Estate and Trust Investment Advisory Fees: 2% Limit Applies

In William L. Rudkin Testamentary Trust, 124 TC No. 19 (2005), the Tax Court ruled (in a reviewed opinion, 18–0) that investment advisory fees incurred or paid by an estate or trust were deductible only to the extent they exceeded 2% of adjusted gross income (AGI). Of the three circuit courts that have ruled on this issue (discussed below), two agreed with the Tax Court, but one allowed a full deduction for such fees. Rudkin has been appealed to the Second Circuit, which has not yet weighed in on the issue.

Background

Sec. 67(a) allows individuals to deduct miscellaneous itemized deductions only to the extent that they exceed 2% of AGI. Temp. Regs. Sec. 1.67-1T(a)(1)(ii) includes Sec. 212 investment advisory fees under this rule. According to Sec. 67(e), the AGI of estates and trusts is calculated in the same manner as for individuals; however, expenses paid or incurred in estate or trust administration, “which would not have been incurred if the property were not held in such trust or estate,” are fully deductible in calculating AGI.

Cases

In O’Neill Trust, 98 TC 227 (1992), rev’d, 994 F2d 302 (6th Cir. 1993), the Tax Court ruled that only expenses unique to estate or trust administration qualify for the Sec. 67(e)(1) exception to the 2% rule, such as trustee or estate fiduciary fees and accounting fees required by state law or the governing trust or estate instrument. The Tax Court concluded that investment advisory fees are not unique, because they are routinely incurred by individual investors. Further, the fact that a trustee or estate fiduciary might feel compelled to hire investment advisers to satisfy prudent person standards imposed by state law, does not make investment advisory fees unique to estate or trust administration.

In reversing, the Sixth Circuit emphasized that individual investors are neither required to consult investment advisers, nor do they incur penalties or potential liability if they act negligently for themselves. However, trustees and estate fiduciaries uniquely occupy positions of trust and can incur penalties or potential liability for acting negligently in managing assets on beneficiaries’ behalf. Thus, the court concluded that an estate or trust must incur investment advisory fees that would not be incurred if the assets were not held in the estate or trust, to permit a full deduction.

Two circuits have rejected the Sixth Circuit’s reasoning and adopted the Tax Court’s position; see Mellon Bank, N.A., 265 F3d 1275 (Fed. Cir. 2001), aff’g 47 Fed.Cl. 186 (2000), and Scott, 328 F3d 132 (4th Cir. 2003), aff’g 186 FSupp2d 664 (ED VA 2002). In Scott, the Fourth Circuit observed that Sec. 67(e)(1) does not ask whether an expense is commonly incurred in estate and trust administration, but whether it is commonly incurred outside of such administration. Because investment advisory fees are commonly incurred outside, the Fourth Circuit ruled that they are subject to the 2% rule.

Both the Federal and the Fourth Circuits reasoned that if investment advisory fees were fully deductible under the Sec. 67(e)(1) exception, then the phrase, “which would not have been incurred if the property were not held in such trust or estate,” would become superfluous; all administration expenses would qualify. Thus, both circuits concluded that investment advisory fees do not qualify for the exception. Finally, the Federal Circuit added that Sec. 67(e) is intended to limit taxpayers’ ability to use trusts to lower their taxes. (For more discussion of O’Neill, Mellon and Scott, see Satchit, “Trusts, Investment Advisory Fees and the 2% Floor,” TTA, February 2004.)

Rudkin

In Rudkin, the trust instrument provided the trustee with broad authority to manage the trust property, which included employing investment advisers. In 2000, the trustee deducted $22,241 for investment management fees. The IRS disallowed $12,461 under the 2% rule.

In Tax Court, the trustee argued that the fiduciary duties imposed on trusts make professional investment advice a “necessary and involuntary component of trust administration,” whereas individuals can voluntarily choose to hire investment advisers. The IRS maintained that investment advisory fees are commonly incurred by individuals outside of trust administration. Also, neither state law (Connecticut) nor the trust instrument legally required the trustee to obtain professional investment advice.

The Tax Court ruled that investment advisory fees are subject to the 2% rule under Sec. 67(e)(1), for the reasons given by it in O’Neill and by the circuit courts in Mellon and Scott.

Conclusion

Rudkin reinforces the Tax Court’s opinion in O’Neill and clarifies its position for the (1) Second Circuit, because the case has been appealed, (2) Sixth Circuit, if that court reconsiders its position and (3) circuits that have not yet addressed this issue. Rudkin is binding in all states except the Sixth Circuit states of Ohio, Michigan, Kentucky and Tennessee.

Although Sec. 67(e)(1) is open to interpretation, the most straightforward reading appears to be that the 2% rule applies to the investment advisory fees, because they are commonly incurred outside of estates and trusts. However, the question then arises whether other factors are relevant (such as fiduciary duties, state law and the wording of the governing estate or trust instrument). As explained above, only the Sixth Circuit found such items to be relevant. Finally, none of the cases raised the issue of whether the full amount of the trustee fees would be deductible if they included investment advice provided by a trustee with such expertise.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, University of Wisconsin–Whitewater, Whitewater, WI (Not Affiliated with PKF North American Network)