U.S. Supreme Court Rules That Trust Investment Fees Are Subject to the 2% Deduction Floor - But More Fees May Escape the Floor in the Future

April 6, 2009 | Roger McEowen



On January 16, 2008, the U.S. Supreme Court decided 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.  The Court ruled unanimously in affirming the opinion of the U.S. Circuit Court of Appeals for the Second Circuit that such expenses will usually be subject to the 2% floor.  It's an important issue because financial institutions often set a single "bundled" fee for all of the services that they perform. 

The legal issue in the case arose 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.  The Circuit Courts of Appeal had split on the issue.

The Supreme Court’s analysis

The Court’s test is whether the expense at issue is "commonly" or "customarily" incurred outside of a trust or an estate.  If so, then the 2 percent floor applies and the exception does not.  The Court reasoned that because investment advisory fees are commonly incurred by individuals (and not just trusts and estates), they do not come within the exception to the 2 percent floor rule (i.e., the 2 percent floor limitation applies).  But, the Court noted that it is possible that some types of advisory fees may exclusively relate to trusts and estates, in which case the 2 percent floor would not apply.  However, incurring advisory fees simply to comply with fiduciary "prudent investor" rules is not enough to escape the 2% floor.

As for unitary or “bundled fees” (which are common, are not usually paid by individuals, and are typically welcomed by most grantors and beneficiaries and reflect the full range of services provided and the availability, reputation, judgment and assumption of risk by the fiduciary), the Court’s opinion does not require the “unbundling” of unitary fiduciary fees, as do the IRS proposed regulations.  So, the Court’s opinion now makes it possible for trustees to “reverse unbundle” by identifying costs that are unique to the trustee’s fiduciary responsibilities.  The result will be that such costs will escape the 2 percent floor.

Future Implications

In this case, the taxpayer lost.  But, that may not always be the case.  The Court, while affirming the holding of the Second Circuit, actually adopted a less rigorous test than what the Second Circuit had applied in the case.  The Second Circuit indicated that trust expenses would escape the 2 percent floor only if they were of a type that could not be incurred by an individual.  The Supreme Court’s test is broader, and thus more expenses should qualify for the exception to the 2 percent floor.

Also, the IRS had issued proposed regulations that were patterned on the Second Circuit’s narrower test - essentially allowing deductions to avoid the 2 percent floor only if they were unique to trusts or estates.  That would require taxpayers to somehow unbundle the fee to be able to allocate the fees to those that are subject to the 2 percent floor  and to those that aren't subject to the 2 percent floor.  Since the Supreme Court adopted a broader test for the exception to the 2 percent floor for trusts and estates, revised regulations will likely be forthcoming.  Knight v. Commissioner, 128 S. Ct. 782 (2008).

IRS Regulations.  On February 27, 2008, the IRS issued Notice 2008-32, 2008-1 C.B. 593, providing interim guidance on the treatment of investment advisory fees and other costs subject to the 2 percent floor of I.R.C. Sec. 67(a) that are bundled as part of one commission or fee paid to the trustee or executor (a bundled fiduciary fee) and are incurred by a non-grantor trust or an estate.  For tax years beginning before January 1, 2008, IRS says that taxpayers won't be required to determine the part of a bundled fiduciary fee that is subject to the 2 percent floor under I.R.C. Sec. 67.  Thus, taxpayers may deduct the full amount of the bundled fiduciary fee (even if it includes investment advisory fees) on their 2007 IRS Form 1041s without regard to the 2 percent floor.  But, IRS says that any payments made by the fiduciary to third parties for expenses subject to the 2 percent floor are readily identifiable and must be treated separately from the otherwise bundled fiduciary fee.

IRS indicated in the Notice that final regulations may contain safe harbors for the allocation of fees and expenses between those costs that are subject to the 2 percent floor and those that are not.  IRS is requesting comments on whether safe harbors would be helpful and how the safe harbors may be formulated.  In particular, IRS would like comments on reasonable estimates of the percentage of the total costs of administering a non-grantor trust or estate that is attributable to costs subject to the 2 percent floor.  IRS is also requesting comments on whethe the safe harbors should reflect the nature or value of the assets in the non-grantor trust or estate and/or the number of beneficiaries of the non-grantor trust or estate. 

IRS extended the guidance to tax years beginning before 2009 in Notice 2008-116, 2008-2 C.B. 1372 issued on December 11, 2008, and has now extended the guidance again in Notice 2010-32, 2010 I.R.B. LEXIS 188, issued on April 1, 2010.  The new guidance applies to tax years beginning before January 1, 2010, and applies to non-grantor trusts and estates.  That means that full deductibility is allowed for bundled fees irrespective of the 2 percent floor.