Alert January 29, 2008

U.S. Supreme Court Upholds 2% Floor for Deduction of Investment Advisory Fees by Trusts

The U.S. Supreme Court (the “Court” or the “Supreme Court”) held that expenses incurred by trusts for investment advisory services are generally subject to the 2% floor for miscellaneous itemized deductions under Section 67(e) of the Internal Revenue Code (the “Code”).  The ruling, in a case that has been closely watched by professional fiduciaries and investment advisers, is an important victory for the IRS.  However, the Court did not adopt the approach to determining whether particular expenses are subject to the 2% floor put forward by the IRS in controversial proposed regulations issued in July 2007.  The fiduciary and investment adviser community expects that the IRS will issue new proposed regulations incorporating the Court’s approach.  A number of experts have also predicted that, although the Court’s ruling appears to resolve the issue, the result of the ruling may in fact be increased litigation, as fiduciaries attempt to apply the Court’s analysis on a case-by-case basis.

Section 67(e) of the Code extends the 2% floor on miscellaneous deductions applicable to individuals to estates and non-grantor trusts, but makes an exception for the deduction of administration expenses “which would not have been incurred if the property were not held” in an estate or trust.  Whether or not this exception applies to investment advisory fees incurred by a trust or estate has been disputed in a number of cases, and the U.S. Courts of Appeals were divided on the issue.  The U.S. Court of Appeals for the Sixth Circuit, in O’Neill v. Commissioner, 994 F.2d 302 (6th Cir. 1993), held that the exception does apply, allowing trustees to fully deduct investment advisory fees in computing a trust’s adjusted gross income.  Both the Fourth and the Federal Circuits, however, have held that such fees are subject to the 2% floor because individuals commonly incur similar expenses in relation to property held outside a trust. 

The Supreme Court’s ruling, which resolved the split among the circuit courts, resulted from Rudkin Testamentary Trust v. Commissioner, 467 F.3d 149 (2d Cir. 2006) (“Rudkin”), a case decided by the U.S. Court of Appeals for the Second Circuit.  The trustee in Rudkin argued that his fiduciary duty under the state-law prudent investor standard required him to consult an investment adviser and that the adviser’s fees were therefore caused by the fact that the property was held in a trust.  The Second Circuit disagreed, interpreting Section 67(e) as allowing a full deduction only for trust expenses that could not (rather than would not, as Section 67(e) itself reads) have been incurred by individuals. 

The trustee in Rudkin petitioned the Supreme Court to review the Second Circuit’s decision and resolve the circuit split.  In a unanimous opinion delivered by Chief Justice John Roberts, the Court rejected both the trustee’s argument, noting that the prudent investor standard refers to a prudent individual investor, as well as the Second Circuit’s approach, which it found inconsistent with the language of Section 67(e).  Instead, the Court adopted the approach taken by the Federal and Fourth Circuits in Mellon Bank, N.A., v. United States, 265 F.3d 1275 (Fed. Cir. 2001), and Scott v. United States, 328 F.3d 132 (4th Cir. 2003), which held that only expenses that are either not commonly or customarily incurred by individuals or unique to the administration of trusts are fully deductible and not subject to the 2% floor.  “Since investment advice fees,” Chief Justice Roberts wrote, “are not unique to the administration of a trust and are customarily also incurred by individuals, such costs incurred by a trust are deductible only in excess of the two-percent floor.”

Chief Justice Roberts’s opinion leaves a variety of open questions that fiduciaries and investment advisers will have to grapple with as they determine which costs of administering estates and non-grantor trusts are subject to the 2% floor.  Most notably, the approach taken by the IRS in its proposed regulations (which were issued after the Supreme Court had agreed to hear the case, to the puzzlement of commentators) was based on the Second Circuit’s more exacting approach and is expected to be withdrawn and replaced in a new set of proposed regulations.  In addition, the Supreme Court, suggesting that its approach is more flexible than the Second Circuit’s, indicated that the investment advisory fees incurred by a trustee might be fully deductible if an adviser imposes “a special, additional charge” only on fiduciary accounts or if a trust has an unusual investment objective or requires special balancing of the interests of various parties, “such that a reasonable comparison with individual investors would be improper.”  The Court did not address whether or how fiduciaries who provide investment as well as administrative services should unbundle investment and other fees, as required in the current set of proposed regulations.