, the itemized deduction rules have exceptions. One of these exceptions is 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” are not subject to this 2% threshold.
For decades, taxpayers, courts and the IRS have wrangled over the parameters of this exception. Was an investment advisor or lawyer hired because of the trustee’s fiduciary obligations or because management of certain property (whether held in trust or not) requires professional advice? The IRS and taxpayers tended to have differing answers. More significantly, different US courts also had different answers.
In May of 2014, the IRS issued final regulations to clarify which costs incurred by estates and are subject to the 2% threshold.
These regulations reflect the U.S. Supreme Court’s holding in Knight v. Commissioner, 552 US 181 (2008) that costs paid by trusts or estates remain subject to the 2% floor to the extent that they would “commonly or customarily would be incurred by a hypothetical individual holding the same property.” The regulations treat the type of product or service rendered to the trust or estate as determinative. The regulations identify 4 different categories of costs for purposes of this analysis.
Ownership costs are costs that would be commonly or customarily incurred by a hypothetical individual owner of property. While a trust may pay maintenance fees for property held in the trust, an individual owning such property would presumably pay the same maintenance fees.
Tax preparation costs are divided between a specific list of “trust and estate” returns and all other returns. Investment Advisory Fees are generally subject to the 2% floor, but the regulations grant that some Investment Advisory Fees may be specifically related to holding property in trust for beneficiaries. Appraisal fees and certain other fiduciary expenses are divided between amounts deemed to be trust specific and amounts which individuals would presumably also expend. Of course, lines between these different categories can become (un)intentionally blurred at times, and the regulations provide guidance for allocation of “Bundled Fees” among the different categories.
Taxpayers and their advisors should give careful review to these regulations to determine whether their current structures of asset ownership, invoicing and payment of professional fees and other business and investment activities should be adjusted for maximum efficiency.
It will be particularly important to determine whether managing trust assets or advising trustees involves complexity or legal burdens that warrant trust-specific fee structures. Of course, when operating in multiple jurisdictions there may be specific considerations that pertain to trusts and estates not addressed by the regulations.
This is also a good opportunity to reflect on the variation in tax treatment that can arise from subtle changes in ownership.
Invitation for Discussion:
If you would like to discuss any tax or estate planning matter, please do not hesitate to contact one of the lawyers in the Tax & Estate Planning group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.