Changes may tip the scale in favor of distributing property.
The Tax Cuts and Jobs Act of 2017 (the Act), was signed into law on Dec. 22, 2017, bringing a myriad of changes to the Internal Revenue Code and sparking a substantial amount of commentary and analysis. While much attention has been centered on the consequences of the Act for individual and business taxpayers, relatively little focus has been given to the impact of the Act on trusts and estates. Many of the provisions of the Act that apply to individuals are indeed equally applicable to trusts and estates, but the suspension of miscellaneous itemized deductions under IRC Section 67(g) should prompt a renewed focus on the allocation of expenses of trusts and estates and may, for some trustees and executors, tip the scales in favor of distributing trust property to individual beneficiaries who are in a more advantageous income tax position as a result of the Act.1
Background
Deductions for estates and non-grantor trusts2 fall into two general categories:
(1) “Above-the-line” deductions (including expenses arising from a trade or business) are generally enumerated in IRC Section 62(a) and are subtracted from gross income in calculating adjusted gross income (AGI); and
(2) “Below-the-line” or “itemized” deductions (including most expenses arising from profit-oriented activities other than a trade or business) generally include deductions not enumerated in Section 62(a) and are subtracted from AGI in calculating taxable income (on which a taxpayer’s actual tax liability is calculated).
This distinction is meaningful because, as further discussed, below-the-line deductions are subject to certain limitations that don’t apply to above-the-line deductions.
Prior to 1941, taxpayers and the Internal Revenue Service treated expenses arising from a trade or business and expenses arising from profit-oriented activities other than a trade or business as above-the-line deductions under the predecessor to IRC Section 162, which on its face provided deductions only for expenses incurred in “carrying on any trade or business.”3 In 1941, however, the U.S. Supreme Court, in Higgins v. Commissioner,4 drew a clear distinction between profit-oriented expenses and trade or business expenses, rejecting the proposition that the petitioning taxpayer was engaged in a trade or business by virtue of managing his own investment portfolio, notwithstanding that the portfolio was large enough, and required enough attention, to warrant an office and administrative staff.5 Further, the Court held that the expenses of profit-oriented activities that didn’t rise to the level of a trade or business weren’t deductible under the predecessor to Section 162, reasoning that such an interpretation was contrary to the existing authority.6
In 1942, in response to Higgins, Congress enacted the predecessor to IRC Section 212 with the goal of, to some degree, restoring the equivalence between profit-oriented expenses and trade or business expenses.7 The current version of Section 212 provides:
In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—(1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.
Section 212 expenses may include: (l) investment advisory fees; (2) subscriptions to investment advisory publications; (3) qualifying attorney’s fees; (4) expenses for clerical help and office rent in managing investments; (5) fees to collect interest and dividends; (6) losses on deposits in insolvent or bankrupt financial institutions; (7) service charges on dividend reinvestment plans; and (8) a trustee’s fees for an individual retirement account if separately billed and paid.8
Although the predecessor to Section 212 was enacted to establish a measure of equality between profit-oriented expenses and trade or business expenses, the latter have always enjoyed preferential treatment as above-the-line deductions.9 Profit-oriented expenses, on the other hand, generally constitute itemized deductions, and as a result of the Act, the bias against profit-oriented expenses is stronger than ever.
The 2 Percent Floor
Section 67(a) requires that taxpayers further divide their itemized deductions (including most deductions for profit-oriented activities) into: (1) “miscellaneous itemized deductions” and (2) all other itemized deductions. Section 67(b) provides that all itemized deductions other than those specified therein are miscellaneous itemized deductions. Accordingly, because they’re not mentioned in Section 67(b), investment advisory expenses, tax preparation and other professional fees generally constitute miscellaneous itemized deductions.
Prior to 2018, a taxpayer’s miscellaneous itemized deductions were allowed only to the extent that their aggregate value exceeded 2 percent of a taxpayer’s AGI.10 Put differently, the deductions were added together and then reduced (but not below zero) by 2 percent of AGI. This limitation has often been referred to as the
“2 percent floor.” Miscellaneous itemized deductions that were disallowed as a result of the 2 percent floor were permanently lost, as they couldn’t be carried forward to future tax years.
Section 67(e): An exception to the 2 percent floor. Section 67(e) directs that certain deductions of a trust or estate that would otherwise be miscellaneous itemized deductions be treated as above-the-line deductions. Specifically, “deductions for 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 to be deducted in computing AGI of a trust or estate.11 Accordingly, these deductions aren’t subject to the 2 percent floor.
Treasury Regulations Section 1.67-4, effective for tax years beginning on or after Jan. 1, 2015, clarifies that an expense isn’t subject to Section 67(e) if it “commonly or customarily would be incurred by a hypothetical individual holding the same property” and that “it is the type of product or service rendered to the estate or non-grantor trust in exchange for the cost, rather than the description of the cost of that product or service, that is determinative.”12 This latter distinction is in keeping with the U.S. Supreme Court’s decision in Knight v. Comm’r,13 in which it held that a trust’s investment advisory costs were miscellaneous itemized deductions because it’s common for individuals to hire investment advisors, notwithstanding that an individual, acting in his individual capacity, wouldn’t have the fiduciary duty of a trustee and couldn’t incur trust investment advisory fees.14
Treas. Regs. Section 1.67-4 provides the following nonexclusive list of the types of costs that are commonly and customarily incurred by individuals: (1) costs incurred in defense of a claim against the estate, the decedent or the non-grantor trust that are unrelated to the existence, validity or administration of the estate or trust, (2) ownership costs; (3) tax preparation fees; (4) investment advisory fees; and (5) appraisal fees.15 Specifically excluded from this category of expenses are certain fiduciary expenses, such as probate court fees and costs, fiduciary bond premiums, legal publication costs of notices to creditors or heirs, the cost of certified copies of the decedent’s death certificate and costs related to fiduciary accounts.16
The proposed version of the regulation also indicated that the cost of products or services related to the following items would be considered “unique” to an estate or trust: (1) fiduciary accountings; (2) judicial or quasi-judicial filings required as part of the administration of the estate or trust; (3) fiduciary income tax and estate tax returns; (4) the division or distribution of income or corpus to or among beneficiaries; (5) trust or will contest or construction; (6) fiduciary bond premiums; and (7) communications with beneficiaries regarding estate or trust matters.17 This list was nonexclusive and was ultimately omitted from the final version of the regulation following the Knight decision and the resulting shift in the standard of evaluation from “uniqueness” to whether a cost was “commonly and customarily incurred by individuals.” Nonetheless, the list remains instructive.
Generally, the regulation requires that if an estate or trust pays a single fee, commission or other expense for both types of costs (and if the costs that would be subject to the 2 percent floor are more than de minimis in amount), the taxpayer must allocate the payment using “any reasonable method” between the costs that are subject to the 2 percent floor and those that aren’t.18 If a bundled fee isn’t computed on an hourly basis, however, only the portion of that fee that’s attributable to investment advice is subject to the 2 percent floor; the remaining portion isn’t subject to the 2 percent floor.19 Additionally, out-of-pocket expenses billed to the estate or non-grantor trust are treated as separate from the bundled fee and aren’t subject to allocation.20 In contrast, “payments made from the bundled fee to third parties that would have been subject to the 2 [percent] floor if they had been paid directly by the estate or non-grantor trust are subject to the 2 [percent] floor, as are any fees or expenses separately assessed by the fiduciary or other payee of the bundled fee (in addition to the usual or basic bundled fee) for services rendered to the estate or non-grantor trust that are commonly or customarily incurred by an individual.”21 Among the facts that may be considered in determining whether an allocation is reasonable are: (1) “the percentage of the value of the corpus subject to investment advice;” (2) “whether a third party advisor would have charged a comparable fee for similar advisory services;” and (3) “the amount of the fiduciary’s attention to the trust or estate that is devoted to investment advice as compared to dealings with beneficiaries and distribution decisions and other fiduciary functions.”22
The New Section 67(g)
To this framework, the Act adds the new Section 67(g), which provides that “no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.” Clearly, that portion of a trust’s expenses that would previously have been subject to the 2 percent floor will be disallowed as a result of this provision. This result is consistent with the treatment of such expenses when incurred directly by individuals under the Act. However, the application of Section 67(g) to expenses that weren’t previously subject to the 2 percent floor is less clear. One may argue that because they’re not among the costs enumerated in Section 62(a), but are instead dealt with under Section 67, which otherwise addresses which itemized deductions are subject to the 2 percent floor, Section 67(e) expenses are, by implication, itemized deductions. It would follow that because these expenses also aren’t among those enumerated in Section 67(b), they must be miscellaneous itemized deductions (albeit miscellaneous itemized deductions that were granted preferential treatment prior to 2018). Based on this interpretation, the profit-oriented expenses of a trust that were previously treated as above-the-line deductions under Section 67(e) and weren’t subject to the 2 percent floor would now be disallowed as miscellaneous itemized deductions.
We believe the better argument is that, in spite of being mentioned in Section 67 rather than Section 62, expenses addressed by Section 67(e) aren’t itemized deductions and thus can’t be miscellaneous itemized deductions. Pursuant to Section 63(d), “the term itemized deductions means the deductions allowable under [Chapter 1 of the IRC (which includes Section 212)] other than—(1) the deductions allowable in arriving at adjusted gross income, and (2) the deduction for personal exemptions provided by section 151.” Accordingly, based on the plain language of the statute, Section 67(e) expenses that are allowable under Section 67(e) in arriving at AGI can’t be itemized deductions. Section 67(e) specifically states these deductions are to be taken to arrive at AGI and so by statute are defined as not being a miscellaneous itemized deduction. While the concept of a standard deduction (which may be taken in lieu of itemized deductions) isn’t applicable to trusts and estates, the above definition is consistent with the idea that deductions that may be taken in arriving at AGI can’t be itemized deductions because they may be taken by an individual taxpayer even if he takes the standard deduction rather than itemizing.
Form 1041, Schedule I, on which a trust or estate calculates its alternative minimum tax (AMT) liability, also supports this interpretation. For AMT purposes, “[n]o deduction shall be allowed for any miscellaneous itemized deduction (as defined in section 67(b)).”23 This disallowance was effective prior to 2018, so logic would dictate that if Section 67(e) expenses were classified as miscellaneous itemized deductions, Schedule I would provide a clear indication that such costs are disallowed for AMT purposes. However, Schedule I doesn’t include among its adjustments any item that could reasonably be interpreted to include Section 67(e) expenses, as it directs the taxpayer to transfer to Schedule I the amount of miscellaneous itemized deductions reported on Form 1041, an amount that’s reported separately from the taxpayer’s Section 67(e) expenses.
Benefit to Trusts and Estates
Viewed in isolation, the suspension of all miscellaneous itemized deductions under Section 67(g) doesn’t disadvantage trusts and estates relative to individual taxpayers, as it applies to both groups of taxpayers. The same may be said of the $10,000 limitation on state and local taxes, which similarly applies to both groups of taxpayers. However, when one considers the overall impact of the changes, some trusts and estates will see the disparity between their tax bills and the tax bills of similarly situated individuals increase beyond 2017 levels, while others will see a relative reduction of the penalty imposed on trusts and estates under the IRC. Unlike individuals, who may elect to take a standard deduction equal to not less than $12,000 in lieu of itemizing, trusts and estates don’t receive the benefit of a minimum below-the-line deduction. Moreover, while individuals previously were subject to an overall limitation on itemized deductions under IRC Section 68 that didn’t apply to trusts and estates, that limitation has also been suspended from 2018 through 2025 under Section 68(f). Nevertheless, due to the compressed rate structure applicable to trusts and estates, the reduction in marginal tax rates under the Act provides a greater benefit to trusts and estates, all other factors being equal, and this benefit increases as the trust’s or estate’s taxable income increases. As discussed above, it also appears that trusts and estates will continue to be permitted to deduct those expenses that were previously deductible under Section 67(e). It’s unclear, then, which group of taxpayers has been made relatively better off under the Act, and those with an opportunity to remove assets from a trust or estate should consider their particular circumstances in evaluating whether, from an overall perspective, it makes sense to distribute trust assets into the hands of beneficiaries. If the goal is simply to minimize income taxes, this may or may not be accomplished by simply distributing income to trust beneficiaries,24 though a variety of factors, including state income taxes, will be relevant to this determination. Nevertheless, the trustee, in discharging the trustee’s fiduciary duty, should also consider such factors as the current and future transfer tax impact of a distribution and the desirability of putting trust principal in the hands of a beneficiary (and the beneficiary’s creditors).
Endnotes
1. For a more thorough analysis of the deductibility of trust expenses prior to 2018, see Domingo P. Such, III and Tina D. Milligan, “Understanding the Regulations Affecting the Deductibility of Investment Advisory Expenses by Individuals, Estates and Non-Grantor Trusts,” 50 Real Prop Prob. & Tr. J. 439.
2. All references to “trusts” in this article refer to non-grantor trusts, which are treated as distinct taxpayers under the Internal Revenue Code. The income and expense items of grantor trusts, on the other hand, are consolidated with those of the trust’s deemed owner (generally, the trust’s grantor).
3. Section 23(a) of the Internal Revenue Act of 1928 provided as follows:
In computing net income there shall be allowed as deductions:
. . . All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered; traveling expenses (including the entire amount expended for meals and lodging) while away from home in the pursuit of a trade or business; and rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.
4. Higgins v. Commissioner, 312 U.S. 212 (1941).
5. Ibid., at p. 218.
6. Ibid.
7. See IRC Section 23(a)(2) (1942). Section 23(a)(2) provided as follows: “[In computing net income, there shall be allowed as deductions:] In the case of an individual, all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.” See also S. Rept. 1631, 77th Cong., 2d Sess., reprinted in 1942-2 C.B. 504, 570 (stating that amendment allows a deduction for “the ordinary and necessary expenses of an individual paid or incurred during the taxable year for the production and collection of income, or for the management, conservation, or maintenance of property held by the taxpayer for the production of income, whether or not such expenses are paid or incurred in carrying on a trade or business”) (emphasis added).
8. See Temp. Treasury Regulations Section 1.67-IT(a)(1)(ii); see also Internal Revenue Service, U.S. Dep’t of the Treasury, Pub. 529, miscellaneous deductions (2014).
9. See IRC Section 62(a).
10. Ibid.
11. IRC Section 67(e).
12. Treas. Regs. Section 1.67-4(a)-(b)(1).
13. Knight v. Comm’r, 552 U.S. 181 (2008).
14. Ibid., at pp. 187-188 (2008).
15. Treas. Regs. Section 1.67-4(b)(1)-(5).
16. Treas. Regs. Section 1.67-4(b)(6).
17. Prop. Treas. Regs. Section 1.67-4(b).
18. Treas. Regs. Section 1.67-4(c)(1).
19. Treas. Regs. Section 1.67-4(c)(2).
20. Treas. Regs. Section 1.67-4(c)(3).
21. Ibid.
22. Treas. Regs. Section 1.67-4(c)(4).
23. IRC Section 56(b)(1).
24. While a full discussion of the income taxation of estates and trusts is beyond the scope of this article, pursuant to IRC Section 661(a), an estate or trust is entitled to deduct the lesser of “distributable net income” and the sum of “(1) any amount of income for such taxable year required to be distributed currently… and (2) any other amounts properly paid or credited or required to be distributed for such taxable year.” Accordingly, distributed income becomes taxable to the beneficiary and not the estate or trust.