Supreme Court Holds Investment Advisory Fees Are Subject to 2% Floor

Under Sec. 67(a), miscellaneous itemized deductions are allowed only to the extent that they exceed 2% of a taxpayer’s adjusted gross income (AGI). The AGI of an estate or trust is computed in the same manner as for an individual for these purposes, except that, under Sec. 67(e)(1), administrative costs that “would not” have been incurred if the property were not held in an estate or trust are allowed in full as deductions in arriving at AGI (i.e., they are not subject to the 2% floor).

Courts have split over what trust administrative costs fall under this exception. For example, the Sixth Circuit has held that investment advisory fees are not subject to the 2% floor and are fully deductible (O’Neill, 994 F2d 302 (6th Cir. 1993)). In contrast, the Second, Fourth, and Federal Circuits have all held that investment advisory fees are subject to the 2% floor (Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006), aff’d sub nom. Knight, S. Ct. Dkt. 06-1286 (U.S. 1/16/08); Scott, 328 F3d 132 (4th Cir. 2003); Mellon Bank, N.A.,265 F3d 1275 (Fed. Cir. 2001)).

In October 2006, in Rudkin, the Second Circuit held that “would not” means “could not” in Sec. 67(e). The court held that Sec. 67(e) grants an estate or trust an exception from the 2% floor for itemized deductions only for “costs of a type” that “individuals are incapable of incurring.”

By contrast, the Fourth and Federal Circuits, while still subjecting trust investment advisory fees to the 2% floor, held that trust administrative costs of a type that would not “commonly” or “customarily” be incurred by individuals are not subject to the 2% floor.

The Supreme Court granted certiorari in the Rudkin case in June 2007 and has now issued a decision (Knight, S. Ct. Dkt. 06-1286 (U.S. 1/16/08)). The Court held that investment advisory fees are generally subject to the 2% floor (overruling O’Neill) but refused to go as far as the Second Circuit in saying that the exclusivity test requires that the fees could not have been incurred by an individual. Chief Justice Roberts, writing for a unanimous Court, said, “[t]his approach flies in the face of the statutory language.” The Court also noted that such an interpretation would make redundant the language “paid or incurred in connection with the administration of the . . . trust” in Sec. 67(e)(1).

Instead, the Court emphasized that Sec. 67(e)(1) says “would not,” which, according to the Court, “is best read to express concepts such as custom, habit, natural disposition, or probability.” The Court agreed with the test adopted by the Fourth and Federal Circuits that trust administrative costs not subject to the 2% floor are those that would not “commonly” or “customarily” be incurred by individuals.

The Court specified that this test “turns on a prediction of what would happen if . . . the property were held by an individual rather than by a trust.” The Court did not spell out how to make this prediction, but acknowledged it “may not be . . . easy.”

The Court noted that there might be investment advisory fees that would be fully deductible “if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts” or that a trust might have an unusual investment objective or require special balancing of the beneficiaries’ interests, in which case the incremental advisory fee, beyond what would have been charged to an individual, might be fully deductible. However, in the case before it, the Court found no such special circumstances and held that the trust’s investment advisory fees were subject to the 2% floor.