IRS Issues Proposed Regulations on Administrative Expense Deductions for Estates and Trusts

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August 29, 2007

Responding to a split in circuits of the United States Courts of Appeal, the IRS has issued proposed regulations (REG-128224-06, 72 Fed. Reg. 41243) providing guidance on which expenses incurred by a trust (or an estate) are deductible under section 67(e). Section 67(a) allows individuals to take miscellaneous itemized deductions only if, in the aggregate, the deductions exceed 2 percent of their adjusted gross incomes. Section 67(e) provides that the AGI of a trust is computed the same as it is for an individual. However, section 67(e)(1) provides an exception to the 2 percent AGI limitation for trust expenses that: (1) are paid or incurred in connection with the administration of the trust and (2) would not have been incurred if the property were not held in such trust.

The conflicts in the circuit courts result from the interpretation of the second prong of section 67(e)(1) (i.e., whether the expense - specifically, investment advisory fees - would not have been incurred if the property were not held in a trust). The 6th Circuit has held that investment advisory fees are deductible under section 67(e)(1) when the trustees, lacking experience, must hire an investment adviser in order to meet their fiduciary obligations. The 2nd, 4th and federal circuits have held that investment advisory fees are expenses an individual would routinely incur and therefore are subject to the 2 percent AGI floor.

Seeking to provide a uniform standard for identifying the types of costs to which the 2 percent AGI limitation do or do not apply, the proposed regulations provide that costs incurred by a trust that are unique to the trust are deductible under section 67(e)(1). A cost is considered unique if an individual could not have incurred the cost in connection with property not held in a trust. Costs not meeting the standard are subject to the 2 percent AGI limitation. The proposed regulations also provide that a trust may not circumvent the 2 percent AGI limitation by "bundling" costs that are not unique to a trust with costs that are unique to a trust (e.g., bundling investment advisory fees with trustee fees). If a trust bundles such costs, the trust must use a reasonable method to allocate the single fee between the two types of costs. Finally, the proposed regulations provide a nonexclusive list of services for which the cost is either exempt from or subject to the 2 percent AGI limitation.

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