A unanimous U.S. Supreme Court on Jan. 16, 2008, ruled that trust investment advisory fees (IAFs) are subject to the 2 percent floor, handing a defeat to banks and taxpayers who'd hoped all IAFs would be found to be fully deductible.
In Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner, 128 S. Ct. 782 (2008) — which is known both as the Knight case and the Rudkin case — the question was whether IAFs incurred by a trust in managing its investments are subject to Internal Revenue Code Section 67(e)'s 2 percent floor. That section allows a trust to deduct certain expenses from taxable income — but only to the extent the deductions exceed 2 percent of adjusted gross income.
Section 67(e)(1) provides that such expenses may be deducted in full and are not subject to the 2 percent floor if the expenses are paid or incurred in connection with trust administration and would not have been incurred if the property were not held in trust.
The Tax Court held that the trust's IAFs were subject to the 2 percent floor, affirming a ruling by the U.S. Court of Appeals for the Second Circuit (467 F.3d 149 (2006)).
The decision was widely seen as problematic for banks and trusts, that would then have to separate out IAFs from other fees charged to clients. But the decision did have a few bright spots for them. The high court did say that some trust IAFs could be fully deductible. For example, if an investment advisor were to impose special, additional charges applicable only to its fiduciary accounts.
The Second Circuit had held that fees and expenses that could be incurred if the property were held individually and not in trust were subject to the 2 percent floor. But the high court held that the expenses were subject to the 2 percent floor because they would have been incurred if the property were not held in trust. This test follows the phrasing in the relevant statute (“would” instead of “could”), and is arguably more lenient to taxpayers than a “could” test.
The court explained that “would” requires a prediction of what would happen if the property were held individually and not in trust — whether it would be uncommon or unusual for such expenses to be incurred if not held in trust.
The Internal Revenue Service responded with Notice 2008-32. This interim guidance specifically addresses the treatment of IAFs and other costs subject to the 2 percent floor that are bundled as part of one commission or fee paid to the trustee or executor (bundled fiduciary fees). Under the guidance, for any taxable year beginning before Jan. 1, 2008, taxpayers may deduct the full amount of the bundled fiduciary fees without regard to the 2 percent floor and will not be required to determine the portion of a bundled fiduciary fee that is subject to the 2 percent floor. But payments by the fiduciary to third parties for expenses subject to the 2 percent floor that are readily identifiable must be treated separately from the otherwise bundled fiduciary fees.
The IRS stated that final regulations will be issued under Treasury Regulations Section 1.67-4 consistent with the decision in Knight. The regs also will address the issue raised when a non-grantor trust or estate pays bundled fiduciary fees, some of which are subject to the 2 percent floor and some of which are fully deductible. The final regs may contain one or more safe harbors for the allocation of fees and expenses between those costs that are subject to the 2 percent floor and those that are not. These final regs will apply prospectively.