Brilliant Deduction

April 4, 2008

Brilliant Deduction - By Jonathan M. Forster , Todd I. Steinberg , Jennifer M. Smith

In a decision likely to affect millions of trusts and their beneficiaries, the U.S. Supreme Court has ruled that trust investment advisory fees are subject to the 2% floor for miscellaneous itemized deductions. This decision could impact the tax deductibility of many common trust and estate expenses, thereby increasing the overall costs for managing large estates and trusts. It may also force trustees, accountants, attorneys, financial advisors and family offices to change their cost reporting and allocation procedures.

The decision in Knight v. Comm'r involves the classification of a trust's income tax deductions for its investment advisory fees as "above-the-line" or "below-the-line" deductions. Costs classified as "above the line" are fully deductible in determining a taxpayer's adjusted gross income ("AGI"). Under Section 67(a) of the U.S. Code, however, miscellaneous itemized deductions, or below-the-line deductions, normally are allowed only to the extent that the aggregate of such deductions exceeds 2% of a taxpayer's AGI. This "2% floor" applies to deductions taken by individuals, trusts and estates. Section 67(e)(1), however, provides an exception to the 2% floor for deductions taken by a nongrantor trust or an estate that meets the following requirements:

  1. The deductions are for costs that were paid or incurred in connection with the administration of the estate or trust; and
  2. Such costs would not have been incurred if the property were not held in the estate or trust. The issue in Knight is whether a trust's investment advisory fees are fully deductible as costs that would not have been incurred if the property were held outside of a trust.
Prior Law-Split in Circuits
Before Knight, four separate U.S. Court of Appeals circuits had addressed this issue, producing three different standards for deductibility:

1. Maximum Deductibility
The 6th U.S. Circuit Court of Appeals, in William J. O'Neill Jr. Irrevocable Trust v. Comm'r, held that a trust could take an above-the-line deduction for investment advisory fees, since the costs were "caused by the fiduciary duties" of the trustees. In other words, the costs were "incurred because the property was held in trust" and thus were fully deductible.

2. Limited Deductibility
In two separate different cases, Mellon Bank N.A. v. U.S., and Scott v. U.S., the 4th Circuit and the Federal Circuit both stated, respectively, that a trust could fully deduct only those costs that were unique to trust administration and were "not customarily or commonly incurred by individuals." The examples cited in Scott of uncommon or uncustomary expenses included expenses related to judicial accountings, the preparation of fiduciary tax returns and trustee fees. Since individuals commonly incur investment advisory fees, however, the 2% floor applied to a trust's deduction for such fees.

3. Minimum Deductibility
The 2nd Circuit, in Rudkin v. Comm'r (now Knight v. Comm'r) held that trusts could take above-the-line deductions only for costs that individuals "are incapable of incurring," citing Scott's examples of the types of expenses that would be fully deductible. Thus, the Second Circuit essentially interpreted "would not" as "could not." Since individuals could incur almost all other costs, the 2% floor applied to a trust's deduction of investment advisory expenses.

Final Resolution-Knight v. Comm'r
By unanimous decision, the U.S. Supreme Court held in Knight that the 2% floor applies to a trust's deduction of investment advisory fees, since it would not be "uncommon," "unusual" or "unlikely" for an individual to incur such costs in connection with his or her own property. In other words, trust or estate expenses also commonly or customarily incurred by individuals do not qualify for the exception to the 2% floor. Thus, although the Supreme Court affirmed the Rudkin decision, it rejected the 2nd Circuit's reasoning in favor of the 4th Circuit's and Federal Circuit's "common" or "customary" analysis.

The Supreme Court did state, however, that: "Some trust-related investment advisory fees may be fully deductible 'if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts.' ... It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor." (Emphasis is added; internal citations were omitted.) Thus, the Knight opinion raises the concept of unbundling investment fees to determine if any incremental amounts are allocable to "special" trust needs.

IRS Actions
Before the Knight decision, the IRS proposed amendments to the regulations (Section 1.67-4) 1.67-4 providing that only costs that are "unique" to an estate or a trust are fully deductible for purposes of Section 67(e)(1). Following the 2nd Circuit's reasoning in Rudkin, the proposed regulation classifies a cost as "unique" if "an individual could not have incurred the cost in connection with property not held in an estate or trust." To illustrate, the proposed regulation provides "non-exclusive" lists of "unique" and "non-unique" costs:

Unique costs include those incurred in connection with:

  • Fiduciary accountings;
  • Judicial or quasi-judicial filings regarding estate or trust administration;
  • Fiduciary income and estate tax returns;
  • The division or distribution of income or principal to or among beneficiaries;
  • Trust or will contests or construction proceedings;
  • Fiduciary bond premiums; and
  • Communications with beneficiaries regarding trust or estate matters.

Non-unique costs include those incurred in connection with:
  • Custody or management of property;
  • Advice on investing for total return;
  • Gift tax returns;
  • Defense of claims by creditors of the decedent or grantor; and
  • The purchase, sale, maintenance, repair, insurance or management of any non-trade or business property.

"Bundled Fees." Unlike the Knight decision, the proposed amendment addresses the issue of "bundled fees." Bundled fees generally involve a trustee who charges one flat fee for all tasks, including investment management. Trustee's fees are generally fully deductible. The preamble to the proposed regulation, however, specifically states that "taxpayers may not circumvent the 2% floor by 'bundling' investment advisory fees and trustees' fees into a single fee." Accordingly, the proposed regulation says that the trustee must "identify the portion (if any) of the legal, accounting, investment advisory, appraisal or other" expense that is unique, using "any reasonable method to allocate" the bundled fee between the unique and non-unique costs. During a public hearing in November 2007, the IRS received substantial comments from professional fiduciaries concerned about the administrative burdens of the proposed rules. With the IRS victory in Knight, however, it is uncertain to what extent the IRS will make any revisions based on such comments.

Recent statements made by Catherine Hughes, an attorney with the U.S. Treasury Department's Office of Tax Policy, may provide some insight into the potential revisions.  Hughes noted that, after the Knight decision, the IRS may "need to go back and rethink the definition of uniqueness." She signaled continued support, however, for an approach that involves an allocation of costs. Hughes commented, "You've got to look at the particular services that have been rendered. ... You may have to do an allocation. The main thrust of the proposed regs is that you don't look at the label of the service; you look at the nature of what is being done." While Hughes hinted that the IRS may develop safe harbors for certain deductions, they would be "specific, and services would have to be 'unbundled.'" Thus, based on Hughes' comments, the concepts of unbundling and fee allocation may remain in the final regulation.

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