Corporate Trustee Commissions

Deductibility of Corporate Trustee Commissions

By Sharon L. Klein, Esq. Senior Vice President, Trust Counsel and Director of Estate Administration, Fiduciary Trust Company International, New York, NY

On January 16, 2008, the Supreme Court ruled that investment advisory fees incurred by individual trustees are deductible only under certain limited circumstances (Knight v. Comr., No. 06-1286 (U.S. 1/16/08)).

We believe that corporate trustee commissions, which include an investment management component, are fully deductible for 2007 fiduciary income tax return purposes. An overview of the state of the law follows.

I. THE ISSUE–DEDUCTIBILITY OF INVESTMENT ADVISORY FEES

Some expenses incurred by estates and non-grantor trusts are deductible only to the extent that they exceed 2% of adjusted gross income (otherwise known as the “2% floor”). Under §67(e)(1), costs incurred by an estate or trust “which would not have been incurred if the property were not held in such estate or trust” are not subject to the 2% floor.

A. THE BACKGROUND–U.S. COURTS WERE SPLIT ON INTERPRETATION

There was a split among the U.S. Courts of Appeals as to the interpretation of the language in §67(e)(1). The split turned on the interpretation of the phrase “would not have been incurred if the property were not held in such estate or trust” and has arisen with regard to the deductibility of investment advisory fees.

In the Sixth Circuit, investment advisory fees were held to be fully deductible, the court determining that fiduciaries uniquely occupy a position of trust and have an obligation to the beneficiaries to exercise proper skill and care with trust assets. O’Neill v. Comr., 994 F.2d 302 (6^th Cir, 1993). In the Fourth and Federal Circuits, investment advisory fees were held subject to the 2% floor, the courts reasoning that individuals commonly incur investment advisory fees outside of trusts. Mellon Bank v. U.S., 265 F.3d 1275 (Fed. Cir. 2001) and Scott v. U.S., 328 F.3d 132 (4^th Cir. 2003). In Rudkin, the Second Circuit went even further in saying that a trust can only take a full deduction for costs that could nothave been incurred by an individual. Rudkin v. Comr., 467 F.3d. 149 (2d Cir. 2006). On June 25, 2007, the U.S. Supreme Court granted certiorari in the Rudkin case, appealed by the Trustee to the Supreme Court under the name Knight v. Comr., No. 06-1286.

B. THE IRS–ISSUED PROPOSED REGULATIONS BEFORE THE SUPREME COURT RULED

On July 27, 2007, the IRS published proposed regulations (REG-128224-06, 72 Fed. Reg. 41243 (7/27/07)) regarding the extent to which certain expenses incurred by estates and non-grantor trusts are deductible for income tax purposes.

1. IRS PROPOSAL: UNIQUE COSTS NOT SUBJECT TO 2% FLOOR

Closely tracking the Second Circuit opinion in Rudkin, the proposed regulations provide that only costs that are “unique” to an estate or trust are not subject to the 2% floor. A cost is defined to be unique if an individual could not have incurred that cost in connection with property that is not held in an estate or trust.

2. SERVICES THAT ARE UNIQUE:

The regulations provide a non-exclusive list of services that are unique to estates and trusts and include: fiduciary accountings, required court filings, preparation of fiduciary income tax and estate tax returns, distributions to beneficiaries, trust or will contests, fiduciary bond premiums and communications with beneficiaries.

3. SERVICES THAT ARE NOT UNIQUE:

The regulations also provide a non-exclusive list of services that are not unique to estates or trusts and include: custody and management of property, investment advice, preparation of gift tax returns, defense of claims by creditors of the decedent or the grantor and the purchase, sale, maintenance, repair, insurance or management of non-trade or business property.

The services categorized as not “unique” will be subject to the 2% floor.

4. IRS PROPOSAL: FEES SHOULD BE UNBUNDLED

Many fiduciaries do not charge separate fees for the different services provided. Rather, fees are bundled to include investment advisory fees, custody, preparation of fiduciary income tax returns and other services. The proposed regulations require the unbundling of fees and areasonable allocation of the single fee between (i) costs unique to estates and trusts and (ii) other costs. The result could be that the fees associated with many services will not overcome the 2% hurdle; consequently, they will not be deductible for income tax purposes.

C. THE SUPREME COURT RULED

The Supreme Court specifically rejected the reasoning in the Second Circuit.

1. COULD IS NOT WOULD

The statutory provision at issue asks whether the costs wouldnot have been incurred if the property were not held in trust. The Second Circuit, in applying the statute, asked whether a cost at issue could not have been incurred by an individual: an approach which the Supreme Court held “flies in the face of the statutory language.”

2. THE DEDUCTIBILITY TEST

A cost would not have been incurred by an individual, the Supreme Court held, if that cost would be uncommon (unusual or unlikely) for an individual to incur. Applying that test, the Supreme Court found that investment advisory fees are subject to the 2% floor, since individuals commonly engage investment advisors.

II. THE PRACTICAL APPROACH–FILING 2007 RETURNS IN LIGHT OF KNIGHT

A. INVESTMENT ADVISORY FEES PAID BY AN INDIVIDUAL TRUSTEE

Investment advisory fees paid by an individual trustee are subject to the 2% floor, unless (pursuant to the Supreme Court decision) the trustee can show that there is an incremental cost or special additional charge or unusual investment objective, other than what would normally be required for an ordinary taxpayer.

B. BUNDLED TRUSTEES’ FEES

The proposed regulations, which require unbundling, by their terms apply only to payments made after the publication of final regulations. In other words, unbundling is not required until the regulations are finalized. The proposed regulations closely track the Second Circuit’s reasoning, which was rejected by the Supreme Court. The consensus among the U.S. banking community is that the IRS regulations will have to be revised in light of the Supreme Court decision. Moreover, the Supreme Court never mentioned unbundling in its decision. In fact, the Supreme Court agreed with the reasoning in the Federal and Fourth Circuits in which trustees fees were held to be fully deductiblebecause such fees are not commonly incurred by individuals.

Accordingly, we are taking the position that bundled corporate trustee commissions are fully deductible for 2007 fiduciary income tax purposes.

For more information, in the Tax Management Portfolios, see Acker, 852 T.M., Income Taxation of Trusts and Estates