Trusts, investment advisory fees and the 2% floor.

• Author: Satchit, Vinu

Under Sec. 67(a), a taxpayer can deduct miscellaneous itemized deductions (as defined in Sec. 67(b)) only to the extent the aggregate exceeds 2% of the taxpayer's adjusted gross income (2% floor). This floor also applies to expenses of trusts and estates. However, there are exceptions for certain expenses that meet two conditions in Sec. 67(e)(1)--the expenses (1) must be incurred in the administration of the trust or estate and (2) "would not have been incurred if the property were not held in such trust or estate"; such expenses are deductible in full.

The IRS and taxpayers have interpreted #2 above differently; the resulting litigation produced a conflict between the Sixth Circuit (O'Neill (1)) and the Federal Circuit (Mellon Bank (2)). The AICPA Tax Division's Trust, Estate, and Gift Tax Technical Resource Panel's 67(e) Task Force (Task Force) published an extensive analysis of these cases, along with planning recommendations, in the wake of this sprit. (3)

In May 2003, the Fourth Circuit joined the fray with its decision in Scott. (4) While this item focuses mainly on the merits of Scott, it first discusses O'Neill and Mellon Bank, to set the stage.

Background

In O'Neill, the Sixth Circuit, reversing the Tax Court, ruled that investment advisory fees paid to third-party advisers by individual trustees (who personally lacked investment experience) met Sec. 67(e)(1) and, thus, wine fully deductible. The court based its decision on the fact that the trustees were required to incur such expenses under state law fiduciary obligations, whereas an individual owner of the same property would be under no similar obligation.

The Federal Circuit later reached the opposite conclusion in Mellon Bank, which involved a corporate trustee that paid management and investment advisory fees to related parties. Interpreting the plain and unambiguous meaning of Sec. 67(e)(1)'s second requirement to refer only to expenses unique to trust or estate administration and not customarily incurred outside of that context, the court concluded that the investment advisory and management fees the taxpayer paid were commonly incurred outside of the trust context and, thus, subject to the 2% floor.

Scott

In Scott, the individual trustees of a testamentary trust with $25 million in assets paid investment advisory, custodian, trustees' and return preparation fees in 1996 and 1997. The investment advisory fees, totaling over $100,000 per year, were fully deducted on the...