Irrevocable Trusts, other than the special “grantor trusts” which we typically use for life insurance and other gifts, are taxed at the highest rate after just $12,150 of taxable income, so the effect of deductible expenses on the tax are significant. Unfortunately, many expenses that are not specific to the administration of the trust are not deductible unless and to the extent they exceed the threshold of 2% of (adjusted) gross income (AGI) for the Trust.
Final regulations have been issued to clarify this fairly recent (and punitive) interpretation of the tax code.
Investment management fees. Investment management fees will be subject to the 2% floor, since individuals often incur such fees. If, however, a portion of the investment management fees are attributable to the specialized needs uniquely attributable to the fact that the assets are held in a trust, then that portion will not be subject to the 2% floor. The Regulations give two examples:
• Special incremental fees charged to a trust solely because the advice is rendered to a trust rather than an individual.
• Fees attributable to “an unusual investment objective or the need for a specialized balancing of the interests of various parties (beyond the usual balancing of the varying interests of current beneficiaries and remaindermen).”
Attorney’s fees. Costs of defending against a claim will be subject to the 2% floor, since individuals customarily incur such costs. But costs of defending against a will contest or a trust contest will not be subject to the 2% floor. Ordinary legal fees incurred in connection with the “administration of the estate or trust” will not be subject to the 2% floor.
Ownership costs. In general, costs associated with the ownership of property will be subject to the 2% floor, since individuals would commonly incur the same costs. These include condominium fees, property insurance, utilities, property maintenance, vehicle registration, and vehicle insurance. Nevertheless, these expenses will be fully deductible if the trust or estate is engaged in a trade or business, since under Section 62(a)(1) business expenses are not miscellaneous itemized deductions.
Tax preparation fees. Trusts and estates may fully deduct (without regard to the 2% floor) the cost of preparing estate and generation-skipping transfer (GST) tax returns and fiduciary income tax returns. But gift tax returns are commonly filed by individuals, and thus are subject to the 2% floor. Oddly, the decedent’s final individual income tax return is not subject to the 2% floor, even though individuals commonly file individual income tax returns.
Appraisal fees. The cost of appraisals prepared for purposes of estate taxes, GST taxes, or for determining distributions are not subject to the 2% floor. Apparently appraisals for gift tax return purposes are also not subject to the 2% floor, since the Regulations provide an exception for appraisals “required to properly prepare the estate’s or trust’s tax returns.” But the cost of appraisals for other purposes, such as determining insurance values, are subject to the 2% floor.
Fiduciary expenses. The Regulations exempt from the 2% floor expenses customarily incurred by fiduciaries, and not customarily incurred by individuals, including probate court fees, fiduciary bond costs, expenses of publication of notice to heirs and creditors, costs of certified copies of death certificates, and costs related to fiduciary accountings.
State and local taxes. Under Section 67(b)(2), such taxes are not miscellaneous itemized deductions, and thus are not subject to the 2% floor.