Application of two-percent floor on itemized deductions to trusts and estates.

• Author: Madden, David

The Tax Reform Act of 1986 introduced the so-called "two-percent floor" on miscellaneous itemized deductions in Sec. 67(a). Under that section, for individual taxpayers, certain below-the-line deductions are acceptable only to the extent that the deductions, in the aggregate, exceed two percent of a taxpayer's adjusted gross income (AGI). However, with little explanation, Congress also added Sec. 67(e), under which a trust or estate must compute its AGI in the same manner as an individual, except "the deductions for costs which are 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" would be allowed without regard to the Sec. 67(a) two-percent limit in calculating AGI.

It was not until William J. O'Neill, Jr. Irrevocable Trust, 994 F2d 302 (6th Cir. 1993), rev'g 98 TC 227 (1992), that the courts determined the meaning and scope of Sec. 67(e)(1). In O'Neill, the Tax Court had held that certain fees that the trustees paid to independent investment advisers were subject to the two-percent floor on itemized deductions. The Sixth Circuit reversed the Tax Court and held that the fees were deductible without limit, because the expenses "would not have been incurred if the property was not held in trust." The Sixth Circuit relied on the "prudent investor" rule imposed on fiduciaries under Ohio law to find that the trustees in O'Neill, unlike individual investors, were required to incur the investment advisory costs to avoid personal liability.

Despite the Tax Court's explicit rejection of this reasoning, and the IRS's nonacquiescence in O'Neill, many fiduciaries in other states with a prudent-investor rule believed that other circuits would agree that similar costs would also be excepted from the two-percent limit. However, the Court of Federal Claims, in Mellon Bank, N.A., 47 Fed. Cl. 86 (2000), explicitly rejected the Sixth Circuit's reasoning and found that expenses paid to an independent investment adviser were subject to the two-percent floor. Mellon Bank has since been appealed to the Federal Circuit. A victory for Mellon Bank on appeal may signal at least a temporary end to the uncertainty surrounding the scope of Sec. 67(e). However, if the Federal Circuit affirms, fiduciaries and tax practitioners will face a split in the circuits and conflicting guidance as to the proper treatment of many common trust expenses.

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