"Rudkin" Regulations Proposed During Appeal

How's this for uncertainty & conflict: Proposed federal treasury regulations were just published for comment, before oral argument in an appeal to the U.S. Supreme Court on the same issues.

Well, that's the situation spawned by the tax litigation in William L. Rudkin Testamentary Trust v. Commissioner (PDF, 19 pages), 467 F.3d 149, 98 AFTR2d 2006-7368 (2d Cir. 10/18/06).

[Note: See Updates (below) for developments, including the decision by the U.S. Supreme Court on January 16, 2008, which resolved the litigation in this case.]

Buffalo Springfield sang about similar chaotic forces intersecting with institutional attempts at control & consolidation in the late 1960s.

Well, perhaps I overstate this case. I admit, the subject now is not quite so hot or divisive for the general public -- but it does send fiduciary administrators & investment managers reeling.

The subject: deduction for investment advisory fees on a fiduciary income tax return in excess of a 2% floor.

The controversy has raged throughout the country, as evidenced by numerous conflicting federal district & circuit court decisions, and a full-panel tax court decision.

It is the Rudkin case, most recently decided by the Second Circuit, U.S. Court of Appeals, that focused the debate for finalization.

The legal issues & the prior ruling as delivered by that court were addressed by Robert S. Balter, Esq., of Guggenheim Partners LLC, in King of Prussia, PA, in his BNA Tax Management article posted online in October, 2006, entitled "Second Circuit Holds Trust's Investment Advisory Fees ARE Subject to 2% Floor".

The United States Court of Appeals for the Second Circuit has held [on October 18, 2006] that the 2% threshold imposed generally on miscellaneous itemized deductions applies to investment advisory fees charged to trusts and estates, affirming a unanimous reviewed decision of the United States Tax Court.

In so holding, the Second Circuit reached a result in accord with decisions of the Fourth and Federal Circuits and contrary to a decision of the Sixth Circuit Court of Appeals. * * *

Because of the fiduciary obligations imposed on personal representatives and trustees, these conflicting decisions affect every trust and every estate that files an income tax return.

One commentator said, “In the world of fiduciary income taxation, the proper application of the 2% floor imposed by §67(a) on the deductibility of a fiduciary's administrative costs is perhaps the most vexing controversy currently outstanding.”

Of the three decisions holding that a trust's or estate's investment advisory fees are subject to the 2% of adjusted gross income reduction, the Second Circuit's rationale is by far the most restrictive. * * *

The Second Circuit held:

We believe the plain text of §67(e) requires that we determine with certainty that [fully deductible] costs could not have been incurred if the property were held by an individual. We therefore hold that the plain meaning of the statute permits a trust to take a full deduction only for those costs that could not have been incurred by an individual property owner. (emphasis added). * * *

Overall, it had been hoped that the Second Circuit Court of Appeals decision in this matter would bring some enlightenment to this area of 20-year uncertainty. The fiduciary community in general had hoped that an intelligent distinction would be drawn between fully deductible fees and those not fully deductible.

Instead, apparently falling victim to the maxim “that great cases, like hard cases make bad law, the Second Circuit's opinion in Rudkin is a significant disappointment in the development of the law in this area.

[Footnotes omitted; reparagraphing applied.]

His article provided a full statutory & case law analysis, with citations under 26 footnotes, just as it appeared in the January 11, 2007, issue of the Tax Management Estates, Gifts and Trusts Journal.

Particularly for Pennsylvanians, there remains uncertainty on this issue. Robert noted, in footnote 8, that "the Third Circuit has not spoken on this issue to date."

Then, in late June, 2007, the U. S. Supreme Court granted review of the Rudkin decision. This was noted in an article dated July 2, 2007, entitled "Supreme Court To Hear Case On Taxation Of Trust Fees", distributed by the Dow-Jones News Service, & posted by Financial Advisor Magazine.

The nation's highest court has agreed to take on a case involving taxes and trusts in a move banks and financial advisors are watching closely.

Last week, the U.S. Supreme Court said it will hear a 2005 tax court case involving a section of the tax code that allows trustees to deduct money management fees associated with running trusts.

The case has created a stir among companies that advise on managing trusts because an adverse ruling would mean trusts would have to pay more tax. It could discourage trustees from hiring banks and others by increasing the tax they pay on fees to outside advisors. And it might leave in place inconsistencies between states that make it more difficult for trustees to be sure they are dispatching their duties properly.

"This particular decision affects the trust industry dramatically," said Susan Porter, a managing director at U.S. Trust, Bank of America Private Wealth Management.

An estimated $1 trillion in assets are held in trusts and estates in the U.S. Each year, trustees earn fees for managing trusts; they also pay billions of dollars for outside advice they seek on investing and managing money in the trusts.

The article quoted ACTEC Fellow & tax practitioner Ronald D. Aucutt, Esq., who had written & posted an article on June 25, 2007, entitled "Supreme Court Grants Certiorari in Rudkin" He & other experts were quoted about the possible impact of a ruling:

The biggest problem for taxpayers will be if the Supreme Court rules that all fees can't be deducted, according to Ronald D. Aucutt, a partner in the McLean, Va., offices of McGuireWoods LLP, and counsel on another well-known case involving the deductibility of fees.

"I don't think it will drive away a lot of business or even change dramatically what banks do," said Aucutt. "But I do think it will be an annoyance to customers when banks have to explain that their taxes will go up."

It would also present tax preparers and trust administrators with new complexity in computing trust-related income taxes, according to Aucutt.

The judicial attention paid to the case has been extraordinary, according to Jeffrey N. Pennell, a law professor at Emory University in Atlanta.

"The issue is relevant to every single trust and estate that files an income tax return," said Pennell. "The dollar amount may not be great in any given trust, but the applicability of the issue — it's everywhere."

But the Internal Revenue Service advanced its position further on July 26, 2007, by publishing proposed regulations covering this issue, for public comment. The Proposed Regulations, regarding application of Internal Revenue Code, Section 67(e), are available here (PDF, 5 pages), as posted by BNA.

These regulations were reviewed by Commerce Clearing House in a report in its "Tax Newsletter", posted July 27, 2007, entitled "Proposed Regulations Would Exclude Certain Estate and Trust Expenses from 2-Percent Floor for Itemized Deductions (NPRM REG-128224-06)".

The Treasury and the IRS have proposed regulations that would clarify the 2-percent floor for itemized deductions as applied to expenses paid by estates and non-grantor trusts. The regulations would apply to payments made after the date the final regulations are published in the Federal Register.

Under the proposed regulations, only costs incurred by estates and non-grantor trusts that are unique to an estate and trust are excluded from the two-percent floor that applies to miscellaneous itemized deductions.

For this purpose, a cost is unique to an estate or trust if it cannot be incurred by an individual in connection with property that is not held in an estate or trust. Costs that are not unique to an estate or trust are subject to the 2-percent floor.

If an estate or non-grantor trust pays a single fee that includes both unique and non-unique costs, the estate or trust must use a reasonable method to allocate that fee between the two types of cost.

These rules do not apply to expenses that are otherwise excluded from the definition of miscellaneous itemized deduction, or to expenses related to a trade or business. * * *

Comments on the proposed regulations must be received by the IRS by October 25, 2007. A public hearing is scheduled for November 14, 2007, in the IRS Auditorium in the Internal Revenue Building, 1111 Constitution Ave. NW., Washington, D.C. * * *

The entire CCH Report & Commentary was reposted by the Center for Tax Studies, here.

On July 27, 2007, Ronald Aucutt aired reactions to the IRS Proposed Regulations in an article entitled "IRS Publishes Proposed Regulations on Deductibility of Fiduciary Expenses", posted on the website of McGuire Woods, LLP. He notes the nitty-gritty effects of the "harshest approach" of the Proposed Regulations:

As proposed, these regulations would go much further than any of the court cases to date. Not being restricted by any particular facts, as the court cases are, the Service is proposing to take the harshest approach possible.

Basically, the proposed regulations would apply the 2% floor to all expenses of an estate or trust except expenses that are “unique” to an estate or trust. An expense is considered “unique” only if “an individual could not have incurred that cost in connection with property not held in an estate or trust.”

As “unique” fiduciary activities, the cost of which is fully deductible, the proposed regulations cite fiduciary accountings, required judicial filings, fiduciary income tax returns, estate tax returns, distributions and communications to beneficiaries, will or trust contests or constructions, and fiduciary bonds.

As examples of services that are not “unique” to a trust or estate, the costs of which are subject to the 2% floor, the proposed regulations cite the custody and management of property, investment advice, preparation of gift tax returns, defense of claims by creditors of the grantor or decedent, and the purchase, sale, maintenance, repair, insurance, or management of property not used in a trade or business. * * *

Now, we wait . . . for a ruling from "the Supremes" -- so that we can fill out fiduciary income tax returns correctly next year.

Hey, I know. It's really only a tax issue. So, "For What It's Worth", please forgive me for melodrama.

What a field-day for the heat
A thousand people in the street
Singing songs and carrying signs
Mostly say, "Hooray for our side!"

It's time we stop, hey, what's that sound
Everybody look what's going down

Paranoia strikes deep
Into your life, it will creep
It starts when you're always afraid
You step out of line, the man come and take you away

We better stop, hey, what's that sound
Everybody look what's going down

-- Buffalo Springfield, "For What It's Worth" (1967)

Update: 08/24/07:

Various bankers associations filed a single "friend-of-the-Court" brief with the United States Supreme Court on August 23, 2007, in this matter. See: PA EE&F Law Blog posting, Bankers Associations File Amicus Brief in Rudkin Case (08/24/07).

Update: 11/19/07:

Various organizations submitted comments to the proposed regulations, and the IRS held a hearing on Wednesday, November 14, 2007. See: PA EE&F Law Blog posting, IRS Gets Comments on "Rudkin" Regs Proposed (11/19/07).

Update: 01/17/08:

On January 16, 2008, the United States Supreme Court issued its decision in Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue Service. (No. 06–1286; PDF, 16 pages). In short, the IRS won. But the drama may not be over, either.

See: PA EE&F Law Blog posting "IRS Wins Rudkin Case in U.S. Supreme Court" (01/17/08).