Tax Court Limits Trust Deductions
Will the Second Circuit Appeals Court Allow Them?

By David Schaengold

E-mail Story Print Story

The full deduction of fees incurred by a trust for investment advice has been the subject of many court cases. The issue concerns the application of the 2% rule to itemized deductions in the context of trust administration. Recent cases in the Fourth Circuit and the Federal Circuit have supported the IRS’s contention that a trust’s deduction for such fees must be limited by the 2% rule. An older decision in the Sixth Circuit, however, had supported the taxpayer’s claims for the full deduction of such fees.

Trusts Versus Individuals

The issue is whether a trust is entitled to deduct, in full, fees paid for investment advice. An individual taxpayer is not. Under IRC section 67(a), an individual taxpayer’s deduction is limited to the amount by which the sum of those fees, plus the taxpayer’s other miscellaneous itemized deductions, exceeds 2% of the taxpayer’s adjusted gross income (AGI). The limit also applies to trusts, but with an exception: it allows full trust-related administrative costs “which would not have been incurred if the property were not held in such trust” [IRC section 67(e)].

O’Neill

The issue first came up in Tax Court in 1992. The issue was decided in favor of the IRS with a ruling that the fees incurred by the trustees of the William J. O’Neill, Jr., trust were not unique to the property held in the trust. Accordingly, the court ruled that the fees would be subject to the 2% AGI floor for miscellaneous deductions.

But the Sixth Circuit Appeals Court reversed the decision on appeal, and a ruling favorable to trusts was set forth [William J. O’Neill, Jr., Irrevocable Trust v. Comm’r, 93-1 USTC 50,332, 994 F. 2d 302 (6th Cir.1993)]. In their appeal, the trustees argued that, “[w]here a trustee lacks experience in investment matters, professional assistance may be warranted.” They pointed out that because they lacked experience in investing and managing large sums of money, they hired an investment advisor. Without such assistance, they would have placed the assets of the trust at risk. They urged the court to find that “the investment advisory fees were necessary for the continued growth of the trust and were caused by the fiduciary duties of the trustees.”

The argument was successful. The Sixth Circuit Appeals Court reversed the Tax Court decision and ruled that the fees are fully deductible. It stated:

[A] trustee is charged with the responsibility to invest and manage trust assets as a “prudent investor” would manage his own assets. See III Scott on Trusts, section 227 (4th Ed. 1988) (trustee must “exercise the care and skill and caution that a prudent person would exercise under the circumstances”). … [F]iduciaries uniquely occupy a position of trust for others and have an obligation to exercise proper skill and care with the assets of the trust.

Mellon Bank

In late 2001, the IRS was successful in the Federal Circuit, which upheld a lower court ruling denying a full deduction to Mellon Bank as trustee [Mellon Bank, N.A. v. United States, 2001-2 USTC 50,621, 265 F.3d 1275 (Fed. Cir. 2001)]. In this case, the IRS prevailed in arguing that the investment advisory fees are not a “type” of cost that is unique to trust administration. The IRS insisted that investment advisory fees are no different from the same type of cost incurred by individual taxpayers administering large sums of money.

In explaining why it agreed with the IRS, the Appeals Court held that such fees did not qualify for the full deduction under IRC section 67(e). It explained:

The second clause of [IRC] section 67(e)(1) serves as a filter, allowing a full deduction only if such fees are costs that “would not have been incurred if the property were not held in such trust or estate.” The requirement focuses not on the relationship between the trust and costs, but the type of costs, and whether those costs would have been incurred even if the assets were not held in trust. Therefore the second requirement treats as fully deductible only those trust-related administrative expenses that are unique to the administration of a trust and not customarily incurred outside of trusts.

Investment advice and management fees are commonly incurred outside of trusts. An individual taxpayer, not bound by fiduciary duty, is likely to incur these expenses when managing a large sum of money. Therefore, those costs are not exempt under IRC section 67(e)(1) and are required to meet the 2% floor of section 67(a).

J.H. Scott

The issue came up again in the Fourth Circuit, where it was again decided in favor of the IRS [J.H. Scott v. United States, 328 F.3d 132 (4th. Cir. 2003)]. Here the Appeals Court decided the case based on its interpretation of the meaning and relationship between the provisions of IRC sections 67(a) and 67(e).

The court first pointed out that the exception under section 67(e)(1) has two requirements that must be met before certain costs can be deducted in full in computing the adjusted gross income of a trust:

Two requirements must be satisfied in order for costs to qualify for the Section 67(e)(1) exception. First, the costs incurred by the trust must have been “paid or incurred in connection with the administration of the … trust” [IRC section 67(e)]. There is no dispute that the investment-advice fees at issue satisfy this requirement.

Second, and importantly for this case, the costs must have been expenses “which would not have been incurred if the property were not held in such trust.” … Put simply, trust-related administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by individual taxpayers.

Next, the court focused specifically on whether investment-advice fees as a category of trust-related administrative expenses fulfill the second requirement. It concluded that they do not:

Because investment-advice fees are commonly incurred outside the context of trust administration, they are subject to the 2% floor created by [IRC section] 67(a). Other costs ordinarily incurred by trusts, such as fees paid to trustees, expenses associated with judicial accountings, and the costs of preparing and filing fiduciary income tax returns, are not ordinarily incurred by individual taxpayers, and they would be fully deductible under the exception created by [IRC section] 67(e). Such trust-related administrative expenses are solely attributable to a trustee’s fiduciary duties, and as such are fully deductible under [IRC section] 67(e). Investment-advice fees, by contrast, are often incurred by individual taxpayers in the management of income-producing property not held in trust.

The court explained its reasoning and described why the issue of “fiduciary duty” is not relevant:

As the Government points out, we would, by holding that a trust’s investment-advice fees were fully deductible, render meaningless the second requirement of [IRC section] 67(e)(1). All trust-related administrative expenses could be attributed to a trustee’s fiduciary duties, and the broad reading of [IRC section] 67(e)(1) urged by the taxpayers would treat as fully deductible any costs associated with a trust. But the second clause of [IRC section] 67(e)(1) specifically limits the applicability of [IRC section] 67(e) to certain types of trust-related administrative expenses. To give effect to this limitation, we must hold that the investment-advice fees incurred by the Trust do not qualify for the exception created by [IRC section] 67(e). Rather, they are subject to the 2% floor established by [IRC section] 67(a).

It would have been bad enough for trust-taxpayers had the court simply ruled on the issue as it did. But the court went on to dissect and criticize the Sixth Circuit’s reasoning in O’Neill:

The Sixth Circuit reasoned that “where a trustee lacks experience in investment matters, professional assistance may be warranted.”[994 F.2d at 304] According to the court, without investment advice “the co-trustees would have put at risk the assets of the Trust. Thus, the investment advisory fees were necessary to the continued growth of the Trust and were caused by the fiduciary duties of the co-trustees.” … In our judgment, this analysis contains a fatal flaw. Of course, trustees often (and perhaps must) seek outside investment advice. But the second requirement of [IRC section] 67(e)(1) does not ask whether costs are commonly incurred in the administration of trusts. Instead, it asks whether costs are commonly incurred outside the administration of trusts. As the Federal Circuit decided in Mellon Bank, investment-advice fees are commonly incurred outside the administration of trusts, and they are therefore subject to the 2% floor established by [IRC section] 67(a).

Rudkin

The issue came up again in William L. Rudkin Testamentary Trust v. Commissioner [124 T.C. No. 19]. It had been 12 years since the matter first appeared in Tax Court, with the decision in favor of the IRS in O’Neill, which, as noted above, was reversed by the Sixth Circuit Appeals Court. But this time the Tax Court’s original decision in favor of the IRS had the backing of both the Fourth and Federal Circuits. Therefore it comes as no surprise that the Tax Court rejected the taxpayer’s argument for a full deduction. In ruling for the IRS, the court repeated what it had said in O’Neill:

Individual investors routinely incur costs for investment advice as an integral part of their investment activities. Consequently, it cannot be argued that such costs are somehow unique to the administration of an estate or trust simply because a fiduciary might feel compelled to incur such expenses in order to meet the prudent person standards imposed by State law.

The court concluded that “investment advisory fees are not fully deductible under the exception provided in [IRC] section 67(e)(1) and are deductible only to the extent that they exceed 2% of the trust’s adjusted gross income pursuant to section 67(a).”

Appeal to U.S. Supreme Court Possible

The Tax Court ruling in Rudkin provides no new insight to the controversy. The split among the circuits over how to apply the law still remains. Because this decision falls under the Second Circuit, it is of concern to New York–, as well as Connecticut- and Vermont-, domiciled trusts.

A more favorable decision may be found on appeal. The trustees in Rudkin have appealed the matter to the Second Circuit Appeals Court, which is expected to rule in the coming months. In addition, given that there is a split among the circuits over how the law should be applied, the issue could ultimately be decided by the U.S. Supreme Court.