Did the Second Circuit err in Rudkin Testamentary Trust?

• Author: Cantrell, Carol A.

EXECUTIVE SUMMARY

* In Rudkin, the court determined that the 2%-of-AGI floor applies to an estate or trust's administrative costs, unless the cost is one that individuals are incapable of incurring.

* Millions of beneficiaries will be affected by the court's decision, as the IRS will treat beneficiaries in the Second Circuit differently from others.

* Before the Service issues regulations or the Supreme Court resolves the issue, trustees and practitioners wishing to avoid penalties for underestimated taxes have several options.

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The Second Circuit recently ruled that a trust's investment advisory fees were subject to the 2%-of-adjusted-gross-income limit, based on an analysis that conflicts with other circuit courts and IRS interpretations. This article discusses how the court reached its decision and the potential effect on other cases and taxpayers.

In October 2006, in Rudkin, (1) a two-judge panel of the Second Circuit Court of Appeals declared that "would" means "could" in Sec. 67(e). If this interpretation remains, it virtually eliminates the Sec. 67(e) exception to the 2% rule for estates and trusts and puts the Second Circuit in conflict with every other circuit that has interpreted this statute. (2)

The Second Circuit held that Sec. 67(e) grants an estate or trust an exception from the 2% reduction in itemized deductions only for "costs of a type" that "individuals are incapable of incurring." On the surface, the court appeared to create a narrow window for an estate or trust to claim a full deduction for its administrative costs. In reality, however, it potentially eliminates a full deduction for any administrative cost of an estate or trust.

The court endorsed only three costs as fully deductible, because "individuals are incapable of incurring" them--"fees paid to trustees, expenses associated with judicial accountings, and the costs of preparing and filing fiduciary income tax returns." However, one could argue that even these do not pass muster under the Second Circuit's strict interpretation, because individuals are fully capable of incurring these costs. It makes sense that they would, because trustees are nothing more than titleholders for property beneficially owned by an individual. Thus, it is nearly impossible to conceive of a cost that trustees can incur with respect to property that an individual cannot.

This article examines how the Second Circuit reached its decision and how trustees and practitioners should respond to this questionable ruling.

The Controversy

Dozens of law reviews and journals have discussed the interpretation of Sec. 67(e) since the controversy first arose in O'Neill. (3) So far, none has urged the interpretation adopted by the Second Circuit. Indeed, the panel's interpretation even conflicts with IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, and most state fiduciary income tax forms, which allow a full deduction for legal and accounting fees. Under the court's definition, legal and accounting fees should not be fully deductible (at least in the Second Circuit), because individuals are capable of incurring them. Thus, the court's interpretation is bound to foster confusion and noncompliance.

While the $4,448 deficiency in Rudkin is undoubtedly small, the Second Circuit's position has serious implications. Its endorsement and application will create a substantial tax debt for trustees who must incur costs to comply with their legally mandated duties, such as those imposed under the Uniform Prudent Investor Act. It will also generate substantial litigation over a basic deduction that Congress intended for trustees carrying out such duties, all based on a questionable interpretation.

The Case

Two-Prong Test

The question before the Second Circuit was whether Sec. 67(e) exempted $22,241 of investment advisory fees paid by the Rudkin Trust from the "2% rule" in Sec. 67(a), or required the fees to be reduced by 2% of the trust's adjusted gross income (AGI). Sec. 67(a) allows individuals to deduct miscellaneous itemized deductions only to the extent that they exceed 2% of AGI. Estates and trusts are generally subject to the same rules for determining income and deductions as individuals, except when specifically provided otherwise in numerous other Code sections. (4) Sec. 67(e) is one of these many exceptions. It allows estates and trusts a full deduction for miscellaneous itemized deductions "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 trust or estate."

The exception is structured as a two-prong test. First, costs must be "paid or incurred in connection with the administration of the estate or trust" Second, those costs "would not have been incurred if the property were not held in such trust or estate." While the first prong is not in contention, no one can agree on what the second prong means.

Other Circuit Decisions

Four circuits have now weighed in on the meaning of the disputed phrase. In 1993, the Sixth Circuit interpreted Sec. 67(e) to allow estates and trusts a full deduction for costs "incurred because of fiduciary duties." (5) But, in 2001, the Federal Circuit disagreed and construed Sec. 67(e) as allowing a full deduction only for costs "not commonly incurred by individuals." (6) Two years later, the Fourth Circuit (7) echoed the Federal Circuit's opinion. Most recently, the Second Circuit resoundingly rejected them all, declaring that Sec. 67(e) allows a full deduction only for costs that "individuals are incapable of incurring." Ironically, the only controversy the four circuits resolved is that the statute is "plain and unambiguous." Accordingly, none of them considered it necessary to consult the statute's legislative history.

Court's Rationale

In holding that the second clause of...