Knight, the trustee of a testamentary Trust, sued the Internal Revenue Service after the Trust was audited and assessed a tax deficiency. The deficiency was found in the area of miscellanous itemized deductions, which for individuals and Trusts are subject to a 2% floor. The Trust had deducted $22,241 for investment advisory fees from $624,816 in income; the IRS ruled that the fees were only deductible to the extant that they exceeded 2% of the Trust’s adjusted gross income.
In tax court, the Trust argued that it was required by its fiduciary obligations to obtain investment advisory services, and therefore to pay investment advisory fees. Because such fees are unique to trusts they should be fully deductible under 26 U. S. C. §67(e)(1), which allows for full deduction of the costs 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. The Tax Court rejected this argument, holding that §67(e)(1) allows full deductibility only for expensesthat are not commonly incurred outside the trust setting.
The Second Circuit Court of Appeals affirmed, concluding that, in determining whether costs such as investment advisory fees are fully deductible or subject to the 2% floor, §67(e) requires “an objective determination of whether the particular cost is one that is peculiar to trusts and one that individuals are incapable of incurring.” The court held that because investment advisory fees were “costs of a type that could be incurred if the property were held individually rather than in trust,” deduction of such fees by the Trust was subject to the 2% floor.
There is a deep, irreconcilable and widely noted conflict among the Second, Fourth, Sixth and Federal Circuits about the meaning of 26 U.S.C. § 67(e) — which permits trusts and estates to deduct on their income tax returns certain administrative expenses — and whether the statute permits fees for investment management and advisory services to be fully deducted on trust’s and estate’s income tax returns. This is an important and recurring question of federal tax law that involves deductions by trusts and estates that total in the billions of dollars annually.
The Question Presented is:
Whether 26 U.S.C. § 67(e) permits a full deduction for costs and fees for investment management and advisory services provided to trusts and estates.