Financial Implications
For
any one trust, moving the deduction of many expenses from
above-the-line to below-the-line could increase the after-tax cost of
fiduciary services, although the actual financial impact will likely
depend on the size of the trust. For example, assume that a trust with
$20 million of assets and $2 million of AGI pays an investment advisory
fee of $200,000. If the 2% floor applies, $40,000 is lost, leaving the
trust with only a $160,000 deduction. Thus, the trust's taxable income
increases by $40,000. Assuming that a tax rate of 35% applies, the
trust has additional income tax of $14,000. Although incremental costs
representing charges special to the trust may be fully deductible, this
allowance is unlikely to increase the total available deduction. In our
example, the trust may deduct $160,000 after application of the 2%
floor. To increase this deductible amount because of "incremental
costs," the trustee would need to show that more than $160,000, or 80%
of the $200,000 investment fee, was attributable to the special needs
of the trust, which is likely a difficult proposition. The bigger
issue may come in the form of the alternative minimum tax (AMT), which
does not allow deductions for miscellaneous itemized deductions.
Accordingly, the trust in our example would need to include the
$160,000 (assuming that the expenses have reached the 2% floor) in
determining its taxable income under the AMT. This addition may cause
the trust to face an AMT liability that it would not otherwise have.
At a maximum AMT rate of 28%, the cost could be substantial (up to
$44,800 in our example, depending on exemptions, deductions, credits,
etc.). To the extent deductions for incremental costs remain
above-the-line, those trusts facing an AMT liability may want those
costs identified.
Administrative Burdens
Based
on the Knight decision, outside investment firms may need to unbundle
their investment fees in order to identify for fiduciaries whether any
of the costs are special for a trust or an estate. This task may be
extremely difficult for corporate investment managers that do not have
billing systems or fee schedules in place to itemize their services in
this manner. Family offices may also feel a significant impact, since
they often incur substantial outside investment management fees in
connection with large family trusts and frequently use service
providers that charge bundled fees.
Fiduciaries could experience similar increases in their administrative burdens as they determine the deductibility of various trust and estate expenses, including legal fees, accounting fees, etc. Unfortunately, the Supreme Court provides no guidelines for determining what types of expenses ordinary individuals commonly incur. For example, must more than 50% of the population incur a cost for it to be common? How do we obtain this statistic? Also, does the answer vary by value-i.e., if most people with a net worth of $500,000 or less do not obtain investment advice, may trusts of similar value take a full deduction for their investment fees? The Supreme Court's opinion leaves these and many more questions unanswered.
Final Word
While
the Knight decision resolves the split among the circuit courts, the
IRS will have the final word regarding the practical implementation of
the decision. When an attorney for a trust company asked that Hughes go
easy on trusts, however, she said, "It's unlikely that the service is
going to give away the issue and side with the taxpayer." Thus,
fiduciaries may be faced with even more complex challenges after
issuance of the final regulation.