Estates and Trusts: 2 Percent Floor
Doug H. Moy
February 18, 2008 — 1,523 views
Recently, the U.S. Supreme Court unanimously held that “[i]nvestment advisory fees generally are subject to the 2% floor when incurred by a trust” [Michael J. Knight, Trustee of the William L. Rudkin Testamentary Trust v. Comm’r, 552 U.S. _____ (2008), aff’g 467 F.3d 149 (2d Cir. 2006)]. So ends the judicial debate among the circuit courts of appeal on the subject [before Knight, the Courts of Appeals were divided on the issue. The Sixth Circuit has held that investment advisory fees are fully deductible [O’Neill v. Comm’r, 994 F. 2d 302, 304 (1993)]. In contrast, both the Fourth and Federal Circuits have held that such fees are subject to the 2 percent floor, because they are “commonly” or “customarily” incurred outside of trusts [See Scott v. United States, 328 F. 3d 132, 140 (4th Cir. 2003); Mellon Bank, N. A. v. United States, 265 F. 3d 1275, 1281 (Fed. Cir. 2001)]. The Second Court of Appeals came to the same conclusion but allowed “full deduction only for those costs that could not have been incurred by an individual property owner” (467 F. 3d 149 at 156) (emphasis supplied).
Under the Internal Revenue Code (“IRC;” “Code”), individuals may subtract from their taxable income certain itemized deductions but only to the extent the deductions exceed 2 percent of adjusted gross income. A trust may also claim those deductions, also subject to the 2 percent floor, except that costs incurred in the administration of the trust, which would not have been incurred if the trust property were not held by a trust, may be deducted without regard to the floor. In the case of individuals, investment advisory fees are subject to the 2 percent floor; the question presented in Knight was whether such fees are also subject to the floor when incurred by a trust. The Court held that they are and affirmed the judgment of the Court of Appeals, albeit, for different reasons than those given by the Court of Appeals.
The Code imposes a tax on the “taxable income” of both individuals and trusts [IRC§1(a)]. The Code instructs that the calculation of taxable income begins with a determination of “gross income,”capaciously defined as “all income from whatever source derived” [IRC §61(a)]. “Adjusted gross income” is then calculated by subtracting from gross income certain “above-the line” deductions, such as trade and business expenses and losses from the sale or exchange of property [IRC §62(a)]. Finally, taxable income is calculated by subtracting from adjusted gross income “itemized deductions,” also known as “below-the-line” deductions, defined as all allowable deductions other than the “above-the-line” deductions identified in IRC Section 62(a) and the deduction for personal exemptions allowed under IRC Sections151 and 63(d).
Before the passage of the Tax Reform Act of 1986 [Pub. L. No. 99-514, 99th Cong., 2d Sess. (22 October 1986), 1986-3 C.B. 1)], below-the-line deductions were deductible in full. This system resulted in significant complexity and potential for abuse, requiring “extensive [taxpayer] record-keeping with regard to what commonly are small expenditures,” as well as “significant administrative and enforcement problems for the Internal Revenue Service” [H. R. Rep. No.99–426, at 109 (1985)]. In response, Congress enacted what is known as the “2 percent floor” by adding Section 67 to the Code. Section 67(a) provides that “the miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.” The term “miscellaneous itemized deductions” is defined to include all itemized deductions other than certain ones specified in IRC Section 67(b). Investment advisory fees are deductible pursuant to IRC Section 212. Because IRC Section 212 is not listed in IRC Section 67(b) as one of the categories of expenses which may be deducted in full, such fees are “miscellaneous itemized deductions” subject to the 2 percent floor [Treas. Reg. §1.67–1T(a)(1)(ii) (Mar. 28, 1988)].
Code Section 67(e) makes the 2 percent floor generally applicable not only to individuals but also to estates and trusts, with one exception that is relevant to Knight. Under this exception, “the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual, except that . . . the 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 . . . shall be treated as allowable” and not subject to the 2 percent floor [IRC §67(e)(1)]. [Emphasis added]
In William L. Rudkin Testamentary Trust, U/W/O Henry A. Rudkin, Michael J. Knight, Trustee v. Commissioner [124 T. C. 304, 309–311 (2005)], the Court of Appeals concluded that, in determining whether costs such as investment advisory fees are fully deductible or subject to the 2 percent floor, IRC Section 67(e) “directs the inquiry toward the counterfactual condition of assets held individually instead of in trust” and requires “an objective determination of whether the particular cost is one that is peculiar to trusts and one that individuals are incapable of incurring” [467 F. 3d 149, 155, 156 (2d Cir. 2006), aff’g 124 T.C. 304 (2005)]. The court held that, because investment advisory fees were “costs of a type that could be incurred if the property were held individually rather than in trust,” deduction of such fees by the Trust was subject to the 2 percent floor [Id., at 155–156]. [Emphasis added] In Knight, the reasoning of the Supreme Court focused on what the trustee would do, as opposed to what the trustee could do. In the final analysis, the Supreme Court agreed with the Solicitor General’s position that 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.” However, the court acknowledged that nothing in the record suggested that the Trustee was charged anything extra by the investment advisor or treated the trust any differently than it would have treated an individual with similar objectives because of the trustee’s fiduciary obligations. Further, the court acknowledged that “[i]t 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 2% floor. Here, however, the Trust has not asserted that its investment objective or its requisite balancing of competing interests was distinctive. Accordingly, we conclude that the investment advisory fees incurred by the Trust are subject to the 2% floor.”
Thus, the 2 percent floor for estate or trust itemized deductions applies, notwithstanding that the personal representative or trustee, who may be held to the Uniform Prudent Investors Act, may believe that the 2 percent floor does not apply to estates and trusts. Accordingly, only “...the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor.” [Emphasis added]
Copyright © 2008 by Doug H. Moy. All rights reserved
Doug H. Moy
Doug H. Moy is a nationally recognized author, consulting specialist, seminar instructor and educator. He has an undergraduate degree from Willamette University and a Masters degree from Washington State University. Since 1979, Mr. Moy has consulted to attorneys, tax practitioners and their clients, as well as assisted practitioners representing clients before the IRS Conference of Right and Appeals Division and Settlement Conference Negotiations. He is noted for his ability to communicate his unparalleled knowledge and experience to practitioners at all levels in his field of expertise; namely, estate/gift taxation and planning, with special expertise in living trusts; community property; lottery prize winnings; structured settlement trusts; extricating clients from abusive trust tax shelters; designing effective estate plans; and preparation of Form 706 Estate Tax Returns and 709 Gift Tax Returns. He offers particular assistance and exceptional skill designing creative, practical solutions to challenging and difficult estate planning situations.