Limits on Deduction of Trust Fees Dodd S. Griffith Shareholder & Director Gallagher, Callahan & Gartrell, P.C. Dodd S. Griffith Shareholder & Director Gallagher, Callahan & Gartrell, P.C.

gcglaw.com Limits on Deduction of Trust Fees The Rudkin Case. –January 16, 2008 U.S. Supreme Court Case. –Resolved dispute among Circuit Courts regarding deductibility of investment advisory fees by trusts. Court Holding. –Investment advisory fees are subject to the 2% deduction floor for miscellaneous itemized deductions.

gcglaw.com Limits on Deduction of Trust Fees The Prequels to the Rudkin Case. –The O’Neill Trust Case. –The Mellon Bank. –The Scott Trust Case.

gcglaw.com Limits on Deduction of Trust Fees The fiduciary wins the O’Neill Trust case. –On appeal, the Sixth Circuit reverses the Tax Court. –The Sixth Circuit focuses on the common law duties of the fiduciary, not the provisions of the IRS Code. –This proves to be a losing position at the U.S. Supreme Court.

gcglaw.com Limits on Deduction of Trust Fees The Mellon Bank Case and the Scott Case. Fiduciaries lose cases at trial court and on appeal. The fiduciaries lose because the courts in these cases focus on the IRS code.

gcglaw.com Limits on Deduction of Trust Fees The IRS Code sets the rules. IRS Code Section 67 governs. Default Rule – Miscellaneous itemized deductions are limited by application of 2% deduction floor (2% of AGI). Limited exception to default rule for trusts and estates – See IRC 67(e).

gcglaw.com Limits on Deduction of Trust Fees IRC Section 67(e). Generally provides that AGI of trusts and estates must be computed in same manner as individuals. Exception allows full deduction for costs paid or incurred in connection with administration of trusts which would not have been incurred if property was not held in trust.

gcglaw.com Limits on Deduction of Trust Fees What does exception in IRC Section 67(e) mean? Fiduciaries want it to mean that any expense incurred with respect to the administration of a trust is deductible. The IRS and the Courts have vetoed this approach.

gcglaw.com Limits on Deduction of Trust Fees In the O’Neill case, the fiduciary won on appeal based on the argument that fiduciary duty required the retention of an investment advisor. In the Mellon Bank and Scott cases, and in the Rudkin case, the courts all rejected this argument based on a two part test.

gcglaw.com Limits on Deduction of Trust Fees The Two Part Test. First – Were the fees paid or incurred in connection with the administration of a trust? Second – Were those fees of a type that would not have been incurred if the property were not held in trust?

gcglaw.com Limits on Deduction of Trust Fees The Rudkin Case adopted the two part test used by the lower courts. The U.S. Supreme Court’s formulation of the two part test in Rudkin is potential more lenient than the formulation stated by the lower courts. It is definitely more lenient than the test formulated in temporary IRS regulations.

gcglaw.com Limits on Deduction of Trust Fees The U.S. Supreme Court revised the second part of the test. The revised formulation of the second part of the test asks whether the expenses for which a deduction is sough are of a type “customarily” incurred outside of trusts.

gcglaw.com Limits on Deduction of Trust Fees In the Rudkin case, the court concluded that the investment advisory fees were of a nature that would “customarily” be incurred outside of a trust. The Court did, however, leave the door open for a successful argument that certain investment fees are not “customary” incurred outside of trusts.

gcglaw.com Limits on Deduction of Trust Fees The U.S. Supreme court noted that some trust-related investment advisory fees may be fully deductible. Such fees may be fully deductible if the investment adviser imposes a special, additional charge applicable only to its fiduciary accounts.

gcglaw.com Limits on Deduction of Trust Fees What was the problem for the fiduciary in the Rudkin case? The fiduciary could not show that the fees charged were different, in any material respect, from what would be charged to an individual investor outside of the trust context.

gcglaw.com Limits on Deduction of Trust Fees The temporary IRS Regulations. –Were adopted by the IRS due to the split in the Circuit Courts. –Are not effective until final regulations are adopted. –Nevertheless, they show the clear policy of the IRS in this area. –The regulations should be revised in light of the Rudkin case.

gcglaw.com Limits on Deduction of Trust Fees The IRS regulations apply a test that is more strict than the one adopted by the U.S. Supreme Court in Rudkin. The IRS standard is whether the expenses are “unique” to trusts. The IRS regulations attack “bundled fees” and require “unbundling” of fees.

gcglaw.com Limits on Deduction of Trust Fees The IRS regulations identify categories of approved, fully deductible expenses: –Fiduciary accountings; –Judicial or quasi-judicial filings required to administer a trust or estate; –Fiduciary income tax and estate tax returns; –The division or distribution of income or corpus to or among beneficiaries; –Trust or will contests or construction;

gcglaw.com Limits on Deduction of Trust Fees The IRS regulations identify categories of approved, fully deductible expenses (continued): –Fiduciary bond premiums; and –Communications with beneficiaries regarding trust or estate matters.

gcglaw.com Limits on Deduction of Trust Fees The IRS regulations identify categories of expenses subject to the 2% floor: –Custody or management of property; –Advice on investing for total return; –Gift tax returns; –The defense of claims by creditors of the decedent or grantor; and

gcglaw.com Limits on Deduction of Trust Fees The IRS regulations identify categories of expenses subject to the 2% floor (continued): –Purchase, sale, maintenance, repair, insurance or management of non-trade or business property.

gcglaw.com Limits on Deduction of Trust Fees The IRS regulations note that the lists of approved and non-approved items are non- exclusive. The lists merely provide examples for each category.

Limits on Deduction of Trust Fees Dodd S. Griffith Shareholder & Director Gallagher, Callahan & Gartrell, P.C. Dodd S. Griffith Shareholder & Director Gallagher, Callahan & Gartrell, P.C.