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Deductibility 5/27/2009 10:46:08 AM EST Knight v. Commissioner Limits Investment Fee Deductibility by Trusts Rudkin Trust Holding Heard by Sonia Sotomayer Affirmed Associate Professor of Law
In Knight v. Comm'r, 552 U.S. 181 (U.S. 2008), the Supreme Court settled a long-standing split of authority regarding the applicability of the 2% AGI limit to the deductibility of investment fees by trusts. Holding that the fees are commonly or customarily incurred by individuals, the Court determined that the IRC § 67(e)(1) exception for trusts is inapplicable.
Knight v. Comm'r, 552 U.S. 181 (U.S. 2008) affirms William L. Rudkin Testamentary Trust v. Comm'r, 467 F.3d 149 (2d Cir. 2006). U.S. Supreme Court nominee Sonia Sotomayor wrote the opinion in Rudkin. In Rudkin, The trustee claimed a tax deduction for the full amount of the investment advisory fees paid by the trust. The Internal Revenue Service permitted a deduction only for the portion of the fees that exceeded two percent of the trust's adjusted gross income. The trustee argued that the investment advisory fees were fully deductible under 26 U.S.C.S. § 67(e)(1) because the trustee's fiduciary duties under the Connecticut Uniform Prudent Investor Act, Conn. Gen. Stat. §§ 45a-541 to 45a-541l (2005), required the trustee to engage investment advisory services. On appeal, the court determined that 26 U.S.C.S. § 67(e)(1) unambiguously exempted from the two-percent floor of § 67(a) only those costs incurred by a trust that could not have been incurred if the property were held by an individual. Thus, the trust's investment-advice fees were deductible only to the extent that they exceeded two percent of the trust's adjusted gross income. This conclusion followed from the fact that individual property owners could incur investment-advice fees and from a regulation explicitly including investment-advice fees among the miscellaneous itemized deductions subject to § 67(a)'s two-percent floor.
Rudkin Testamentary Trust v. Comm'r, 467 F.3d 149 (2d Cir. 2006) relied on the relevant statute's plain meaning. In doing so, the court deviated from the Sixth Circuit's holding inO'Neill v. Commissioner, 994 F.2d 302, 303 (6th Cir. 1993), and followed holdings by the Fourth Circuit in Scott v. United States, 328 F.3d 132 (4th Cir. Va. 2003) and the Federal Circuit in Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001).
Professor Joseph Grant writes: The United States Supreme Court very rarely issues opinions that affect income taxation. More exceptionally, income taxation decisions issued by the Supreme Court even more rarely deal with the taxation of trusts. However, in the unanimous opinion Knight v. Commissioner of Internal Revenue, 128 S.Ct. 782, 2008 U.S. Lexis 1096 (U.S. 2008) (Jan. 16, 2008), the Supreme Court issued a critical ruling that examined § 67 of the Internal Revenue Code (I.R.C.). Generally, § 67 of the I.R.C. provides that miscellaneous itemized deductions are only allowable to the extent that such deductions exceed 2% of the taxpayers adjusted gross income (AGI). With regard to taxation of trusts, § 67(e)(1) provides an exception to the 2% AGI floor and allows for the 100% deductibility of costs and expenses associated with the administration of trusts and estates. Additionally, in proposed regulations the Internal Revenue Service (IRS) has decided to speak to the deductibility of costs and expenses associated with trusts squarely. The Knight decision will have tremendous impact on both individual and corporate trustees and the deductibility of costs and expenses for trusts in the future. This Commentary explores the Knight case in greater detail and the proposed IRS regulations on the horizon.
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Normally, individuals can deduct from their taxable income certain miscellaneous itemized deductions, pursuant to § 63(d) of the I.R.C. However, as provided in § 67(a), these deductions are only allowable to the extent that they exceed 2% of AGI. A trust or estate can claim similar deductions to those claimed by individuals pursuant to § 67(e). However, 67(e)(1) holds that a trust can deduct, costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate, without regard to the 2% AGI floor.
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Knight, the trustee had argued that due to his fiduciary duties, investment advice was a necessary requirement in order to satisfy those obligations. Furthermore, the argument went, individuals cannot incur trust investment advisory fees. Individuals are not required to answer to anyone in regard to their own finances. A trustee on the other hand does have to answer to the beneficiaries of a trust as a result of state statutory requirements of fiduciary responsibility, such as the Prudent Investor Act in Connecticut in this case. However, the Court rejected this notion and saw no evident distinction. Because individuals regularly seek, consult, and gain investment advice, the Court reasoned there is no difference when a trustee does the same, regardless of any statutory responsibility to seek such advice.
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Proposed Regulation § 1.67-4 sets forth rules that specifically affect the singular fees charged by corporate trustees for trust services and investment advisory services. The proposed regulation would also require that an estate or trust unbundle fees into unique and non-unique categories in order to correctly achieve proper deducting of expenses. Thus, where a trust pays singular fees for trust services and investment advice, the trust is obligated to clearly identify that portion of the fees that is unique to a trust and thereby not governed by the 2% AGI floor. Proposed Regulation § 1.67-4 forces the trust taxpayer to use a reasonable method in allocating unique fees and expenses and those that are subjected to the 2% AGI floor. This provision appears to be an attempt at stopping trusts from getting around the 2% AGI floor by bundling all fees with what could be considered unique fees and other fees and costs.
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The retroactive impact of Knight is unclear. However, prospectively the Knight promises to have an enormous impact on the full deductibility of investment advisory fees associated with the administration of trusts. In light of the impact of Knight and Proposed Regulation § 1.67-4, a trust taxpayer should conduct a comprehensive and thorough review of its investment advisory fees with the trusts legal advisors and accountants to determine the level of their deductibility (whether fully deductible or subject to the 2% AGI floor). The language of the Knight decision itself may create opportunities to fully deduct specialized fees and costs associated with trust administration as distinguished from fees incurred commonly by individuals.
Subscribers can access the complete commentary on the LexisNexis Tax Center. Additional fees may be incurred.
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