Trust investment advisory fees and the 2%-of-AGI limit.

On June 2, 1993, the Sixth Circuit reversed the Tax Court and held that investment advisory fees incurred by a trust are not subject to Sec. 67(a), which limits certain itemized deductions by 2% of adjusted gross income (AGI). Although the Service may pursue this issue in other circuits, the decision in O'Neill, 994 F2d 302 (6th Cir. 1993), represents a significant taxpayer victory.

O'Neill involved a trust with substantial assets and co-trustees with little investment experience. Applicable state law required trustees to invest and manage trust assets as "prudent investors," but also provided a list of preapproved investments.

Although Sec. 67(a) limits certain itemized deductions by 2% of AGI, Sec. 67(e)(1) contains a special exception for trusts and estates. An "above-the-line" (i.e., no limitation) deduction is allowed for costs "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 ...... The Tax Court interpreted this exception to apply only to costs "unique" to trusts and estates. Since individuals frequently hire investment advisers, the Tax Court deemed that such fees were not unique.

Citing Stevens v. National City Bank, 544 N.E.2d 612 (Ohio 1989), the Sixth Circuit noted that the mere selection of approved investments did not automatically meet the prudent investor standard. The trustee had the duty to diversify the investment of trust assets, and to distribute the risk of loss within the trust. The Sixth Circuit stated:

Where a trustee lacks experience in investment matters, professional assistance may be warranted. The trustees here lacked experience in investing and managing large sums of money and, therefore, sought the assistance of an investment advisor. Without [the manager], the co-trustees would have put at risk the assets of the Trust. Thus, the investment advisory fees were necessary to the continued growth of the Trust and were caused by the fiduciary duties of the co-trustees.

[Individuals] are not required to consult advisors and suffer no penalties or potential liability if they act negligently for themselves. Therefore, fiduciaries uniquely occupy a position of trust for others and have an obligation to the beneficiaries to exercise proper skill and care with the assets of the trust. (Emphasis in original.)

Based on this language, it appears that there may be factual elements (e.g., the trustee's investment sophistication and state law requirements) in determining whether such fees are subject to limitation. Trustees and/or their legal counsel are the appropriate source of information on such factual elements. The O'Neill decision, together with the statutory language of Sec. 67, suggests such a factual determination and supports the position that trustees can claim investment advisory fees without limitation, if such fees would not have been incurred absent the trust. Note the possibility that even a sophisticated trustee may engage an investment adviser to diversify the risk inherent in relying on its sole judgment and analysis.

If prior years' returns applied the limitation and the tax impact was material, trustees may consider amending returns to seek refunds. Alternatively, because the IRS may pursue the issue in other circuits, some trustees may choose to monitor the situation, being careful not to let the statute of limitations expire. Given the current state of this issue, it may be imprudent for a trustee to apply the 2% floor in most fact situations. Trustees should be aware of the continued risk of disallowance and, ultimately, the potential for interest on any resulting deficiency.