Taxation & Estate Planning

TRUST INVESTMENT FEES ARE SUBJECT TO 2% DEDUCTION FLOOR

By Charles Rubin

The question of whether trust expenses for investment advisory fees are fully deductible or may be deducted only to the extent they exceed 2% of adjusted gross income has been resolved by the U.S. Supreme Court. The Court ruled that such expenses will usually be subject to the 2% floor.

The controversy came from an exception to the 2% floor for expenses "paid or incurred in connection with the administration of the estate or trust...which would not have been incurred if the property were not held in such estate or trust" and whether investment advisory fees fit within that exception. Several Circuit Court of Appeals had differed on the question.

The benchmark test adopted by the Court is whether the expense at issue is "commonly" or "customarily" incurred outside of trusts and estates - if yes, then the 2% floor applies and the exception does not. Since investment advisory fees are commonly incurred by individuals (and not just trusts and estates), they do not come within the 2% floor exception.

The Court did note that it is possible that some types of advisory fees may exclusively relate to trusts and estates, in which case the 2% floor would not apply. However, incurring advisory fees simply to comply with fiduciary "prudent investor" rules is not enough to escape the 2% floor.

While the taxpayer here did not benefit, the Court was helpful to taxpayers since it adopted a less rigorous test than that applied by the lower court in determining whether the trust and estate exception from the 2% floor applies. The lower court indicated that trust expenses would escape the 2% floor only if they were of a type that COULD NOT be incurred by an individual. The Supreme Court test is less narrow than that, and thus more expenses should qualify for the exception to the 2% floor.

Note that the IRS had issued proposed regulations that were patterned on the lower court test, essentially allowing deductions to avoid the 2% floor only if they were unique to trusts or estates. Since the Supreme Court adopted a broader test for the exception to the 2% floor for trusts and estates, revised regulations should be forthcoming.

Knight, Trustee of William L. Rudkin Testamentary Trust, Case No. 06-1286 (2008)

Full post as published by Rubin on Tax on January 17, 2008 (boomark / email).