I. Background
Section 67 of the Internal Revenue Code, enacted in 1986, allows “miscellaneous
itemized deductions” for income tax purposes only to the extent those “miscellaneous itemized
deductions” exceed 2 percent of adjusted gross income (the “2% floor”). “Miscellaneous
itemized deductions” are defined in section 67(b) and include deductions under section 212 for
ordinary and necessary expenses for the production or collection of income, for the management,
conservation, or maintenance of property held for the production of income, and in connection
with the determination, collection, or refund of any tax..
Section 67(e) provides for the calculation of adjusted gross income of an estate or trust in
the same manner as in the case of an individual (thereby clarifying the application of subchapter
J, which provides, in section 641(b), that the taxable income of an estate or trust is computed in
the same manner as in the case of an individual). Section 67(e)(1) provides that “the 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 ...
shall be treated as allowable in arriving at adjusted gross income.” The effect is to exempt such
costs from the 2% floor.
On January 16, 2008, the Supreme Court decided Michael J. Knight, Trustee v.Commissioner, 552 U.S. ___, 128 S. Ct. 782 (No. 06-1286, Jan. 16, 2008). In a unanimous
opinion by Chief Justice Roberts, the Court affirmed the Court of Appeals for the Second Circuit
and held that for federal income tax purposes trust investment advisory fees are subject to the 2%
floor.
While Knight was pending, the Service released proposed regulations under section
67(e), addressing the application of the 2% floor to trusts. Proposed Reg. § 1.67-4, REG-128224-06 (July 26, 2007). In general, the proposed regulations would exempt from the 2%
floor only costs that are “unique” to a trust, including costs of fiduciary accountings, required
judicial or quasi-judicial filings, fiduciary income tax returns, estate tax returns, division or
distribution of income or corpus to or among beneficiaries, trust or will contests or constructions,
fiduciary bonds, and communications with beneficiaries regarding trust matters. As examples of
services that are not “unique” to a trust, the costs of which are subject to the 2% floor, the
proposed regulations cite the custody and management of property, advice on investing for total
return, gift tax returns, the defense of claims by creditors of the decedent or grantor, and the
purchase, sale, maintenance, repair, insurance, or management of property not used in a trade or
business. The proposed regulations would also require the “unbundling” of unitary fiduciary
fees or commissions for fiduciary services, so as to identify the portions attributable to activities
and services that are not “unique” and are therefore subject to the 2% floor.
As proposed, the regulations would apply to “payments made after the date final
regulations are published in the Federal Register.” Proposed Reg. § 1.67-4(d). The Service
received written comments about the proposed regulations and held a public hearing on
November 14, 2007.
On February 27, 2008, the Service issued Notice 2008-32, 2008-11 I.R.B. 1,
acknowledging the Supreme Court’s Knight decision, expressing an intention to finalize the
regulations consistently with Knight, providing that “unbundling” of a “Bundled Fiduciary Fee”
would not be required for taxable years before 2008, and requesting further comments on the
proposed regulations by May 27, 2008. Among other things, Notice 2008-32 stated that the
Service and Treasury were considering percentage “safe harbors” for unbundling a “Bundled
Fiduciary Fee” and requested comments on such safe harbors.
This letter is written in response to Notice 2008-32.
II. The Legislative History Focuses on Simplification as the Purpose of the 2% Floor One of the chief criticisms of the Service’s attempt to subject trusts to the 2% floor, and
of the cases that have supported that attempt, is that the purposes of the 2% floor – reducing
recordkeeping and reducing erroneous deductions of personal expenditures – simply do not apply
to trusts, which generally are required to keep accurate records and distinguish personal
expenditures anyway.
Admittedly, there are many ways to identify the purposes of a congressional statute,
because there are several ways to look at “legislative intent.” The following is a sampling:
• What Congress “must have” intended, given the mood of the times and the personalities involved.
• What Congress “actually” intended, which is usually “known” only by “insiders” of the
day (and since Congress has 535 Members and many more staff members, such
“knowledge” might be accidental and unreliable).
• What Congress said, typically in committee reports.
• What the purpose of any given provision should be understood to be, given the
provision’s terms and effect and the law-school notion of asking the “reason for the rule”
when application to a given set of facts is unclear.
In this letter, I rely, as I believe the drafters of regulations should, on what Congress (and the
Administration) said with immediate reference to the 2% floor and also on a “reason for the
rule” approach, which leads to the same conclusion.
A. Administration Proposals
“Tax Reform for Fairness, Simplicity, and Economic Growth” (popularly called
“Treasury I”) was published by Treasury on November 27, 1984, just weeks after President
Reagan’s landslide reelection. It included a proposal that would subject miscellaneous itemized
deductions (along with unreimbursed employee expenses and state and local taxes other than
income taxes) to a floor equal to 1% of adjusted gross income. At pages 115-16 of volume 2,
Treasury justified this proposal as follows (emphasis added):
Reasons for Change
Allowance of the various employee business expense deductions and the
miscellaneous itemized deductions complicates recordkeeping for many
taxpayers. Moreover, the small amounts that are typically involved present
significant administrative and enforcement problems for the Internal Revenue
Service. These deductions are also a source of numerous taxpayer errors
concerning what amounts and what items are properly deductible.
....
Analysis
Disallowance of a deduction for a normal level of employee business
expenses and miscellaneous itemized deductions would simplify recordkeeping,
reduce taxpayer errors and ease administrative burdens for the Internal Revenue
Service while still providing fair treatment for taxpayers who incur an unusually
high level of such expenses.
In 1982, one-half of all itemizers claimed miscellaneous deductions of less
than one-half of one percent of their AGI. Fifty-eight percent claimed deductions
of less than one percent of their AGI, and 93 percent claimed deductions of less
than five percent of their AGI. Thus, introduction of a “floor” or “threshold” of
one percent of AGI would substantially reduce the number of returns claiming
this deduction. The proposed extension of the miscellaneous deduction to
nonitemizers would partially offset the revenue gain from introduction of the
floor.
The proposal would broaden the tax base and, thus, contribute to the
reduction in marginal tax rates. Any increase in tax liability resulting from this
proposal should be more than offset by the reduced marginal rates and the
increase in the zero bracket amount and the personal exemption.
“The President’s Tax Proposals to the Congress for Fairness, Growth, and Simplicity”
(often called “Treasury II”) was published by the White House on May 29, 1985, to
communicate the President’s recommendations to Congress. Treasury II included the proposed
1% floor on miscellaneous itemized deductions from Treasury I. On pages 104-105, Treasury II
reproduced the same justification quoted above, except that the last paragraph (referring to
broadening the tax base) was omitted.
Thus, the original proposal of a special rule for miscellaneous itemized deductions
focused on the taxpayer’s recordkeeping burden, the potential for taxpayer errors, and the
Service’s administrative burdens. Elaboration in terms of itemizers and nonitemizers confirmed
that individuals were in view. An initial reference to base-broadening was clearly secondary, in
that it appeared at the end of the initial discussion and in subsequent formulations was not
mentioned at all.
Under the heading of “Tax Abuses—Income Shifting,” Treasury I and Treasury II also
proposed the taxation of the unearned income of children under 14 at the marginal tax rate of
their parents, outlined sweeping changes in the income taxation of trusts, and suggested the
continuation of a decedent’s taxable year without starting a new taxable year upon death.
The proposal for changing the income taxation of trusts would eliminate the separate rate
schedule for trusts (based on the rate schedule applicable to married individuals filing separate
returns). At page 105 of volume 2, Treasury I summarized the proposal as follows (emphasis
added):
Because all trust income would be taxed to the grantor, taxed to trust
beneficiaries, taxed to the trust at the grantor’s marginal rate (during the grantor’s
lifetime), or taxed to the trust at the highest individual rate (after the grantor’s
death), the proposal would eliminate the use of trusts as an income-splitting
device. In this respect, the proposal would reinforce the integrity of the
progressive rate structure and thus enhance the fairness of the tax system.
Thus, it was for these proposals, not the special rule for miscellaneous itemized deductions, that
propping up revenue was an immediate articulated objective of the Administration proposals.
B. The House of Representatives
The original House bill that became the Tax Reform Act of 1986 (H.R. 3838, introduced
December 5, 1985, and reported by the Ways and Means Committee December 7, 1985)
proposed a new section 67 of the Internal Revenue Code, subjecting “miscellaneous itemized
deductions” to a floor equal to 1% of adjusted gross income, as in the Administration proposals.
In explaining this proposal, the House Ways and Means Committee stated:
The committee believes that the present-law treatment of employee
business expenses, investment expenses, and other miscellaneous itemized
deductions fosters significant complexity. For taxpayers who anticipate claiming
itemized deductions, present law effectively requires extensive recordkeeping with regard to what commonly are small expenditures. Moreover, the fact that
small amounts typically are involved presents significant administrative and
enforcement problems for the Internal Revenue Service. These problems are
exacerbated by the fact that taxpayers may frequently make errors of law
regarding what type of expenditures are properly allowable as miscellaneous
itemized deductions.
H.R. REP. NO. 99-426, 99TH CONG., 1ST SESS. 109 (1985) (emphasis added).
The House bill included the following new section 67(c):
(c) DETERMINATION OF ADJUSTED GROSS INCOME IN CASE OF ESTATES
AND TRUSTS.—For purposes of this section, the adjusted gross income of an estate
or trust shall be computed in the same manner as in the case of an individual,
except that the deductions for costs paid or incurred in connection with the
administration of the estate or trust shall be treated as allowable in arriving at
adjusted gross income. C. The Senate
The Senate Finance Committee’s version of the 1986 bill proposed a new section 280I of
the Internal Revenue Code, subjecting certain employee expenses to a floor equal to 1% of
adjusted gross income. The Senate bill would have added the following new subsection (b) to
section 62 (the definition of “adjusted gross income”):
(b) DETERMINATION OF ADJUSTED GROSS INCOME IN CASE OF ESTATES
AND TRUSTS.—For purposes of this subtitle, the adjusted gross income of an
estate or trust shall be computed in the same manner as in the case of an
individual, except that the deductions for costs paid or incurred in connection with
the administration of the estate or trust shall be treated as allowable in arriving at
adjusted gross income.
With respect to miscellaneous itemized deductions, the Senate bill would have repealed
such deductions altogether. The Finance Committee’s explanation of this proposal resembled
the Ways and Means Committee’s explanation of the House bill. The Finance Committee began
its discussion of “Reasons for Change” with the following:
The committee believes that, as part of the approach of its bill to reduce
tax rates through base-broadening, it is appropriate to repeal the miscellaneous
itemized deductions and to limit deductions for certain employee expenses. The
committee also concluded that allowance of these deductions under present law
fosters significant complexity, and that some of these expenses have
characteristics of voluntary personal expenditures.
S. REP. NO. 99-313, 99TH CONG., 2D SESS. 78 (1986) (emphasis added).
Thus, with respect to miscellaneous itemized deductions, in contrast to Treasury and the
Ways and Means Committee, the Finance Committee was apparently more concerned with
revenue enhancement through base-broadening. In addition, its concern about voluntary
personal expenditures was not only that errors might be made, but that some miscellaneous
itemized deductions inherently resembled such expenditures. Consistently with those concerns,
the Senate bill would have eliminated miscellaneous itemized deductions altogether.
As a result, with respect to the Senate bill, it would be harder to argue that simplification
was the dominant concern and base-broadening was only secondary. But then, under the
Senate’s approach of total repeal, the identification of “unique” costs, the “unbundling” of
unitary fees, and the allocations between the trust and its beneficiaries, which make application
of the 2% floor so complicated and burdensome, would not be necessary. Total repeal might,
ironically, have been “simpler.” But that is not what Congress chose to do.
D. The House-Senate Conference
The House-Senate conference refused to go as far as the Senate’s repeal, but it increased
the 1% floor of the House bill to the 2% floor now imposed by section 67. It was the House-
Senate conferees who added to section 67(e) the words “and would not have been incurred if the
property were not held in such trust or estate.” (The Technical and Miscellaneous Revenue Act
of 1988 (Public Law No. 100-647) redesignated this statutory provision as section 67(e)(1),
added the second “which” in section 67(e)(1), and added a new section 67(e)(2) to clarify that
the personal exemption and the distribution deduction are exempt from the 2% floor.)
It was the 1986 conference report that first mentioned trusts in committee report
language:
Pursuant to Treasury regulations, the floor is to apply with respect to
indirect deductions through pass-through entities (including mutual funds) other
than estates, nongrantor trusts, cooperatives, and REITs [the rule contained in
section 67(c)]. The floor also applies with respect to indirect deductions through
grantor trusts, partnerships, and S corporations by virtue of present-law grantor
trust and pass-through rules. In the case of an estate or trust [i.e., other than a
grantor trust], the conference agreement provides that the adjusted gross income is
to be computed in the same manner as in the case of an individual, except that the
deductions for costs that are paid or incurred in connection with the
administration of the estate or trust and that would not have been incurred if the
property were not held in such trust or estate are treated as allowable in arriving at
adjusted gross income and hence are not subject to the floor [the rule contained in
section 67(e)]. The regulations to be prescribed by the Treasury relating to
application of the floor with respect to indirect deductions through certain passthrough
entities are to include such reporting requirements as may be necessary to
effectuate this provision.
H.R. REP. NO. 99-841, 99TH CONG., 2D SESS. II-34 (1986) (conference report).
The single sentence of the legislative history that specifically addresses section 67(e) adds nothing to the statutory language. Thus, it could be argued, as it has been in the ensuing
litigation, that the context suggests a congressional concern only with other kinds of passthrough
entities, and that the sole purpose of section 67(e) was to relieve estates and non-grantor
trusts from the application of the 2% floor.
In any event, Congress did not accept the proposals of the Administration to make
sweeping structural changes to the income taxation of trusts and estates. Instead, the ’86 Act
simply compressed the rate brackets applicable to trusts, so that the top rate (28%) would be
reached at the level of a taxable income of $5,000 (indexed for inflation), rather than $79,500
(indexed for inflation) as under pre-1986 law. (Section 1411 of the ’86 Act did follow through
on the Administration proposal regarding the unearned income of children, by enacting the
“kiddie tax” now found in section 1(g).)
E. Summary of the Legislative History
In short, Congress’s stated purposes in subjecting certain deductions to the “2% floor”
were simplification (by reducing recordkeeping) and fairness (by removing the opportunity to
mix personal expenditures with legitimately deductible expenses). Anyone who has ever
administered a trust knows that the trustee’s fiduciary duties to beneficiaries (and sometimes
accountability to a court) require careful recordkeeping and identification of the character of
expenditures, without regard to tax rules. Congress, judging by its stated purposes, did not aim
section 67 at trusts.
F. The Justice Department’s Treatment of the Legislative History
One of the things about the controversy over section 67(e) that has most exasperated
fiduciaries and their advisors is what has been perceived as the Justice Department’s reconstruction of the legislative history to sway the recent decisions of federal courts, where of
course Justice Department attorneys enjoy great credibility.
For example, on page 34 of the Justice Department’s brief in the Supreme Court Knight case, counsel cited the Senate Finance Committee’s 1986 references to “complexity” and
“voluntary personal expenditures” in S. REP. NO. 99-313, 99TH CONG., 2D SESS. 78-79 (1986)
(quoted above). In the next paragraph, on the same page, of the Government’s brief, counsel
added the following:
Congress also recognized that “[t]he present rules relating to the taxation
of trusts and estates permit the reduction of taxation through the creation of
entities that are taxed separately from the beneficiaries or grantors of the trust or
estate.” 1986 Senate Rep. 867.
Conspicuously, pages 78-79 and page 867 of the Finance Committee report are 788 pages
apart. In fact, the Finance Committee’s “permit the reduction of taxation” comment was made in
the context of explaining the compression of the income tax rates in section 1(e) applicable to
estates and trusts (also described above). The Finance Committee, just two paragraphs later,
went on to add:
On the other hand, the committee believes that significant changes in the
taxation of trusts and estates are unnecessary to accomplish this result.
Accordingly, the bill attempts to reduce the benefits arising from the use of trusts
and estates by revising the rate schedule applicable to trusts and estates so that
retained income of the trust or estate will not benefit significantly from a
progressive tax rate schedule that might otherwise apply. This is accomplished by
reducing the amount of income that must be accumulated by a trust or estate
before that income is taxed at the top marginal rate. The committee believes that
these changes will significantly reduce the tax benefits inherent in the present law
rules of taxing trusts and estates while still retaining the existing structure of
taxing these entities.
S. REP. NO. 99-313, 99TH CONG., 2D SESS. 868 (1986). Thus, the Finance Committee disclaimed
any disposition to implement its “permit the reduction of taxation” objective through any
changes to the rules (other than rates) governing the taxation of trusts and estates and in any
event gave no indication that it had directed its “permit the reduction of taxation” comment to the
treatment of miscellaneous itemized deductions it had addressed 867 pages earlier.
I was counsel for the trustees in Scott v. United States, 328 F.3d 132 (4th Cir. 2003),
where Justice Department attorneys perpetrated the same 867-page ellipsis, and we pointed that
out in our responsive brief. Nevertheless, counsel persisted in obscuring the stated congressional
focus on simplification, which makes application of the 2% floor to trusts seem so unnecessary
and just plain wrong. While I cannot claim much objectivity in the matter, I respectfully ask
Treasury and the Service – Justice’s clients – to consider if public respect for the tax administration system is not worth some caution here. If so, then perhaps Treasury and the
Service might step back and take another look at the 2% floor in light of Congress’s stated
purposes, rather than merely codifying their lawyers’ judicial successes in collecting a few
marginal tax dollars under an unclear statute.
III. Case Law Leaves the Door Open to a Reasonable Application of the 2% Floor
In Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001), the Court of
Appeals for the Federal Circuit became the first court of appeals to hold a trustee’s investment
advisory fees to be subject to the 2% floor. The court stated that section 67(e)(1) “treats as fully
deductible only those trust-related administrative expenses that are unique to the administration
of a trust and not customarily incurred outside of trusts.” Id. at 1281. Nevertheless, despite the
use of the word “unique,” the court rested its conclusion merely on the observation that
“[i]nvestment advice and management fees are commonly incurred outside of trusts.” Id.
In Scott, the Court of Appeals for the Fourth Circuit reached the same result. The court
quoted the reference to “unique” expenses in Mellon Bank, but immediately added that “[p]ut
simply, trust-related administrative expenses are subject to the 2% floor if they constitute
expenses commonly incurred by individual taxpayers.” Id. at 140.
Writing for a unanimous Court in Knight, Chief Justice Roberts adopted an approach of
“hypothetical” “prediction” – the Court’s words. Rejecting the notion (entertained by the Second
Circuit) that “would not” means “could not,” the Court seemed more inclined to the tests
employed by the Federal Circuit and the Fourth Circuit. The Court quoted the statement in Mellon Bank that section 67(e)(1) “treats as fully deductible only those trust-related
administrative expenses that are unique to the administration of a trust and not customarily
incurred outside of trusts” and said “[w]e agree with this approach.” 128 S. Ct. at 789.
Nevertheless, like the Federal and Fourth Circuits, the Supreme Court did not rest its decision on
the concept of “uniqueness.” The Court reduced the operation of the statute to a simple question:
“whether a particular cost would have been incurred if the property were held by an individual
instead of a trust.” Id. at 787 n.4. The Court’s approach is to imagine, hypothetically, that the
property in question were not held in trust and then ask if the expense in question “would have
been incurred” by the individual owning it.
But the Court stopped far short of viewing the statute as clear and unambiguous and
compelling any particular result. To the contrary, the Court said that “[w]e appreciate that the
inquiry into what is common may not be as easy in other cases, particularly given the absence of
regulatory guidance.... Congress’s decision to phrase the pertinent inquiry in terms of a
prediction about a hypothetical situation inevitably entails some uncertainty, but that is no
excuse for judicial amendment of the statute.” Id. at 791.
Moreover, the Court supported its view of section 67(e)(1) by quoting the statement in its
1989 opinion in Commissioner v. Clark, 489 U.S. 726, 739 (1989) (a case involving the
treatment of “boot” received in a “triangular merger” as a dividend rather than capital gain under
the exception in section 356(a)(2)) that “[g]iven that Congress has enacted a general rule ..., we
should not eviscerate that legislative judgment through an expansive reading of a somewhat
ambiguous exception.” 128 S. Ct. at 789.
These references to “a somewhat ambiguous exception,” “some uncertainty,” and “the
absence of regulatory guidance” leave the door open for Treasury to provide definitive practical
guidance. The Supreme Court mandates that the courts give wide deference to Treasury’s
interpretation of its own ambiguous regulations. Chevron v. Natural Resources Defense Council,Inc., 467 U.S. 837 (1984); Auer v. Robbins, 519 U.S. 462 (1997). As a result, when a court
reviews a construction of a statute, the court must determine only whether the regulation is based
on a permissible construction of the statute. Thus, courts need not conclude that the regulatory
construction was the only permissible construction, or even the construction the court would
have reached if it examined the statute in the first place. Chevron, 467 U.S. at 843-44.
Although Congress did not explicitly delegate rulemaking authority with respect to
section 67(e)(1), rulemaking authority is derived from the general delegation in section 7805(a).
As a result, if Treasury’s administrative interpretation of the statutory provision is reasonable,
courts will grant the regulation deference and uphold it. Id. Courts may not simply impose their
own construction of section 67, but instead must defer to Treasury’s reasonable, and thus
permissible, regulatory construction of the statutory provision.
In other words, Treasury and the Service are free to publish final regulations providing a
reasonable interpretation of section 67(e)(1) and a reasonable application of the 2% floor. Such
regulations would be consistent with Knight, as Notice 2008-32 forecast.
IV. It Would Be Reasonable to Exempt Multi-Beneficiary Trusts from the 2% Floor
A. Exemption Would Carry Out the Purpose of the Statute
As described above, the dominant purposes identified in the legislative history of the 2%
floor are to reduce recordkeeping, avoid disproportionate administrative efforts, and reduce the
occasions for errors of law in distinguishing legitimately deductible expenses from personal
expenditures. Even if it is contended that the 1986 House-Senate conferees did not consciously
intend a broad exemption for trusts when they added what is now the last clause of section 67(e)(1), it would certainly be reasonable to view simplification as the primary “reason for the
rule” in determining the limits of section 67(e)(1) when application to a given set of facts is
unclear.
As stated above, the “reasons for the rule” of reducing recordkeeping and reducing
erroneous deductions of personal expenditures generally do not apply to trustees, which are
required to keep accurate records and distinguish personal expenditures in any event. Moreover,
as other commentators have no doubt demonstrated, application of the 2% floor to trusts would
be disproportionately complicating, not simplifying.
Although I write this letter on my own behalf and not on behalf of any client or
organization, I am familiar with the practices and challenges of fiduciaries, particularly corporate
fiduciaries responsible for large numbers of fiduciary income tax returns each year. I am
convinced of the burdens the 2% floor in general, and particularly the “unbundling” requirement
set forth in the proposed regulations, will impose. The comments that your office has received
and is likely to receive from fiduciaries are not whining to secure a tax benefit for those
fiduciaries’ clients. These administrative burdens are real. It is also important to remember that
recordkeeping and other duties imposed on fiduciaries already protect against the confusion
between legitimate deductions and personal expenditures – there are no “abuses” or “tax
shelters” here.
For additional confirmation, I recommend consultation with revenue agents in the field.
It is hard to believe that many would view it as an efficient use of resources to sift through a
trustee’s admittedly legitimate expenses, coordinate the 2% floor with distributable net income,
determine the correct allocations among beneficiaries, ensure the proper flow-through to K-1s,
and arrange for integration with the beneficiaries’ own 2% floors and the trust’s and
beneficiaries’ alternative minimum tax profiles, all in pursuit of a doubtful congressional
mandate and often in the context of small numbers. The calculations and allocations involved
even for a discrete payment to a third-party service-provider can be quite intricate, and probably,
by reason of their complexity, they themselves introduce an element of arbitrariness into the
result.
This complexity is only compounded in the case of unitary fiduciary fees that must be
unbundled, where first the unbundling must be done and then all of the same intricate
calculations and allocations must still follow.
Corporate fiduciaries spend many thousands of hours each year on preparing tax returns
that are thorough, accurate, and understandable. Even in the environment of low audit rates
experienced for fiduciary income tax returns, those fiduciaries perform yeoman service on the
front line of compliance and make an important contribution to the integrity of the selfassessment
system. It is counterproductive to incur the risk of exasperating and demoralizing
those professionals by imposing complex requirements that serve questionable ends.
Some have suggested consideration of safe harbors in the form of percentages, and
Notice 2008-32 specifically asked for comments on such percentage safe harbors. In my view,
percentage safe harbors will not work. Besides the fact that such safe harbors would retain much
of the complexity that offends the legislative purpose and, on the thesis of this letter, would be
implementing a flawed principle, percentage safe harbors might actually add to complexity.
Even with safe harbors available, trustees held to the high standards of fiduciary duties might be
obliged to attempt a more precise allocation anyway, so as not to harm the trust and the
beneficiaries by accepting an overly conservative or otherwise inappropriate short-cut. A low
safe harbor percentage (measured in terms of the amount that is exempt from the 2% floor)
would not be accepted and would not achieve its purpose. A high percentage would only
highlight the lack of proportion between the required compliance effort and the marginal
difference it makes. Either way, additional controversy would be likely.
Moreover, safe harbors can be abused, whether intentionally or inadvertently, such as by
segregating clearly “unique” costs into separately identified payments and applying a percentage
safe harbor to the balance of largely non-unique costs (or whatever nomenclature is used in the
final regulations). Anti-abuse rules could be prohibitively complex. For example, any effort to
deny or limit the use of safe harbors when there are separated costs would be arbitrary and could
penalize trustees who outsource. Again, additional controversy would be likely.
On the other hand, in the words of Notice 2008-32, “safe harbors [that] reflect the nature
or value of the assets” could be written to limit the 2% floor to “in rem” expenses, and “safe
harbors [that] reflect ... the number of beneficiaries” could be written to limit the 2% floor to
single-beneficiary trusts that are the equivalent of outright individual ownership – views that are
both embraced in this letter.
The dominant stated purpose and principal logical reason for the 2% floor is
simplification. That purpose is not served, but is clearly frustrated, by imposition of the 2% floor
in the context of trusts. Despite the foregoing comments about judicial deference to any
reasonable interpretation, it could easily be concluded that exempting trusts from the 2% floor is
the most reasonable interpretation, because it alone would meaningfully serve the objective of
simplification.
To the extent a purpose for the 2% floor is fairness, exemption of trusts would not defeat
that purpose in any way. I assume for purposes of this analysis that it promotes the objective of
fairness to level the playing field among individual itemizers by removing what had become an
occasion (and perhaps sometimes even a temptation) to commingle personal and deductible
expenditures in an environment of relatively small numbers where an examination is unlikely to
occur and would be disproportionately burdensome to the Service if it did occur. In that light, I
also assume that it promotes the objective of fairness to prevent the use of trusts to achieve
benefits not available to an individual. That interest of fairness would be fully protected by
exempting only trusts with multiple beneficiaries. Subjecting a trust for a single beneficiary –
such as a “2503(c) trust” (or 2642(c)(2) trust) created for a minor as a substitute for an outright
gift – to the 2% floor would also be complicating and burdensome in some cases, particularly
those involving “unbundling,” but that might nevertheless represent a reasonable balancing of
the objectives of simplification and fairness.
B. Exemption Would Be Consistent with the Language of the Statute
Finally, the case law has shown that the statute is difficult, even though it has been seen
clearly – but differently! – by various courts. In fashioning a workable “reasonable”
interpretation, it will be necessary to respect the words “would not have been incurred if the
property were not held in such trust or estate.” The words “would not have been incurred” are
unusual in the Internal Revenue Code. The only analogs are the definition of acquisition
indebtedness in the context of unrelated debt-financed income in section 514(c) and the similar
restriction in section 2031(c)(4) added in 1997 in the context of the estate tax treatment of
conservation easements. In the long-standing unrelated debt-financed income rules, it is clear
that the words “would not have been incurred” are susceptible of a simple single-taxpayer
balance sheet analysis (see the examples in Reg. § 1.514(c)-1(a)(2)), and presumably the new
conservation easement estate tax rules can be applied in the same way. There is no known
precedent for the behavior-predictive analysis contemplated by the Supreme Court.
Against that background, the standard of reasonableness for a regulatory interpretation
seems quite broad. Surely it would be reasonable for Treasury and the Service to interpret such
quixotic language with a view to its simplification objective.
It also must be acknowledged that the “two prong” approach to section 67(e)(1) has been
overworked. Certainly we must start with an effort to give meaning to both the clause “are paid
or incurred in connection with the administration of the estate or trust” and the clause “would not
have been incurred if the property were not held in such trust or estate” – so as not to “render
part of the statute entirely superfluous, something we are loathe to do.” Knight, 128 S. Ct. at
788-89, quoting Cooper Industries, Inc. v. Aviall Services, Inc., 543 U. S. 157, 166 (2004).
Indeed, the Supreme Court in Knight applies that principle in both directions, because, in
rejecting the Second Circuit’s “could not be incurred” approach, the Court states that “[w]e can
think of no expense that could be incurred exclusively by a trust but would nevertheless not be
‘paid or incurred in connection with’ its administration.” 128 S. Ct. at 788. And here is the nub
of the matter: the Court does not explain how that dilemma is avoided merely by changing
“could” to “would.”
In between these two observations, the Court cites Bogert on Trusts for the proposition
that “the payment for expenses must be reasonably necessary to facilitate administration of the
trust.” Id., citing G. BOGERT & G. BOGERT, LAW OF TRUSTS AND TRUSTEES §801, at 134 (2d rev.
ed. 1981). Thus, it seems inevitable that the so-called first prong of section 67(e)(1) will always
be met and therefore arguably will always be superfluous, and Treasury and the Service should
feel free to finalize the regulations in a manner that reasonably deals with that inevitability.
The way to deal with the “would” standard is to do what most courts have seemed
reluctant to do, but which regulations surely can do and some Justices in the Knight oral
argument found intriguing – and that is to look at the context and occasion for incurring the
expense. This would be a natural extension of the analysis that often supports deductibility in
the first place, which, after all, is the framework in which miscellaneous itemized deductions
arise and the 2% floor operates.
For example, I might ask: Can I get an income tax deduction for what I pay someone to
mow my lawn? The obvious answer is no – that’s a personal expenditure. But what if I am a
landlord, the lawn is associated with a residence I rent to tenants, and the lease obligates me to
maintain the lawn? That surely is different. Or what if the lawn is associated with the converted
residence I use for a business? That is different still. Same lawn, same mowing, different
income tax results. Likewise, I might ask: Can I deduct the rent I pay for a safe deposit box?
That depends on what I keep in the box. Again, same box, different income tax results.
In the context of the 2% floor, the fiduciary relationship is just as significant. While the
grass grows the same at the rental residence as it does at the personal residence, fiduciary
expenditure decisions are more likely to always be informed by fiduciary duties. They really are
different from an individual’s expenditure decisions. And in advising a fiduciary about fiduciary
relationships and duties (including investment advice), the fiduciary relationship sometimes
might not matter to the advisor, but for the reasons set forth in this letter and by others, the final
regulations should indulge the reasonable simplifying presumption that the pervasive fiduciary
relationship always matters.
As suggested above, an exception for “in rem” expenses that truly run with the property
(such as the condo fee mentioned by taxpayer’s counsel in the Knight oral argument) should be
an acceptable compromise that truly respects the words of both clauses of section 67(e)(1) –
distinguishing in a logical way between expenses that solely follow “the property” in the second
clause and expenses that relate to “the administration of the ... trust” in the first clause.
V. Recommendation
Thus, in light of the Supreme Court’s treatment of the statute, in effect, as ambiguous,
affirming the discretion of Treasury and the Service to address these issues in regulations, I
recommend that the final regulations clarify the application of the statute in a bold, practical,
palatable, and statesmanlike manner. The following considerations should inform that process:
• As described above, the stated purposes of section 67 (alleviating a recordkeeping
burden and removing the temptation to deduct personal expenses) generally do not
apply to fiduciaries.
• The “which would not have been incurred if the property were not held in such trust or
estate” clause in section 67(e)(1) has been overworked as an alleged “second prong” of
the statutory test. In the acknowledged absence of any authoritative articulation of
congressional intent, there is no reason to view it as anything more than a completion of
the overall thought of a relationship to estate or trust administration.
• To the extent that the test of section 67(e)(1) nevertheless suggests elements of both
context (“in connection with”) and motivation or occasion (“would not have been
incurred”), the interests of tax administration demand the simplifying and realistic
assumption that a fiduciary’s actions (including requests of an investment advisor or
other service provider) are always informed by the unique standards of fiduciary duties.
• Even if it is thought necessary to give greater independent effect to the “would not have
been incurred” “second prong” of the section 67(e)(1) test, then that effect should
reflect the reference in the statute to “property,” suggesting that it is the nature of the
property that is critical, not the circumstances of the holder, and that therefore an
appropriate carve-out would be limited to incremental “in rem” expenses that run with
the property.
• Administration of a test such as that reflected in the proposed regulations would require
disproportionate expenditure of compliance and audit resources and would inevitably
lead to widely divergent results, especially in the complex task of reflecting an overall
correct approach in the fiduciary’s K-1s and the beneficiaries’ individual returns – just
the opposite of the simplification that was Congress’s stated purposes.
• Unitary or “bundled” fees are welcomed by trust grantors and beneficiaries and reflect
not only à la carte services but also the fiduciary’s availability, reputation, big-picture
judgment, and assumption of risk. While “unbundling” fees may be a superficially
appropriate way to encourage similar treatment of similar taxpayers, it might only add
complexity and might in any event operate imperfectly in the marketplace of negotiated
fee structures (which could include negotiated unbundling methods), and it would
represent one more administrative burden in conflict with Congress’s stated purposes.
All these considerations suggest that, as a matter of sound tax policy and oldfashioned
self-restraint, the final regulations should affirm that fiduciary administration
expenses, including the costs of investment advice, in decedents’ estates and in trusts with
more than one beneficiary, will not be subject to the 2% floor.
VI. The Benefit of a Further Hearing or Conference
While Notice 2008-32 reopened the period for comment on the proposed regulations, it
did not schedule a further public hearing. Because the intervening event of the Supreme Court’s Knight decision has been viewed as so fundamental, many will view a second public hearing as a
good idea. I share that view. Alternatively, a less formal conference could be scheduled with
those who have provided comments pursuant to Notice 2008-32. Because of the intensely
practical nature of the issues and practical consequences of the way those issues are addressed,
that kind of dialogue could be extremely useful, both to the personnel who are responsible for
preparing the final regulations and to the fiduciary and professional communities whose
acceptance is important to tax administration.
In any event, I am prepared to offer any additional input or assistance that you might find
helpful.
Sincerely,
Ronald D. Aucutt |
