Overview of Estate Planning Expenses
Estate planning is a crucial endeavor for individuals who want to ensure that their assets are distributed according to their wishes upon their death. However, estate planning can be a complex process that requires a significant investment of time and resources. As such, it is essential to understand the types of fees that are typically charged by estate planning attorneys and how those fees can impact an estate plan.
When it comes to estate planning, there are generally two types of legal fees that may apply: upfront fees and ongoing fees. Upfront fees cover the cost of drafting estate planning documents such as wills, trusts, and powers of attorney. Ongoing fees may apply if the estate plan includes a trust that requires administrative services to be performed over time , such as filing annual tax returns and managing assets.
In addition to these fees, there may also be costs associated with other services, such as title transfers or retitling of real estate in the name of the trustee. These costs are separate from the legal fees but should be factored into the overall cost of the estate plan.
Understanding the costs associated with estate planning fees is essential for individuals who are considering their options for developing a comprehensive estate plan. By educating themselves on the types of fees and expenses that may apply, individuals can make informed choices about how to allocate their resources and develop a plan that meets their needs.
Are Estate Planning Fees Tax-Deductible?
General Rules
The deductibility of professional fees for estate planning or estate tax matters is a complicated subject. It’s a gray area of the law.
The expense of preparing a will or of administering an estate of someone who has passed away, is generally considered a personal matter, which is not deductible for federal income tax purposes. However, fees for creating a trust that will own assets in the future, are considered to be "tax planning" and are therefore deductible. The same goes for fees for estate tax planning and for estate tax returns.
There are two main issues in deciding if the expense is deductible:
1. Is the fee for a personal service (which is not deductible) or for a service that produces taxable income (which is deductible)?
2. If the non-deductible personal expense is combined with services that are deductible, can the deduction be separated to exclude the cost of the non-deductible portion?
Which Estate Planning Fees are Deductible?
IRS Publication 529 contains a list of miscellaneous expenses which may be deductible on Schedule A of an income tax return. Among the listed expenses are the costs of preparing a will or trust and other estate planning documents. The pub instructs that these costs may be deductible if they are "ordinary and necessary" to the taxpayer’s trade or business, but are not incurred in connection with a divorce or related controversy. Therefore, some estate planning fees may be deductible as a business expense under the ordinary and necessary test in order to minimize the income tax consequences. However, the same fees may be subject to the 2% floor on miscellaneous deductions.
The estate planning fees are deductible under the ordinary and necessary test utilizing the standard of objective review. Under this standard the deduction is allowed, or disallowed, based upon whether a hypothetical reasonable person viewing the facts and circumstances could determine that the expense is ordinary and necessary. An example of an ordinary and necessary expense may be legal fees incurred by a taxpayer to create a trust in order to obtain funds for a service provided in the taxpayer’s trade or business. In this example the taxpayer may use the newly created trust to pay wages to domestic employees without incurring certain employment tax obligations. Therefore, the legal fees incurred would be deductible.
In treating fees for wills, trusts, guardianships, and powers of attorney, the IRS indicates that these expenses are incurred to conserve money and property and are therefore personal in nature. According to the IRS, payments for services that produce tax savings or impose nondeductible tax liability may be deductible. Payments that create, increase, extinguish or otherwise change a tax liability are deductible; however the prohibition applies to estate planning fees which are not related to the size of the estate or business, or which do not affect the net worth of an entity.
The IRS denies the deductibility of fees paid to establish definite plans for the management of assets to be used by successors. The IRS deems these plans merely reflective of the taxpayer’s general intentions for the future. This is contrasted with the deductibility of fees paid for advice on the administration of a decedent’s estate under instructions from fiduciary.
Non-Deductible Estate Planning Fees
Certain estate planning fees are not deductible in calculating the taxable estate of an individual who dies. I have included a list of fee examples to help illustrate what types of costs qualify, what types of costs do not qualify, and a couple of cases about common estate planning fees that were considered non-deductible.
Here is a list of fee examples:
• Non-planning costs
• Preparation of income tax returns or state death tax returns
• Costs for tax advice not related to estate tax planning
• Fees for litigation (during life)
• Filing fees (death and gift tax returns)
• Tax return preparation for income and estate taxes
• Allocations for unequally or unevenly distributed property
• Tax return preparation fee of non-related tax counsel (where gift exclusions, distributions, etc. were incorrectly applied (to the entire family), and not just to the specific taxpayer), where donor survived the transfer, but died within three years of the transfer
• Investment management fees, where the revocable trust/estate was the owner
• Allocation of fees for estate tax planning and gift tax returns
• Real property not strictly devoted to income production
• Debt incurred for personal purposes
• Tax advice unrelated to the estate planning activity
• Tolerance with regard to fees upset the decedent to the extent that he declined to agree to them
There are two interesting and common issues regarding estate planning fees that were made non-deductible. Drake v. U.S., 709 F.2d 1303 (7th Cir., 1983) This involved a son and daughter, beneficiaries of a trust. They hired the same CPA to prepare gift tax returns, argues that they should be able to deduct the amount. The court disagreed, holding that is should have been allocated to the trust, and that the trust, not Drake, incurred the cost. The court pointed out that a fiduciary relationship does exist between the trustee and trust beneficiaries. Since the CPA has some responsibility to the beneficiaries of the trust, the beneficiaries’ fee is related to the relationship with the trustee, not the estate. Parker v. Commissioner, 786 F.2d 290 (6th Cir., 1986) Another case involving trusts, it concerned fees for a husband and wife that were paid to an attorney. The court held that only income tax return fees on the rental properties owned by the trust could be deducted, but fees for administration of the decedent’s probate estate were nondeductible. The court upheld that the expenses should be allocated between the estate and the trust.
How to Take Estate Planning Deductions
Claiming Deductions for Estate Planning Costs
In the event you have suffered a loss during the year, the deduction for estate planning costs might apply. A loss occurs on the sale or exchange of property if your tax basis in the property exceeds the real estate loss. The cost of an attorney to prepare a will, create a revocable trust or make other legal arrangements; the cost of accounting services to prepare a tax return for the wise estate; and the cost of establishing a living trust may all be deductible if they are incurred because of an estate or gift tax and the costs were not otherwise deductible. If such costs are incurred because of the sale or exchange of property, the loss must exceed the costs. If your estate plan resulted from a loss or exchange, strictly speaking, the costs may not be deducted; however, the estate planning costs do come in when the planning is done to prevent a loss or exchange and your tax basis in the property is less than the amount received for the property . This treatment is more likely in estate planning when your family business is sold after you die or you die while the property is being sold; only then could that be seen as resulting in the loss that would result in the deductibility of the attorney’s fees.
Who can claim the deduction? You can deduct these expenses on your Stand Alone IRS 1040, Schedule A, if you incur the expense during the year in which the planning occurred. In the event you create a revocable trust, your spouse and/or partner may claim the deduction as long as they are a joint owner of the property owned by the revocable trust. If there are not joint owners, neither party can claim the deduction. Costs that are incurred after the decedent’s death are deductible on the decedent’s return. The cost incurred in preparing the estate tax return, preparing your final income tax return, and the costs of the attorney to make a determination of allowable credits when there is no estate tax due can all be deducted; any costs incurred in making transfers of property that are both taxable and non-taxable grants to charities or family members may be deductible.
Recent Tax Law Changes Regarding Deductions
Any modifications to estate planning laws and rules for calculating gross income could affect deductibility. With President Biden’s proposed regulations earlier this year, certain tax deductions could be eliminated with the new 3% federal tax for those whose income exceeds $1 million. While not finalized, this proposed change will, if enacted, have significant implications for all taxpayers, including those doing tax planning as part of their estate planning process. However, even with these proposed changes, the deduction of fees for estate planning may still be capped at 2% of adjusted gross income.
Most state estate tax laws allow a deduction for federal estate tax in calculating the state estate tax. This means those fees are not deductible on your federal return. Furthermore, even in states where an estate tax is not imposed, the lack of an actual state estate tax means that there is no need for a concomitant deduction of the (theoretical) amount of that tax on your federal return. In some states, like Kentucky, the lack of an estate tax is not a "they didn’t tax it, so we should get to take it as a deduction." You can deduct any allowable fee up to the applicable limitation discussed above. But Kentucky expects you to pay the applicable state tax when determined, and thus there is no deduction eliminated or reduced.
Consulting with a Tax Professional
Because tax laws and regulations are subject to change, it is always a good idea to talk with a tax professional to ensure compliance when planning your estate and taking advantage of tax deductions. A tax professional can also personalize your advice to your income, family structure, and estate, giving you the best opportunity to limit your tax liability.
Keep in mind that even if you are eligible for the deduction, you may be limited based on your income. For example, if you work in a low-income household, your personal deduction on Schedule A is limited. However, if you are in a high income household, your deduction will be phased out and may be even more limited.
Additionally, just because your tax professional says that your estate planning costs are deductible doesn’t mean they won’t be challenged by the IRS. When the IRS looks at an estate, they are looking for the reason why you drafted your will or made other estate planning choices. If there is no business reason for your prerequisites—besides tax avoidance—then the IRS may challenge your deductions. In this event, you will be required to prove that there is a legitimate business benefit to your planning.
A tax professional can help you work through the difficult process of proving that your tax planning does indeed have a legitimate business reason, which saves you from penalties, interest accrual, and tax payments.
Conclusion and Planning Takeaways
Understanding the complex relationship between tax deductions and estate planning fees is crucial for effective long-term financial planning. In addition to managing the costs of the attorneys and accountants involved in planning an estate, you must also be mindful of potential gift and income tax liabilities. Strategically incorporating charitable gifts into your estate planning can also help ensure that your estate minimizes these tax liabilities, and that your assets are maximized for your beneficiaries or your intended cause.
Implementing best practices will help ensure that your estate planning is not only cost-effective , but also beneficial to your estate. Some of these considerations include:
• Keeping complete records of estate planning fees, including invoices, logs, and memos;
• Working with your estate planning attorney and accountant to maximize tax deductions;
• Implementing a system for documenting charitable gifts for the benefit of your estate;
• Open communication with your estate planner and accountant to ensure risk mitigation; and
• Planning for possible challenges to any charitable gifts made as part of the estate planning process.