Are a Trust's Advisory Fees Subject to the 2%-of-AGI Deduction Floor?

The Federal Circuit affirmed the Court of Federal Claims in Mellon Bank, NA, 9/7/01, holding that a trust's deduction of fees paid for outside investment advice and other services were subject to the 2% floor on miscellaneous itemized deductions. This decision creates a split with the Sixth Circuit, which held in William O'Neill, 994 F2d 302 (1993), that such expenses were deductible without regard to the 2% floor.

Under Sec. 67(a), individuals can deduct miscellaneous itemized deductions only to the extent the aggregate amount of the deductions exceeds 2% of the taxpayer's adjusted gross income (AGI). Sec. 67(e) addresses the application of the 2%-of-AGI rule to estates and trusts. Sec. 67(e)(1) provides an exception from the 2% rule for costs paid or incurred for administration of an estate or a trust, and which the taxpayer would not have incurred if the property were not held in such estate or trust.

In Mellon Bank, the trustees took a broad approach. They contended that their fees (which were acknowledged as fully deductible) were merely a label for all services for which they were responsible under state fiduciary law. They argued that services delegated by the trustee for investment strategy advice, accounting and tax preparation and management should be fully deductible, because they were within the range of the bank's fiduciary duties.

In O'Neill, the trustees took a focused approach. They contended that the investment advisory fees paid by the trust were unique to trust administration and excepted from the 2% floor. The trustees had no expert knowledge in the investment of large sums of money. In fact, none of the individuals agreed to serve as trustee until an investment adviser was hired to manage and invest the trust's assets.

In Mellon Bank, the trustees wanted all expenses resulting from fiduciary obligations to be fully deductible. The court stated that accepting this reasoning would render the second clause of Sec. 67(e)(1) superfluous. Further, the second-clause requirement focuses not on the relationship between a trust and costs, but on the type of costs and whether the trust would have incurred them even if it did not hold the assets. Investment advice and management fees are commonly incurred outside of trusts.

In O'Neill, the court found that in light of the co-trustees' lack of experience, the trust's assets would have been at risk without the assistance of an investment adviser. Therefore, the investment advisory fees were necessary to the continued growth of the trust assets and were fully deductible.

An uncertain market environment and an increase in states' prudent-investor rules that seek total return on investments may force trustees to defend a position for not seeking investment advisory services. A trustee's decision as to which case to follow should be made only after careful review of the facts and circumstances with the trust's tax advisers. Trustees should seriously consider the tax savings derived under O'Neill against the costs of a tax examination and litigation with the IRS armed with Mellon Bank.

Ultimately, the irresolution of the issue may cause the Supreme Court to step in and define the scope of Sec. 67(e)(1).

From Paul J. Weireter, CPA, New York, NY