Second Circuit Rules on Deductibility of Investment Advisor Fees Incurred by Trusts

By David S. Kulakoff

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The 2% Floor

The U.S. Tax Court decision in Rudkin allowed as a deduction only that portion of investment advice fees that exceeded 2% of the trust’s adjusted gross income (AGI), and the trust appealed. Because the parties to the case were able to stipulate to the facts, the Second Circuit’s task was to interpret the statute, namely IRC section 67(e). The Code states that “costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such estate or trust” are allowable in arriving at adjusted gross income.

The taxpayer in Rudkin argued that the Second Circuit should follow the Sixth Circuit, which held that investment advisor fees paid by a trust are incurred because the property is held in trust and, therefore, such costs should be fully deductible under IRC section 67(e). The Sixth Circuit reasoned that, because a trustee has a fiduciary duty to manage trust assets as a prudent investor (and can be personally surcharged or held liable for failure to do so), investment advisory fees are necessary expenses incurred in the proper administration of a trust, and thus should be fully deductible. Although the Sixth Circuit acknowledged that individuals often incur fees for investment advice, individuals are not required to consult advisors and suffer no penalty or liability for failure to consult an investment advisor. (Obviously, individuals are free to invest their own money as they see fit, and, unlike a trustee, individual investors have only themselves to answer to.)

The Second Circuit rejected this reasoning, and held that the statute requires an “objective determination of whether the particular cost is one that is unique to trusts and one that individuals are incapable of incurring.” Because individuals commonly pay fees to investment advisors, the Second Circuit ruled, such fees are not unique to trusts and are therefore not fully deductible but rather subject to the 2% floor. The court noted that only costs that individuals are incapable of incurring, such as trustee fees and commissions, expenses associated with judicial accountings, and the costs of preparing fiduciary income tax returns, would be fully deductible for a trust.

To the Supreme Court

The U.S. Supreme Court granted the trust’s petition for certiorari on June 25, 2007, meaning it will hear the appeal of the case. Presumably, the Court will use Rudkin to resolve the conflicting circuit court decisions. The full text of Rudkin, posted by the court on October 18, 2006, can be found at www.ca2.uscourts.gov.

©2009 The New York State Society of CPAs. Legal Notices