As reported here by the North Carolina Estate Planning Blog, on June 25 the U.S. Supreme Court agreed to review a Second Circuit Court of Appeals case addressing whether the investment expenses of trusts are fully deductible or subject to a 2% floor [see here]. The Circuit Courts are in disagreement on this issue. The Second Circuit Court of Appeals case is Michael J. Knight, Trustee of the William L. Rudkin Testamentary Trust v. Comm’r of Internal Revenue, and is available here.

In Rudkin the Second Circuit held that IRC Sec. 67(e) grants an estate or trust an exception from the 2% reduction in itemized deductions only for "costs of a type" that "individuals are incapable of incurring." On the surface, the Second Circuit appeared to create a narrow window for an estate or trust to claim a full deduction for its administrative costs. In reality, however, it potentially eliminates a full deduction for any administrative cost of an estate or trust.

Not surprisingly, the Second Circuit’s ruling has been the subject of some controversy.  The following is a representative example from Did the second circuit err in Rudkin Testamentary Trust?

Dozens of law reviews and journals have discussed the interpretation of Sec. 67(e) since the controversy first arose in O’Neill. (3) So far, none has urged the interpretation adopted by the Second Circuit. Indeed, the panel’s interpretation even conflicts with IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, and most state fiduciary income tax forms, which allow a full deduction for legal and accounting fees. Under the court’s definition, legal and accounting fees should not be fully deductible (at least in the Second Circuit), because individuals are capable of incurring them. Thus, the court’s interpretation is bound to foster confusion and noncompliance.

While the $4,448 deficiency in Rudkin is undoubtedly small, the Second Circuit’s position has serious implications. Its endorsement and application will create a substantial tax debt for trustees who must incur costs to comply with their legally mandated duties, such as those imposed under the Uniform Prudent Investor Act. It will also generate substantial litigation over a basic deduction that Congress intended for trustees carrying out such duties, all based on a questionable interpretation.