Supreme Court Holds Investment Advisory Fees Incurred By Trustees Subject to 2% Floor
On January 16, 2008, the United States Supreme Court held, in its decision in Knight v. Commissioner, that the deduction for investment advisory fees incurred by a trust is subject to the 2% floor on miscellaneous itemized deductions. The decision resolved a conflict among the federal circuit courts and affirmed a decision of the Second Circuit Court of Appeals holding that, because investment advisory fees are the type of expense that could be incurred by an individual, those fees are subject to the 2% floor.
Under the Internal Revenue Code, a taxpayer's miscellaneous itemized deductions, which include investment advisory fees, are allowed only to the extent that such deductions exceed 2% of the taxpayer's adjusted gross income. In the case of an estate or trust, the statute provides an exception to the 2% floor for deductions "which would not have been incurred if the property were not held in such trust or estate."
A trustee is under a fiduciary duty to invest prudently, in a manner consistent with the prudent investor standard under state law. It was argued by the Trustee in Knight that, as a result of this obligation, it is incumbent upon a trustee to obtain investment advice. In construing the statute, the Supreme Court found that the prudent investor standard does not refer specifically to a prudent trustee, but to any prudent individual investor, and that it would not be uncommon for any such investor to incur investment advisory fees. The Supreme Court held that because investment advisory fees are not unique to a trust and are expenses commonly incurred by individual taxpayers, the deduction allowable to a trust or estate for investment advisory fees is subject to the 2% floor (as it is for individual taxpayers).
In July 2007, the Internal Revenue Service issued proposed regulations
addressing the costs that are unique to trusts and estates. These
regulations will likely be revisited in light of the decision in Knight.
Repeal of Special Valuation Rules For Estate and Gift Tax For Fractional Interests In Tangible Personal Property
The Pension Protection Act of 2006 substantially revised the income, estate and gift tax consequences of charitable gifts of fractional interests in tangible personal property such as art. Briefly, the 2006 Act provides that when making transfers of partial interests, the value for purposes of the income, estate and gift tax charitable deduction is generally based on the value of the property at the time of the first transfer so that, for transfers made after the initial transfer, any increase in value from the time of the initial transfer is not taken into account. This rule remains in computing the income tax charitable deduction for subsequent transfers of partial interests, but has been repealed in determining the estate and gift charitable deductions. For example, if a partial interest is being transferred to charity at death, the interest the decedent owns in the property is includible in the estate at its then fair market value, but, prior to repeal, the estate tax charitable deduction would have been based on the value of the property at the date of the initial transfer, resulting in estate tax on the appreciation in value notwithstanding that the appreciated property was passing to charity. The Technical Corrections Act of 2007 amended the applicable estate and gift tax provisions of the Internal Revenue Code to avoid this result, but leaves in place the provisions of the 2006 Act relating to the income tax charitable deduction, as well as the provisions requiring recapture of the charitable deductions if the entire property is not transferred to charity within 10 years of the initial transfer. The amendments are effective for gifts and bequests made after August 17, 2006 (retroactive to the effective date of the Pension Protection Act).
February 2008 Federal Interest Rates
The annual short-term, mid-term and long-term applicable federal rates for February are 3.11%, 3.51% and 4.46%, respectively. These are the minimum required interest rates used for loans in order to avoid below-market loans that have income and gift tax consequences related to the forgone interest. The Section 7520 rate is down to 4.2% (from 4.4% for January). The Section 7520 rate is the interest rate used to calculate the value of a transfer of certain interests in property, e.g., transfers to grantor retained annuity trusts (GRATs). These low rates provide very attractive estate planning opportunities given that the goal of many estate planning structures is to outperform these rates over time.
Annual Gift Giving
In 2008, each individual may make gifts of up to $12,000 per year, per person free of gift tax. A married couple can make gifts of $24,000 per year regardless of who owns the property being transferred (but must file a gift tax return to "split" the gift if only one spouse owns the property). The annual exclusion in 2008 for gifts to non-citizen spouses is $128,000.
Estate and Gift Tax Exemptions
The federal estate tax exemption and the exemption from the generation-skipping transfer tax remains at $2,000,000 in 2008 and the top estate tax bracket remains at 45%. In 2009, the exemption is scheduled to increase to $3,500,000 and the top bracket remains at 45%. The federal gift tax exemption remains at $1,000,000. The New York State estate tax exemption remains at $1,000,000 and is not scheduled to increase; New York has no gift tax.
Copyright ©2008 by Kaye Scholer LLP. All Rights Reserved. This publication is intended as a general guide only. It does not contain a general legal analysis or constitute an opinion of Kaye Scholer LLP or any member of the firm on the legal issues described. It is recommended that readers not rely on this general guide in structuring individual transactions but that professional advice be sought in connection with individual transactions. References herein to "Kaye Scholer LLP & Affiliates," "Kaye Scholer," "Kaye Scholer LLP," "the firm" and terms of similar import refer to Kaye Scholer LLP and its affiliates operating in various jurisdictions.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with Treasury Department regulations, we inform you that any U.S. federal tax advice contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the U.S. Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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