Trust Investment Fees Revisited

There currently is a split in the courts of appeal concerning the deductibility by trusts of expenses they pay for investment advice. The Fourth Circuit Court of Appeals has now joined the debate.

In 1944 John Stewart Bryan’s will established a trust for his children and grandchildren. In 1996 and 1997 the trust had assets of approximately $25 million. In those years it paid—and deducted—$107,000 and $120,000, respectively, for investment advice. The IRS rejected the deductions on the grounds they were miscellaneous itemized deductions subject to the 2% floor. The trust paid the tax and sued for a refund. The district court ruled in favor of the IRS in part on the grounds the trustees could have avoided personal liability by using the states’ “legal list” of investments and thereby avoided the expense of hiring advisers. The taxpayer appealed.

Result. For the IRS. As a general rule, trusts are entitled to the same deductions as individuals. As a consequence, miscellaneous itemized deductions are subject to the 2% floor described in IRC section 67. Subsection (e) contains an exception to the 2% floor for expenses incurred in administering a trust the taxpayer would not have had to pay if the property was not in a trust.

The first question the Fourth Circuit addressed was the extent to which it should rely on the legislative history of section 67(e). The general rule of interpretation is that a court should refer to the legislative history only if a provision is ambiguous. The appeals court found the code section clear and unambiguous and therefore did not rely on any of the legislative history the parties cited in their appeal.

According to the Fourth Circuit, the exception to the 2% floor for trusts has two requirements. First, the expenditures had to have been incurred in the administration of a trust. Both parties agreed the taxpayer fulfilled this condition. The second requirement is that the costs “would not have been incurred if the property were not held in such trust.” This requirement was where the dispute laid. The taxpayer argued the trustees had needed the investment advice to fulfill their obligation to the beneficiaries. The IRS argued the expenses were not unique to trusts.

In its decision the Fourth Circuit agreed with the Federal Circuit Court of Appeals that this provision requires the expenses to be unique to the administration of a trust. Put another way, the expense cannot be one individuals commonly incur. Since it is common for individual taxpayers with large portfolios to use outside advisers and pay for their advice, the trust did not incur a unique expense. Therefore investment advice expenditures are subject to the 2% floor.

With this decision the Fourth Circuit joins the Federal Circuit in treating these expenses as miscellaneous itemized deductions. The Sixth Circuit Court of Appeals, on the other hand, has ruled they are fully deductible on the grounds that a trustee without investment experience must hire an outside adviser to fulfill his or her fiduciary responsibility to the beneficiaries. Additional litigation on the issue is likely in the future to resolve this interpretation conflict.

Prepared by E dward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.