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Trusts, Investment Advisory Fees and the Supreme Court Knight Decision

Because of the enormous responsibilities that come with acting as a trustee, many trustees utilize the services of a professional investment advisor to manage trust assets. The involvement of investment advisors has resulted in the question of whether or nor fees paid by the trust to the investment advisor were fully deductible or subject to the 2% miscellaneous deduction limit (which is similar to the percentage limit for individuals utilizing investment advisors).

Section 67(e)(1) of the Internal Revenue Code provides that whenever a cost would not have been incurred if the property were not held in such a trust, the 2% limitation does not apply. The Supreme Court (the Court) addressed this question in 2007 in its ruling on Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue. The Court was charged with deciding if the trustee had a fiduciary responsibility to the beneficiaries to use professional investment advisors. If the Court deemed that such expenses were necessary, the investment advisor expenses would not be subject to the 2% limitation.

While the Court weighed the 2% limitation question, the IRS issued proposed regulations, which interpret Section 67(e)(1). The proposed regulations only allow "unique" costs of a trust to be fully deductible, while other costs are subject to the 2% limitation. The proposed regulations defined "unique" as those costs that an individual would not incur if the property were held outside the trust. In determining whether a cost is unique, the focus is on the type of service provided rather than the characterization or "label" of a service. For example, some investment advisors complained that banks were hiding their "investment advisory costs" under the label "trustee fees," which have historically been fully deductible. The interpretation was that bank charges for trustee fees might have to be "unbundled" if they include investment advisory type services.

The subsequent Court decision did find that the investment advisory fees in the Knight case were not required and therefore were subject to the 2% limitation. However, the Court did not adopt the reasoning utilized by the IRS in the proposed regulations. Rather, the Court indicated that there could be situations where a trust could incur investment advisory fees that would not be subject to the 2% limitation. The Court believes that the trustee has the burden of proof in these circumstances to show why an expense is not subject to the limitation. However, the Court did not believe that the cost must be "unique" to a trust, only that it would be "uncommon, unusual or unlikely" for an individual to incur such an expense.

Consequently, it appears that the IRS proposed regulations are at odds with the decision of the Supreme Court. Fortunately, the regulations are not final and are likely to be changed to more closely align with the reasoning of the Court. Investment advisory fees appear in most instances to be subject to the 2% limitation. The second question is: How will the IRS approach "unbundling" in the final regulations? Notice 2008-32 does not require taxpayers to break out "bundled fees" for returns whose tax year begins before January 1, 2008.

For more information, please contact Mike Calahan at 312-980-2996 or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.