ESTATES AND TRUSTS

January 2000

IRS WANTS TO RELITIGATE TWO PERCENT DEDUCTION ISSUE

By David Schaengold, CPA, David Tarlow & Co.

An IRS auditor has advised members of the New York State Society of CPAs Income of Estates and Trusts Committee that the IRS is trying to bring about another court proceeding involving trust administration expenses. In 1993, a Tax Court decision favoring the IRS was overruled by the Sixth Circuit Appeals Court in William J. O'Neill, Jr., Irrevocable Trust v. Comm'r [994 F. 2d 302 (1993)]. The following year, the IRS announced that it would not acquiesce to the appeals court decision. However, no litigation has followed.

The issue is whether an irrevocable trust's expenditures for investment advice are fully deductible from gross income under IRC section 67(e) or are limited by the same two percent rule that limits an individual's deductions under IRC section 67(a). Generally, IRC section 67(a) provides that "miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds two percent of adjusted gross income." Under IRC section 67(e), however, if such costs "would not have been incurred if the property were not held in such trust," administrative costs are deductible in full.

In 1992, the Tax Court upheld the IRS position that the investment advisory fees incurred by the trustees of the William J. O'Neill, Jr., trust were not unique to property held in trust. Accordingly, they would be subject to the two percent adjusted gross income floor for miscellaneous deductions.

However, the O'Neill trustees appealed to the Sixth Circuit. The trustees argued that a trustee must "meet the prudent investor standard," which imposes on the trustee a duty to diversify in order to "distribute the risk of loss within the trust.... Where a trustee lacks experience in investment matters, professional assistance may be warranted." They pointed out that because they lacked experience in investing and managing large sums of money, they hired an investment advisor. Without such assistance, they would have placed the assets of the trust at risk. They asked the court to find that "the investment advisory fees were necessary to the continued growth of the trust and were caused by the fiduciary duties of the trustees."

The Sixth Circuit agreed with the O'Neill trustees and reversed the Tax Court decision. In its opinion, the appeals court reasoned that the fees are fully deductible because "fiduciaries uniquely occupy a position of trust for others and have an obligation to exercise proper skill and care with the assets of the trust."

The IRS auditor stated that he recently began sorting out trust returns and searching for those in which the two percent limitation would be an issue. He has the national office's support to move the issue to litigation in the New York District, which is in the Second Circuit. *