Trusts, investment advisory fees and the 2% floor.

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 1996 and 1997 trust returns. On audit, the IRS subjected these expenses to the 2% floor.

District court: Without directly addressing O'Neill or Mellon Bank, a Virginia district court granted the IRS summary judgment, basing its decision on a Virginia laws that provided a trustee absolute immunity from claims (and violations of the "prudent investor" rule) if the trustee chose investments from a list the statute prescribed. Because absolute immunity was available, the trustee was not required to consult an outside investment adviser under state law to meet fiduciary obligations; thus, such expenses were not unique to the trust at issue. Although the court purported not to rely on O'Neill or Mellon Bank, its line of reasoning seems analogous to the Sixth Circuit's, because it focused on whether the trustee has to incur investment advisory fees to avoid liability under state law. Taxpayers residing outside of Virginia arguably benefited from this decision, as most states do not offer absolute immunity to a trustee for choosing from a list of prescribed investments.

Fourth Circuit: On appeal, the Fourth Circuit affirmed the district court's decision, but on alternate legal grounds. Following reasoning similar to that in Mellon Bank, the court focused on Sec. 67(e)(1)'s language to ascertain the threshold Congress intended for full deductibility. Based on the ordinary meaning of "would" as used in Sec. 67(e)(1)--custom, habit, natural disposition or probability--the Fourth Circuit concluded that the clear and unambiguous meaning of Sec. 67(e)(1)'s second requirement was to limit its applicability to "trust-related administrative expenses that are unique to the administration of a trust and not customarily incurred outside of trusts:' The court cited trustee, fiduciary return preparation and judicial accounting preparation fees as examples of unique expenses that would meet the Sec. 67(e) requirements.

Defining "Unique Expense"

Whether an expense is "not commonly incurred" outside the trust context is a difficult standard to apply objectively, as evidenced by the Fourth Circuit's arbitrary application of that standard when dealing with tax return preparation costs. Return preparation fees, according to the court, are "unique," while investment advisory fees are not. However; individuals commonly incur return preparation fees. Why are investment management fees more common between individuals and trusts than return preparation fees? Presumably, the Fourth Circuit's logic is that individuals do not file the same income tax forms as trusts; thus, preparation expenses for trust forms are unique expenses that meet Sec. 67(e). If the need to use different forms is sufficient to cause trust return preparation fees to be classified as "unique," the threshold for categorizing an expense "unique" seems to be very low.

The same logic, if extended to investment advisory fees, would war rant an investigation into exactly what services were provided, to determine if they were "unique" to a trust or estate. The nature of investment advice given to trustees usually differs from that given to individuals, because of income and remainder beneficiaries' needs, stipulations in trust agreements, state law restrictions on allowable investments, etc. The Fourth Circuit did not consider any such issues before concluding that investment advisory fees are not "unique" to trusts.

Canons of Statutory Construction

The canons of statutory construction that the Fourth and Federal Circuits purport to be bound by in reaching their decisions are not rigid mathematical principles that bar consideration of Sec. 67(e)(1)'s legislative intent. In American Tracking Assn's, Inc., (6) the Supreme Court sanctioned departure from words' literal meaning in interpreting statues, even when such plain meaning "did not produce absurd results but merely an unreasonable one plainly at variance with the policy of legislation as a whole." The Fourth Circuit refused to consider the taxpayer's argument that it look to the legislative history, because the statute was "clear and unambiguous." In American Trucking, the Supreme Court stated, "[w]hen aid to construction of the meaning of words, as used in the statute, is available, there certainly can be no 'rule of law' which forbids the use, however clear the words may appear on 'superficial examination.'" [Citation omitted.]

Arguably, the Fourth Circuit's focus on the literal meaning of "would" and its outright refusal to consider legislative history is simply superficial. Does the approach produce an unreasonable result? Unfortunately, yes. The Service and the courts acknowledge that trustee fees are fully deductible under Sec. 67(e).Trustee fees are compensation to the trustee for the various duties that he or she must perform under state law, including investing and managing trust assets. To infer that Congress intended to permit a full deduction for fees paid to a trustee for his or her services, but intended to deny a full deduction for the same services if delegated by the trustee to a third party, seems illogical. Why would Congress he concerned to whom the fees are paid (as opposed to the type of fees paid) in determining deductibility? The decision currently produces a tax incentive to use corporate trustees over individual trustees (who may be trusted friends of the grantor or decedent, but lack investment experience). Surely, this is an unreasonable result. The Sixth Circuit's decision is a more plausible reflection of legislative intent, as it gives more weight to the fees' substance (i.e., whether required under state law) than the form in which paid (i.e., to the trustee or a third party).

Planning

From a practical standpoint, use of full-service corporate or individual trustees with investment experience may avoid this issue. However, the IRS may request that full-service-trustee fees be unbundled, to separate the investment-advisory-fee component on audit (in some cases, IRS auditors have requested unbundling of corporate trustee fees, even though the audit results left the matter unchanged). Capitalization of part of the costs as transaction costs (an option previously investigated in detail (7)) is another option.

Taxpayers in the Sixth Circuit (Michigan, Ohio, Kentucky and Tennessee) are well advised to continue to fully deduct investment advisory fees if their facts are analogous to those in O'Neill. Taxpayers in other circuits should discuss with legal counsel whether O'Neill could be followed in their specific situation.

Some time may elapse before Sec. 67(e)'s proper legal interpretation is completely resolved. The Task Force will continue to monitor this issue and report new developments.

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

(2) Mellon Bank, N.A., 265 F3d 1275 (Fed. Cir. 2001), aff'g 47 Fed. C1. 186 (2000).

(3) See AICPA Tax Division's Trust, Estate, and Gift Tax Technical Resource Panel's Section 67(e) Task Force, "Deducting Third-Party Investment Mgmt. Fees Under Sec. 67(e)," 33 The Tax Adviser 646 (October 2002).

(4) J.H. Scott, 328 F3d 132 14th (Cir. 2003), aff'g 186 FSupp2d 664 (EDVA 2002).

(5) See Va. Code Ann. [section] 26-45.1.

(6) American Trucking Assn's, Inc., 310 US 534 (1940)

(7) See note 3, supra.

VINU SATCHIT, CPA, BDO SEIDMAN LLP, HIGH POINT, NC, AND MEMBER OF THE AICPA TAX DIVISION'S TRUST, ESTATE, AND GIFT TAX TECHNICAL RESOURCE PANEL'S SECTION 67(e) TASK FORCE