Deducting third party investment mgnt. fees under Sec. 67(e).

EXECUTIVE SUMMARY

* A judicial controversy surrounds deducting investment management fees charged by a nontrustee third party.

* Taxpayers in the Sixth Circuit seeking to use O'Neill should ensure that their facts are squarely on point.

* Trustees considering amending returns that previously limited investment management fees to 2% of AGI should seek litigation counsel's advice before amending.

When an estate or trust pays investment management fees to a third party, are such costs deductible above the line or subject to the 2%-of-adjusted-gross-income floor? The Sixth and Federal Circuits have disagreed on this issue.

This article explains the controversy and offers planning strategies.

Generally, trusts and estates can deduct administrative expenses (e.g., executors' commissions, trustee fees, appraisal and court costs and investment management and legal fees) as miscellaneous itemized deductions. Such costs are deemed expenses for the production of taxable income under Sec. 212. However, the deductibility of some expenses is limited by other Code provisions. For example, Sec. 265 disallows a deduction for expenses incurred in the production of tax-exempt income. Another limit is the Sec. 56(b)(1)(A)(i) requirement that miscellaneous itemized deductions be added back in computing the alternative minimum tax (AMT).

One deduction limit has triggered considerable controversy. For individuals, Sec. 67(a) allows miscellaneous itemized deductions only to the extent that the aggregate deduction exceeds 2% of adjusted gross income (AGI). However, Sec. 67(e)(1) calculates estate or trust AGI by deducting costs "... 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 ..." Thus, Sec. 67(e)(1) effectively carves out certain administration expenses from the 2% rule, by reducing AGI by those expenses. Most commentators agree that this treatment also excludes deductible administrative expenses from the AMT addback provisions.

However, no regulations have been issued to provide guidance, and courts substantially disagree over which expenses Sec. 67(e)(1) excludes from the 2% rule. One controversial issue--on which two circuits are split--is whether estate or trust investment management fees fall within the Sec. 67(e)(1) exception. This controversy centers around Sec. 67(e)(1)'s second requirement, that the expense would not have been incurred had the property not been held in such trust or estate. Courts will frequently look to a statute's legislative history if its plain meaning is not clear. (1) However, the courts have found no legislative history specifically addressing this issue.

All courts agree that trustees' fees attributable to managing trust assets should fall within this Sec. 67(e)(1) exception. However, problems arise when a trustee employs others to perform investment and management services.

Courts Disagree

Sixth Circuit

O'Neill (2) was the first judicial determination of whether investment management fees paid by the trustees to third parties should be exempted from the 2% rule. In O'Neill, Ohio state law required trustees to adhere to the "prudent person" standard; the trustees had little or no investment experience and would not have served without the assistance of professional advisers.

Nonetheless, the Tax Court held that Sec. 67(e) means that fees must be "unique" to an estate's or trust's administration to be excluded from the 2% limit. Because individual investors routinely pay for investment advice, investment management fees are not "unique" to trusts. The Tax Court also noted that Ohio law provided fiduciaries with a detailed list of pre-approved investment assets, so that the trustees did not need to seek professional advice.

The Sixth Circuit reversed, holding that the trustees' investment management fees were fully deductible above the line. The court reasoned that hiring an outside investment adviser was required under the state fiduciary standard that trustees invest and manage the trust as prudent persons would manage their own assets; thus, the fees would not have been incurred had the property not been held in trust.

The court also pointed out that merely selecting investments from the approved list of assets did not automatically relieve the trustees of their duty to diversify. Thus, even sophisticated trustees may need professional advisory services to diversify a trust portfolio and manage investment risk.

The IRS did not acquiesce in O'Neill; it continues to subject trusts' investment advisory fees to the 2% floor. (3)

Federal Circuit

After the Sixth Circuit's O'Neill decision, the trustees in Mellon Bank, N.A. (4) claimed refunds by filing amended returns reducing AGI by the cost of outside investment management fees. The Court of Federal Claims held that these costs did not meet Sec. 67(e)'s test because, even if the trustee incurred the costs to meet its legal obligation to exercise proper skill and care, an individual could also reasonably be expected to incur such costs in a nontrust situation.

Mellon argued that "trustee fees" are merely a label encompassing many different types of fiduciary obligations. Trustees have a duty to delegate services that they are not competent to render; however, delegated services remain Subject to the same fiduciary standards. Trustees' fees have always been fully deductible under Sec. 67(e)(1), the trustees argued; thus, whether a trustee delegates a fiduciary duty to a paid professional should not render the fees nondeductible as nonfiduciary services.

The Federal Circuit upheld the Court of Federal Claims, stating that only costs that would not have been incurred if the property were not held in trust could qualify for the exclusion. The Federal Circuit rejected Mellon's argument that Pennsylvania law required the trustees to seek professional advice to fulfill their fiduciary obligations; thus, the fees would not have been incurred absent the trust. The court held that fiduciary obligations alone are insufficient to meet the test.

Fourth Circuit

A third case, Scott, (5) is currently on appeal to the Fourth Circuit. A district court held that the trustees in Scott did not meet either the "unique" test or the "fiduciary requirement" test. Virginia law affords a fiduciary (individual or corporate) absolute immunity from claims that it did not follow the prudent investor rule in managing trust assets, if the fiduciary invested in assets specifically prescribed under state law. Thus, even if a trustee arbitrarily decided to invest 100% of the assets in U.S. savings bonds and the assets suffered substantial depreciation over time, the trustee would nonetheless be deemed to have met the prudent investor standard.

The district court's holding in Scott highlights the importance of examining the applicable state's version of the prudent person or prudent investor rule before comfortably relying on O'Neill. (6) In O'Neill, Ohio law required trustees to adhere to the prudent person standard and, like Scott, provided a list of preapproved investments. But in Ohio, as the Sixth Circuit pointed out, merely selecting from the approved list of assets did not automatically relieve the trustee of the duty to diversify. Since the time these cases were decided, Ohio, Pennsylvania and Virginia have adopted the Uniform Prudent Investor Act (1994), which raises the bar on their prior fiduciary investment standards.

Return Positions

Within Sixth Circuit

Estates and trusts in the Sixth Circuit (i.e., Michigan, Ohio, Kentucky and Tennessee) with facts analogous to O'Neill can comfortably rely on O'Neill and deduct investment management fees above the line. This is because, under the "Golsen (7) rule" a circuit's precedent binds the Tax Court when the precedent is squarely on point and the case can only be appealed to that circuit. Taxpayers should carefully assess their facts to ensure they are squarely on point with O'Neill, including the size and nature of the portfolio, the trustees' investment sophistication, state law and other factors.

Outside Sixth Circuit

Estates and trusts outside the Sixth Circuit are almost assured that the IRS will continue to argue that investment management fees (and perhaps other such expenses) are subject to the 2% limit, unless it can be proved that they are unique to the estate's or trust's administration. Proving this may not be easy. Trustees considering amending returns that previously limited investment management fees to 2% of AGI should seek litigation counsel's advice before amending. The cost of the dispute could easily exceed the potential tax savings.

Substantial authority? Another concern is whether O'Neill constitutes "substantial authority" under Sec. 6662 to avoid the 20% accuracy-related penalty if trustees deduct investment advisory fees on the return without limit. Most commentators believe that O'Neil constitutes substantial authority if the trustee can establish that such fees would not have been incurred absent the trust.

Tax Court petition or refund claim? If the IRS challenges the full deduction and the trustee wishes to contest the matter in court, the trustee will usually have two choices. First, if the trustee does not wish to pay the tax first, his or her only choice is to petition the Tax Court under Sec. 6213(a). However, that court has already stated its position on this issue (O'Neill). The trustee may, however, appeal the Tax Court's decision to the circuit court for the circuit in which the trust's legal residence is located, under Sec. 7482(b)(1). Unfortunately, this means that trusts may not "forum shop" into the Sixth Circuit unless the trust is domiciled there. For an estate, there is some question as to whether the residence of the executor (or the decedent, at death) controls. (8)

Alternatively, a trustee may choose to pay the disputed tax and file a petition for a refund in either the appropriate circuit or the Court of Federal Claims. (9) The Court of Federal Claims (and the Federal Circuit, to which its cases may be appealed) have already made its position known (Mellon). Thus, the only real choice is district court. If a trustee loses in district court, he or she may appeal to the appropriate circuit court in the geographic area of the trust's legal residence.

Recommendations

Use Full-Service Trustees

Because a judicial controversy surrounds investment management fees charged by a nontrustee third party, the issue may be avoided if the trustee provides those investment management services. A trustee that provides such services under the umbrella of fiduciary fees has not heretofore been challenged on the full deductibility of fees under Sec. 67(e). While this may be labeling, it may provide a viable alternative to the problem.

There appear to be no legal or regulatory reasons why trustees cannot provide the investment management services in-house. This assumes that the trustee can meet the state's prudent investor or prudent person requirements. The controversy seems to surround trustees who lack one or more particular areas of investment expertise. Thus, the initial trustee should be chosen carefully, to provide the investment management services the trust needs. Alternatively, a trustee may allocate the assets among different investment managers and "manage the managers." The trustee should then charge enough to pay the management fees itself.

Under the Mellon rationale (that fees not customarily incurred in a nonfiduciary capacity are excluded from the 2% rule), a court could find that even investment management fees charged by a trustee are subject to the 2% rule. In fact, under the Mellon reasoning, many services that fall under the fiduciary label (such as return preparation and construction proceedings) are customarily incurred in a nonfiduciary capacity (and, thus, potentially subject to the 2% limit).

Capitalize Portion as "Transaction Costs"

One of the factors exacerbating the problem is the move by investment managers away from transaction-based charges to fee-based charges. Transaction charges are thought to encourage brokers to "churn" their customers' accounts. Instead, fee-based charges give greater rewards to investment managers and brokers, who increase the investment portfolio value regardless of the number of transactions. Often, the total fees are about the same, whether fee- or transaction-based, yet their tax treatment is markedly different.

Unlike fee-based charges, transaction charges are added to the investments' bases and ultimately result in smaller capital gains or larger capital losses. Because many fee-based charges are merely a substitute for transaction charges, it seems reasonable to capitalize all or a portion of the fees as "transaction costs" into the securities' bases. Some brokerage firms are already implementing programs to capitalize their fees and track basis for their customers. A larger portion is allocated to equity securities than fixed-income securities, because fees tend to be higher for equity management. While fee capitalization only reduces capital gains, it may be better than losing the deduction altogether.

Trustees who allocate their fees to capital assets should note that they might be affecting the competing rights of income and principal beneficiaries. Compensating adjustments may be needed to reimburse principal beneficiaries for the allocation of expenses from income to principal. In the majority of states, this can generally be accomplished by exercising the "power to adjust" under the state's Uniform Principal and Income Act. (10) Trustees in the minority of jurisdictions that have not adopted the new uniform power to adjust may need to seek other means of compensating the principal beneficiaries.

Conclusion

Some time may elapse before Sec. 67(e)'s proper legal interpretation is resolved. In the meantime, trustees and their advisers should be fully aware of the IRS'S position on this matter and the best judicial route if challenged. The safest course is for trustees to provide investment management services. Failing that, the second best option would be to charge fees in amounts sufficient to enable a trustee to pay for investment management from nontrust assets. Until the Supreme Court speaks (if ever) on this issue, tax advisers should proceed carefully.

Editor's note: The Sec. 67(e) Task Force members are: Carol Cantrell (Chair), Scott Beane, Robert Blume, Barbara Bond, Larry Graham, Eileen Sherr (AICPA Tax Division Technical Manager) and Evelyn Capassakis (AICPA Trust, Estate and Gift Tax Technical Resource Panel Chair).

Authors' note: The Task Force wishes to thank Prof. Ira Shepard, University of Houston Law Center, and W. Patrick Cantrell, J.D., CPA, for their assistance in reviewing the procedural portions of this article.

(1) 2A Singer, Sutherland Stats. and Stat. Construction, [section] 45.06 (West Group, 6th ed., 2000).

(2) William J. O'Neill, Jr., 994 F2d 302 (6th Cir. 1993), rev'g 98 TC 227 (1992).

(3) AOD 1994-6, 1994-2 CB 1.

(4) Mellon Bank, N.A., 265 F2d 1275 (Fed. Cir. 2001), aff'g 42 FedCl 86 (2000).

(5) J.H. Scott, 186 FSupp2d 664 (ED Va. 2002), appeal docketed, No. 02-1464 (4th Cir., 4/30/02).

(6) See Uniform Prudent Investor Act (1994), U.L.A. (Supp. July 2001).

(7) Jack E. Golsen, 54 TC 742 (1970), aff'd, 445 F2d 985 (10th Cir. 1971), cert. den.

(8) See Est. of Willis E. Clack, 106 TC 131 (1996).

(9) 28 USC Section 1346; Walter W. Flora, 362 US 145 (1960).

(10) Uniform Principal and Income Act (1997) [section] 104, U.L.A. (Supp. July 2001).

AICPA Tax Division's Trust, Estate and Gift Tax Technical Resource Panel's Sec. 67(e) Task Force Washington, DC