Many trust fiduciaries incur investment adviser fees while administering the trust. To reduce taxable income, the trustee wants to deduct these costs against trust income—but the courts are split on the issue. The Tax Court recently was asked to reconsider the question.
Henry Rudkin established a testamentary trust with the proceeds of the sale of his business, Pepperidge Farm, to Campbell Soup Co. The trustee hired Warfield Associates Inc. to provide investment advice, and then deducted payments to Warfield of $22,241 on the trust’s 2000 income tax return. The IRS rejected the deduction on the grounds the expenditure was a miscellaneous itemized deduction subject to the 2% floor.
Result. For the IRS. A trust calculates income the same way an individual does. It can deduct IRC section 62 expenses from its gross income to arrive at adjusted gross income and is then permitted the section 63 itemized deductions from adjusted gross income.
Section 67 limits miscellaneous itemized deductions to expenditures in excess of 2% of adjusted gross income. Section 67(e) exempts from this 2% floor “costs that 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.” All parties in Rudkin agreed the challenged expenditure was incurred in the administration of the trust. The question was whether it was incurred because the trust owned the assets.
The trustee argued that he had met the requirement because his fiduciary responsibility obligated him to hire an investment adviser where individuals are not obligated to do so. The IRS said that, as many individuals do hire investment advisers, the expenditures for investment advice were not incurred because of the trust’s existence.
The Tax Court previously had considered this argument in O’Neill v. Commissioner, 98 TC 227 (1992), and ruled for the IRS. The Sixth Circuit Court of Appeals reversed the decision, reasoning that fiduciaries can incur penalties for negligence if they failed to hire an adviser but individuals are not similarly penalized. Thus, the expenditure was incurred because the trust existed.
Subsequently, the Federal and Fourth Circuits ruled for the IRS. In their opinion, the expenditures did not meet the requirement because individuals commonly incur them. In addition a ruling in favor of the trust would allow a fiduciary to argue he or she incurred all expenditures as a result of his or her fiduciary responsibility and, thus, the ruling would nullify the second requirement.
After reviewing the argument on both sides, the Tax Court sided with the Federal and Fourth Circuits and held the expenditures were subject to the 2% floor.
Courts continue to disagree on this issue, which must be settled through legislation or additional litigation. At this point taxpayers should tailor their position to the appeals court that would hear their case.
William Rudkin Testamentary Trust v. Commissioner, 124 TC no. 19.
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.