LeAnn Luna

Investment Advisory Fees for Trusts Now Subject to Two Percent Floor

Why CPAs may need to break out bundled trust fees.

March 24, 2008
by LeAnn Luna

In general, both trusts and individuals are permitted to deduct miscellaneous itemized deductions — such as investment advisory fees — to the extent that such deductions exceed two percent of adjusted gross income (AGI) However, Section 67(e)(1) provides an exception to this general rule. Under this exception, expenses that "would not have been incurred if the property were not held in such trust" are deductible without regard to the two percent floor.

Courts have been conflicted about the treatment of investment advisory fees for trusts. The Sixth Circuit held that investment advisory fees are fully deductible; however, the Fourth and Federal Circuits held that such fees are subject to the two percent floor. The dispute centers on whether investment advisory fees are of a type that are incurred primarily because the investments are held in trust. If the trust imposes unique requirements, expenses incurred to fulfill those unique requirements are not subject to the two percent floor. If the fees are normal inside or outside the trust setting, such expenses would be subject to the two percent floor as long as they are of a type normally deductible by individuals.

In Knight v. Commissioner, 467 F. 3d 149 (2008), the trustee (Knight) argued that because meeting his legal obligations as trustee required that he hire an investment advisor to oversee the trust's investments, the expenses were not subject to the two percent floor. The Tax Court ruled against the taxpayer arguing that individuals often hire independent investment advisors and that the fees incurred by the trustee were not of a different character than those incurred by individuals faced with managing investments with similar goals. The U.S. Court of Appeals for the Second Circuit went further, arguing that 67(e) provides an exception only for expenses "that individuals are incapable of incurring." In other words, the Second Circuit argued the test is whether the expense "could" have been incurred by an individual. If so, the expenses are subject to the normal two percent floor.

The Supreme Court Ruling

The Supreme Court in Knight resolved the conflict between the lower courts by rejecting the Second Circuit's "could" standard in favor of the reasoning adopted by the Tax Court and Fourth Circuit, which held that the question hinged on whether the fees "would not" have been incurred if the property was held by an individual instead of a trust. According to the Supreme Court's opinion, "§67(e)(1) excepts from the two percent floor, only those costs that it would deem uncommon (or unusual or unlikely) for such a hypothetical individual to incur." In the case of investment advisory fees, the Court reasoned that any "prudent individual investor" tasked with managing his or her own investment account would in fact hire a capable advisor if he or she was unable or unwilling to effectively oversee those investments. In other words, the trustee was acting exactly as an individual normally would under similar circumstances. Accordingly, the fees are deductible subject to the two percent floor.

What Does the Ruling Mean for CPAs?

The Supreme Court ruling makes it clear that investment advisory fees are normally subject to the two percent floor. However, the Supreme Court did not hold that all investment advisory fees are subject to the two percent floor but only those expenses incurred because such investments were held in trust would be exempt. Per the ruling:

It is conceivable, moreover, that 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.

What Does This Mean for Tax Preparers?

The bottom line for tax return preparers is that the taxpayer has the burden of proving that trustee fees are deductible without regard to the two percent floor. However, several common situations arise in which a portion of a trustee's fees would be deductible. For example, institutional trustees, such as banks, often charge an overall fee for managing the investments, dealing with trust beneficiaries, and making required distributions. In such cases, taxpayers should ask for the fees to be broken out between ordinary investment advisory fees and those fees that only are incurred because the property is held in trust. In this example, the incremental fees relating only to trust administration would be deductible without regard to the two percent floor. Taxpayers might consider comparing fees charged to individuals versus fees charged to trusts to determine the amount of the "incremental" fees related to trust administration.

More importantly, the ruling gives taxpayers a clear standard going forward to evaluate investment advisory fees and other deductions subject to the two percent floor for individuals. If the expense is one that would not normally be incurred by an individual in similar circumstances, the standard suggests that they would be deductible without regard to the floor. By rejecting the inflexible "could not have been incurred by an individual" standard of the Second Circuit in favor of a "would not normally" standard, the Supreme Court leaves planning options open for taxpayers.

In Summary

Trusts that relied on the Sixth Circuit's ruling have a changed environment. For future returns, investment advisory fees that were deducted in full will now normally be subject to the two percent floor. The IRS has not issued guidance for past returns which were filed under the Sixth Circuit ruling. Taxpayers should consult legal counsel regarding whether an amended return is necessary.

Rate this article 5 (excellent) to 1 (poor).
Send your responses here.

LeAnn Luna is an assistant professor and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.