AICPA Offers Important Guidance for Form 1041: Deducting Trust Administrative Costs

AICPA Offers Important Guidance for Form 1041: Deducting Trust Administrative Costs

News story posted in Compliance on 8 February 2008| comments
audience: National Publication | last updated: 18 May 2011
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Summary

AICPA has issued guidance for members who prepare fiduciary income tax returns to comply with the Supreme Court's decision in Knight v. CIR, aff'ing Rudkin Testamentary Trust v. CIR, with respect to deducting trust administrative costs on 2007 Form 1041. With respect to charitable trusts, Form 1041 is required for all nongrantor charitable lead trusts and grantor lead trusts that do not elect alternate reporting. Form 1041 is no longer required for charitable remainder trusts that have unrelated business taxable income.

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Feb. 7, 2008

Important AICPA Guidance for Practitioners
Filing 2007 Forms 1041 -- Deducting Trust Administrative Costs
in Light of Knight v. CIR

In order to assist our AICPA members who prepare fiduciary income tax returns comply with the Supreme Court's decision in Knight v. CIR, S.Ct. Docket No. 06-1286 (Jan. 16, 2008), aff'ing Rudkin Testamentary Trust v. CIR, 467 F. 3d 149 (2nd. Cir. Oct. 18, 2006), the AICPA offers this guidance. The AICPA Trust, Estate and Gift Tax TRP's Section 67(e) Task Force developed this guidance specifically for CPAs. But it is useful for anyone who prepares fiduciary income tax returns. It is not meant to replace a member's judgment. Nor does it constitute authority for purposes of the return preparer penalties. Further, each case will differ depending on the unique facts and circumstances and substantiation available. Therefore, members should use this guide only to instruct their own judgment in taking and supporting their return positions.

Background. IRC Section 212 allows a deduction for expenses incurred in connection with investments. IRC Section 67(a) limits the deduction of total miscellaneous deductions, including investment expenses, to the excess over 2-percent of adjusted gross income (the 2-percent floor). IRC Section 67(e)(1) exempts certain administrative costs of an estate or trust from the 2-percent floor on miscellaneous itemized deductions. On January 16, 2008, the U.S. Supreme Court resolved a 15 year debate that resulted in a circuit split over the proper reading of IRC Section 67(e)(1), which provides that costs are exempt if they were ". . . incurred in connection with the administration of an estate or trust and which 'would not have been incurred' if the property were not held in such trust or estate." The Rudkin Trust in the Knight case, which involved fees paid for investment advisory services, argued that the statute allows a full deduction for all costs caused by the trustee's fiduciary duties. The government argued that a full deduction is allowed only for costs that individuals are incapable of incurring. The government also published Prop. Reg. Section 1.67-4 (REG-128224-06, 72 Fed. Reg. 41243 (July 27, 2007)) taking that position.

Holding. The Supreme Court rejected both readings and instead held that the proper reading of IRC Section 67(e)(1) ". . . requires determining what would happen if a fact were changed; such an exercise necessarily entails a prediction; and predictions are based on what would customarily or commonly occur. Thus, in asking whether a particular type of cost "would not have been incurred" if the property were held by an individual, [IRC Section] 67(e)(1) excepts from the 2% floor only those costs that it would be uncommon (or unusual or unlikely) for such a hypothetical individual to incur." Further, the Supreme Court held that the taxpayer has the burden of proof in establishing its right to the deduction.

Applying that reading to the investment advisory fees paid by the Rudkin Trust, the Supreme Court found that they were subject to the 2-percent floor on miscellaneous itemized deductions because the Rudkin Trust did not show ". . . that its investment objective or its requisite balancing of competing interests was distinctive" from an ordinary individual.

Administrative Costs Affected. IRC Section 67(e)(1) applies to investment advisory fees and all other miscellaneous itemized deductions of an estate or trust, including trustee fees, tax return preparation fees, legal and accounting fees, consulting fees, appraisal fees, property maintenance, insurance, office supplies, travel, telephone, and family office expenses, to name a few. Because the outcome of each case "turns on a prediction" of what would commonly occur if the property were held by an individual, it is not possible to separate costs into categories that are subject to the 2-percent floor and those that are not. However, the Supreme Court's opinion does offer some guidance in the following areas.

Investment Advisory Fees. Based on the Supreme Court's reading of IRC Section 67(e)(1), investment advisory fees paid by the trust to an investment advisor are subject to the 2-percent floor unless the trustee can show that there is an ". . . incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer . . . " or that the ". . . investment advisor impos[ed] a special, additional charge applicable only to its fiduciary accounts" or that trust has ". . . an unusual investment objective, or require[es] a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor." Thus, to satisfy the Supreme Court's test that any part of an investment advisory fee may be deductible without regard to the 2-percent floor under IRC Section 67(e), the trustee must substantiate that it would be unusual for an individual who owned the same property to have incurred the same cost. Such substantiation could include, for example, the trust agreement investment directives, the special needs of the trust beneficiaries, fee schedules, descriptions of the services provided, or surveys and statistics about common investor traits to the extent they are obtainable. Tax practitioners and their clients should be cautioned that the classification of any part of investment advisory fees as unusual or uncommon will be subject to scrutiny by the IRS.

Trustee Fees. The Supreme Court did not require, or even address, whether trustee fees should be unbundled. The Court agreed with the approach of the Federal and Fourth Circuits in Mellon Bank v. United States, 265 F.3d 1275 (Fed. Cir. Sept. 7, 2001) and Scott v. United States, 328 F.3d 132 (4th Cir. May 1, 2003). And those courts have held that trustee fees are fully deductible because they are not commonly incurred by individuals. Moreover, applying the Supreme Court's reading to trustee fees, it would appear that trustee fees are exempt from the 2-percent floor because they ". . . would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur."

Unbundling. Practitioners should be aware that the Prop. Reg. Section 1.67-4 requires the unbundling of trustee fees. However, the proposed regulations are effective only for payments made after the date final regulations are published in the Federal Register. Therefore, unbundling is not required until and unless the final regulations require such treatment. AICPA submitted comments on the proposed regulations, noting among other problems with the proposed regulations, the difficulties involved with the regulations' unbundling approach.

Fiduciary Tax Return Preparation Fees. Based on the Supreme Court's agreement with Mellon and Scott, and as provided in the proposed regulations, which are not binding until final, tax return preparation fees and judicial accounting fees are exempt from the 2-percent floor because it would be uncommon (or unusual or unlikely) for a hypothetical individual to incur the cost of preparing fiduciary tax returns.

Other Costs. Whether other costs, such as legal and accounting fees, are subject to the 2-percent floor also depends on the degree to which it ". . . would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur" such a cost. As the Supreme Court stated, ". . . Congress's decision to phrase the pertinent inquiry in terms of a prediction about a hypothetical situation inevitably entails some uncertainty. . . ." Tax return preparers should inquire about the nature of these costs and determine on a case by case basis whether it would be unusual or uncommon for an individual with the same property to incur the cost.

In some cases it will be easy to decide whether a cost is uncommon to individuals, such as disputes over income and principal. However, most types of fees, such as consulting fees, appraisal fees, family office expenses, will require a high level of judgment and adequate substantiation to claim a full deduction.

Substantiation. Although the Supreme Court's reading of the statute is fairly straightforward, substantiating a position based on that reading is very subjective and may be difficult in some cases. If a preparer makes a good faith effort to apply the Supreme Court's interpretation, the preparer may be able to conclude that his or her position has a more likely than not chance of prevailing on the merits. In cases where the preparer cannot conclude one way or the other, the preparer should evaluate whether, under IRS Notice 2008-13, 2008-3 I.R.B. 282, the preparer can recommend a tax return position to the taxpayer without being exposed to a possible preparer penalty under section 6694 (see Tax E-Alert, January 3, 2008).

Effective Date. The Supreme Court's decision is the law of the land until the IRS and Treasury provide further guidance in final regulations. Therefore, tax preparers should read the decision carefully and apply the Supreme Court's reading of the statute to each client situation as best they can. Since the Supreme Court ruled on this issue on January 16, 2008, preparers filing tax returns on January 16, 2008 or later should be applying the Supreme Court's interpretation to all relevant tax returns.

The case, relevant documents, and background materials on this issue prepared by the AICPA Tax Division's Trust, Estate, and Gift Tax Technical Resource Panel's Section 67(e) Task Force can be found on the AICPA website. Also, see prior Tax E-Alert, October 18, 2007 and Tax E-Alert September 11, 2007.

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