Tax News

CCH (cch.taxgroup.com) reports:

  A unanimous Supreme Court handed the IRS an important victory on January 16 when it ruled that investment advisory fees incurred by trusts are subject to the two-percent floor for miscellaneous deductions under
Code Sec. 67(e). While the decision dashed the hopes of many trust and estate administrators that the Court would allow these fees to be fully deductible, the Court did not adopt the analysis of the Second Circuit Court of Appeals on which the IRS based controversial proposed regulations (NPRM REG-128224-06, I.R.B. 2007-36, 551; TAXDAY, 2007/07/21, I.2). It is likely the IRS will have to repropose the regulations to reflect the Supreme Court's decision, several experts told CCH.

  "The decision puts us back to square one," Carol A. Cantrell, co-counsel for the trustee in Rudkin , told CCH. Cantrell, a shareholder with Briggs & Veselka Co., Bellaire, Texas, and a member of the AICPA Fiduciary Accounting Task Force, predicted more litigation as trusts proceed on a case-by-case basis.

Circuit Split

  The decision resolves a split among the circuit courts of appeal over the deductibility of fees paid by nongrantor trusts and estates for investment advice (TAXDAY, 2007/11/28, J.5). The U.S. Court of Appeals for the Sixth Circuit interpreted Code Sec. 67(e) as allowing trusts and estates to fully deduct investment advisory fees ( W.J. O'Neill, Jr., Irrevocable Trust, CA-6, 93-1 USTC ¶50,332). To the contrary, the Federal Circuit in Mellon Bank, N.A. (CA-FC,
2001-2 USTC ¶50,621) and the Fourth Circuit in J.H. Scott (CA-4, 2003-1 USTC ¶50,428) held that Code Sec. 67(e) does not permit the full deduction of investment advice fees because those fees are commonly incurred outside of the trust context.

  The Supreme Court's decision involves yet another circuit. The Second Circuit held in Rudkin that Code Sec. 67(e) permits a full deduction only for those costs that could not have been incurred by an individual. Because investment advisory fees are costs that could be incurred by individuals, the deduction was subject to the two-percent floor, the Second Circuit found.

  The trustee in Rudkin asked the Supreme Court to resolve the split among the circuits. The Supreme Court heard oral arguments in November 2007 (TAXDAY, 2007/11/28, J.5). Chief Justice John G. Roberts, Jr., delivered the opinion of the Court.

Could v. Would

 
Code Sec. 67(e), Justice Roberts wrote, generally provides that a trust's AGI is computed in the same manner as an individual's, including the two-percent floor for miscellaneous itemized deductions. However, Code Sec. 67(e) provides an exception to the two-percent floor if the relevant costs are paid or incurred in connection with the administration of the trust and the cost would not have been incurred if the property was not held in trust.

  The Court rejected the Second Circuit's approach of asking if the cost could have been incurred by an individual. "This approach flies in the face of the statutory language," Justice Roberts wrote. "The provision asks whether the costs would not have been incurred if the property was not held in trust, not ... whether the costs could have been incurred." If Congress had intended this result, it would have used the word "could" in the statute, and not "would," he added.

No Causation Test

  The Court also rejected the trustee's argument that Code Sec. 67(e) establishes a causation test. According to the trustee, the inquiry into deductibility of an expense turns on whether a particular expense of a trust was caused by the fact that the property was held in trust. "The statute ... does not establish a causation test but, rather, invites a hypothetical inquiry into the treatment of the property were it held outside a trust," Justice Roberts wrote.

Unique Expenses

  Having rejected both the Second Circuit's reasoning and the trustee's arguments, the Court then discussed the interpretations of
Code Sec. 67(e) by the Mellon Bank and Scott courts. The Scott court held that costs incurred by trusts that escape the two-percent floor are those that would not commonly or customarily be incurred by individuals. The Mellon Bank court found that Code Sec. 67(e) 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. "We agree with this approach," Justice Roberts wrote.

  "The question of whether a trust-related expense is fully deductible turns on a prediction about what would happen if a fact were changed, specifically, if the property were held by an individual rather than by a trust. In the context of making such a prediction, when there is uncertainty about the answer, the word "would" is best read as expressing concepts such as custom, habit, natural disposition, or probability," the Court held.

  Custom varies by location, Cantrell observed. "In Texas we have many individuals who manage their own portfolios. The top five percent hire an advisor. In other parts of the country, individuals automatically hire investment advisors."

Specialized Balancing

  The decision is a disappointment but may leave the door open a little, Jacqueline Patterson, CPA, JD, a partner with Hanney, Buchanan and Patterson, LLP, Los Angeles, and a member of the AICPA Trust, Estate and Gift Tax Technical Resource Panel, observed. At the very end of its opinion, the Court noted that the Solicitor General believes that, "[s]ome 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."

Proposed Regulations

  "The IRS lifted the language for the proposed regulations right from Rudkin ," Patterson explained. Because the Supreme Court rejected the Second Circuit's reasoning, the IRS will have to repropose the regulations, she predicted.

  A spokesperson for the American Bankers Association also predicted that the IRS will issue new proposed regulations. "We hope the IRS will quickly provide trustees with transitional and other guidance as needed."

  However, some provisions in the proposed regulations are not from Rudkin , Eileen Sherr, technical manager-taxation, for the AICPA, observed. The proposed regulations require the "unbundling" of fees charged to administer trusts. Investment advisory fees and administrative fees, including tax preparation fees, cannot be combined to, in the words of the IRS, "circumvent the two percent floor." The Supreme Court did not address the unbundling of fees.

  Affirming CA-2, 2006-2 USTC ¶50,569.

  By George L. Yaksick, Jr. and Deborah Petro, CCH News Staff

Michael J. Knight, Trustee of William L. Rudkin Testamentary Trust, SCt, 2008-1 USTC ¶50,132

Other References:

 
Code Sec. 67

  CCH Reference -2008FED ¶6064.75

  Tax Research Consultant

  CCH Reference - TRC ESTTRST: 12,054