ElderLaw News

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TRUSTS AND TAXES

On January 16, 2008, the U.S. Supreme Court settled a long-running conflict among federal appeals courts regarding fiduciary income taxes for trusts.

In Knight v. Commissioner, (No. 06-1286), the Court ruled in a unanimous opinion that investment advisory fees paid by a trust cannot be deducted in full for income tax purposes. The Court held that the deductibility of such fees is limited by the 2% floor on miscellaneous itemized deductions.

The Knight case is also known as "Rudkin" because it involves a trust established under the will of Henry A. Rudkin, who, with his wife, founded the Pepperidge Farm Company. In 2000, the trustee, Henry Knight, hired an outside firm to advise him on investing the trust's assets. The trust had approximately $2.9 million in marketable securities, and it paid $22,241 in investment advisory fees. The trust deducted all of the fees, but the IRS said that the fees had to be limited by the 2% floor. The IRS allowed the trust to deduct the investment advisory fees only to the extent that they exceeded 2% of the trust’s adjusted gross income. The result was that the IRS said the trust owed an additional $4,448 in taxes. The trust said that the trustee had a fiduciary duty to act as a "prudent investor" under Connecticut law and therefore was required to hire an investment professional and pay investment advisory fees. The trust said that the fees should be fully deductible because they were unique to trusts.

The Court first reviewed the language of the statute governing deductions from gross income, 26 U.S.C. 67(e). The general rule of the statute is that "[T]he adjusted gross income of [a] ... trust shall be computed in the same manner as in the case of an individual." This means that trusts can deduct costs subject to the same 2% floor that applies to individual taxpayers. The statute provides an exception to the 2% floor when two conditions are met. First, the cost must be "paid or incurred in connection with the administration of the ... trust." Second, the cost must be one "which would not have been incurred if the property were not held in such trust." The Court said that "[t]he statute does not ask whether a cost was incurred because the property is held by a trust; it asks whether a particular cost 'would not have been incurred if the property were not held in such trust.'" The Court quoted the IRS Commissioner’s brief: "Far from examining the nature of the cost at issue from the perspective of whether it was caused by the trustee's duties, the statute instead looks to the counterfactual question of whether individuals would have incurred such costs in the absence of a trust." The Court agreed with this view and the view of the Fourth and Federal Circuits that "[c]osts that escape the 2% floor are those that would not ‘commonly’ or ‘customarily’ be incurred by individuals." The Court said that "whether a trust-related expense is fully deductible turns on a prediction about what would happen is a fact were changed – specifically, if a property were held by an individual rather than by a trust."

Applying this reading of the statute to the case at issue, the Court said that it is not uncommon for individuals to hire an investment adviser, and that the "prudent investor" standard does not only apply to trustees. The standard "looks to what a prudent investor with the same investment objectives handling the investor's own affairs would do, i.e., a prudent individual investor." The Court said that it would be difficult to say that it would be uncommon or unusual for investment advisory fees to be incurred if the same property were held by an individual investor. The Court did say that it was conceivable "that a trust may have an unusual investment objective, or may require a specialized rebalancing of the interests of the various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor." The trustee in the case before the Court did not make such an assertion, and, therefore, the Court held that the investment advisory fees were subject to the 2% floor.

This decision is particularly significant for large trusts that routinely spend substantial amounts on investment advisory fees. Many trusts, and beneficiaries will be paying higher taxes.

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