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Good Knight – The Supreme Court Rules on Deductibility of Investment Advisory Fees
By Sarah Vincentsen
The Supreme Court rarely hears cases involving tax decisions but in June, 2007, the Court agreed to hear Knight vs. Commissioner to resolve an existing conflict between the Sixth Circuit and the Federal, Second, and Fourth Circuits as well as the Court of Federal Claims. At issue was whether trusts and estates could fully deduct the fees they pay for investment management and advisory services.
Basic Facts of the Knight case
Michael J. Knight served as Trustee of the William L. Rudkin Testamentary Trust, a Trust established under the will of William's father, Henry A. Rudkin. Initially, the trust was funded primarily with the proceeds from the 1961 sale to Campbell Soup Company of Pepperidge Farm, Inc. a baked goods company founded in 1937 by Margaret Fogary Rudkin, Henry's wife. The Trustee was given broad authority to invest the trust assets and to employ any experts or advisors in connection with the administration of the trust. The trustee engaged Warfield Associates of New York to provide investment management services for the Trust and during the taxable year 2000, the Trustee paid Warfield $22,241 for such services. On its 2000 federal income tax return, the Rudkin Trust fully deducted these fees.
Following the Knight case through the courts
The IRS later determined that these investment advisory fees paid to Warfield were not fully deductible but instead were a miscellaneous itemized deduction and therefore, deductible only to the extent that they exceed 2 percent of the Trust's adjusted gross income. As such, the IRS adjusted the deduction to $9,780, the amount by which $22,241 exceeded 2% of the trust's adjusted gross income. The trustee challenged this treatment under the exception to the general rule these fees were always miscellaneous itemized deductions and that these particular fees represented "deductions for costs which are paid or incurred in connection with the administration of [an] estate or trust and which would not have been incurred if the property were not held in such trust or estate" and therefore should be fully deductible in arriving at adjusted gross income.
The trustee first had to plead its case to the Tax Court who sided with the IRS, classifying these investment advisory fees as miscellaneous itemized deductions (and subject to the 2% limitation. Further appeal to The Second Circuit yielded agreement with the Tax Court and framed the issue for the last appeal to the Supreme Court to determine what exactly the exception to the general rule was allowing to trusts and estates.
In January of this year, the Supreme Court, affirming the Court of Appeals of the Second Circuit, held that investment advisory fees paid by a trust are deductible only to the extent that they exceed 2% of the trust's adjusted gross income. The Supreme Court reasoned that in determining whether a particular type of cost incurred by a trust "would not have been incurred" if the property were held outside a trust or estate (for example, by an individual), the exception excludes from the 2% floor limitation only those costs that would be uncommon (or unusual or unlikely) for an individual to incur. Because investment advisory fees were routinely seen outside the trust and estate arena as being paid by individuals, these fees were not unique to trusts and estates and therefore did not fit into the exception on which the trustee was relying to claim full deductibility.
IRS issues proposed regulations
In the end, the ruling in Knight might end up being much ado about nothing as the IRS had already issued proposed regulations in late July of 2007 with respect to their interpretation of the exception, which essentially defined investment advisory fees as non-unique costs to trusts and estates and therefore miscellaneous itemized deductions subject to the 2% adjusted gross income floor.
If you would like to discuss this subject further, please contact Sarah Vincentsen (svincentsen@pmn.com) or any member of our tax service team at (617) 426-9440.
Note: This article represents a general overview of or opinion on certain tax issues or developments and should not be relied upon without an independent, professional analysis of how any of these provisions may apply to a specific situation. We recommend you consult your professional tax advisor before taking any action based on anything in this article.
IRS CIRCULAR 230 NOTICE: In compliance with U.S. Treasury Circular 230 Regulations and any applicable state laws, we hereby notify you that any tax advice contained in the body of this document, or attachments thereto, was not intended or written to be used, and cannot be used, by the recipient or any other party for the purpose of (1) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions, or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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