Court Ruling Limits Fee Deductions For Trusts

The basic tax rule for miscellaneous itemized expenses—which normally cover such things as an employee’s business expenses or the costs of producing investment income—is that individual deductions may be taken only to the extent that outlays exceed 2% of a taxpayer’s adjusted gross income (AGI). This rule also applies to trusts and estates, but there are a few exceptions. For example, one provision allows costs to be fully deducted if they’re directly attributable to the assets being held by a trust or estate.

A trust or estate’s investment advisory fees, however, are subject to the 2% floor, at least in the eyes of the IRS. But not every court has agreed. In one case, the Sixth Circuit Court of Appeals reversed a Tax Court decision in ruling that investment advisory fees paid by trustees who are fulfilling their fiduciary responsibilities are fully deductible. That contrasts with a Federal Circuit Court of Appeals ruling that investment advisory fees don’t qualify for a full deduction, because they constitute expenses commonly incurred by an individual. The Fourth Circuit reached a similar conclusion, while the Second Circuit Court of Appeals, in a case involving the Rudkin Testamentary Trust, also denied a full deduction for a trust’s investment advisory fees. It was that final case the Supreme Court agreed to review.

The trustee of the Rudkin trust deducted the full amount of the fees it paid to investment advisors. However, the IRS imposed the 2% floor, reducing the deduction amount from $22,241 to just $4,448. And while the high court ultimately agreed with the Second Circuit Court’s outcome, it took issue with the lower court’s reasoning. The Second Circuit had held that the issue was whether the fees could have been incurred by an individual. But in an opinion written by Chief Justice John Roberts, the Supreme Court found that costs paid or incurred by trusts are subject to the 2% floor unless they represent fees that would not commonly be incurred by individuals. If Congress had wanted the Second Circuit’s interpretation, it would have used could, not would, in the statute, Roberts wrote.

Thus, the Supreme Court essentially agreed with earlier decisions and left the door open—if only a crack—for full deductions for certain unusual expenses that wouldn’t have been required if assets were not in a trust.

A side effect of the Supreme Court ruling is that proposed regulations issued in 2007, which adopted some language from the Second Circuit’s decision, will now have to be revised.