IRS Trustee Fee Unbundling Rule: Will You be in Compliance? ABA Briefing/Webcast Tuesday, August 5, 2014 2:00 – 3:30 p.m. ET

Speakers Ronald Aucutt, Partner, McGuireWoods Donald Roman, Partner, PricewaterhouseCoopers Carol Cantrell, Partner, Cantrell & Cantrell Phoebe Papageorgiou, Senior Counsel II, American Bankers Association (Moderator)

Agenda Overview and Background on Section 67(e) Final Rule Unbundling Requirement: Reasonable Method of Allocation Other Practical Considerations with the Final Rule

Internal Revenue Code Section 67(e) (e) 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- (1) 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, and (2) the deductions allowable under sections 642(b), 651, and 661, shall be treated as allowable in arriving at adjusted gross income. Under regulations, appropriate adjustments shall be made in the application of part I of subchapter J of this chapter to take into account the provisions of this section.

Tax Reform Act of 1986 Section 132 of the Tax Reform Act of 1986 added Section 67 to the Code. JCT “Bluebook,” p. 78 (1987): “The Congress concluded that the prior-law treatment of … miscellaneous itemized deductions fostered significant complexity …. For taxpayers who anticipated claiming such itemized deductions, prior law effectively required extensive record- keeping with regard to what commonly are small expenditures. Moreover, the fact that small amounts typically were involved presented significant administrative and enforcement problems for the Internal Revenue Service.”

Short History of a Long Line of Cases Federal Circuit Court Cases O’Neill v. C.I.R., (6th Cir. 1993) Mellon Bank, NA v. U.S., (Fed. Cir. 2001) Scott v. U.S., (4th Cir. 2003) Rudkin v. C.I.R., (2nd Cir. 2006) Supreme Court Case: Knight v. C.I.R. (2008)

Elements of IRS Final Rule 1.67-4 In General A cost is subject to the 2-percent floor to the extent that it is included in the definition of miscellaneous itemized deductions under section 67(b), is incurred by an estate or non- grantor trust, and commonly or customarily would be incurred by a hypothetical individual holding the same property.

Elements of IRS Final Rule 1.67-4, cont. ‘‘Commonly’’ or ‘‘Customarily’’ Incurred In analyzing a cost to determine whether it commonly or customarily would be incurred by a hypothetical individual owning the same property, it is the type of product or service rendered to the estate or nongrantor trust in exchange for the cost, rather than the description of the cost of that product or service, that is determinative.

Elements of IRS Final Rule 1.67-4, cont. Ownership costs: costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property. e.g.: partnership costs passed through to a partner if these costs are miscellaneous itemized deductions condominium fees insurance premiums maintenance and lawn services automobile registration insurance costs

Elements of IRS Final Rule 1.67-4, cont. Tax preparation fees Investment advisory fees Appraisal fees Certain fiduciary expenses Unbundling requirement

Elements of IRS Final Rule 1.67-4 Effective/applicability date: As initially released, the rule would have applied to taxable years beginning on or after May 9, 2014. Would have applied immediately to newly created trusts, estates of decedents who died after May 8, and estates with a fiscal year starting after May 8. On July 17, IRS delayed effective date to taxable years beginning on or after January 1, 2015

To Submit a Question, Click on the General Chat Tab Below. Questions and Answers To Submit a Question, Click on the General Chat Tab Below. Enter Your Question in the Box Below the Chat Area and Press ENTER or Click Send.

Unbundling Requirement: Reasonable Method of Allocation In General: Single (bundled) fees paid from an estate or a non-grantor trust for costs that are both subject to the 2-percent floor and costs that are not subject to the 2-percent floor must be allocated properly for purposes of calculating AGI Exception – If a bundled fee is not computed on an hourly basis, only the portion of the fee that is attributable to investment advice is subject to the 2- percent floor

Rule: Expenses Not Subject to Allocation Out of pocket expenses billed to the estate or non- grantor trust are treated as separate from the bundled fee Payments made from bundled fee to third parties that would have been subject to 2-percent floor if paid to third party directly from estate or non- grantor trust What about third party expenses that are part of overhead of bank trust department?

Rule: Reasonable Method of Allocation “Fiduciaries may use ‘any reasonable method’ to allocate bundled fees between costs that are subject to the 2- percent floor and costs that are not, including without limitation the allocation of a portion of a fiduciary commission that is a bundled fee to investment advice.” “Facts that may be considered in determining whether an allocation is reasonable include, but are not limited to, the percentage of the value of the corpus subject to investment advice, whether a third party advisor would have charged a comparable fee for similar advisory services, and 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.”

Possible Methods of Allocation Top down approach – what portion of the bundled fee is attributable to investment advice? Comparisons of fee schedules (typically referencing basis points) IMA v. Trustee IMA v. Custody Directed Trustee v Trustee Comparison of Statutory Fee Schedules Does your fee schedule describe the components of the bundled fee?

Possible Methods of Allocation, cont. Bottom up approach – what does it cost to deliver the fully deductible trustee services versus the investment advisory services? Internal cost structure – trust administration v. investment management. Consider job descriptions, headcount and third party costs relating to each. Perform Time study? Hours/expense of administrative trustee/investment management services provided

Other Considerations Regarding Allocation Is the allocation different for different types of accounts? Discretionary versus non-discretionary? Estates versus trusts? Institutional versus personal trust? Is the allocation different for a trust invested in fixed income versus a trust invested in equities? If one portion of your services is negotiable, such as investment advisory services, and the other portion is almost never, how is that taken into account?

Other Considerations Regarding Allocation Should the unbundling be risk rated? What aspect of a trustee’s services give rise to the greatest litigation risk? If tax prep fees are currently included in the bundled fee, do you allocate that as a separate component? (Not required under the final rules)

Implementation Considerations Is the allocation “booked” in your trust accounting system or just handled within the tax preparation software? If recorded in the trust accounting system, does anything change on your clients monthly statements? Does this unbundling affect how the fees are allocated for P&I purposes?

To Submit a Question, Click on the General Chat Tab Below. Questions and Answers To Submit a Question, Click on the General Chat Tab Below. Enter Your Question in the Box Below the Chat Area and Press ENTER or Click Send.

Other Practical Considerations with the Final Rule Investment Advisory Fees: “Fees for investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) are incurred commonly or customarily by a hypothetical individual investor and therefore are subject to the 2-percent floor. However, certain incremental costs of investment advice beyond the amount that normally would be charged to an individual investor are not subject to the 2-percent floor.”

Investment Advisory Fees, cont. “Such an incremental cost is a special, additional charge that is added solely because the investment advice is rendered to a trust or estate rather than to an individual or 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) such that a reasonable comparison with individual investors would be improper.”

What is Investment Advice? The final regulations consistently refer to “investment advice” and “investment advisory services” numerous times without defining them. The Investment Advisers Act of 1940 defines an investment adviser as any natural person or company who: “for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities.”

Are Trustees Investment Advisors? Are trustees giving investment advice or providing investment advisory services as the term is used in the final regulations? Does investment advice include investment management? If there are co-trustees, can the co-trustees be said to be advising one another?

Tax Preparation Fees “Costs relating to all estate and generation- skipping transfer tax returns, fiduciary income tax returns, and the decedent’s final individual income tax returns are not subject to the 2-percent floor. The costs of preparing all other tax returns (for example, gift tax returns) are costs commonly and customarily incurred by individuals and thus are subject to the 2-percent floor.”

Tax Preparation Fees, cont. Final federal income tax return. How broad is this? What about a decedent’s final gift tax return and final FBARs? Foreign taxation of or reporting on US domestic trusts (e.g., France, Israel, Canada)

Passthrough Costs from Partnerships Final regulations provide that passthrough costs from partnerships are “ownership costs” subject to the 2- percent floor to the extent they are miscellaneous itemized deductions. Are “bundled fees” paid by a partnership subject to the same rules as bundled fees paid by a trustee? What part of passthrough costs from a partnership are fully deductible – preparation of Form 1065, consulting fees, managing partner fees, etc.? Who makes this determination?

AMT Considerations for the Trust and Beneficiaries None of the miscellaneous itemized deductions subject to the 2-percent floor may be deducted from the alternative minimum taxable income of the trust or its beneficiaries. Trust may distribute income to beneficiaries to avoid or reduce AMT. However, this distribution merely passes out the AMT adjustment to the beneficiary who must add it to his or her AMT income.

Other Considerations Fiduciary accounting for court proceedings Audit flags – what might cause a trust return to be audited? When are salaries paid to trust employees subject to 2- percent floor Likely no new design of Form 1041, because there are no new categories of deductions. However, there could be some changes to the instructions.

Planning Considerations for Trustees Carefully document the evidence and the analysis used to determine what portion of a trustee fee is for providing investment advice to a particular trust. Consider the unique circumstances of each individual trust. Consider obtaining a tax opinion letter from outside counsel or the trust’s tax return preparer in large or unusual situations.

To Submit a Question, Click on the General Chat Tab Below. Questions and Answers To Submit a Question, Click on the General Chat Tab Below. Enter Your Question in the Box Below the Chat Area and Press ENTER or Click Send.