September 2003

Investment Advice Fees of Estates and Trusts Subject to 2% Floor

By Peter C. Barton and Clayton R. Sager

In Scott v. U.S. [2003 U.S. App. LEXIS 8293, aff’g. 186 F.Supp.2d 664 (2002)], the Fourth Circuit ruled that investment advice fees paid by a trust or estate are a miscellaneous itemized deduction subject to the 2% of adjusted gross income (AGI) floor under IRC section 67(a). There is a split among the Court of Appeals circuits on this issue, making a Supreme Court appeal likely.

IRC section 67(a) allows individuals to deduct miscellaneous itemized deductions only to the extent that their total exceeds 2% of AGI. IRC section 212 investment advice fees are included under this 2% rule. IRC section 67(a) applies to estates and trusts under IRC section 67(e)(1), which states that the AGI of estates and trusts is computed in the same manner as the AGI of individuals, except for estate and trust administration expenses “which would not have been incurred if the property were not held in such trust or estate.” The expenses qualifying for this exception are deductible in full by the estate or trust in computing AGI. No regulations have been issued to clarify the scope of IRC section 67(e)(1).

Sixth Circuit: O’Neill Trust

In O’Neill Trust v. Comm’r [98 TC 227 (1992), rev’d. 994 F.2d 302 (6th Cir. 1993)], the trust argued that trustees must seek investment advice to satisfy the prudent person standard of care requirement imposed on trustees and other fiduciaries by the applicable Ohio statutes. Therefore, the trust must incur investment advice fees that would not be incurred if the assets were not in trust, thereby satisfying IRC section 67(e)(1). In its only case on this issue, the Tax Court rejected this argument by ruling that only costs “unique to the administration of an estate or trust” are deductible under IRC section 67(e)(1). Fees for investment advice do not qualify, because individual investors routinely incur them. Therefore, they are subject to the 2% floor.

The Tax Court also noted that the trust did not prove a trustee must incur investment advice fees under Ohio law. In fact, the Ohio statutes provide a list of preapproved investments not requiring investment advice. In addition, the Tax Court ruled that the trustee’s unwillingness to serve without outside investment advice is irrelevant. Finally, the court did not address the trust’s argument that it could have paid larger trustee fees, which are fully deductible under IRC section 67(e)(1), and the trustees could pay the investment advisors directly.

The Sixth Circuit reversed the Tax Court decision, ruling that because trustees are required as fiduciaries to invest and manage trust assets as a “prudent investor,” trustees that lack investment experience are required to incur investment advice fees to avoid liability. These fees satisfy IRC section 67(e)(1) because they are directed toward the prudent investor standard, which is unique to fiduciaries and not required of individual investors. Also, the Sixth Circuit pointed out that following the Ohio statutes’ investment list does not necessarily satisfy the prudent investor standard because the list does not provide guidance on diversifying investments, which is part of the prudent investor standard under Ohio case law.

Federal Circuit: Mellon Bank

In Mellon Bank v. U.S. [265 F.3d 1275 (Fed. Cir. 2001), aff’g. 47 Fed. Cl. 186 (2000)], Mellon Bank argued that expenses for all trustee services, whether performed by the trustees or others, are subject to fiduciary standards under state law and therefore should be fully deductible under IRC section 67(e)(1). Agreeing with the Sixth Circuit that special legal obligations apply to assets held in a trust, the Federal Circuit nevertheless ruled that it was not bound by state fiduciary law in interpreting federal income tax law.

The Federal Circuit then interpreted IRC section 67(e)(1) to require fully deductible trust expenses to be “unique to the administration of a trust and not customarily incurred outside of trusts.” Because investment advice fees are commonly incurred outside of trusts, the court ruled that they are subject to the 2% floor. In addition, the Federal Circuit noted that the Mellon Bank’s argument that all trust expenses should be fully deductible ignores the IRC section 67(e)(1) full deductibility requirement that the expense would not have been incurred if there had been no trust.

Fourth Circuit: Scott

In Scott v. U.S., the Bryan Trust, with assets of $25 million, deducted in full investment advice fees exceeding $100,000 per year in 1996–97. The trust also paid custodian fees, trustees’ fees, fees for the preparation of income tax returns, and fees for accountings. The trust authorized the trustees to hire investment advisors and to choose investments that exceeded inflation rates, without regard to losses or current income. The trustees refused to serve without investment advisors. The IRS determined that the investment advice fees were miscellaneous itemized deductions subject to the 2% floor. The Federal District Court ruled that Virginia statutes, unlike the Ohio statutes, do not require fiduciaries to hire investment advisors. Therefore, the 2% floor applies because an estate or trust is treated the same as an individual investor.

The Fourth Circuit affirmed without considering state law. The court ruled that IRC section 67(e)(1) clearly and unambiguously states that “trust-related administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by individual taxpayers.” Because investment advice fees are commonly incurred by individual taxpayers, the Fourth Circuit ruled they are subject to the 2% floor. The court also ruled that the following are fully deductible under IRC section 67(e)(1) because they are not commonly incurred by individual taxpayers who manage income-producing property: trustees’ fees, expenses for judicial accountings, and fees for preparing fiduciary income tax returns.

In denying the full deduction for investment advice fees, the Fourth Circuit and the Federal Circuit simply interpreted IRC section 67(e)(1) without analyzing the
different legal status of fiduciary and individual investors as it affects their need for investment advice. The Sixth Circuit, however, applying state fiduciary law, found significant differences between fiduciary and individual investors. Which approach to IRC section 67(e)(1) is correct is difficult to determine, since they represent different perspectives. The full deduction for investment advice fees is currently allowed only in the Sixth Circuit states of Ohio, Michigan, Kentucky, and Tennessee. Undoubtedly there will be appeals to other circuits on this issue.

If instead of hiring outside investment advisors, the trustees’ fees included in-house investment advice, it is unclear if the Fourth Circuit and the Federal Circuit would allow a deduction for the full amount of the trustees’ fees or require that the portion of the trustees’ fees relating to investment advice be subject to the 2% floor.

Peter C. Barton, JD, CPA, is a professor of accounting, and Clayton R. Sager, PhD, an associate professor of accounting, both at the University of Wisconsin-Whitewater.

Edwin B. Morris, CPA
Rosenberg Neuwirth & Kuchner

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