Deducting investment advice fees.

Since the Tax Reform Act of 1986 there has been uncertainty about the tax treatment of fees for investment advice paid by estates and trusts. The language of Internal Revenue Code sections 67(a) and 67(e) has been construed as either allowing a full deduction for such fees or imposing a 2% of adjusted gross income (AGI) floor before fees are deductible. This article describes a court case that ends the uncertainty for some taxpayers.

In William J. O'Neill, Jr., Irrevocable Trust v. CIR, y; 98 T.C. 227 (1992), the Tax Court held that investment advice fees were subject to a 2% floor. The Sixth Circuit Court of Appeals reversed that decision, allowing the fees to be deducted in their entirety (William J. O'Neill, Jr., Irrevocable Trust v. CIR, 994 F2d 302 [6th Cir. 1993]).

In a 1994 action on decision, the Internal Revenue Service said it did not acquiesce to the Sixth Circuit's decision. Consequently, investment advice fees are fully deductible for estates and trusts within the Sixth Circuit, which includes Kentucky, Michigan, Ohio and Tennessee. CPA practitioners in the Sixth Circuit therefore should consider amending the estates and trusts tax returns for 1994, 1995 and 1996 that limit deductions for investment advice fees to amounts above 2% of AGI. Taxpayers outside the Sixth Circuit may rely on the court's O'Neill decision. However, since the Tax Court is not formally bound by the decision outside the Sixth Circuit, outside taxpayers may want to evaluate whether substantial authority exists before making a challenge.

JUST THE FACTS

The William J. O'Neill, Jr., Trust was formed in 1965 under Ohio law. None of the trustees was an investment expert or willing to serve unless an investment adviser was hired. From 1979 to 1991, the trustees received investment advice from a professional investment management company. On its 1987 Form 1041, U.S. Fiduciary Income Tax Return, the trust deducted in full the investment fees it had paid. The trustees declined compensation for their services.

During an audit of the trust's 1987 return, the IRS allowed the deduction for the fees only to the extent they exceeded 2% of the trust's AGI. The trust challenged the IRS decision in Tax Court.

THE ISSUE

The deductibility question arose because section 67(e) generally requires the AGI of an estate or trust to be "computed in the same manner as in the case of an individual." Under section 67(a), investment fees for individuals are miscellaneous itemized deductions subject to a 2% floor. A trust or estate's administrative expenses, "costs... which would not have been incurred if the property were not held in such trust or estate," are fully deductible for purposes of determining AGI. The investment advice fees were construed by the IRS to be subject to the 2% floor and by the trust to be a fully deductible administrative expense.

THE TAX COURT DECISION

In Tax Court, the trust advanced two arguments to support its position.

Role of local law. In the absence of Treasury regulations and little legislative history on section 67(e), local law determines what constitutes an administrative expenditure. Ohio statutes require trustees to invest trust assets and prescribe the type and quality of investments they can make. As with most states, Ohio law holds trustees to the "prudent person" standard of care, under which trustees' investment decisions are evaluated in light of all circumstances to determine whether they acted honestly, in good faith and with the degree of care and prudence ordinary persons would exercise in transacting their affairs. The trust argued that Ohio trustees must seek investment advice if they are to fulfill their fiduciary obligations. Hence, investment advice fees are fully deductible trust administration expenses.

Source of payments. The other argument was that investment advice payments should be given the same tax treatment regardless of whether they are paid from the trust or directly by the trustees. Trustee fees are administrative expenses. No such fees were paid to the trustees in the period involved. However, had the trust paid fees to the trustees, who then could have paid the investment advice fees, the trustees argued that the trust would have been entitled to fully deduct the trustee fees and the investment fees would have been fully deductible by the trustees.

The Tax Court said it did not find the trust's arguments persuasive because

1. The language of section 67(e) means only expenses unique to trust administration, such as trustee fees and trust accounting fees mandated by law or the trust agreement, are fully deductible. Investment advice fees are not unique to trust administration simply because a fiduciary might feel compelled to incur them to meet the prudent person standard imposed by state law. In addition, individual investors routinely incur them.

2. Ohio law does not specifically require trustees to incur investment advice fees to avoid a breach of fiduciary duty. The Tax Court reasoned the Ohio statutes, which provide a fiduciary with a detailed list of preapproved investments, obviate the need to purchase investment advice. The trustees' unwillingness to serve unless an investment adviser was retained was not considered determinative. The application of section 67(e) does not hinge on a fiduciary's subjective considerations.

3. The trust's argument that investment fees would have been fully deductible if paid by the trustees out of their trust fees is irrelevant. The tax consequences of events must be considered as they actually occur.

THE SIXTH CIRCUIT DECISION

The Sixth Circuit reversed the Tax Court, reasoning investment advice fees paid by the trust were fully deductible administrative expenses because they would not have been incurred had the property not been held in trust. Although individuals routinely incur investment advice fees, they are not required to do so. Individuals suffer no penalties or potential liabilities if they act negligently on their own behalf.

The O'Neill trustees lacked skill in investing and managing large sums of money. Had they not sought an investment adviser's assistance, they would have put the trust's assets at risk. Therefore, the court reasoned, the investment advice fees were a result of the trustees' fiduciary duties.

The mere selection of an investment from a preapproved list does not meet the prudent person standard, according to the court. Such a list limits a trustee's investment options and diversification of trust assets. The Sixth Circuit did not address whether the O'Neill trustees' unwillingness to serve without a professional investment adviser was relevant to the application of section 67(e). The court decided the case entirely on the prudent person line of reasoning.

UNRESOLVED ISSUES

O'Neill appears to make investment advice fees fully deductible without limit by all trusts within the Sixth Circuit. Yet language in the decision calls into question the full deductibility of investment advice fees by all trusts: "Where a trustee lacks experience in investing matters, professional assistance may be warranted." (Emphasis added.) This language may provide the basis for a challenge by the IRS in other circuits. The IRS could argue that investment advice fees are not fully deductible by a trust if at least one trustee has experience in investing or managing large sums of money.

PRACTICAL CONSIDERATIONS

Most states impose some type of prudent investor duty on a fiduciary either statutorily or through common law. Therefore, although O'Neill was based on Ohio statutes, the decision has much wider applicability.

The Sixth Circuit's decision gives practitioners within that circuit substantial authority to amend fiduciary income tax returns that were prepared based on the original Tax Court decision. While practitioners outside the Sixth Circuit may rely on the appeals court's decision, they also may want to consider the Tax Court decision in deciding whether substantial authority exists. Refunds may be sought for investment advice fees that were limited to amounts in excess of 2% of a trust's AGI. A note of caution: If trustees have investment or financial management experience, the prudent person standard, as determined by local law, may not require retention of independent investment advisers. The outcome of a case in which the trustees have such experience may differ from the O'Neill case.

One way to remedy reliance on the local prudent person standard may be to draft the trust agreement so the trustees are required to retain investment advisers. Ia trust does this, the Tax Court ruling on the subjective nature of the O'Neill trustees' refusal to serve (not reviewed by the Sixth Circuit) may be circumvented. Such a clause would not impose a burden on the trust if it already was likely to retain investment advisers. This technique may reduce the chances the IRS will relitigate the issue.

UNCERTAINTY REMAINS

Although the O'Neill decision paved the way for estates and trusts to fully deduct investment advice fees, there remains some uncertainty on the breadth of the decision. If trustees have appropriate financial experience and the trust does not require investment advice to be retained, deduction could be vulnerable. CPAs should be sensitive to this in making recommendations to clients.

Deductibility of Investment Advisory Fees

XYZ Family Trust
Adjusted gross income (AGI)......................$250,000
Investment advice fees...........................$  7,500

                                                    Sixth
                                     Tax Court      Circuit
                                     decision       decision

                                     (Fees          (Fees not
                                     subject        subject to
                                     to 2% of       2% of AGI
                                     AGI floor)     floor)

Investment advice fees               $7,500         $7,500
Less: 2% of AGI floor                (5,000)           N/A
Deductible investment advice fees    $2,500         $7,500

CHARLES J. BURT II, CPA, is a tax manager with KPMG Peat Marwick, LLP, in Cleveland. HANS SPROHGE, CPA, PhD, is professor of accountancy at Wright State University, Dayton, Ohio.

EXECTIVE SUMMARY

* UNCERTAINTY ABOUT THE deductibility of investment advice fees has existed since 1986. It was not clear whether the fees were fully deductible or limited to a floor of 2% of adjusted gross income.

* IN THE O'NEILL CASE, THE SIXTH CIRCUIT Court of Appeals reversed a Tax Court decision and said the fees were deductible in their entirety. The Internal Revenue Service, however, did not acquiesce, meaning investment advice fees are deductible for estates and trusts within the Sixth Circuit (Kentucky, Michigan, Ohio and Tennessee) but the IRS will continue to challenge the decision outside that circuit.

* THE DEDUCTIBILITY QUESTION AROSE because IRC section 67 generally requires estates and trusts to compute their AGIs in the same way individuals do. An investment fee for an individual is subject to a 2% floor as a miscellaneous itemized deduction. However, section 67(e) allows a full deduction for the administrative expenses of an estate or trust--costs that would not be incurred if the property were not held in an estate or trust.

* PRACTITIONERS IN THE SIXTH CIRCUIT have substantial authority to amend fiduciary income tax returns that were prepared based on the original Tax Court decision limiting the deduction. Caution is advised, however, when trustees have investment or financial management experience and retention of independent advisers may not be warranted.