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

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.

Briefs on behalf of Mellon Bank and the Department of Justice (DOJ) have already been filed with the Federal Circuit. Based on its brief, Mellon Bank will be offering similar arguments to those approved by the Sixth Circuit. Specifically, Mellon Bank will argue the fact that expenses paid to outside advisers to satisfy fiduciary obligations do not change the fiduciary nature of the services and applicable fees. Just as a trustee fee is incontrovertibly an expense not subject to the two-percent floor, fees paid to outside advisers to assist the trustee in carrying out its duties under state law should also be an expense "unique" to a trust's administration. According to Mellon Bank, this reasoning is the only proper interpretation of Sec. 67(e)'s plain language.

On the other hand, the DOJ will argue that the Court of Federal Claims provided the proper interpretation of Sec. 67(e). Rather than focusing on whether the trustee would be required to incur a particular expense because of state-imposed fiduciary obligations, the proper inquiry is whether the expenses would have been incurred by an individual investor notwithstanding the trust's existence. Because individual investors incur investment advisory expenses routinely, it cannot be said that expenses paid by a trustee for outside investment advice are expenses that "would not have been incurred if the property were not held in such trust." According to the DOJ, the legislative history of Sec. 67(e) demonstrates that Congress was concerned with equating the tax consequences for individuals who hold property for investment in trust to individuals who invest without the use of a trust. The DOJ argues that the interpretation of Sec. 67(e) presented by the Court of Federal Claims is the only interpretation consistent with this stated congressional purpose.

Another interesting aspect of the Mellon Bank appeal is the anticipated resolution of the issue of whether, if the DOJ argument prevails, trusts charged a comprehensive trustee fee must "unbundle" the fee. This process would require a trustee to allocate a portion of its fee to the various services provided to the trust, and then determine whether each portion should be subject to the two-percent floor. This issue was first raised in an amicus brief filed in Mellon Bank. Although the court did not say that "unbundling" was indeed required, the court did state that the Service could require the "unbundling" of trustee fees. As of now, the IRS has not issued any such directive. A victory in the Federal Circuit, however, could mean that formal guidance is forthcoming. In any case, the decision in Mellon Bank's appeal will be closely followed by fiduciaries and tax practitioners alike.

FROM JEFFREY T. RODRICK, J.D., LL.M., WASHINGTON, DC