Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City

The Supreme Court recently affirmed Tax Court and Second Circuit decisions limiting the deductibility of investment advisory fees incurred by a trust. Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue (No. 06-1286, January 16, 2008). The Court in Knight affirmed decisions of the Tax Court and the Second Circuit, both supporting the Internal Revenue Service position that the trust’s investment advisory fees were only deductible to the extent the fees exceeded 2% of the trust’s adjusted gross income. This decision is notable for trust fiduciaries as they engage investment advisors and structure fee schedules.

Background

Petitioner Knight, as trustee of the testamentary trust in question, hired an investment firm to provide advice for trust investments, incurring fees for these services. The advisory fees were then deducted in full on the trust’s fiduciary income tax return. Investment advisory fees of individuals are subject to the 2% floor, and the IRS determined that the trust’s fees were similarly subject to the 2% floor. The IRS determination resulted in allowance of the deduction only to the extent the fees exceeded 2% of the trust’s adjusted gross income. The Tax Court found in favor of the commissioner when the trustee challenged the IRS determination, and the Second Circuit affirmed the Tax Court decision on appeal. The trustee appealed to the Supreme Court, and the issue before the Court was whether investment advisory fees incurred by a trust are subject to the same 2% floor as investment advisory fees incurred by an individual investor.

Analysis and Holding

The Internal Revenue Code imposes tax on the “taxable income” of both individuals and trusts. Taxable income is determined by first reducing gross income by certain “above-the-line” deductions, such as trade or business expenses and losses on sales of property, to determine “adjusted gross income.” A taxpayer’s adjusted gross income is then reduced by “itemized deductions” to determine taxable income.

Code Section 67(a) imposes the “2% floor” by providing that “miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.” All deductions except for those specifically identified in Code Section 67(b) are considered miscellaneous itemized deductions. Investment advisory fees are deductible pursuant to Code Section 212, which is not listed in Section 67(b). As a result, investment advisory fees are generally deductible only as miscellaneous itemized deductions subject to the 2% floor.

Code Section 67(e) applies the 2% floor to estates and trusts by providing that the adjusted gross income of an estate or trust is computed in the same manner as individuals, except that “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 . . . shall be treated as allowable” and therefore not subject to the 2% floor. This exception was the basis for the trustee’s position in Knight.

The trustee argued that the proper inquiry under this exception is whether a particular expense was caused by the fact that the property was held in trust. The Court rejected this position, noting that the “Trustee’s argument that the proper inquiry is whether a particular expense of a particular trust was caused by the fact that the property was held in trust fails because the statute by its terms does not establish a straightforward causation test, but instead looks to the counterfactual question whether an individual would have incurred such costs in the absence of a trust.”

Even though the Second Circuit result was affirmed, the Court also rejected the Second Circuit’s analysis of Section 67(e): “The Second Circuit’s approach, which asks whether the cost at issue could have been incurred by an individual, flies in the face of the statutory language. Had Congress intended the Court of Appeals’ reading, it easily could have replaced ‘would’ with ‘could’ in Section 67(e)(1), and presumably would have.”

In holding that investment advisory fees generally are subject to the 2% floor when incurred by a trust, the Court noted that Section 67(e)(1) requires a prediction regarding whether the fees in question would be incurred if the property were held by an individual rather than by a trust. The court states that “although the statutory text does not expressly ask whether expenses are ‘customarily’ incurred outside of trusts, that is the direct import of the language in context.”

After determining this standard for the application of Section 67(e)(1), the Court went on to hold that the Knight trust’s investment advisory fees were subject to the 2% floor. The Court noted that the trustee did not meet his burden of proof by demonstrating that it would be uncommon or unusual for individuals to hire an investment advisor, and rejected the trustee’s argument that individuals cannot incur “trust” investment advisory fees.

The trustee also argued that he engaged an investment advisor because of his fiduciary obligations as a trustee to invest and manage the assets as a “prudent investor.” The Court also rejected this prudent investor argument, noting that “it is quite difficult to say that the investment advisory fees ‘would not have been incurred’ – i.e., that it would be unusual or uncommon for such fees to have been incurred – if the property were held by an individual investor with the same objectives as the Trust in handling his own affairs.”

Planning

The Court’s final summation of the Knight case does offer two circumstances when a trust may be able to deduct investment advisory fees under the exception to the 2% floor. First, the Court notes that “some trust-related investment advisory fees may be fully deductible if an investment adviser were to impose a special, additional charge applicable only to its fiduciary accounts.” There was nothing in the record of the Knight case to indicate special investment adviser charges applicable because the assets were in trust, but there may be other circumstances where such fees could be demonstrated.

Second, the Court notes, “Nor does the Trust assert that its investment objectives or balancing of competing interests were so distinctive that any comparison with those of an individual investor would be improper.” Again, there was no support for this distinction in the Knight case, but there may be trust investments with sufficiently unique circumstances that would not be comparable to an individual investor.

Of course, the IRS will likely scrutinize any trust deductions of investment advisory fees taken “above-the-line” without application of the 2% floor. As a result, trustees should make a careful record with their investment advisors to demonstrate that investment fees incurred by the trusts in question would not similarly be incurred by individuals with similar assets and investments.