US SCT: Supreme Court rules that general stock picking advice is subject to 2 percent-of-AGI floor but specialized fiduciary advice is fully deductible
Knight v. C.I.R. , --- S.Ct. ----, 2008 WL 140749 (U.S. Jan 16, 2008)
In an opinion that will have significant implications for every estate or trust paying U.S. income taxes, the Supreme Court has just ruled on the level of deductibility Internal Revenue Code Section 67(e)(1) permits for trust investment advisory fees (IAFs). The trustee/taxpayer in this case argued that IAFs are fully deductible before arriving at a trust's taxable income. As I previously reported [click here], this argument lost both at trial and before the Second Circuit.
Unfortunately for the trustee he also lost before the Supreme Court, which ruled in the linked-to opinion that most IAFs are are deductible only to the extent that they exceed 2 percent of a trust's adjusted gross income (AGI), often referred to as the “2 percent-of-AGI floor.”
But the news isn't all bad. Some IAFs remain fully deductible if they can be construed as being uniquely applicable to trusts. Chief Justice Roberts hinted at this reading of the statute during oral arguments, as reported here on law.com:
Several times during the argument hour, Chief Justice John Roberts brought up the idea of breaking up the costs for investment advice into those representing "general stock picking advice," and those for "specialized fiduciary advice," and only providing an exception for the latter. Justice Antonin Scalia, however, expressed skepticism about whether it would be possible to "slice up" adviser fees.
And here's how this approach was expressed in the Court's linked-to opinion (which was written by Chief Justice Roberts):
As the Solicitor General concedes, some trust-related investment advisory fees may be fully deductible “if an investment advisor were to impose a special, additional charge applicable only to its fiduciary accounts.” Brief for Respondent 25. 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. See App. 24-27. 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.
Thanks for breaking down the decision and its implications. I wonder if corporate trustees will respond by including within their fee schedules a specific fee structure for advice to fiduciaries. If the trust states a specific purpose, and sometimes when it does not, the trustee often faces a dilemna in balancing the interests of the beneficiaries. For example, where a trust provides income to a surviving spouse, with the remainder to kids from a prior marriage. Does the trustee invest to maximize trust accounting income (making the spouse happy), or long-term growth (making the kids happy), or try to balance the two? The advice would have an immediate impact upon the surviving spouse. The advisor who is aware of the trust terms could arguably be liable to beneficiaries who were hurt by the advisor's advice. That type of specialized advice should be worth an additional premium.
Jeff - I think it will now become standard practice to split investment advisory fees between those fees paid for "general stock picking advice" vs. "specialized fiduciary advice." Failure to do this means a very valuable 100% income tax deduction for fees related to specialized fiduciary advice would be wasted. The real question now becomes: would such waste expose a fiduciary to liability?