One of the most talked about cases among panelists at the “Recent Developments-2005” session at this year's Heckerling Institute on Estate Planning, held Jan. 9 through 13 in Miami, was Rudkin — a case in which the Internal Revenue Service is trying to close a potential tax loophole for the wealthy. The issue in William L. Rudkin Testamentary Trust v. Comm'r, 124 T.C. 19 (June 27, 2005) is: to what extent are trustee fees deductible by a trust for income tax purposes?
In Rudkin, the Tax Court agreed with the Service that a trust's investment advisory fees are not fully deductible: Only the portion that exceeds 2 percent of the trust's adjusted gross income (AGI) is deductible. The case is on appeal to the U.S. Court of Appeals for the Second Circuit.
Trustees that include the cost of investment advice in their general fees might be at an advantage, because this “rolled up” fee might be fully deductible. At least, the IRS has not yet tried to force a trustee to itemize a rolled up fee and denied deductions for investment advice portions.
What the IRS has done, however, is go after deductions for clearly identified investment advisory fees.
The Tax Court previously held in O'Neill v. Comm'r, 98 T.C. 227 (1992), that deductions for separate investment advisory fees are subject to the 2 percent rule. But not all circuit courts have agreed. Of the three that have ruled on the issue, two are in line with the Tax Court: the Fourth Circuit in Scott v. U.S., 328 F.3d 132 (4th Cir. 2003) and the Federal Circuit in Mellon Bank, N.A., 265 F.3d 1275 (Fed. Cir. 2001), aff'g 47 Fed. Cl. 186 (2000); but the Sixth Circuit reversed the Tax Court in O'Neill, 98 T.C. 227 (1992), rev'd, 994 F.2d 302. (6th Cir 1993) and imposed the 2 percent rule.
Under IRC Section 67(a), individuals are allowed miscellaneous deductions to the extent that they exceed 2 percent of a trust's AGI. Section 67 (e) states that the AGI is calculated in the same way for trusts and estates as for individuals, but expenses incurred in administrating an estate or trust that “would not have been incurred if the property were not held in such trust or estate” are fully deductible when the AGI is calculated.
David A. Handler, a partner in the Chicago office of Kirkland & Ellis LLP, provides this example:
“Say a trust has $100,000 of AGI and incurred $5,000 of investment management fees. If the investment management fees are deductible only to the extent they exceed 2 percent of AGI, then $3,000 is deductible ($5,000 minus $2,000, which is 2 percent of AGI). If the management fees are fully deductible, then all $5,000 may be deducted. If a trustee charges a $10,000 fee with no separate investment management fee, then all $10,000 may be deductible. However, if the IRS's view is that investment management fees are subject to the 2 percent floor, the Service could require trustees to break out that portion of their fees that represents investment management and limit its deductibility accordingly.”
The reason the full deduction is seen as a tax loophole for the rich: Individuals who hold their money outside a trust receive no income tax deductions for the cost of investment advice.
The American Bankers Association put forth a counterargument in its amicus brief in Rudkin, filed Jan. 6 with the Second Circuit: Fiduciary duties force trustees to incur investment advisory expenses.