Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
Is That the End? Section 67(e) and Trust Investment Advisory Fees After Knight v. Commissioner
Proper federal income tax treatment of investment advisory fees incurred by trusts has puzzled trustees, tax practitioners, and the judiciary alike for two decades. The confusion stems from a problematic Code provision that leaves trust tax return filers with a dilemma: either consider these fees fully deductible as adjustments to gross income, or subject them to the two percent floor on miscellaneous itemized deductions. While taxpayers prefer the former approach, the Service obviously favors the latter. Three courts of appeals previously split over the issue; the most recent decisions have subjected the deduction to the two percent floor whereas the first reached the opposite result. The trend to lump these fees into the miscellaneous deduction category, supported by the Service, found its most ardent advocate with the Second Circuit’s ruling in William L. Rudkin Testamentary Trust v. Commissioner.
The Second Circuit emphatically stated in Rudkin that trust investment fees are subject to the two percent floor, simply because the costs could have been incurred by individuals outside of the trust context. Like its three sister circuits, the court reached its decision by focusing on statutory language in section 67(e), which carves out an exception to the two percent floor for trust administrative costs “which would not have been incurred if the property were not held in such trust.” And as with the three circuit courts preceding it, the Second Circuit deemed the statute unambiguous. Although the court took a firm stand explaining section 67(e), its faulty analysis made less clear how investment fees of trusts should be treated.
The Second Circuit’s opinion in Rudkin is flawed in a number of ways. First, the Second Circuit followed its sister circuits and described section 67(e) as unambiguous, characterizing its interpretation as in the plain meaning of the statutory language. Second, the court radically departed from other interpretations on the trust administrative costs exception by focusing on a hypothetical individual rather than the trust property, substituting into the statutory language “could” in place of “would,” and adopting a generic approach to trust costs in the face of statutory terms like “the” and “such” that target specific treatment of trust costs. Finally, the Second Circuit glossed over legislative history that points to a narrower congressional intent for section 67(e).Having granted certiorari to the Second Circuit’s decision, the Supreme Court positioned itself to resolve the conflict and confusion about the meaning of section 67(e). Renamed Knight v. Commissioner, the Court affirmed the Rudkin result that investment fees incurred by trusts are subject to the two percent floor, but it unanimously disapproved of the Second Circuit’s unsound reasoning and favored the rationale of the Fourth and Federal Circuits. At the same time, the Supreme Court announced that certain trust investment fees could merit full deduction and so pass section 67(e)’s exception. Thus, while the Court ostensibly resolved the circuit split, it left the door open for disparate treatment of trust investment fees, which may produce circumvention problems and administrative burdens on the Service. How trusts will deduct their investment advisory fees, it seems, will remain unsettled until the Service establishes appropriate regulations for their treatment.