April 2003

Will New York’s Prudent Investor Act Result in Full Deduction of Investment Advice?

By David Schaengold

The full deduction of fees incurred by a trust for investment advice has been the subject of a number of court cases. The issue concerns the application of the 2% rule to itemized deductions within the context of trust administration. Two recent cases have supported the IRS’ contention that a trust’s deduction for such fees should be limited by the 2% rule, whereas an older decision had supported the taxpayer’s claims for the full deduction of such fees.

Trusts vs. Individuals

The issue is whether a trust’s expenditures for investment advice are fully deductible from gross income under IRC section 67(e) or, as the IRS contends, are limited by the same 2% rule that limits an individual’s deduction for such expenditures under IRC section 67(a). Section 67(e) allows deductions to trusts in full if those deductions “would not have been incurred if the property were not held in trust.”

In 1992, the Tax Court agreed with the IRS and ruled that the fees incurred by the trustees of the William J. O’Neill, Jr., trust were not unique to property held in the trust. Accordingly, the court ruled that the fees would be subject to the 2% adjusted gross income floor for miscellaneous deductions.

O’Neill trustees appealed the Tax Court ruling to the Sixth Circuit Court of Appeals [William J. O’Neill, Jr., Irrevocable Trust v. Comm’r, 93-1 USTC para. 50,332, 994 F. 2d 302 (6th Cir. 1993)]. They argued that “Where a trustee lacks experience in investment matters, professional assistance may be warranted.” The trustees 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 for the continued growth of the trust and were caused by the fiduciary duties of the trustees.”

The Sixth Circuit Court of Appeals, agreeing with the O’Neill trustees, reversed the Tax Court decision. It ruled that the fees are fully deductible:
[A] trustee is charged with the responsibility to invest and manage trust assets as a “prudent investor” would manage his own assets. … [F]iduciaries uniquely occupy a position of trust for others and have an obligation to exercise proper skill and care with the assets of the trust.

In 1994, the IRS announced that it would not acquiesce to the Sixth Circuit Appeals Court and made it known that it would continue to litigate the matter.

Mellon Bank. In late 2001, the IRS was successful in the Federal Circuit, which upheld a lower court ruling denying a full deduction to Mellon Bank as trustee [Mellon Bank, N.A. v. United States, 2001-2 USTC para. 50,621, 265 F.3d 1275 (Fed. Cir. 2001)]. In this case, the IRS prevailed in arguing that investment advisory fees are not a “type” of cost that is unique to trust administration. They insisted that investment advisory fees are no different from the same type of cost incurred by individual taxpayers administering large sums of money.

In explaining its concurrence with the IRS, the Mellon Bank court held that such fees did not qualify for the 100% deduction under IRC section 67(e):
The second clause of section 67(e)(1) serves as a filter, allowing a full deduction only if such fees are costs that “would not have been incurred if the property were not held in such trust or estate.” The requirement focuses not on the relationship between the trust and costs, but the type of costs, and whether those costs would have been incurred even if the assets were not held in trust. Therefore the second requirement treats as fully deductible only those trust-related administrative expenses that are unique to the administration of a trust and not customarily incurred outside of trusts.

Investment advice and management fees are commonly incurred outside of trusts. An individual taxpayer, not bound by fiduciary duty, is likely to incur these expenses when managing a large sum of money. Therefore, those costs are not exempt under section 67(e)(1) and are required to meet the two percent floor of section 67(a).

Scott. In J.H. Scott v. United States (2002-1 USTC para. 50,364), the taxpayer lost the decision but the IRS’ position was not supported by the District Court of the Fourth Circuit. In this case, the taxpayer asked the court to reject the reasoning of Mellon Bank and follow the precedent of O’Neill.

But unlike in O’Neill, the Scott trustees could not convince the court that they were required to hire investment advisors in order to fulfill their fiduciary duty. According to the court, “here it is unnecessary to elect which precedent to follow.” The court referred to Virginia statutes that set forth a list of stocks, bonds, and securities in which a fiduciary may invest, and pointed out that a fiduciary who follows the list, according to Virginia law, “shall be presumed to have been prudent” and concluded that “unlike the situation in O’Neill, a trustee in Virginia is not required to consult a financial advisor to fulfill his statutory obligations.”

Although Virginia’s unique fiduciary investment statutes made it unnecessary for the Scott court to choose which precedent to follow, it appears that the court may have been willing to follow O’Neill. The court discussed the distinction in O’Neill between engaging investment advisors out of a requirement to do so rather than a “need” to increase profitability:

[A] trustee may choose to invest in assets not listed in the statutes…. The assets of the estate may suffer substantial depreciation if he does so, but the situation is no different than what would exist if a private individual invested in identical assets. In both cases, the parties would be better served by consulting with a financial advisor, but unlike the situation in O’Neill, nothing in the law requires either to do so. If a trustee elects to hire a financial consultant to assist in financial planning for the trust, he is doing nothing different than what an individual investor might do. A trust’s “need” to incur the costs of a financial advisor is no different than the “need” of an individual. Both “needs” spring from the same desire, i.e. to increase profitability. Here, the Plaintiffs have established that the trust incurred costs for investment advice in order to preserve principal and income. Accordingly, it was entitled to a deduction under 26 U.S.C. para. 67(a). What they have not shown is that those same expenses would not have been incurred but for the fact that property was held in trust.

New York State

To date, there have been no cases in New York’s Second Circuit. Moreover, the recent cases were litigated under situations governed by the “prudent man rule,” whereas most states' trust laws have by now adopted the Prudent Investor Act.

The Prudent Investor Act (New York EPTL 11-2.3) governs the behavior of New York trustees. In effect, it requires fiduciaries to develop an overall investment strategy that will enable the fiduciary to make appropriate present and future distributions to beneficiaries in accordance with risk and return objectives suitable for a portfolio viewed in its entirety. The prudent man rule, however, focuses primarily on prudence in the selection of individual investments.

With regard to the deductibility of trust expenses, the question now is whether the new standards of behavior imposed on trustees by the Prudent Investor Act are tantamount to requiring investment advice. If so, then are the costs of such advice necessary and unique to property held in trust? It is likely that this will be the subject of the next Tax Court proceeding.

David Schaengold, CPA, practices in New York City and specializes in estate and trust matters. He served as the AICPA observer to the drafting committee to revise the Uniform Principal and Income Act and is a member of the NYSSCPA Income of Estates and Trusts Committee.

Mitchell A. Drossman, JD, CPA
U.S. Trust Company of New York

Robert L. Ecker, JD, CPA
Ecker Loehr Ecker & Ecker LLP

Contributing Editors:
Peter Brizard, CPA

Jeffrey S. Gold, CPA
J.H. Cohn LLP

Ellen G. Gordon, CPA
Margolin Winer & Evens LLP

Jerome Landau, CPA

Harriet B. Salupsky, CPA

Debra M. Simon, MST, CPA

Richard H. Sonet, JD, CPA
Marks Paneth & Shron LLP

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