final irs sect. 67(e) regs for estate and trust taxpayers...

Final IRS Sect. 67(e) Regs for Estate and Trust Taxpayers:

Applying the Required 2% Deduction Floor

WEDNESDAY, OCTOBER 15, 2014, 1:00-2:50 pm Eastern

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Final IRS Sect. 67(e) Regs for Estate and Trust Taxpayers

Oct. 15, 2014

Tina D. Milligan

HarrismyCFO

[email protected]

Domingo P. Such, III

Perkins Coie

[email protected]

mailto:[email protected]

mailto:[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

5

October 15, 2014

Final IRS Sect. 67(e) Regs for Estate and

Trust Taxpayers: Applying the Required 2%

Deduction Floor

Domingo P. Such III, Partner

Perkins Coie, Chicago

Tina D. Milligan, Managing Director

CTC | myCFO

AGENDA

7

Agenda

• Background: Court cases and Regulations prior to finalized I.R.C. Section

67(e) Regulations

• Details on final Regulations

• Practical examples and strategies

8

BACKGROUND

9

Evolution of the deductibility of investment advisory

expenses

• Section 23(a) of the Internal Revenue Code Act of 1928

– Predecessor to I.R.C. Section 162 – Trade or business expenses

– Allowed deductions for both taxpayer’s trade or business and other profit-oriented expenses

• Higgins v. Commissioner, 312 U.S. 212 (1941)

– Ruled in favor of the IRS

– Taxpayer not entitled to deduction for expenses incurred in a profit-oriented activity unless part

of a trade or business

– IRS revoked all prior guidance and authority permitting deduction for non-business, profit-

oriented expenses

• Section 23(a)(2) of the Internal Revenue Code (1942)

– predecessor to I.R.C. Section 212 – Expenses for production of income

10

Overview of I.R.C. Section 212

• I.R.C. Section 212

– Deduction for all ordinary and necessary expenses paid or incurred during the taxable year:

• For the production or collection of income;

• For the management, conservation, or maintenance of property held for the production of

income; or

• In connection with the determination, collection or refund of any tax

– Deductions are not included on the I.R.C. Section 67(b) list of non-miscellaneous deductions

– Generally permits deductions for expenses, such as fiduciary fees, incurred in connection with

the administration of an estate or trust.

– Classifies trust or estate administration expenses, if not allowed in computing AGI under I.R.C.

Sections 62(a) or 67(c), as miscellaneous itemized deductions subject to the 2% of AGI floor

11


• Section 67(a)

– Taxpayer’s “miscellaneous itemized deductions” may be deducted only to the extent such

expenses exceed 2% of the taxpayer’s AGI

– “2% floor”

– Trusts and estate are subject to the same limitation

• Section 67(b) defines “miscellaneous itemized deductions” as:

– Not described in one of twelve categories of deductions listed in I.R.C. Subsections 67(b)(1)-

(12)

– A deduction not allowed in computing AGI, other than a personal exemption

– Interest expenses under I.R.C. Section 163 are not miscellaneous itemized deductions

– Certain taxes under I.R.C. Section164 are not miscellaneous itemized deductions

12


• Section 67(e) will not apply to expenses paid or incurred in connection with

administration of an estate or trust if would not have been incurred if the

property were not held in such estate or trust.

13

Slide Intentionally Left Blank


• Section 68

– Reduces a taxpayer’s itemized deductions by an amount equal to the lesser of :

• 3% multiplied by the excess of AGI over the applicable amount, or

• 80% of the total itemized deduction otherwise allowable for such taxable year

15


• Section 56

– No deduction is allowed for Section 212 expenses for purposes of AMT

– Any amount deducted from AGI for miscellaneous itemized deductions will be “added back”

into taxpayer’s AGI to compute AMT

16

Definition of AGI for a trust

• Section 67(e) definition of AGI for a trust

Gross income: All income from whatever source derived

Less: Deductions

• Deductions taken directly against gross income - “above the line”

– Deductions that would be allowed in computing an individual’s AGI under section

62(a),

» such as deductions attributable to a trade or business, or

» to property held in the production of rents or royalties;

– Deductions for distributions to beneficiaries under sections I.R.C. Sections 651 or

661;

– Personal exemptions under I.R.C. 642(b); and

– Deductions “for costs which are paid or 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.”

= Adjusted Gross Income

• 17

Taxable income

• Tax is imposed on “taxable income” of both individuals and trusts1

Gross income: All income from whatever source derived

Less: Deductions

• Deductions taken directly against gross income - “above the line”

= Adjusted Gross Income

• Deductions taken from AGI - “below the line” (i.e. Investment advisory fees)

= Taxable Income

18

Court cases

• Split between Sixth Circuit and Fourth/Federal Circuit rulings

• Knight v. Commissioner U.S. Supreme Court Decision

– Knight V. Commissioner, 522 U.S. 181 (2008)

– Criticized the Treasury’s interpretation of exception in Proposed Regulations

– Proposed Regulations limit the Section 67(e) exception to costs which were “unique” to a trust

or estate

• costs that could not be incurred by an individual

– The court held Treasury’s interpretation too narrow

• Trust and estate expenses should not be subject to the 2% floor

– if not “customarily or commonly incurred” by an individual

• Even investment advisory fees could fall within the category of expenses not “customarily

or commonly” incurred by individuals

19

Treasury guidance and Proposed Regulations

• Temporary guidance leading up to final Regulations

– Treasury responded to the Knight decision

– Notice 2008-32

– Proposed Regulations in 2011

• Left lack of clarity

– Confusion over investment advisory fees

20

FINAL REGULATIONS

22

The final 67(e) regulations

• 2% floor applies if they are costs “commonly or customarily” incurred by a

hypothetical individual holding the same property

23


• Fiduciary expenses that will be subject to the 2% floor

– Ownership costs

– Tax preparation fees other than those incurred for:

• estate tax returns

• Generation skipping transfer tax returns

• Fiduciary income tax returns

• Decedents’ final income tax returns

– Investment advisory fees (subject to a limited exception)

– Appraisal fees, except those required:

• in preparation of the trust’s transfer tax returns, or

• income tax returns, or

• needed to measure distributions (i.e. annual unitrust amount)

24


• Fiduciary expenses that will not be subject to the 2% floor

– Not “commonly or customarily” incurred by individuals

• Probate court fees

• Fiduciary bond premiums

• Fees for publishing notices legally required in the administration of a decedent’s estate

• Costs of certified copies of a death certificate

• Costs of preparing fiduciary accountings

25


• Investment advisory fees – not “commonly or customarily” incurred by

individuals

– Additional charges for the implementation of an unusual investment objective:

• required by the terms of the estate or trust, or

• resulting from the need to balance interests of the beneficiaries

– Incremental cost of these services should not be subject to the 2% floor

– Final Regulations state that this portion of investment advisory fees is limited to the amount in

excess of those normally charged to individual investors

26


• Bundled fees

– Fiduciaries charging a single fee for mixed services where a portion would be exempt from 2%

floor must “unbundle” fees

– Reasonable method for allocation

• Allocate and separately state the portion subject to 2% floor versus exempt

• If not calculated on an hourly basis: only the portion reasonably allocated to investment

advice must be subjected to 2% floor

• Only general guidance on reasonable method

27


• Effective date

– Existing estates with fiscal years ending December through April, calendar year

• No earlier than January 1, 2015

– Estates of decedents dying on or after May 9, 2014

• May 9, 2014

– Trusts created on or after May 9, 2014

• May 9, 2014

– Trusts with fiscal year end during months of May through November

• May 9, 2014 (accelerated)

28

PRACTICAL EXAMPLES AND

STRATEGIES

30

Methods for allocating fees

• “Any reasonable method”

• Possible to support method with best result in smallest allocation to investment

management, so long as reasonable method

• Consistency not required for a fiduciary of multiple trusts and estates

– Depending on facts and circumstances: one reasonable method for one trust and another

reasonable method for a different trust

• Final regulations appear to permit the use of multiple factors in allocating fees

31


• Time spent on investment management duties and assets under investment

management

– Example: fiduciary determines time spent on investment management based on percent of trust

assets requiring investment management - remainder not subject to 2% limitation

32

Total Fiduciary Fee $100,000

Investment Management

Activities

Subject to 2% AGI limitation

All Other Fiduciary Duties

Not subject to 2% AGI

limitation

Percent of trust assets under investment management 50%

Percent of time on investment management 50%

Total percent of fee (50% x 50%) = 25% 75% remaining

Fee allocation $25,000 $75,000


• Trust instrument requires asset be retained

– Closely held business

– Home for beneficiary(ies)

– Insurance

• Investment policy of trust counter to prudent investor standards

• Number, percent and types of professionals

– Relationship management

– Investment advisors

– Investment committee

– Trust administrators

– Legal professionals

• Track time on investment versus fiduciary activities

33


• Comparison to other fees: fiduciary insurance or investment fee only (without

fiduciary service)

• Comparison of fees paid to fiduciary with no special investment skill

• Comparison of fees paid to directed trustee

34

Total Fiduciary Fee Insurance Fee Difference = Investment Fee

$150,000 $100,000 $50,000

Total Fiduciary Fee Investment Manager Fee – 80 bps Difference = Fiduciary Fee

$150,000 $80,000 $70,000

Comparison of “above the line” and “below the line”

35

$100,000 Fiduciary Fee “Below the line”

deduction

“Above the line” deductions

Gross income $1,000,00

0

$1,000,00

0

$1,000,000

Above the line deduction - (50,000) (75,000)

Adjusted Gross Income 1,000,000 950,000 925,000

Miscellaneous itemized

deduction

100,000 50,000 25,000

2% floor (20,000) (19,000) (18,500)

Allowable miscellaneous

itemized deduction

(80,000) (31,000) (6,500)

Taxable income $920,000 $919,000 $918,500

Impact of I.R.C. 67 as AGI increase

36

AGI $1 million AGI $10 million AGI $20 million

Investment income $1,000,000 $10,000,000 $20,000,000

AGI 1,000,000 10,000,000 20,000,000

Investment management

fees

500,000 500,000 500,000

2% Floor (20,000) (200,000) (400,000)


deduction

480,000 300,000 100,000

Percent of deduction lost 4% 67% 80%

Limit on itemized deductions (20,849) (240,000) (80,000)

Total itemized deductions 459,151 60,000 20,000


Impact of I.R.C. 67 as AGI increase

37

Adjusted Gross Income

Impact of I.R.C. 67 as 212 expenses increase

38

AGI $10 million all cases $400,000 subject 2% $600,000 subject 2% $800,000 subject 2%

Investment income $10,000,000 $10,000,000 $10,000,000

AGI 10,000,000 10,000,000 10,000,000

Investment management

fees

400,000 600,000 800,000

2% Floor (200,000) (200,000) (200,000)


deduction

200,000 400,000 600,000


Limit on itemized deductions (160,000) (290,849) (290,849)

Total itemized deductions 40,000 109,151 309,151


Planning considerations

• Consider AGI implications

• Consider planning around I.R.C. Section 212 classification

• Consider reasonable method for allocation of fees

39

40

Disclosure

CTC | myCFO is a brand delivering services through CTC myCFO, LLC an investment adviser registered with the Securities and Exchange Commission and a Commodity Pool

Operator registered with the National Futures Association; certain divisions of BMO Harris Bank N. A., a national bank with trust powers; and BMO Delaware Trust Company, a

Delaware limited purpose trust company. Not all products and services are available in every state and/or location.

Investment products offered: ARE NOT A DEPOSIT – NOT INSURED BY THE FDIC OR ANY FEDERAL GOVERNMENT AGENCY – NOT GUARANTEED BY ANY BANK – MAY

LOSE VALUE. CTC | myCFO also offers Family Office Services, including tax consulting services, through CTC myCFO, LLC. Family Office Services are not fiduciary services and

are not subject to the Investment Advisers Act of 1940 or the rules promulgated thereunder.

Capital Advisory Services is part of CTC | myCFO, a brand for various companies of BMO Financial Group. Capital Advisory Services are only offered by a division of BMO Harris

Bank N.A. in its Chicago, IL and Milwaukee, WI locations. Banking deposit and loan products and services are provided by BMO Harris Bank N.A. and are subject to bank and credit

approval. BMO Harris Bank N.A. Member FDIC.

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As of June 30, 2014, CTC | myCFO had approximately $41 billion in assets under management or advisement, including $20 billion in discretionary assets under management and

$21 billion in nondiscretionary consulting asset under advisement, and approximately $43 billion in assets under administration and custody.

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categories by providing answers regarding their business model, services offered, growth in client count and assets managed countries of operation, service innovation, and

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the Top 50 investment advisors and investment advisories: (1) all firms are registered investment advisors ranked based on discretionary assets under management as defined by the

Securities and Exchange Commission as of Sept. 30, 2010; (2) greater than 50% of their business must serve the retail marketplace; (3) advisors must provide financial planning

services or portfolio management for individuals or conduct due diligence on third-party advisors; (4) they must not be doing business as a broker/dealer, bank or insurance company;

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taxpayer. This information is being used to support the promotion or marketing of the planning strategies discussed herein. CTC | myCFO and its affiliates do not provide legal advice

to clients. You should review your particular circumstances with your independent legal and tax advisors.

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