Knight v. Commissioner of Internal Revenue...and deduction of advisor fees

This case presents us with what we in law call "statutory interpretation." The law in view here is a section of the Internal Revenue Code ("IRC"), that one part of law which strokes terror into the hearts of most law students, not a few legal practitioners and most Americans. Its often obscure language and obtuse sections and subsections try to put into words what would much more easily be put into a series of numerical examples. But this is not the place to excoriate the Code; we must interpret it. At issue in this case has to do with the "2% rule" of deductions in the case of the fees paid to those investment advisors who help administer a trust. It can best be understood by looking first at the Code itself and then the facts of the case.

The Law in Question

IRC chapter 67 provides, in relevant part:

"(a) General rule.--In the case of an individual, the miscellaneous itemized deductions for any taxable year shall be allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income."

The chapter goes on to define what miscellaneous itemized deductions are, but those sections aren't at issue in this case. Then, we read:

"(e) Determination of adjusted gross income in case of estates and trusts.--For purposes of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as in the case of an individual, except that--

(1) the deductions for costs which are paid or 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....shall be treated as allowable in arriving at adjusted gross income."

Your question, if you agree to take on this mission, is to decide if expenses to pay investment advisors for a trust come under (a), and thus are deductible only if these expenses exceed 2% of the adjusted gross income of the trust, or if they come under (e)(1) and thus are fully deductible. Let's look at the pertinent facts.

The Trust and Facts

In 1967 Henry Rudkin set up a trust for the benefit of his son William and William's wife and descendants. It was partially funded from the sale of Pepperidge Farm to Campbell Soup. Thus, these aren't poor people we are talking about. In its 2000 tax return, the trustee (Michael Knight) reported an income of $624,816 and claimed a deduction of $22,816 for investment-management fees. This amount was reported on line 15a of the return (labeled as "deductions not subject to the 2% floor"). Well, the wheels of justice grind slowly, but they grind exceeding small, and so about three years later the IRS sent the trust a "notice of deficiency" for the year 2000. The way the IRS calculated it was that only the amount above 2% of the trust earnings, so about $9,700, was tax deductible. Applicable tax rules at the time meant that the Trust thus owed $4,448 in taxes to the IRS.

As my former law colleague Gershom Goldstein used to say, when the IRS sends you a "notice of defiency" it is only the first gambit in a complex chess game, and so the issue was litigated both before the US Tax Court in Hartford, CT as well as on appeal to the 2nd Circuit. But the courts held firm, affirming the determination of the IRS--that money paid for investment advisors by a trust was subject to sec. 67(a)--a deduction when the fee only exceeds 2% of adjusted gross income of the trust.

The Second Circuit's Reasoning

Crucial to the disposition of this case below, in addition to the fact that most circuit courts called on to answer the question had sided with the IRS, is the phrase regarding the costs, that they "would not have been incurred if the property were not held in such trust." Are investment fees like that? The petitioner tried to argue that fees paid to personal investors are optional because we have freedom to choose whether or not we want to hire such an advisor, but the fiduciary duties of trustees of trusts require them to hire financial advisors. Thus, these fees should fall under (e)(1). On the other hand, the IRS pointed to the fact that under their regulations:

"Investment-advice fees are generally treated as itemized deductions under § 212. 26 C.F.R. § 1.212-1(g) (specifying the circumstances in which “[f]ees for services of investment counsel ... are deductible under section 212”). They are not listed in § 67(b), so are therefore not exempt from the two-percent floor established by § 67(a). Temp. Treas. Reg. § 1.67-1T(a)(1)(ii) (1988) (stating that “investment advisory fees” are subject to the two-percent floor of § 67(a)),"
467 F3d 149, 153 (2nd Cir 2006).

Ultimately the lower court went along with the tax court judgment and the request of the IRS and found that such fees are similar enough to the kind of fees that individuals incur that the hiring of financial advisors for trusts falls under (a).

So, the Supreme Court has this simple question right before it. The petitioner's application for the writ of certiorari said that "billions" of dollars is at stake here. I don't know if that is actually true, but it is a practical question that probably should be solved by someone authoritative. Once the Supreme Court decides it, it will be decided. I think the Court will agree with the IRS.

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