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Financial Planning > Trusts and Estates > Trust Planning

High Court Rules On Trust Costs

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The U.S. Supreme Court last week handed down a unanimous decision limiting the ability of trusts to deduct investment expenses.

The decision in the case, Knight, Trustee of William L. Rudkin Testamentary Trust vs. Commissioner of Internal Revenue, concerns Internal Revenue Code Section 67(e).

Under normal circumstances, the section lets individual taxpayers deduct investment advisory fees only if the advisory fees exceed 2% of adjusted gross income, Chief Justice John Roberts wrote in the opinion for the court.

The same 2% floor applies to trusts, except that trusts can deduct the full cost of expenses “which would not have been incurred if the property were not held in such trust or estate,” according to the text of Section 67(e).

Michael Knight, the trustee for the William L. Rudkin Testamentary Trust, which was established in Connecticut in 1967, tried in 2000 to deduct $22,241 in investment advisory firm fees from the trust’s income of $624,816 and cut the trust’s income tax bill by $4,448.

Knight says he hired the investment advisory firm because of a Connecticut law imposing a fiduciary duty on him to act as a “prudent investor” and seek outside advice.

The U.S. Tax Court held that Section 67(e) “allows full deductibility of trustee costs only for expenses that are not commonly incurred outside the trust setting,” Roberts wrote.

The tax court ruled that trust investment advisory fees are subject to the 2% floor for deductions because investment advisory fees are commonly incurred by individuals.

The 2nd U.S. Circuit Court of Appeals concluded when Knight appealed that the fees were subject to the 2% floor because investment advisory costs “could be incurred” if the property were held individually rather than in a trust, Roberts wrote.

The 6th Circuit has ruled that trust investment advisory fees are fully deductible, but the 4th Circuit and the Federal Circuit have ruled that the 2% floor does apply to deductions of trust investment advisory fees, Roberts wrote.

The Supreme Court says the 2nd Circuit was wrong to consider what kinds of fees an individual could incur. “Would” means something that probably will happen, not could happen, and, “if Congress had intended the Court of Appeals’ reading, it easily could have replaced ‘would’ in the statute with ‘could,’ ” Roberts wrote.

If the Rudkin trust’s investment advisors had imposed special fees that applied only to fiduciary accounts, the trust might have been able to deduct the difference between what an ordinary individual taxpayer would pay for the advice and what a trust would pay for comparable advice, Roberts wrote.

In the Knight case, “the trust has not asserted that its investment objective or its requisite balancing of competing interests was distinctive,” Roberts wrote.

Because the trust investment advisory services were not much different from investment advisory services aimed at individuals, the 2000 investment advisory fees are subject to the 2% floor, Roberts wrote.

Charles Winner, a trust and estates lawyer and senior partner at Fisher & Winner in Baltimore, voiced disappointment with the decision, as did a number of other trust practitioners in various blogs.

Winner said the Supreme Court ruling reflects a trend in court decisions that “does not bode well for fiduciaries involved in preparation of fiduciary tax returns.”

In this case, he said, “the recordkeeping that will be required by this decision is an unwarranted expense that will burden beneficiaries.

“There has always been a distinction between the way in which expenses were treated for trust purposes as compared to trust purposes, and it is sad that this distinction is not going to be maintained,” he said.

In other words, he said, the decision, “takes away another tool in a planner’s bag to provide the best services to the trust.”

Courts are taking a look at tax practices and perceiving them as “loopholes,” he said. “But they are not loopholes; they were put there legislatively and they are therefore for the benefit of taxpayers and if the taxpayers had not taken benefit of it, maybe because they were unaware, that doesn’t make it a loophole.”


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