The Supreme Court case Knight v. Commissioner is in the news again since the IRS re-released its proposed regulations on the deductibility of investment advisory fees by trusts and estates. The issue isn’t whether advisory fees are deductible: they are deductible by both individuals and estates. The issue is the extent of their deductibility.
For individuals, advisory fees are classified as miscellaneous deductions, subject to the 2% floor on deduction. Miscellaneous expenses are deductible only to the extent that they exceed 2% of the taxpayer’s adjusted gross income (AGI). The question answered in Knight and addressed by the proposed regulations is whether a trust’s advisory fees are deductible in full or whether they are limited by the 2% as they are for individuals.
Under both Knight and the proposed regulations, advisory fees charged to a trust or estate are miscellaneous expenses subject to the 2% floor if they are expenses that would commonly be incurred by an individual holding the same property. In other words, you can form a trust and expect to get income tax deductions that wouldn’t be allowed to you as an individual.
The trustee in Knight argued that individuals cannot incur trust investment advisory fees. The Supreme Court disagreed, finding that investment advisory fees are commonly incurred by individuals who are managing their investments.
It is not uncommon or unusual for individuals to hire an investment adviser. Certainly the Trustee, who has the burden of establishing its entitlement to the deduction, has not demonstrated that it is. *** The Trustee’s argument is that individuals cannot incur trust investment advisory fees, not that individuals do not commonly incur investment advisory fees.
Indeed, the essential point of the Trustee’s argument is that he engaged an investment adviser because of his fiduciary duties under Connecticut’s Uniform Prudent Investor Act, Conn. Gen. Stat. §45a–541a(a) (2007). The Act eponymously requires trustees to follow the “prudent investor rule.” See n. 2, supra. To satisfy this standard, a trustee must “invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements and other circumstances of the trust.” §45a–541b(a) (emphasis added). The prudent investor standard plainly does not refer to a prudent trustee; it would not be very helpful to explain that a trustee should act as a prudent trustee would. Rather, the standard looks to what a prudent investor with the same investment objectives handling his own affairs would do—i.e., a prudent individual investor. *** And we 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.
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.