IRS Wins Rudkin Case in U.S. Supreme Court

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.

This is the summary of the Court's holding: "Investment advisory fees generally are subject to the 2% floor when incurred by a trust."

The case, on appeal from the Second Circuit Court of Appeals, was argued before the U.S. Supreme Court on November 27, 2007. The case was decided unanimously by the Court in an opinion written by Chief Justice Roberts. The result favored the position advocated by the Internal Revenue Service.

The Court's opinion summarized the setting and issues as follows:

Individuals may subtract from their federal taxable income certain itemized deductions, 26 U. S. C. §63(d), but only to the extent the deductions exceed 2% of adjusted gross income, §67(a).

A trust may also take such deductions subject to the 2% floor, §67(e), except that when the relevant cost is “paid or incurred in connection with the administration of the . . . trust” and “would not have been incurred if the property were not held in such trust,” the cost may be deducted without regard to the floor, §67(e)(1).

After petitioner Knight (Trustee), the trustee of a testamentary trust (Trust), hired the Warfield firm to advise as to Trust investments, the Trust deducted in full on its fiduciary income tax return the investment advisory fees paid to Warfield.

Respondent Commissioner found the fees subject to the 2% floor and therefore allowed the deduction only to the extent the fees exceeded 2% of the Trust’s adjusted gross income.

The Tax Court decided for the Commissioner, and the Second Circuit affirmed, holding that because such fees were costs of a type that could be incurred if the property were held individually rather than in trust, their deduction by the Trust was subject to the 2% floor. * * * [Text reparagraphed.]

For prior discussion about this case and related IRS rulemaking activities, see PA EE&F Law Blog postings: "Rudkin" Regulations Proposed During Appeal (08/02/07); Bankers Associations File Amicus Brief in Rudkin Case (08/24/07); and IRS Gets Comments on "Rudkin" Regs Proposed (11/19/07).

The Court's opinion stated the issue: "In the case of individuals, investment advisory fees are subject to the 2% floor; the question presented is whether such fees are also subject to the floor when incurred by a trust."

The Court answered that question: "We hold that they are and therefore affirm the judgment below, albeit for different reasons than those given by the Court of Appeals."

But note, tax preparers, that this ruling affects more than trusts; it applies to estates too. Footnote No. 1 advised: "Because this case is only about trusts, we generally refer to trusts throughout, but the analysis applies equally to estates."

The opinion reviewed the arguments of the Trust and the IRS regarding Section 67(e)(1) of the Internal Revenue Code, and the resolutions by the circuit courts that considered the issue. It resolved the interpretation of that section as follows:

Thus, in asking whether a particular type of cost “would not have been incurred” if the property were held by an individual, §67(e)(1) excepts from the 2% floor only those costs that it would be uncommon (or unusual, or unlikely) for such a hypothetical individual to incur.

Having decided on the proper reading of §67(e)(1), we come to the application of the statute to the particular question in this case: whether investment advisory fees incurred by a trust escape the 2% floor. * * *

The Court concluded:

[I]t is quite difficult to say that investment advisory fees “would not have been incurred” — that is, that it would be unusual or uncommon for such fees to have been incurred — if the property were held by an individual investor with the same objectives as the Trust in handling his own affairs. * * *

There is nothing in the record, however, to suggest that Warfield charged the Trustee anything extra, or treated the Trust any differently than it would have treated an individual with similar objectives, because of the Trustee’s fiduciary obligations. * * *

It is conceivable, moreover, that a trust may have an unusual investment objective, or may require a specialized balancing of the interests of various parties, such that a reasonable comparison with individual investors would be improper. In such a case, the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor.

Here, however, the Trust has not asserted that its investment objective or its requisite balancing of competing interests was distinctive. Accordingly, we conclude that the investment advisory fees incurred by the Trust are subject to the 2% floor. * * * [Text reparagraphed.]

What will the effect of this decision be upon the pending IRS proposed regulations on the same matters? See: Internal Revenue Bulletin 2007-36, issued September 4, 2007 (REG-128224-06), "Notice of Proposed Rulemaking and Notice of Public Hearing Section 67 Limitations on Estates or Trusts".

Bob Wolf, Esq., of Pittsburgh, PA, provided some initial thoughts in a message to his P & T Hot Tip Emailees on January 16, 2008, after he recited the case holding (reproduced with his permission):

Since investment advisory fees are commonly incurred by individuals, they are subject to the 2% floor. If there had been a quantifiable cost for investment advisory fees as they dealt specific with unique trust issues, the Court left the door open for a full deduction without the 2% floor. These will be unusual, however, given the Court's opinion.

Very importantly, the IRS wanted to go much further than this and did so in its Proposed Regulations, which would have required trustees to literally unbundle their fees to determine which portion of a unified trustee's fee was truly unique to their functioning as a trustee -- such as accountings or fiduciary income tax return preparation, etc. This would have caused a great deal of trouble in the trust world, and led some also to wonder whether attorneys' fees would have to be "unbundled" in the same way!!

It seems quite unlikely that the IRS will feel encouraged to finalize their proposed regulations, given the specifically unfavorable comments by the Supreme Court in this decision to so draconian a set of rules. Thus at first blush, one would expect the Final Regulations to shift course, and if not, a second battle at the High Court would without doubt be in the offing.

Note also, that in a trust account in which there are not a lot of capital gains realized in a particular tax year, this is not the biggest deal in the world for the taxpayer. If the income in the trust, including capital gains incurred, were 6%, then 2% times the 6% would be a mere 12 basis points of deduction lost out of the investment advisory fee that in most cases is around 1%, depending upon the size of the account. The Rudkin Trust had $624,000 in income in a year in which the trust had a value of $2.9 Million. A little excessive turnover maybe?

So it is clear that investment advisory fees incurred by a trust will be ordinarily be subject to the 2% floor on itemized deductions absent special circumstances, but the likelihood that trustees and attorneys will have to unbundle their normal trustees and counsel fees to engage in highly artificial quantifications has been significantly reduced in this writer's opinion.

The issuance of this decision was noted immediately by Professor Paul L. Caron, of the University of Cincinnati College of Law, on the Tax Prof Blog, in his posting "Supreme Court Issues Unanimous Opinion in Knight: Deduction of Trust's Investment Expenses Is Limited by § 67's 2% Floor" (01/16/08).

He noted that the U. S. Supreme Court "thus followed the position of the Tax Court and Second, Fourth, and Federal Circuits, and rejected the position of the Tenth Circuit." He also posted some resource links about the issues in the case and the proposed, outstanding rulemaking of the IRS.

From among those links, I highly recommend reading the article entitled "The Section 67 Question: Are Fees for Investment Advice Fully or Partially Deductible by Trusts?", by Professor James F. Loebl, of Valparaiso University School of Law, as posted on the Social Science Research Network.

Professor Loebl had correctly predicted the outcome of this case in the U. S. Supreme Court; and he further suggested where the next drama might, or should, play -- in Congress.

Update: 01/17/08:

The Wall Street Journal noted the Rudkin decision in its article entitled "Investment-Advice Fee Ruling", by Mark H. Anderson, published January 17, 2008.

The U.S. Supreme Court yesterday unanimously ruled that investment-advice fees incurred by trusts and estates are subject to routine limits if claimed on federal tax returns.

The opinion, written by Chief Justice John Roberts, affirms a lower court ruling that denied a full deduction to more than $20,000 in investment-advice fees spent by a trust set up in 1967 under the will of Henry A. Rudkin, who, with his wife, founded food company Pepperidge Farm.

Chief Justice Roberts, in the opinion, said in most instances trust or estate investment fees must exceed 2% of adjusted gross income to be deductible. The opinion said investment fees may be fully deductible in some instances, such as when additional fees are incurred for fiduciary obligations. * * *

The WSJ article apparently provided a link for readers to this Blog's posting.

Update: 01/18/08:

Professor Gerry Beyer noted this posting in his own, dated January 18, 2008, entitled "Supreme Court Holds Trust Investment Advisory Fees Subject to the 2% Floor", which appeared on the Wills, Trusts & Estates Prof Blog.

Update: 01/24/08:

Commerce Clearning House (CCH) posted an excellent summary & analysis of the Rudkin (a/k/a/ Knight) case on January 17, 2008, in its Daily Tax News Update, in an article by George L. Yaksick, Jr. & Deborah Petro, of the CCH News Staff, entitled "Supreme Court Limits Trust's Deduction of Investment Advisory Fees to Two-Percent Floor; IRS Likely to Repropose Regulations (Michael J. Knight, Trustee of William L. Rudkin Testamentary Trust, SCt)".

While the decision dashed the hopes of many trust and estate administrators that the Court would allow these fees to be fully deductible, the Court did not adopt the analysis of the Second Circuit Court of Appeals on which the IRS based controversial proposed regulations (NPRM REG-128224-06, I.R.B. 2007-36, 551; TAXDAY, 2007/07/21, I.2). It is likely the IRS will have to repropose the regulations to reflect the Supreme Court's decision, several experts told CCH.

"The decision puts us back to square one," Carol A. Cantrell, co-counsel for the trustee in Rudkin , told CCH. Cantrell, a shareholder with Briggs & Veselka Co., Bellaire, Texas, and a member of the AICPA Fiduciary Accounting Task Force, predicted more litigation as trusts proceed on a case-by-case basis. * * *

Update: 03/04/08:

Attorney Bob Wolf, of Pittsburgh, PA, analyzed the "interim guidance" on these matters, issued by the Internal Revenue Service on February 27, 2008, in this PA EE&F Law Blog posting, "IRS Issues Interim Guidance for Fid Inc Tax Returns" (03/04/08).