Oral argument: Nov. 27, 2007
Appealed from: United States Court of Appeals, Second Circuit (Jun. 25, 2007)
TAX, TAX DEDUCTION, TRUSTS, INTERNAL REVENUE SERVICE, STATUTORY INTERPRETATION
Michael Knight, trustee of the Rudkin Testamentary Trust, petitioned the United States Tax Court to dispute the Internal Revenue Service ("IRS") assessment that the Trust owed taxes for investment-advisory expenses Knight had deducted in full. The Internal Revenue Code contains a 2% floor on all itemized deductions. The IRS assessed that Knight failed to recognize this floor, significantly lowering the deduction amount. Knight argued these expenses should be exempt because they were necessary for Knight to fulfill his fiduciary duties as a trustee. The Tax Court stated that, to be exempt, Knight needed to show these expenses would not have been incurred if the assets were not held in trust. The Tax Court found Knight failed to satisfy his burden of showing that the expenses were unique to trusts and decided in favor of the IRS. The United States Court of Appeals for the Second Circuit affirmed the Tax Court's holding. The Supreme Court of the United States granted certiorari to resolve a conflict between a holding by the Sixth Circuit and those of the Second, Fourth, and Federal Circuits. As trustees spend billions of dollars yearly on management advice, this case will have wide-reaching consequences. A decision for the IRS will result in the same level of taxation on investment-management expenses for individuals and trusts and more taxes to the IRS tempered by decreased use of management services by trustees. A decision for Knight would lower the taxes of trustees and encourage trustees to use investment-management services.
Whether 26 U.S.C. � 67(e) permits a full deduction for costs and fees for investment management and advisory services provided to trusts and estates.
Does the Internal Revenue Code allow trusts and estates to make full deductions on Federal Income tax returns for investment management advisory service fees?
In the late 1930s, entrepreneur Margaret Rudkin founded a small business that ultimately developed into Pepperidge Farm. In 1961, the Campbell Soup Company bought Pepperidge Farm. On April 14th, 1967, Margaret's husband Henry A. Rudkin used the proceeds of the sale to establish a trust in Connecticut for the Rudkins' descendants and the spouses of their descendants. See William L. Rudkin Testamentary Trust v. C.I.R., 467 F.3d 149, 151 (2d Cir. 2006).
The Internal Revenue Code provides for "deductions for costs ... 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." 26 U.S.C. � 67(e)(1). In 2000, Michael J. Knight, a trustee of the William L. Rudkin Testamentary Trust, sought investment-management advice for the Trust from Warfield Associates, Inc. See Rudkin, 467 F.3d 149 at 151. The Trust reported a total income of $624,816 and Knight paid Warfield $22,241 in investment management fees. Id. The Trust sought to deduct the entire $22,241 on its 2000 tax return pursuant to 26 U.S.C. � 67(e)(1). Id. The Internal Revenue Code provides that certain expenses may be deducted as itemized deductions; one can deduct expenses over 2% of one's adjusted gross income (AGI). See Rudkin, 467 F.3d 149 at 151. The Trust claimed the $22,241 paid to Warfield on its 2000 tax return was not subject to this 2% floor. Id. It claimed these expenses on "line 15a" of the tax return for "deductions not subject to the 2% floor'' and not on "line 15b" for ''[a]llowable miscellaneous itemized deductions subject to the 2% floor.'' Id.
On December 5th, 2003, the Internal Revenue Service ("IRS") notified the Trust of tax deficiency for 2000. See Rudkin, 467 F.3d 149 at 151.The IRS rejected the $22,241 on "line 15a" for investment-advice fees from Warfield permitting instead a deduction only for $9,780 (the amount that exceeded 2% of an AGI of $623,050). Id. Knight owed the IRS $4,448 in taxes. Id.
The Trust filed a petition with the United States Tax Court sitting in Hartford, Connecticut, to dispute the IRS assessment. The crux of the Trust's argument was that the Trust had a fiduciary duty under Connecticut law to properly administer its large stock portfolio and that investment-advice fees were fully deductible because they occurred in the service of that duty. See Rudkin, 467 F.3d 149 at 151. The IRS disagreed in part because it intended to propose new regulations regarding the deductibility of investment advisory fees. See Brief of American Bankers Association et al. as Amici Curiae Supporting Petitioner, William L. Rudkin Testamentary Trust v. C.I.R. at 4-5 n.2, 467 F.3d 149 (2d Cir. 2006). The IRS believed that these regulations, once issued, would resolve the matter. Id.
The Tax Court held the expenses were only deductible to the extent that they exceeded 2% of AGI. See William L. Rudkin Testamentary Trust v. C.I.R., 467 F.3d 149,151 (2d Cir. 2006). The Trust appealed to the United States Second Circuit Court of Appeals, which affirmed the Tax Court holding. Id. The Trust then appealed to the Supreme Court of the United States. The Court granted certiorari on June 27th, 2007, due to what the Court noted was "a deep, irreconcilable and widely noted conflict among the Second, Fourth, Sixth and Federal Circuits" regarding this issue. Docket Number 06-1286. The Court noted that this issue implicates deductions for trusts and estates totaling in billions of dollars annually. Id.
U.S. Trusts and Financial Advice
Michael J. Knight acted much like other trustees in his position when he sought outside financial advice to provide investment guidance for the Trust, in 2000. Reports indicate that trustees spend billions of dollars annually on outside financial advice to manage trusts' assets in accordance with trustees' fiduciary responsibilities. See Supreme Court To Hear Case On Taxation Of Trust Fees, Fin. Advisor Mag., Jul. 2, 2007. As of 2003, corporate fiduciary reports filed with federal banking agencies indicated that more than one trillion dollars in assets are held in trusts in the United States. See Robert H. Sitkoff & Max Schanzenbach, Jurisdictional Competition for Trust Funds: An Empirical Analysis of Perpetuities and Taxes, 115 Yale L.J. 356 (2005). In fact, in 2001 U.S. trusts collectively held more capital than the Federal government spent that year on Social Security and National defense combined. See Brian M. Riedl, Most New Spending Since 2001 Unrelated to War on Terrorism, Table 1, The Heritage Foundation, Nov. 13, 2003. In comparison, the William L. Rudkin Testamentary Trust, which Knight managed, contained roughly three million dollars, which amounts to only a fraction of the total sum of assets in U.S. trusts. Furthermore, the approximately $22,000 which Knight expended on outside investment advisory fees, constitutes a mere fraction of the billions of dollars spent on similar services. See Brief for Respondent at 3.
Although this case only centers on a disputed tax amount of $4,448, the Court's decision may have a significant impact on the financial service industry and all beneficiaries of trusts and estates. See Brief for Petitioner at 40. More specifically, if the Supreme Court affirms the lower court's ruling in favor of the Internal Revenue Service ("IRS"), trustees will be unable to claim full tax deductions for outside investment advisory services. Id. at 40. As a result, trustees may be less inclined to seek outside financial advice in order to avoid taxes for investment advice. Id. at 41. Hence, the financial advising industry may lose some of its trust-based clientele and trustees may make uninformed investment decisions. Alternatively, trustees may continue using investment advisors and as a result, trusts may realize a decrease in earnings due to increased taxes paid for advisory services. Id. at 40-41.
The Prudent Trustee and Trust Expenses
Knight's case unfolds before a larger national debate regarding the billions of dollars trustees spend on outside financial advice for trust management. More specifically, trustees like Knight are bound by the Uniform Prudent Investor Act ("UPIA"), which imposes fiduciary obligations and strict standards of care that often encourage trustees to seek outside financial advice. See Brief for Petitioner at 7. In its amicus brief in support of the petitioner, the American Bankers Association ("ABA") argues that trusts should be exempt from the 2% floor due to trustees' fiduciary obligations under the UPIA. According to the ABA, "it is the existence of this legal duty of prudence that differentiates the individual investor from the trustee." Brief for American Bankers Association ("ABA") as Amicus Curiae Supporting Petitioner at 6. The central issue in Knight's case is whether trustees can claim full tax deductions for money spent on outside financial advice under 26 U.S.C. � 67(e)(1). See id. at 14-15.
Lower Courts Divided and the Impact of the Supreme Court's Decision
In O'Neill v. C.I.R., 994 F.2d 302, the Sixth Circuit Court of Appeals determined trustees could claim full deductions for outside investment advisory fees on trust tax returns because prudent investor standards attribute those expenses to the trustee's fiduciary duties. See O'Neill v. C.I.R., 994 F.2d 302, 304 (6th Cir. 1993). Seven years later the United States Court of Appeals for the Federal Circuit, declined to follow O'Neill in Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001). In Mellon Bank, the Court reasoned that investment and management fees were commonly incurred by individuals outside of trusts and thus not within the permissible deductions provided for in section 67(e)(1). Mellon Bank, N.A. v. United States, 265 F.3d at 1280-1281. Two years later, the Fourth Circuit Court of Appeals held consistently with Mellon, finding that "trust-related administrative expenses are subject to the 2% floor if they constitute expenses commonly incurred by individual taxpayers." Scott v. United States, 328 F.3d 132, 139-140 (4th Cir. 2003).
In the case at hand, Knight appeals the Second Circuit Court of Appeals decision from William L. Rudkin Testamentary Trust v. C.I.R., 467 F.3d 149, 151 (2d Cir. 2006)., wherein the Second Circuit affirmed the United States Tax Court's holding against Knight. Consistent with holdings by the Federal and Fourth Circuits, the Second Circuit determined investment advising fees to be subject to the 2% floor, but arrived at its holding under a more demanding test. Under the Second Circuit's approach, expenses may only be deducted if an individual property owner could not have incurred those same trust related expenses. William L. Rudkin Testamentary Trust v. C.I.R., 467 F.3d at 160. According to Knight, if the Supreme Court affirms the Second Circuit's opinion, trustees will be less inclined to seek outside financial advice due to the taxes imposed on the trusts for utilizing investment advisory services. Brief for Petitioner at 40. As a result, Knight argues that the financial advising industry likely would suffer, due to a decrease in demand for financial advising services. Id. Moreover, if the Supreme Court affirms the Second Circuit's holding, Knight claims that beneficiaries would see a decrease in their trust's earnings because assets will be lost due to either inadequate financial advice or additional taxes paid for financial advising. See Brief for Petitioner at 40. The IRS contests this outcome by arguing that the tax increase in this case to be too nominal to alter trustee's fiduciary practices and use of outside financial services. Brief for respondent at 39.
The Supreme Court's decision to grant certiorari to Knight's appeal indicated its willingness to review the question of whether trusts may claim full deductions for investment management and advisory service fees. See Brief for Petitioner at i. In arriving at its decision, the Court must determine whether advisory fees would not have incurred if the property in question had not been held in trust. See id. The Second Circuit Court of Appeals held that management and advisory services are not unique to trusts and can be incurred by private individuals; thus such expenses are subject to the 2% floor and cannot be fully deducted on trust's tax returns. William L. Rudkin Testamentary Trust v. C.I.R., 467 F.3d 149 (2d Cir. 2006).
Legislative Intent and the 1986 Tax Reform Act
The legislative intent behind the 1986 Tax Reform Act is at the heart of this case. The text of 26 U.S.C. � 67(e)(1) does not clearly explain what types of trust related expenses are fully deductible. According to the statutory language, certain trust expenses may be filed as full deductions if those expenses arose in connection with the administration of the trust and the expenses would not have incurred if the property were not held in trust. 26 U.S.C. � 67(e)(1). In the event certain expenses fall outside the section 67(e)(1) full deduction provision, 26 U.S.C. � 67(a) applies. This provision allows deductions "only to the extent the aggregate of such deductions exceeds 2% of adjusted gross income [("AGI")]." 26 U.S.C. � 67(a). For example, if an individual has an AGI of $1,000 and that individual has a $30 expense that he or she wishes to claim as a deduction, the individual will only obtain a $10 deduction, which equates to the portion of the expense that exceeds the 2% floor. See e.g., New York State Society of CPAs, Ten Tax Tasks for December, Dec. 1, 2003, http://www.nysscpa.org /sou nd_advice/money_12.1.03.htm. The use of the word "would" in section 67(e)(1) is at issue; trusts can seek "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..." 26 U.S.C. � 67(e)(1) (emphasis added). The Court must determine if Congress intended to allow deductions for all costs related to the management of trusts, or intended only to allow deductions for expenses individuals could not incur. See Brief for Petitioner at 26, 44-45.
A Broad Reading of Trust Related Expenses
One outcome that the Supreme Court may adopt is to reverse the Second Circuit's holding and determine trusts to be exempt from the 2% floor with regard to outside financial advisor fees. The Court may adhere to the test used in both Mellon and Scott, which recognized "that costs of a type not 'customarily' or 'commonly' incurred by individuals [are] fully deductible by trusts and estates[;]" and recognize the costs in Knight's trust to be of a type not customarily or commonly incurred by individuals. Brief for Petitioner at 15. In support of this potential ruling, Knight argues that trustees must diversify trusts' assets differently from individuals who invest for "total return." This is due to the fact that trustees must often invest assets in the interests of multiple beneficiaries and not one person. See Brief for Petitioner at 18. Additionally, Knight argues the 2% floor was enacted to stop individual taxpayers, not trusts, from deducting "voluntary personal" expenses. Id. at 32.
Alternatively, the court may rule for Knight consistently with the O'Neill standard, which recognizes that trust investment advisory fees are fully deductible due to trust's assets being held in trust where trustees are bound to certain fiduciary standards. See O'Neill v. C.I.R., 994 F.2d 302, 304 (1993). This interpretation is proffered by the American Bankers Association ("ABA"), which filed an amicus brief in support of the petitioner. In its brief, the ABA argues that trusts should claim full deductions for trust related investment advisory services due to standards imposed by the Uniform Prudent Investor Act ("UPIA"), which often requires trustees to seek outside financial advice. See. ABA Brief at 11; Brief for Petitioner at 5. As a result of widely recognized fiduciary duties under the UPIA, all fifty States and the District of Columbia have adopted their own versions of the test, thus subjecting trustees in all fifty States to the UPIA standards. See Brief for Petitioner at 7-8. Knight relies upon the duties imposed by the Connecticut Uniform Prudent Investor Act ("CUPIA") which requires fiduciaries to act with reasonable care, skill and caution in making prudent and diversified investments in beneficiaries' interests. Conn. Gen. Stat. � 45a-541b(a). As a result of the UPIA standards, trustees lacking investment knowledge or experience often seek outside financial advice and thus incur trust expenses that private individuals are not forced to incur. See ABA Brief.
A Narrow Reading of Trust Related Expenses
A more narrow reading of trust related expenses would limit trusts in their ability to claim various expenses as deductions. The Court may decide to apply the test used in Mellon and Scott and determine that investment management advice is 'customarily' or 'commonly' incurred by individuals and thus subject to the 2% floor. Brief for Respondent at 24. Should the Court adopt this standard, the Court would adopt the less stringent test enacted by the Federal and Fourth Circuits. Alternatively, the Court may affirm the lower court's holding and apply the more demanding test used by the Second Circuit that determined trusts cannot claim deductions if private investors are capable of attaining those same kind of expenses. See id. at 17-19. The petitioner argues that this determination is "just wrong" because a ruling in accordance with the lower court "would render a portion of � 67(e) superfluous" and unworkable. See Brief for Petitioner at 45-46.
If the court adopts either standard, Internal Revenue Code section 26 U.S.C. � 67(a) would apply and generally allow deductions "only to the extent the aggregate of such deductions exceeds 2% of adjusted gross income." 26 U.S.C. � 67(a). Therefore, trusts still could claim deductions for investment advice that exceeds the 2% floor. See id.
Future Regulation and Outcome
The Internal Revenue Service ("IRS") unsuccessfully filed a brief with the Supreme Court in opposition to the Court's decision to grant certiorari. The Commissioner stated that the IRS released a Priority Guidance Plan ("PGP") that clarified this matter and provided guidance to the public. See Brief for Respondent in Opposition at 6. The commissioner argued further that the IRS would impose future regulations interpreting section 67(e)(1) in accordance with the lower court's decision and that the Supreme Court need not intervene. Id. The Court clearly rejected this argument when it granted certiorari on June 25, 2007. According to proposed regulative text, the regulations will not have any binding effect on this case because the proposals came after this controversy arose. See Prop. Reg. �1.67-4; See ABA Brief at 4-5 n.2. Although the proposed regulations will not affect this case, the regulations, if enacted, could limit trust deductions to only those expenses associated with trusts and not individual investors. See Prop. Reg. �1.67-4. The proposed regulations embody a list of deductible expenses that are deductible because they are "unique" to trusts and estates. See id. The proposed legislation adopts the rule established by the lower court in this case, as opposed to the more relaxed rule established in Mellon and Scott. See id.
Petitioners argue that if the Court affirms the lower court's holding or the IRS's proposed regulations are enacted, the financial advising industry and trust beneficiaries may suffer. Brief for Petitioner at 40. The financial advising may be affected because trustees may become less inclined to seek outside financial advice in order to avoid tax expenditures. Beneficiaries also could see a decline in their trust's earnings due to either increased taxes paid for financial advice or poorer investment decisions made by ill-informed trustees. See id. The IRS disagrees with this prediction, arguing the tax increase to be too nominal to affect trustees' fiduciary practices and uses of financial advisors. Brief for Respondent at 39. According to the IRS, a trustee will not "risk breaching his or her fiduciary duty by refraining from seeking investment advice merely to save such a small amount of tax." Id. If the IRS is correct in their conclusion, beneficiaries only would experience a small decline in their trust's net earnings. Brief for Petitioner at 40.
The Supreme Court must balance trustees' fiduciary duties under prudent investor standards with fairness and uniformity of standards for individuals outside of trusts. If the Court decides for Knight, trustees would be able to deduct investment advisory fees on their tax forms encouraging trustees to seek out and make use of investment management services. A finding for the IRS, on the other hand, would result in greater tax revenues for the federal government. This outcome may have a potentially adverse effect upon the financial services industry; it would, however, reconcile the taxes applied to trusts with those applied to private individuals for seeking investment-management services.
Edited by: Tim Birnbaum
The authors would like to thank Professors Robert Green and Emily Sherwin and for their insights on trusts in the United States.
- Wikipedia: 1986 Tax Reform Act
- National Association of Estate Planners & Council: Steve Leimberg's Estate Planning Newsletter # 1154 (July 30, 2007)
- Financial Advisor Magazine: case background