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"Phantom Income" and Trusts: A Recent Adverse IRS Proposed Regulations for Investment Management & Custody Fees
As discussed in an earlier article, phantom income is tax jargon for income that you are taxed on but that you don't actually receive.  For example, assume that you earn taxable income of $5 but pay a fee of $3.  If the fee isn't deductible, you've got phantom income of $3 because although you will report $5 of taxable income on your tax return, you only receive $2 in cash (net of the $3 nondeductible fee).


The prior article noted that phantom income can arise with regard to investment activities of individuals because although most investment income (other than tax-exempt municipal bond income) is taxable, investment expenses of individuals are not always deductible due to an overall limitation on certain types of itemized deductions referred to as the "2% floor."  Section 67 of the Internal Revenue Code provides that certain types of itemized deductions are only deductible to the extent that such deductions during the tax year exceed 2% of the taxpayer's adjusted gross income.

In the case of trusts and estates, the concern is whether investment or custody fees paid by a trustee could result in phantom income if it is determined that the fees are not deductible due to the 2% floor.  The lawyers and providers of trust services understand the adverse economic consequences of phantom income and many contend that certain trust expenses are not subject to the floor.

Unfortunately, the Section 67 limitation may apply and thus phantom income could be a problem for trusts and estates.  Code Section 67(e) includes a rule of special importance regarding whether trust or estate expenses are subject to the 2% rule.  Section 67(e)(1) excludes from the 2% floor "...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."  The big question is what trust and estate expenses did Congress intend to be excluded from the 2% floor under the Section 67(e)(1) exception?  For example, does this exclusion permit fees paid by a trustee for investment management on an investment portfolio that were previously paid by an individual before the portfolio was transferred to a trust to escape the 2% floor?  This question has already been litigated by IRS and taxpayers in different courts and the courts have reached conflicting conclusions.

To the alarm of trustees and their advisors, the IRS recently issued proposed regulation section 1.67-4 that draws a hard line and would require trustees to break out investment or custody fees or portions of bundled fees and treat such fees or portions as subject to the 2% floor.  Lawyers contend that Section 67(e)(1) should except such fees from the 2% floor and are upset by this development.  So are trust advisory companies that provide bundled services to trusts.  Fortunately the regulations are only proposed and are not yet effective.  And there are conflicting decisions in federal courts.  It should be noted that the U.S. Supreme Court has agreed to review the issue in the case of the William L. Rudkin testamentary trust.

Trusts utilizing investment advisory services on a bundled basis should track future developments regarding this issue.


DISCLAIMER: The information and views set forth in GainsKeeper Tax Topics are general in nature and are not intended as legal, tax, or professional advice. Although based on the law and information available as of the date of publication, general assumptions have been made by GainsKeeper Tax Topics which may not take into account potentially important considerations to specific taxpayers. Therefore, the views and information presented by GainsKeeper Tax Topics may not be appropriate for you. Readers must also independently analyze and consider the consequences of subsequent developments and/or other events. Readers must always make their own determinations in light of their specific circumstances.