Supreme Court Subjects Fiduciary Investment Advisory Fees to the 2% Floor

January 17, 2008

On January 16, 2008, the Supreme Court decided the “2% floor” case of Michael J. Knight, Trustee v. Commissioner, 552 U.S. ___ (No. 06-1286, Jan. 16, 2008), known to many by its name of William L. Rudkin Testamentary Trust v. Commissioner in the Tax Court and Second Circuit. See “Trusts and the 2% Floor – an FAS Editorial.” In a unanimous opinion by Chief Justice Roberts, the Court affirmed the Second Circuit and held that trust investment advisory fees are subject to the 2% floor of section 67(a) of the Internal Revenue Code. In the words of section 67(e)(1), the Court held that a trustee’s expenses for investment advice are not “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” and therefore do not fall within the exception of that statute.

In the Court’s view, section 67(e) excepts from the 2% floor “only those costs that it would be uncommon (or unusual, or unlikely) for … a hypothetical individual to incur.”

Noting that Mr. Knight himself had cited the “prudent investor” rule to justify his decision as trustee to seek investment advice, the Court concluded:

[W]e have no reason to doubt the Trustee’s claim that a hypothetical prudent investor in his position would have solicited investment advice, just as he did. Having accepted all this, it is quite difficult to say that investment advisory fees “would not have been incurred”–that is, that it would be unusual or uncommon for such fees to have been incurred–if the property were held by an individual investor with the same objectives as the Trust in handling his own affairs.

The references to “in his position” and “with the same objectives” are likely to be battlegrounds. That is largely what the 2% floor cases have been about – the proposition that individuals aren’t in the “position” of a fiduciary and typically don’t have the same “objectives” as a fiduciary. Thus, the Court’s opinion leaves open the very real possibility that there will be continuing controversy. But the gist of the Knight decision is that fiduciary investment advisory fees are subject to the 2% floor.

The Vexing Issue of Unbundling

There is nothing in the Knight opinion that requires “unbundling” of unitary fiduciary fees. In fact, the opposite is true, as fiduciary fees are not commonly paid by individuals. The IRS is always free to demand unbundling in any case, and of course the IRS has included an unbundling requirement in the proposed regulations.

An Open Door to Arguing Special Circumstances

In a curious twist, the Court adds this paragraph to the end of its opinion:

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.” … There is nothing in the record, however, to suggest that [the investment adviser] 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…. 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.

While the resulting complexity is deplorable, it is now apparently possible that trustees can “reverse unbundle” by identifying such “incremental” costs – “unique” to that trustee’s fiduciary circumstances, so to speak – which might escape the 2% floor after all.

Another Open Door – To Regulations

The Court supported its view of section 67(e) by quoting a statement from another of its opinions that “[g]iven that Congress has enacted a general rule…, we should not eviscerate that legislative judgment through an expansive reading of a somewhat ambiguous exception.” The Court said that “[w]e appreciate that the inquiry into what is common may not be as easy in other cases, particularly given the absence of regulatory guidance. … Congress’s decision to phrase the pertinent inquiry in terms of a prediction about a hypothetical situation inevitably entails some uncertainty, but that is no excuse for judicial amendment of the statute.”

These references to “a somewhat ambiguous exception,” “uncertainty,” and “the absence of regulatory guidance” leave the door open for Treasury to provide definitive practical guidance in regulations. The challenges facing Treasury in considering these regulations – and FAS’s hopes for the outcome – are described in “Trusts and the 2% Floor – an FAS Editorial.”

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