Knight v. Commissioner of Int. Rev.

Bill Long 1/16/08

SUMMARY OF 1/16/08 DECISION

As predicted, the US Supreme Court, in a unanimous decision, affirmed the 2nd Circuit and held that, under normal circumstances, fees paid to investment advisors to administer trusts are deductible subject to the 2% rule of IRS Code sec. 67(a). This essay quotes from the opinion of the Court, written by Chief Justice Roberts.

Stating the Issue

Here is the statement of the case, from the opinion.

"Under the Internal Revenue Code, individuals may subtract from their taxable income certain itemized deductions, but only to the extent the deductions exceed 2% of adjusted gross income. A trust may also claim those deductions, also subject to the 2% floor, except that costs incurred in the administration of the trust, which would not have been incurred if the trust property were not held by a trust, may be deducted without regard to the floor. In the case of individuals, investment advisory fees are subject to the 2% floor; the question presented is whether such fees are also subject to the floor when incurred by a trust."

In 1986 Congress enacted the Tax Reform Act of 1986, 100 Stat. 2085, the goal of which was to simplify the Code in many ways. One of the means of simplification was to enact the "2% floor" of Code section 67. The general rule is in sec. 67(a):

"Section 67(a) provides that “the miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.”

There is a significant exception to this rule, relating to trusts (the issue in this case). Under this exception, in sec. 67(e)(1),

"the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual, except that … the deductions for 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 trust or estate … shall be treated as allowable” and not subject to the 2% floor."

The question in this case was whether Knight, the trustee of the William L. Rudkin Testamentary Trust, properly deducted the full trust advisory fees paid to Warfield Associates. The specifics of the amounts are given in my other Knight essay.

The Court's Decision and Reasoning

The crucial phrase for the Court was "would not have been incurred if the property were not held in such trust or estate." Though the Court agreed in result with the 2nd Circuit, the Chief Justice wasted no time in chiding them for their statutory interpretation.

"In applying the statute, the Court of Appeals below asked whether the cost at issue could have been incurred by an individual. This approach flies in the face of the statutory language. The provision at issue asks whether the costs “would not have been incurred if the property were not held” in trust, ibid., not, as the Court of Appeals would have it, whether the costs “could not have been incurred” in such a case, 467 F. 3d, at 156. The fact that an individual could not do something is one reason he would not, but not the only possible reason. If Congress had intended the Court of Appeals’ reading, it easily could have replaced “would” in the statute with “could,” and presumably would have."

But what is the proper framework for deciding the question?

"This brings us to the test adopted by the Fourth and Federal Circuits: Costs incurred by trusts that escape the 2% floor are those that would not “commonly” or “customarily” be incurred by individuals. See Scott, 328 F. 3d, at 140 (“Put simply, trust-related administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by individual taxpayers”); Mellon Bank, 265 F. 3d, at 1281 (§67(e) “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”). The Solicitor General also accepts this view as an alternative reading of the statute. We agree with this approach."

With this approach having been adopted, the Court then turned to whether it was "uncommon" or "unusual" for individuals to hire an investment adviser (why is it spelled adviser rather than advisor? There are nearly 3X as many Google hits for "advisor" than "adviser." Perhaps the Court is conservative in its jurisprudence but wants to inaugurate a radical regime in spelling...). It concluded not only that having such an advisor wasn't unusual but that there was nothing in the record to suggest that Warfield charged the Trustee anything extra, or treated the Trust any differently than it would have treated an individual with similar objectives.

As is normally the case, the Court concluded with a caveat.

"It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor."

This case was not such an instance. Hence, the Court affirmed the judgment of the Court of Appeals.

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