The Supreme Court Answers Some Questions

The Supreme Court of the United States decides several tax-related cases each year. The past term is not yet over, but two cases of some general interest have been decided. This article discusses the first case that will be of special interest to Form 1041 return preparers.

In the first case, the Supreme Court had to determine how trust investment advisory fees would be treated for purposes of computing the income of a non-grantor trust or estate. At issue was whether such expenses were miscellaneous itemized deductions subject to the two-percent-of-AGI floor. The adjusted gross income of an estate or trust is determined in the same manner as an individual’s except that deductions for 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, are treated as allowable in arriving at adjusted gross income. The §212 deduction is taken below the line for individuals, but fiduciaries argued that the special investment duties imposed on a fiduciary were such that the costs would not have been incurred if the fiduciary’s property were held outside the trust. Taxpayers were successful in one case, but lost all others.

The Service issued proposed regulations that defined the exceptional expenses as those that were unique to the trust or estate. A cost was unique to an estate or a non-grantor trust if an individual could not have incurred that cost in connection with property not held in an estate or trust. Since individuals incur such investment advisory fees, the Service staked out a position that precluded such expenses from being anything other than miscellaneous itemized deductions.

What’s in a name? Unique to the trust or estate form are trustee or fiduciary fees. These fees are often stated in a single sum but are in fact for a multiple of different fiduciary functions, including investment advisory duties. The proposed regulations required fiduciaries to “unbundle” the fee to disclose the portion (if any) of the legal, accounting, investment advisory, appraisal or other fee, commission or expense that is unique to estates and trusts and is thus not subject to the two-percent floor; by process of elimination the portion not so identified is subject to the two-percent-of-AGI limitation. This put the burden on the fiduciary to determine which services were “unique.”

The courts adopted a different view. The Second Circuit, from which Knight v. Commissioner was appealed, had taken the position that because an individual could incur investment advisory fees, they could not have been incurred only in connection with the administration of the trust or estate. While rejecting the taxpayer’s contention that the trust caused the expenses by reason of the care the fiduciary must follow in connection with investments, the Supreme Court also rejected the Circuit’s (and Service’s) position that the deductibility above-the-line hinged on uniqueness. The question is not “could”, but “would” such expenses customarily be incurred by an individual outside the trust context.

It is difficult to say that investment advisory fees "would not have been incurred" -- that is, that it would be unusual or uncommon for such fees to have been incurred -- if the property were held by an individual investor with the same objectives as the Trust in handling his own affairs. While

not present in this case, the Supreme Court in dictum suggested that the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the two-percent floor.

This does not close the door on all investment advisory fees; some trust-related investment advisory fees may be fully deductible if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts. In addition, a trust may have an unusual investment objective, or may require a specialized balancing of the interests of 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 two-percent floor.

The Service expects to issue final regulations with the Supreme Court's holding in Knight rather than with the proposed regulations. The final regulations also will address the issue raised when a non-grantor trust or estate pays a bundled fiduciary fee for costs incurred in-house by the fiduciary, some of which are subject to the two-percent floor and some of which are fully deductible without regard to the two-percent floor.

In the next edition, the Supreme Court decides a discriminatory tax is nonetheless constitutional.

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