A unanimous decision recently handed down by the U.S. Supreme Court is bad news for administrators of trusts and estates. (Knight, No. 06-1286, 1/16/08) The highest court in the land ruled that investment advisory fees cannot be deducted in full. Instead, they are subject to the "2 percent floor" for miscellaneous expenses. The decision resolves a split among lower courts and throws a monkey wrench into
|
Pepperidge Farm: The Family
Behind the Court Case
The trust at issue in this Supreme Court case was initially funded by the Rudkin family after they sold Pepperidge Farm to the Campbell Soup Company in the 1960s.
The Pepperidge Farm empire of products that we see in grocery stores today began in 1937 with one type of bread created by a mother trying to feed her child.
Margaret Rudkin was living in Connecticut with her three young sons and her husband, Wall Street Broker Henry Rudkin. The family resided on a property called Pepperidge Farm-named after a type of tree growing there.
The Rudkins discovered their youngest son had severe allergies and asthma and was unable to eat most commercially processed foods.
Through trial and error, Margaret began baking him some all-natural stone ground whole wheat bread with the vitamins and nutrients intact. The bread was a hit with family and friends and her son's health improved after he began eating it.
Margaret approached the local grocer, who began selling the loaves for 25 cents each - more than twice the going price for most other bread at the time. Henry Rudkin also began taking the loaves to be sold at specialty shops in New York City.
The company grew from the Rudkin's kitchen, to a garage on their property, to its first factory in 1940. During the next three decades, Pepperidge Farm branched out into making cookies, frozen pastries, Goldfish crackers and other products.
In 1961, Pepperidge Farm was sold to another family-run food company, Campbell Soup, and Margaret Rudkin became the first woman to serve on its Board. She officially retired in 1966.
Today, Pepperidge Farm has eight manufacturing facilities, annual sales in excess of $1 billion and approximately 5,000 employees.
-- Sources: U.S. Tax Court case
and the Pepperidge Farm Web site |
proposed IRS regulations.
The ruling is especially painful for trusts that spend large amounts annually on investment counseling fees. Many trustees hire investment advisers to help them manage their portfolios and their beneficiaries may receive less income as a result of the decision.
Background: Generally, miscellaneous expenses are deductible only to the extent the annual total for the year exceeds 2 percent of your adjusted gross income (AGI). This is commonly called the 2 percent floor. For trusts and estates, an AGI is computed the same way as it is for an individual, with certain exceptions. Under one key exception, costs paid or incurred in connection with the administration of a trust or estate, which would not have occurred if the assets were not held in a trust or estate, are fully deductible. (Internal Revenue Code Section 67(e)(1))
In one significant case, the Tax Court held that the investment advice costs charged to a trust are subject to the 2 percent floor (O'Neill, 98 TC 227). But then the Sixth Circuit Court reversed the Tax Court. It ruled the investment counseling fees paid by the trust to the trustees in discharging their fiduciary duties qualified under the tax law exception.
The IRS continued to contest this issue. Subsequently, various other courts rejected the Sixth Circuit's holding, including the Second Circuit Court in the Knight case (formerly known by the name of William L. Rudkin Testamentary Trust). The case involved the family of Henry Rudkin, founders of the Pepperidge Farm food products empire. Michael Knight was the trustee of the trust.
In 2000, the trust handling Mr. Rudkin's estate held approximately $2.9 million in marketable securities and deducted the full amount of $22,241 it spent on investment advice. However, the deduction was disallowed in an audit by the IRS, which determined the trust could only deduct $4,448 after applying the 2 percent floor for miscellaneous expenses.
The Second Circuit Court of Appeals sided with the IRS. Reason: The Court said that the tax code exception only applies to costs that could not have been incurred by an individual. Because investment advisory fees can be incurred by an individual, the deduction should be subject to the 2 percent floor.
Now the U.S. Supreme Court has settled the controversy once-and-for-all. In doing so, it rejected both the Second Circuit's interpretation and the trustee's argument. Instead, the Supreme Court held that costs incurred by trusts that escape the 2 percent floor are limited to those that would not commonly or customarily be incurred by individuals.
Thus, it's a difference between fees that "could not" be incurred and those that "would not." This leaves the door open just a crack for a full deduction of certain out-of the-ordinary fees. In its decision on the Knight case, the Supreme Court stated:
"Although some trust-related investment advisory fees may be fully deductible if an investment adviser were to impose a special, additional charge applicable only to its fiduciary accounts, there is nothing in the record to suggest that (the Investment advisory firm) did so, or treated the Trust any differently than it would have treated an individual with similar objectives ..."
It appears that the new Supreme Court ruling will send the IRS back to the drawing board. The new proposed regulations, issued in 2007, virtually lifted language out of the Second Court's decision in the Rudkin case. The IRS is expected to revamp the new regulations quickly to give guidance to financial institutions on the tax treatment of investment advisory fees.
Full Newsletter
