Deducting third party investment mgnt. fees under Sec. 67(e).

EXECUTIVE SUMMARY

* A judicial controversy surrounds deducting investment management fees charged by a nontrustee third party.

* Taxpayers in the Sixth Circuit seeking to use O'Neill should ensure that their facts are squarely on point.

* Trustees considering amending returns that previously limited investment management fees to 2% of AGI should seek litigation counsel's advice before amending.

When an estate or trust pays investment management fees to a third party, are such costs deductible above the line or subject to the 2%-of-adjusted-gross-income floor? The Sixth and Federal Circuits have disagreed on this issue.

This article explains the controversy and offers planning strategies.

Generally, trusts and estates can deduct administrative expenses (e.g., executors' commissions, trustee fees, appraisal and court costs and investment management and legal fees) as miscellaneous itemized deductions. Such costs are deemed expenses for the production of taxable income under Sec. 212. However, the deductibility of some expenses is limited by other Code provisions. For example, Sec. 265 disallows a deduction for expenses incurred in the production of tax-exempt income. Another limit is the Sec. 56(b)(1)(A)(i) requirement that miscellaneous itemized deductions be added back in computing the alternative minimum tax (AMT).

One deduction limit has triggered considerable controversy. For individuals, Sec. 67(a) allows miscellaneous itemized deductions only to the extent that the aggregate deduction exceeds 2% of adjusted gross income (AGI). However, Sec. 67(e)(1) calculates estate or trust AGI by deducting costs "... paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate ..." Thus, Sec. 67(e)(1) effectively carves out certain administration expenses from the 2% rule, by reducing AGI by those expenses. Most commentators agree that this treatment also excludes deductible administrative expenses from the AMT addback provisions.

However, no regulations have been issued to provide guidance, and courts substantially disagree over which expenses Sec. 67(e)(1) excludes from the 2% rule. One controversial issue--on which two circuits are split--is whether estate or trust investment management fees fall within the Sec. 67(e)(1) exception. This controversy centers around Sec. 67(e)(1)'s second requirement, that the expense would not have been incurred had the property not been held in such trust or estate. Courts will frequently look to a statute's legislative history if its plain meaning is not clear. (1) However, the courts have found no legislative history specifically addressing this issue.

All courts agree that trustees' fees attributable to managing trust assets should fall within this Sec. 67(e)(1) exception. However, problems arise when a trustee employs others to perform investment and management services.

Courts Disagree

Sixth Circuit

O'Neill (2) was the first judicial determination of whether investment management fees paid by the trustees to third parties should be exempted from the 2% rule. In O'Neill, Ohio state law required trustees to adhere to the "prudent person" standard; the trustees had little or no investment experience and would not have served without the assistance of professional advisers.

Nonetheless, the Tax...