The Supreme Court recently held that deductible investment fees incurred by a trust or estate are subject to the 2% miscellaneous deduction floor unless they are fees of a type that individuals would not commonly or customarily incur (Knight, S. Ct. Dkt. 06-1286 (U.S. 1/16/08)). This holding affects millions of estates and trusts that have invested trillions of dollars in investment management accounts, thereby incurring billons of dollars of investment management fees.
The petitioner in Knight, as the trustee of a trust, concerned about his ability to manage the trust’s funds, hired an adviser to provide investment advice. The investment adviser’s annual fee was .8% of the trust assets. These fees were fully deducted on the trust income tax return.
The IRS denied the full deduction, claiming that the investment management fees were subject to the 2% floor, and the Tax Court agreed (William L. Rudkin Testamentary Trust, 124 TC 304 (2005)). On appeal, the Second Circuit was even stricter than the Tax Court, holding that any costs that could be incurred if the property were held by an individual rather than in trust are not deductible under Sec. 67(e). The Supreme Court granted certiorari. The key issue was whether investment advisory expenses are costs that are unique to a trust and would not have been incurred if the investment assets were not held in the trust (William L. Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006)).
At issue is the scope of Sec. 67, which allows trusts and estates a miscellaneous itemized deduction for expenses that exceed a 2% floor of the trust’s adjusted gross income (Sec. 67(e)). The 2% floor does not apply to expenses incurred in connection with the trust’s administration if such costs “would not” have been incurred if the property were not held in an estate or trust (Sec. 67(e)(1)). It is this exception that was the crux of the petitioner’s argument. Because of his fiduciary responsibilities to the beneficiaries of the trust, he could not invest the assets in the same way that an individual would. While an individual can choose whether to seek investment advice, it could be argued that trustees are obligated to seek investment advice, because otherwise they are breaching their fiduciary obligations to the trust beneficiaries. The petitioner specifically argued that Connecticut’s Uniform Prudent Investor Act required him to seek professional investment advice (Conn. Gen. Stat. §§45a-541a to 45a-541l).
Supreme Court Opinion
On January 16, 2008, the Supreme Court ruled unanimously in favor of the Service that investment advisory fees incurred by a trust are subject to the 2% floor. The Supreme Court disagreed with the Second Circuit’s strict interpretation that “would not be incurred” means “could not be incurred.” However, this did not save the petitioner because the petitioner failed to demonstrate that an individual would not have sought out investment advice if the individual were acting prudently. In essence, the Supreme Court concluded that a prudent investor and a prudent trustee would each have sought out investment advice (for an investment fee). Therefore, these fees are not unique to a trust or an estate and fall outside the Sec. 67(e)(1) exception.
Implications of the Decision
What is troubling about this decision is that it ignores issues that are truly unique to fiduciaries. Unlike an individual, who chooses whether to be a prudent investor or not, a trustee is under an obligation to serve as a prudent investor on behalf of the beneficiaries. Failure to provide appropriate due diligence and review of the underlying trust assets can subject the trustee to litigation from the beneficiaries for a breach of fiduciary duty. Individual investors who are investing their funds for their own benefit do not have this “sword of Damocles” hanging over their own heads. For individual investors, the decision to use or not to use an investment adviser is completely up to them. If they decide to invest their personal funds for their own benefit, they do so at their own peril. Individuals are under no obligation to anyone regarding what they do with their own assets, while the trustee is accountable to the beneficiaries for the performance of the trust assets.
Income Tax Implications and Opportunities
The obvious consequence of the Knight decision is the reduction of underlying trust deductions due to the imposition of the 2% floor. The bigger issue may concern investment advisers themselves, particularly those who serve as trustees. It is now prudent to unbundle the trustee administration fees (which are still fully deductible) from the investment advisory fees (and this will be required if Prop. Regs. Sec. 1.67-4 is finalized). It may also be important to assess the current fee structure to ensure that investment advisory fees are specifically related to the investment advisory process so that the consequences of Knight are limited as much as possible.
Nick Gruidl, CPA, MBT, Managing Director, National Tax Department, RSM McGladrey, Inc., Minneapolis, MN
Unless otherwise indicated, contributors are members of RSM McGladrey, Inc.
If you would like additional information about these items, contact Mr. Gruidl at (952) 893-7018 or firstname.lastname@example.org.