Lindsay Roshkind, Interpreting I.R.C. § 67(e): The Supreme Court’s Attempt to Nail Investment Advisory Fees to the “Floor”

60 Fla. L. Rev. 961 (2008) | | | |

TEXT :: In the process of statutory interpretation, a court must determine “whether the language at issue has a plain and unambiguous meaning with regard to the particular dispute in the case. [The court's] inquiry must cease if the statutory language is unambiguous and the statutory scheme is coherent and consistent.” To determine the amount of an estate or trust’s taxable income, Internal Revenue Code § 63 provides “the term ‘taxable income’ means gross income minus the deductions allowed by this chapter.” However, even if a deduction is allowed, § 67(a) may limit the amount of the deduction. Section 67(a) provides “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.” This 2% limitation is commonly referred to as the 2% floor. Section 67(e) exempts from the 2% floor “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.” Such deductions are not limited and are fully deductible to determine the taxable income of an estate or trust under § 63.


In the instant case, the Petitioner, trustee of a testamentary trust, hired an institutional investment management firm to provide advice about investing the trust’s assets. In 2000, the trust paid the firm $ 22,241 in investment advisory fees. On the trust’s fiduciary income tax return for 2000, the trust deducted in full the investment advisory fees paid to the firm. After conducting an audit, the Commissioner of the Internal Revenue Service determined that the investment advisory fees were “miscellaneous itemized deductions subject to the 2% floor” of § 67(a). Therefore, the Commissioner allowed the trust to deduct only the investment advisory fees that exceeded 2% of the trust’s adjusted gross income for 2000, resulting in a tax deficiency of $ 4,448.

The Petitioner sought review of the assessed deficiency in the United States Tax Court, arguing that the Petitioner’s fiduciary duty to act as a “prudent investor” required the Petitioner to obtain investment advisory services, and therefore to pay investment advisory fees. Petitioner argued that such fees are unique to trusts and therefore should be fully deductible by reason of § 67(e)(1). The Tax Court rejected this argument, finding that only costs not commonly incurred outside the administration of trusts are fully deductible under § 67(e)(1). Therefore, the Tax Court held that because investment advisory fees were costs commonly incurred outside the administration of trusts, they were deductible only to the extent that they exceeded 2% of the trust’s adjusted gross income pursuant to § 67(a).

The Second Circuit Court of Appeals affirmed the Tax Court’s judgment, concluding that to determine whether investment advisory fees are fully deductible or subject to the 2% floor of § 67(a), “the statutory language directs the inquiry toward the counterfactual condition of assets held individually instead of in trust,” and “demands . . . an objective determination of whether the particular cost is one that is peculiar to trusts and one that individuals are incapable of incurring.” Therefore, the Second Circuit held that the investment advisory fees were subject to the 2% floor because the fees were “costs of a type that could be incurred if the property were held individually rather than in trust.”

The United States Supreme Court granted certiorari, recognizing the need to resolve the conflict among the circuit courts. The Court affirmed the Second Circuit, and HELD that § 67(e)(1) exempts from the 2% floor of § 67(a) only those costs incurred by a trust that would be uncommon (or unusual or unlikely) for a hypothetical individual to incur and because investment advisory fees are not such uncommon costs, they are subject to the 2% floor of § 67(a).

The language of § 67(e) begins with a general proposition: “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 . . . .” This means estates and trusts compute their adjusted gross income by deducting costs subject to the same 2% floor that applies to individuals. However, the general proposition is followed by an exception that applies when two conditions are met. First, the cost must be “paid or incurred in connection with the administration of the estate or trust.” Second, the cost must be one “which would not have been incurred if the property were not held in such trust or estate.” The conflict between the circuits over the application of § 67(e) before Knight revolved around the interpretation of the second condition.

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