Final IRS Sect. 67(e) Regs for Estate and Trust Taxpayers: Applying the Required 2% Deduction Floor

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1 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 IMPORTANT INFORMATION This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection and phone line (no sharing) if you need to register additional people, please call customer service at x10 (or x10). Strafford accepts American Express, Visa, MasterCard, Discover. Respond to verification codes presented throughout the seminar. If you have not printed out the Official Record of Attendance, please print it now. (see Handouts tab in Conference Materials box on left-hand side of your computer screen). To earn Continuing Education credits, you must write down the verification codes in the corresponding spaces found on the Official Record of Attendance form. Complete and submit the Official Record of Attendance for Continuing Education Credits, which is available on the program page along with the presentation materials. Instructions on how to return it are included on the form. To earn full credit, you must remain on the line for the entire program. WHOM TO CONTACT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Program: - On the web, use the chat box at the bottom left of the screen - On the phone, press *0 ( star zero) If you get disconnected during the program, you can simply call or log in using your original instructions and PIN.

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4 Final IRS Sect. 67(e) Regs for Estate and Trust Taxpayers Oct. 15, 2014 Tina D. Milligan HarrismyCFO Domingo P. Such, III Perkins Coie

5 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

6 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 October 15, 2014

7 AGENDA 7

8 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

9 BACKGROUND 9

10 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, profitoriented expenses Section 23(a)(2) of the Internal Revenue Code (1942) predecessor to I.R.C. Section 212 Expenses for production of income 10

11 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

12 Overview of I.R.C. Section 67 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

13 Overview of I.R.C. Section 67 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

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15 Overview of I.R.C. Section 68 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

16 Overview of I.R.C. Section 56 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

17 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

18 Taxable income Tax is imposed on taxable income of both individuals and trusts 1 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

19 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

20 Treasury guidance and Proposed Regulations Temporary guidance leading up to final Regulations Treasury responded to the Knight decision Notice Proposed Regulations in 2011 Left lack of clarity Confusion over investment advisory fees 20

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22 FINAL REGULATIONS 22

23 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

24 The final 67(e) regulations 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

25 The final 67(e) regulations 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

26 The final 67(e) regulations 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

27 The final 67(e) regulations 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

28 The final 67(e) regulations 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

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30 PRACTICAL EXAMPLES AND STRATEGIES 30

31 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

32 Methods for allocating fees 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 Total Fiduciary Fee $100,000 Investment Management Activities Subject to 2% AGI limitation Percent of trust assets under investment management 50% All Other Fiduciary Duties Not subject to 2% AGI limitation Percent of time on investment management 50% Total percent of fee (50% x 50%) = 25% 75% remaining Fee allocation $25,000 $75,000 32

33 Methods for allocating fees 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

34 Methods for allocating fees Comparison to other fees: fiduciary insurance or investment fee only (without fiduciary service) 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 fees paid to fiduciary with no special investment skill Comparison of fees paid to directed trustee 34

35 Comparison of above the line and below the line $100,000 Fiduciary Fee Below the line deduction Gross income $1,000,00 0 Above the line deductions $1,000,00 0 $1,000,000 Above the line deduction - (50,000) (75,000) Adjusted Gross Income 1,000, , ,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 35

36 Impact of I.R.C. 67 as AGI increase 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 2% Floor (20,000) (200,000) (400,000) Miscellaneous itemized deduction 480, , ,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 Percent of deduction lost 4% 88% 96% 36

37 Impact of I.R.C. 67 as AGI increase Adjusted Gross Income 37

38 Impact of I.R.C. 67 as 212 expenses increase 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 2% Floor (200,000) (200,000) (200,000) Miscellaneous itemized deduction 200, , ,000 Percent of deduction lost 50% 33% 25% Limit on itemized deductions (160,000) (290,849) (290,849) Total itemized deductions 40, , ,151 Percent of deduction lost 90% 81% 61% 38

39 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. NMLS # CTC mycfo and its affiliates do not provide legal advice to clients. You should review your particular circumstances with your independent legal advisor. 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. The PAM Awards are awarded annually by Private Asset Management, a financial services industry trade publication. The PAM Awards invites firms to compete for awards in several categories by providing answers regarding their business model, services offered, growth in client count and assets managed countries of operation, service innovation, and performance. In addition, The PAM Awards permits firms to provide additional information of their choosing in support of their candidacy. A panel of independent industry experts selects the nominees and winners based on a number of qualitative and quantitative performance indicators. The PAM Awards do not release statistics on the number of firms competing. Nomination or receipt of a PAM Award is not necessarily indicative of any particular client's experience or a guarantee that the firm will perform in the future as it did during the period evaluated by The PAM Awards. "RIA Giants", Forbes, 1/13/11 was based on information, as of September 30, 2012, collected by RIA Database. The rules for ranking of 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; (5) they can neither charge commissions nor have registered representative employees at the firm; and (6) a majority of the RIA s business must not be invested in proprietary products. This information is not intended to be tax or legal advice. This information cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the 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. 40