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On April 1, 2010, the Internal Revenue Service extended previously issued interim guidance regarding the deductibility of bundled fiduciary fees paid by estates and certain trusts. As in prior years, taxpayers may deduct the full amount of a bundled fiduciary fee without regard to the 2% floor for 2009. However, any payment by a fiduciary to a third-party for expenses subject to the 2% floor must be treated separately from the otherwise bundled fiduciary fee.

Miscellaneous Itemized Deductions and the 2% Floor
Pursuant to IRC Section 67(a), taxpayers may deduct miscellaneous itemized deductions, subject to a 2% floor. In other words, an individual taxpayer may deduct miscellaneous itemized deductions only to the extent the deductions exceed 2% of the individual’s adjusted gross income.

For example, assume an individual has an adjusted gross income of $50,000. That individual’s miscellaneous itemized deductions must exceed $1,000 (2% of $50,000) in order to be deductible and only the excess over $1,000 can be deducted.

Miscellaneous itemized deductions include unreimbursed business expenses, such as professional dues, professional journal subscriptions, courses taken to improve job skills, business-related meals and entertainment and the expenses of looking for a job. They also include tax preparation fees in the year they are paid, some home office expenses, tax advice and investment fees, if the investment fees related to providing taxable income.

Different Rules for Estates and Trusts?
Under IRC Section 67(e), this same 2% floor applies to estates and trusts. However, IRC Section 67(e)(1) provides a hotly-litigated exception to this rule: a full deduction is allowed for costs paid or incurred in connection with the administration of a trust or estate and “which would not have been incurred if the property were not held in such trust or estate.”

Many fiduciaries do not charge separate fees for the different services provided. Rather, fees are “bundled” to include trustee commissions, investment advisory fees, custody, preparation of fiduciary income tax returns and other services. Some of these services would be subject to the 2% floor, while others would not.

The sparse legislative history of this exception led the IRS to challenge the full deductibility of a trust’s investment advisory fee in several notable cases. These decisions led to a split among the Circuit Courts and the Supreme Court resolved the issue with its ruling in Knight v. Commissioner, 128 S. Ct. 782 (2008).

In Knight, the Supreme Court held that investment advisory fees incurred by estates and trusts will generally be subject to the 2% floor, unless the taxpayer can show that those costs would not “commonly” or customarily” be incurred by individuals. The Court found it not uncommon or unusual for individuals to incur investment advisory fees and rejected the Trustee’s claimed deduction. Thankfully, the Court did not completely shut the door on the full deductibility of estate or trust advisory fees - rather, such fees might be deductible if, for example, the trust had a special investment objective or required a specialized balancing of the parties’ interests.

Impact of Knight v. Commissioner
The IRS reacted quickly to Knight and, in Notice 2008-32 announced that taxpayers could deduct the full amount of a bundled fiduciary fee without regard to the 2% floor, pending the issuance of final regulations. Prior to Knight, proposed regulations issued in 2007 provided that an estate or a trust that paid a bundled fiduciary fee would be required to use a “reasonable method” to allocate between costs that are unique to estates and trusts (such as trustees’ fees) and those that are not (such as investment advisory fees). The proposed regulations are more restrictive than the holding in Knight.

With Notice 2008-32, the IRS indicated that final regulations, consistent with the Supreme Court’s holding in Knight, would be “published without delay.” These final regulations may include certain safe harbors for determining how a bundled fiduciary fee might be allocated between costs subject to the 2% floor and those that are not subject to the 2% floor. However, the final regulations have not yet been issued. Notice 2008-116 extended the guidance for 2007 returns to apply to 2008 returns.

Guidance for 2009 Returns
Notice 2010-32 provides that for tax years beginning before January 1, 2010, nongrantor trusts and estates will not be required to unbundle fiduciary fees and may deduct the full amount of a bundled fee, without regard to the 2% floor. However, any payment by the fiduciary to third parties for expenses subject to the 2% floor are readily identifiable and must be treated separately from the otherwise bundled fee.

Please do not hesitate to reach out to your Fiduciary Trust contact for more information regarding Notice 2010-32.

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