Did the Second Circuit Err in Rudkin Testamentary Trust?

Executive Summary

• In Rudkin, the court determined that the 2%-of-AGI floor applies to an estate or trust’s administrative costs, unless the cost is one that individuals are incapable of incurring.
• Millions of beneficiaries will be affected by the court’s decision, as the IRS will treat beneficiaries in the Second Circuit differently from others.
• Before the Service issues regulations or the Supreme Court resolves the issue, trustees and practitioners wishing to avoid penalties for underestimated taxes have several options.

In October 2006, in Rudkin,¹ a two-judge panel of the Second Circuit Court of Appeals declared that “would” means “could” in Sec. 67(e). If this interpretation remains, it virtually eliminates the Sec. 67(e) exception to the 2% rule for estates and trusts and puts the Second Circuit in conflict with every other circuit that has interpreted this statute.²

The Second Circuit held that Sec. 67(e) grants an estate or trust an exception from the 2% reduction in itemized deductions only for “costs of a type” that “individuals are incapable of incurring.” On the surface, the court appeared to create a narrow window for an estate or trust to claim a full deduction for its administrative costs. In reality, however, it potentially eliminates a full deduction for any administrative cost of an estate or trust.

The court endorsed only three costs as fully deductible, because “individuals are incapable of incurring” them—“fees paid to trustees, expenses associated with judicial accountings, and the costs of preparing and filing fiduciary income tax returns.” However, one could argue that even these do not pass muster under the Second Circuit’s strict interpretation, because individuals are fully capable of incurring these costs. It makes sense that they would, because trustees are nothing more than titleholders for property beneficially owned by an individual. Thus, it is nearly impossible to conceive of a cost that trustees can incur with respect to property that an individual cannot.

This article examines how the Second Circuit reached its decision and how trustees and practitioners should respond to this questionable ruling.

The Controversy

Dozens of law reviews and journals have discussed the interpretation of Sec. 67(e) since the controversy first arose in O’Neill.³ So far, none has urged the interpretation adopted by the Second Circuit. Indeed, the panel’s interpretation even conflicts with IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, and most state fiduciary income tax forms, which allow a full deduction for legal and accounting fees. Under the court’s definition, legal and accounting fees should not be fully deductible (at least in the Second Circuit), because individuals are capable of incurring them. Thus, the court’s interpretation is bound to foster confusion and noncompliance.

While the $4,448 deficiency in Rudkin is undoubtedly small, the Second Circuit’s position has serious implications. Its endorsement and application will create a substantial tax debt for trustees who must incur costs to comply with their legally mandated duties, such as those imposed under the Uniform Prudent Investor Act. It will also generate substantial litigation over a basic deduction that Congress intended for trustees carrying out such duties, all based on a questionable interpretation.

The Case

Two-Prong Test

The question before the Second Circuit was whether Sec. 67(e) exempted $22,241 of investment advisory fees paid by the Rudkin Trust from the “2% rule” in Sec. 67(a), or required the fees to be reduced by 2% of the trust’s adjusted gross income (AGI). Sec. 67(a) allows individuals to deduct miscellaneous itemized deductions only to the extent that they exceed 2% of AGI. Estates and trusts are generally subject to the same rules for determining income and deductions as individuals, except when specifically provided otherwise in numerous other Code sections.⁴ Sec. 67(e) is one of these many exceptions. It allows estates and trusts a full deduction for miscellaneous itemized deductions “paid or incurred in connection with the administration of the estate or trust …which would not have been incurred if the property were not held in such trust or estate.”

The exception is structured as a two-prong test. First, costs must be “paid or incurred in connection with the administration of the estate or trust.” Second, those costs “would not have been incurred if the property were not held in such trust or estate.” While the first prong is not in contention, no one can agree on what the second prong means. 

Other Circuit Decisions

Four circuits have now weighed in on the meaning of the disputed phrase. In 1993, the Sixth Circuit interpreted Sec. 67(e) to allow estates and trusts a full deduction for costs “incurred because of fiduciary duties.”⁵ But, in 2001, the Federal Circuit disagreed and construed Sec. 67(e) as allowing a full deduction only for costs “not commonly incurred by individuals.”⁶ Two years later, the Fourth Circuit⁷ echoed the Federal Circuit’s opinion. Most recently, the Second Circuit resoundingly rejected them all, declaring that Sec. 67(e) allows a full deduction only for costs that “individuals are incapable of incurring.” Ironically, the only controversy the four circuits resolved is that the statute is “plain and unambiguous.” Accordingly, none of them considered it necessary to consult the statute’s legislative history.

Court’s Rationale

In holding that the second clause of Sec. 67(e) allows a full deduction only for costs that “individuals are incapable of incurring,” the court explained that this comports with the “plain meaning” of the statute. Yet, it is hard to reconcile the Second Circuit’s assertion that the statute is “plain,” when reaching its conclusion required significant alteration of the statutory text and no other court agrees with its interpretation. 

“Would” Means “Could”

Despite Congress’s deliberate choice of “would” in the second clause of Sec. 67(e), the Second Circuit’s analysis interpreted “would” as “could.” In doing so, it changed the statute from one that allows a full deduction for costs that would not have been incurred without the trust, to one that only allows costs that could not be incurred without a trust. One cannot help but question the court’s justification for this change, because “would” does not mean the same as “could.” “Would” expresses probability or presumption, whereas “could” denotes capability.⁸ These words are not ordinarily interchangeable.

Further, the court held that “such trust” means “a generic trust.” This is also questionable, because “such” is a pointing word with a clear antecedent—the trust that paid or incurred the cost. Changing “such trust” to “a generic trust” changes the statute from a particularized inquiry about whether the costs were incurred because of such trust, to a general inquiry about whether the costs can be incurred outside of a trust at all. Indeed, it guts the very exception that Congress intended for administrative costs of estates and trusts, because there is arguably no cost that trustees can incur that “individuals are incapable of incurring.”

Finally, and without explanation, the Rudkin court concluded that the statute “logically directs the inquiry away from the trust and back toward the hypothetical ownership of the property by an individual.” Yet the statute says nothing about an individual property owner; rather, Sec. 67(e) specifically focuses on “costs which are paid or incurred in connection with the administration of the estate or trust”—not those that might be incurred by an individual. 

Sec. 67(e)

The court appeared to ignore the context in which Sec. 67(e) appears—i.e., as one of many exceptions to the 2% rule. Reading Sec. 67 in its entirety reveals a nearly identical exception contained in Sec. 67(d) for handicapped individuals. Sec. 67(d) allows a full deduction for “expenses in connection with such place of employment which are necessary for such individual to be able to work…” (emphasis added). It is almost a carbon copy of Sec. 67(e). Like Sec. 67(e), it provides an exemption to the 2% rule for a special class of taxpayer not likely to abuse miscellaneous itemized deductions—handicapped individuals. Also like Sec. 67(e), it imposes two requirements to meet the exception. First, expenses must be incurred “in connection with such place of employment.” Second, they must be “necessary for such individual to be able to work.” “Such” clearly refers to the particular handicapped person and his or her place of employment—not a generic handicapped person or place of work.

If one were to interpret Sec. 67(d) in the same manner as the Second Circuit interpreted Sec. 67(e), handicapped individuals could deduct only the types of expenses that nonhandicapped persons are incapable of incurring in a generic place of employment. This would nearly eliminate almost every type of job-related deduction for handicapped people. For example, they could not fully deduct the cost of telephone headsets, speaker phones, voice-activated computers, automatic door openers, elevator service or any other expenses that nonhandicapped individuals are capable of incurring. 

Superfluous Clause

The Second Circuit’s holding that the second prong means costs that “individuals are incapable of incurring,” renders the first prong useless, because all costs described in the second prong are covered under the first. That is, all costs that “individuals are incapable of incurring” are necessarily those incurred “in connection with the administration of the estate or trust.” Thus, the statute could just as easily have been written without the first clause and simply allowed estates and trusts a full deduction only for “costs that individuals are incapable of incurring.” Canons of statutory interpretation do not ordinarily permit interpreting a statute in a manner that renders a portion of it superfluous.⁹ 

Legislative History

If the statute was ambiguous, the court should have embraced the legislative history for clarification. Had it done so, it would have found evidence that Congress intended to broadly exempt all administrative costs of estates and trusts from the 2% floor, except those that are not directly related to the fiduciary’s administrative duties.¹⁰ The Rudkin briefs laid the entire legislative history before the court in a detailed narrative.

The 2% floor was enacted to eliminate extensive recordkeeping for small and essentially personal items that individuals often claimed as miscellaneous itemized deductions, such as “safe deposit expenses…and…subscriptions to widely read publications.”¹¹ However, Congress recognized that not all taxpayers abused miscellaneous itemized deductions. Among those who did not were trustees and executors of nongrantor trusts and estates. Thus, both houses of Congress agreed to grant an exception to the 2%-of-AGI floor for estates and nongrantor trusts. This exception, contained in Sec. 67(e), allowed a full deduction for all administrative costs of estates and trusts.¹² There was no second prong. 

This original version of Sec. 67(e), granting a full deduction for all administrative costs of estates and trusts, remained intact for nearly a year as the House and Senate bills wound their way through Congress and into the Joint Conference Committee. There, the conferees questioned whether the exception for administrative costs of estates and trusts should also cover administrative costs from flowthrough entities in which the trust invested.¹³ Such administrative costs were generally unrelated to the trustee’s administrative duties; rather, they related to the administration of the passthrough entity. Should they also be fully deductible as administrative costs of the estate or trust? To resolve the issue, the conferees added the second prong, which clarified that only administrative costs directly attributable to the trustee’s administrative duties are fully deductible¹⁴ (i.e., those costs that would not have been incurred had it not been for such trust). Congress never intended this phrase to eliminate wholly the exception for administrative costs that it carefully granted in the first prong.

Although the court noted that the legislative history “provides some indication that the second clause of section 67(e) was drafted to address indirect deductions through pass-through entities,” it dismissed this by explaining: 

If Congress’s only purpose had been to restrict the ability of trusts as ultimate taxpayers to deduct fully their share of the administrative costs of pass-through entities in which they had invested, however, it could have drafted the second clause of section 67(e)(1) more narrowly. It could have, for example, permitted full deductibility for those administrative costs which are not pass-through costs restricted under section 67(c).¹⁵ 

However, the court apparently overlooked the fact that Sec. 67(c) is expressly inapplicable to estates and trusts. Thus, the court suggests that the statute should have permitted estates and trusts a full deduction for costs that are not restricted by a statute that does not apply to them. It is doubtful that Congress would have entertained such a meaningless provision.  

The court’s failure to address the legislative history blinded it to Congress’s purpose in drafting the second clause of Sec. 67(e). The language Congress chose, while not perfect, allows a full deduction for costs, including those from pass-through entities that were incurred because of the trustee’s fiduciary duties. Trusts frequently form passthrough entities to carry out some or all of their fiduciary duties. To the extent the trust can show that the administrative costs of the passthrough entity were incurred because of the trustee, they should be fully deductible under the statute. But costs from passthrough entities in which the trust is merely a passive investor and that would have been incurred regardless of the trust are not fully deductible.

Ruling’s Effect

The Rudkin ruling potentially affects the four million estates and trusts that file tax returns with the IRS each year.¹⁶ Moreover, because estates and trusts report over $85 billion of AGI, there is an enormous amount at stake.¹⁷ Estates and trusts pay $9.8 billion a year for legal, accounting, tax reporting, asset management and other costs that are now subject to partial disallowance under the court’s ruling.¹⁸ They also pay trustees $3.9 billion a year to perform these services.¹⁹ This decision is especially hard on fiduciaries and beneficiaries in New York, Connecticut and Vermont, because the Tax Court is bound to follow the Second Circuit’s ruling in cases involving those residents. Approximately 10% of all estates and trusts reside in the Second Circuit.²⁰

How will executors and trustees react to the court’s interpretation? Some will undoubtedly ignore it as an aberration. Others may simply avoid seeking any form of professional advice because it is not tax deductible, and, thus, not cost-effective to do so. To the extreme, some trusts may relocate outside the Second Circuit to a more favorable jurisdiction. Regardless, none of these reactions squares with sound tax policy or Congress’s original intent to allow estates and trusts a full deduction for administrative costs incurred because of their legally mandated duties.

Millions of beneficiaries will also be affected by the court’s decision. On audit, the Service will treat beneficiaries in the Second Circuit differently from all others, even in the same trust. They will owe a tax on “phantom income,” to the extent they receive distributions from a trust that have been reduced by any costs that individuals “are capable of incurring” and for which the trust has been denied a deduction.²¹ This deviation from the standard employed elsewhere will have broad economic and policy implications for all trustees and beneficiaries.

The Second Circuit’s interpretation also conflicts with the IRS’s interpretation of Sec. 67(e).In briefs before the Second Circuit and at oral argument, the government supported the position maintained by the Fourth and Federal Circuits (i.e., the second prong allows a full deduction only for costs that individuals do not “commonly incur”). But, more recently, the government took a different position. In CCA 200630016, ²² the Service held that a bankruptcy estate is a “trust or estate” within the meaning of Sec. 67(e): 

Therefore, applying § 67(e) to a debtor’s estate in bankruptcy, the deduction for expenses paid or incurred in connection with administration of an estate in bankruptcy that would not have been incurred had the property not been held in such estate is treated as allowable in arriving at adjusted gross income. 

The CCA expressly follows In re: Miller,²³ which allowed a debtor’s estate in bankruptcy a full deduction for telephone, postage, mileage, copies, legal and accounting fees and other expenses “paid or incurred in connection with administration of an estate in bankruptcy that would not have been incurred had the property not been held in such estate.” Such costs are frequently incurred outside of bankruptcy. The government’s position in the CCA is certainly not the position it maintained before the Second Circuit in Rudkin. 

Hence, the Second Circuit’s opinion conflicts with the Service’s own interpretation of Sec. 67(e), with the decisions of all the other circuit courts, with every legal scholar who has written on this topic, and with all state and Federal fiduciary income tax forms. Thus, it has grave financial implications for estates and trusts and their beneficiaries, especially in the Second Circuit, and will affect all fiduciaries and beneficiaries if the IRS chooses to adopt the court’s holding. Hopefully, this unusual decision will not be the final word on the issue.

Treasury’s Business Plan

Sec. 67 recently appeared for the first time on Treasury’s “Priority Guidance Plan” for estates and trusts for 2006–2007.²⁴ The IRS’s timing is curious, because it now has three different interpretations from which to choose. Alternatively, it could craft an altogether different interpretation of the statute. Once regulations are promulgated, the courts generally give deference to the agency’s interpretation as the body most knowledgeable and charged with administration.²⁵ However, the Service could also decide to wait until the Supreme Court resolves the issue before finalizing any guidance.

Interim Return Positions

In the meantime, trustees and practitioners wishing to avoid penalties for understatement of taxes have several choices. They can label every administrative cost a “fiduciary fee” based on the circuits’ unanimous agreement that trustee fees are fully deductible in all circumstances. There is some basis for this, at least as to investment adviser fees; the Uniform Prudent Investor Act confers fiduciary status on an agent to whom the trustee has delegated all or a portion of the trust’s investment management duties.²⁶ Thus, investment agents’ fees are fiduciary fees. However, trustees run the risk that the IRS may assert the right to unbundle such fees.²⁷ Alternatively, trustees can avoid professional advice and invest solely in mutual funds and other assets that do not necessarily require an investment adviser, assuming such action is prudent.

Regardless, trustees and their return preparers should pick an interpretation they are comfortable with and support it with a “well-reasoned construction of the statute.”²⁸ This holds true even for trustees in the Fourth and Second Circuits, who are not bound to follow Scott²⁹ and Rudkin. The regulations merely preclude reliance on a case that has been overruled. However, those who take a position contrary to the holding of a circuit court to which their case may be appealed have a guaranteed invitation to file certiorari in the Supreme Court.

Heading for the Supreme Court

Michael J. Knight, trustee of the Rudkin Testamentary Trust, petitioned the Second Circuit to rehear the case en banc.³⁰ However, consistent with its policy against rehearings, the Second Circuit denied the petition. It considers the en banc procedure “an often unwieldy and cumbersome device generating little more than delay, costs and continued uncertainty that can ill be afforded at a time of burgeoning calendars. Further, a rehearing will only delay resolution of a case that is of such extraordinary importance that we are confident the Supreme Court will accept these matters under its certiorari jurisdiction. Accordingly, we speed these cases on their way to the Supreme Court as an exercise of sound, prudent and resourceful judicial administration.”³¹ The Rudkin trustee will test the court’s theory by petitioning the U.S. Supreme Court for certiorari in spring 2007.

Conclusion

This issue has traveled a long and bumpy road since it was first litigated in 1992 in O’Neill. Four circuits have sifted out three different meanings for this “plain and unambiguous” statute, the IRS has maintained inconsistent positions and trustees and tax preparers beg for guidance. Hopefully, the Supreme Court will deem the case worthy of review this fall.

Editor’s note: Ms. Cantrell is a member of the AICPA Tax Division’s Trust, Estate & Gift Tax Technical Resource Panel’s Trust Accounting Income Task Force.

For more information about this article, contact Ms. Cantrell at cantrell@bvccpa.com.

Notes

¹ William L. Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006); only Judges Sotomayor and Hall rendered the decision in this case. Judge Feinberg originally sat on the case, but recused himself after oral argument. The panel opinion does not indicate whether Judge Feinberg participated in the panel’s initial conference deliberation on the case.

² See William J. O’Neill, 994 F2d 302 (6th Cir. 1993), aff’g 98 TC 227 (1992), nonacq., 1994-2 CB 1; Mellon Bank, N.A., 265 F3d 1275 (Fed. Cir. 2001), aff’g 47 Fed. Cl. 186 (2000); and J.H. Scott, 328 F3d 132 (4th Cir. 2003), aff’g 186 FSupp2d 664 (ED VA 2002).

³ O’Neill, note 2 supra; see, e.g., Balter, “Second Circuit Holds Trust’s Investment Advisory Fees Are Subject to 2% Floor,” 32 BNA Tax Management Insights and Commentary 79 (1/11/07); Keebler, “William L. Rudkin Testamentary Trust: Another Loss for Taxpayers on the Investment Advisory Fee Issue,” 84 Taxes 5 (December 2006); Langbein, “Second Circuit Rules Trust Investment Fees Subject to 2 Percent ‘Floor’of Section 67 in Highly Restrictive Decision,” 10 A.S. Pratt & Sons
Community Bank Tax Report 1 (November 2006); Levin, “Limitation on Itemized Deductions for Trusts: What Should a Trustee Do?” 111 Tax Notes 445 (4/24/06); Schaengold, “Tax Court Limits Trust Deductions,” 71 The CPA J 56 (April 2006); Janes, “Fiduciary Administrative Expenses: How Much is Deductible?” 32 Est. Plng. J 21 (November 2005); Schaengold, “Fourth Circuit Decides 2% Rule Limits Trust Deductions—But Will the Uniform Prudent Investor Act Change the Courts’ View?” 29 Tax  Mnmgt. Ests., Gifts and Trusts J 78 (January 2004); Kirk, “To Be or Not To Be: A Trust’s Investment Expense Deduction Subject to the Two-Percent Limitation,” 1 Pittsburgh Tax Review 223 (Spring 2004); Bell and King, “Sweeping Up the Two Percent Floor: Scott and the Deductibility of Investment Advisory Fees,” 38 Real Property, Probate & Trust J 589 (Fall 2003); Englebrecht and Anderson, “Which Side of the Line to Deduct Trust Investment Advice,” 70 Practical Tax Strategies 348 (June 2003); Schaengold, “Will New York’s Prudent Investor Act Result in Full Deduction of Investment Advice?” 73 The CPA J 66 (April 2003); Langstraat and Doss, Jr., “Courts Split Over How to Deduct Investment Advice Fees,” 68 Practical Tax Strategies 217 (April 2002); Cantrell, “Deducting Third-Party Investment Management Fees Under Sec. 67(e),” 35 The Tax Adviser (October 2002); Shepard and McMahon, “Who Says it’s a ‘Net’ Income Tax? What Happened to Those §212 Deductions?” 5 Fla. Tax Rev. 109 (2001); and Martin, “O’Neill v. Comm’r: Misplaced Trust,” 22 Northern Kentucky Law Review 841 (Summer 1995).

⁴ See Regs. Sec. 1.641(a)-1 and 1.641(b)-1.

⁵ See O’Neill, note 2 supra.

⁶ See Mellon Bank, N.A., note 2 supra.

⁷ See Scott, note 2 supra.

⁸ Webster’s New Collegiate Dictionary (1979), pp. 158, 1361.

⁹ See Williams v. Taylor, 529 US 362 (2000), at 404.

¹⁰ See Conf. Rep’t No. 99-841, 99th Cong., 2d Sess. (1986), 1986-3 CB Vol. 4, p. II-34; see also Appellant’s Brief at 38–50, Rudkin, note 1 supra (No. 05-5151-ag, 11/30/06).

¹¹ See H Rep’t No. 99-426, 99th Cong., 2d Sess. (1985), 1986-3 CB Vol. 2, p. 109.

¹² See HR 3838, as passed by the House Ways and Means Committee (12/17/85), Section 132; and HR 3838, as reported by the Senate Finance Committee (5/29/86), Sections 132–133.

¹³ See Joint Committee on Taxation, Conf. Agt., H.R. 3838, I.E.2.a. (JCX-22-86, 8/16/86).

¹⁴ See Conf. Rep’t No. 99-841, note 10 supra.

¹⁵ Sec. 67(c) prohibits an individual from claiming a full deduction for miscellaneous itemized deductions from passthrough entities that would not be deductible if incurred directly by the individual.

¹⁶ See IRS Statistics of Income, Table 1, Total Number of Returns to be Filed with the IRS: Calendar Years 2005–2012, available at www.irs.gov/taxstats/article/0,,id=136767,00.html.

¹⁷ See IRS Statistics of Income, Table 4, Fiduciary Income Tax Returns, Income, Deductions, and Tax Liability, by Type of Entity, Filing Year 2004, available at www.irs.gov/taxstats/indtaxstats/article/0,,id=96425,00.html#2.

¹⁸ See id.

¹⁹ See id.

²⁰ See IRS Statistics of Income, Table 3, Number of Returns by Type of Return and State, available at www.irs.gov/taxstats/indtaxstats/article/0,,id=96442,00.html#2.

²¹ See Jack E. Golsen, 54 TC 742 (1970).

²² See IRS Chief Counsel Advice (CCA) 200630016 (7/28/06).

²³ In re: Miller, 252 B.R. 110 (Bankr. ED TX 2000); see Application for Compensation and Reimbursement of Expenses (In re: Miller, No. 97-10434, 11/2/98).

²⁴ U.S. Department of Treasury and Internal Revenue Service, 2006–2007 Priority Guidance Plan (8/15/06), available at www.irs.gov/newsroom/topic/index.html.

²⁵ See Chevron U.S.A., Inc., 467 US 837 (1984).

²⁶ Uniform Prudent Investor Act §9(b), available at www.nccusl.com.

²⁷ Brief of Respondent-Appellee Commissioner at 56, Rudkin, note 1 supra (No. 05-5151-ag, 11/30/06).

²⁸ See Regs. Sec. 1.6662-4(d)(3). 

²⁹ Scott, note 2 supra.

³⁰ Rudkin, note 1 supra, pet. for reh’g filed, No. 05-5151-ag (11/30/06), reh’g den.

³¹ See Green, 533 F2d 1309 (2d Cir. 1976), rev’d, 430 US 462 (1977) (the Second Circuit denied rehearing en banc because it believed that Supreme Court resolution of the case was inevitable. As anticipated, the Supreme Court granted certiorari and reversed the Second Circuit’s decision).