High Court Affirms Deduction for Investment Advisory Fees Paid by Trust Subject to 2 Percent Floor

A ruling on the tax treatment of investment advisory fees paid by a trust was issued last month by the U.S. Supreme Court in Knight v. C.I.R., 128 S. Ct. 782, 2008-1 U.S. Tax Cas. (CCH) P 50132 (U.S. 2008), issued 1/16/08). The unanimous ruling affirms previous decisions by the Internal Revenue Service, the U.S. Tax Court, and the U.S. Court of Appeals for the Second Circuit, which held that because deductions for investment advisory fees paid by a trust could be incurred even if the property were held individually, the deduction was subject to the 2 percent floor under I.R.C. § 67.

In 2000, Michael Knight, as trustee of the William Rudkin Testamentary Trust, retained Warfield Associates, Inc. to provide investment advice with respect to the trust's approximate $2.9 million in securities. On the fiduciary tax return for that year, the trust deducted the full amount of advisory fees paid to Warfield. Upon audit the IRS determined that the fees were miscellaneous itemized deductions subject to the 2 percent floor under I.R.C. § 67, which resulted in a tax deficiency. The trust petitioned the U.S. Tax Court on the basis that, due to the trustee's fiduciary duty to act as a prudent investor, the state's uniform prudent investor act required the trustee to obtain investment advice. As a result, the fees were unique to the trust and fully deductible under I.R.C. § 67(e)(1). The Tax Court rejected this argument and Knight appealed. The Second Circuit affirmed the decision of the tax court and held that "investment-advice fees incurred by a trust are not fully deductible in calculating adjusted gross income for purposes of the Internal Revenue Code under 26 U.S.C. § 67(e)(1), but instead are deductible only to the extent that they exceed two percent of the trust's adjusted gross income pursuant to § 67(a)." Knight then filed a petition for a writ of certiorari, which was granted June 25, 2007.

Historically, the Courts of Appeals have been split on whether the 2 percent floor applies to trust investment advisory fees. However, the U.S. Supreme Court adopted the criteria used by the Fourth and Federal circuits, looking at whether these types of expense are unique to trusts or are "commonly" and "customarily" incurred by individuals as well.

On behalf of the Court, Chief Justice Roberts stated "Under the Internal Revenue Code, individuals may subtract from their taxable income certain itemized deductions, but only to the extent the deductions exceed 2% of adjusted gross income. A trust may also claim those deductions, also subject to the 2% floor, except that costs incurred in the administration of the trust, which would not have been incurred if the trust property were not held by a trust, may be deducted without regard to the floor. In the case of individuals, investment advisory fees are subject to the 2% floor; the question presented is whether such fees are also subject to the floor when incurred by a trust. We hold that they are and therefore affirm the judgment below, albeit for different reasons than those given by the Court of Appeals."

Source: Westlaw: Knight v. C.I.R., 128 S. Ct. 782, 2008-1 U.S. Tax Cas. (CCH) P 50132 (U.S. 2008); Supreme Court of the United States: Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue, No. 06-1286, January 16, 2008.

A charitable deduction for property passing from decedent's estate to a charitable trust as a result of the beneficiary's disclaimer was disallowed by the U.S. Tax Court recently because the court ruled that the partial disclaimer of the property was not a qualified disclaimer under I.R.C. § 2518.

In Estate of Christiansen v. C.I.R. 130 T.C. 1, Tax Ct. Rep. (CCH) 57301, 2008 WL 199719 (2008), the decedent's will left her entire estate to her only child, while directing that 75 percent of any disclaimed portion would pass to a charitable foundation and the balance to a charitable trust. The will further stipulated that the trust would last 20 years and pay an annuity of 7 percent of the corpus's net fair market value on date of death to the foundation. At the end of 20 years, the remaining trust property would go to decedent's child, if living. Decedent's child disclaimed a portion of the gross estate, but did not disclaim her contingent remainder interest in the property making it a "partial" disclaimer. The estate then claimed an estate tax charitable deduction for the value of disclaimed property passing to the foundation and the present value of the annuity interest in the disclaimed property passing to the charitable trust. The IRS, however, claimed that the disclaimed property did not pass (or, to be more precise, pass only) to a person other than the disclaimant.

The court recognized that the Code allows partial disclaimers, but noted that in order for the property to be treated as if it had never gone to the disclaimant, the disclaimer must be "qualified" and meet the four requirements of I.R.C.§ 2518(b): 1) It must be in writing. 2) It must (exceptions not relevant here) be received by the personal representative of the estate no later than nine months after the date of the transfer creating the disclaimant's interest. 3) It must not allow the disclaimant to accept the disclaimed property or any of its benefits. 4) The disclaimed interest must pass "without any direction on the part of the person making the disclaimer and …to a person other than the person making the disclaimer."

Even though the estate did not deduct the value of the child's contingent-remainder interest in the Trust's corpus in accordance with Treas. Reg. § 25.2518-2(e)(3), this regulation further provides that "If the portion of the disclaimed interest in property which the disclaimant has a right to receive is not severable property or an undivided portion of the property, then the disclaimer is not a qualified disclaimer with respect to any portion of the property. Thus, for example, if a disclaimant who is not a surviving spouse receives a specific bequest of a fee simple interest in property and as a result of the disclaimer of the entire interest, the property passes to a trust in which the disclaimant has a remainder interest, then the disclaimer will not be a qualified disclaimer unless the remainder interest in the property is also disclaimed."

As a result, the court held that "No deduction is allowed for any of the property passing to the trust because the partial disclaimer of that property is not a qualified disclaimer under sec. 2518, I.R.C."

Source: Westlaw: Estate of Christiansen v. C.I.R., 130 T.C. 1, Tax Ct. Rep. (CCH) 57301, 2008 WL 199719 (2008), January 24, 2008; United States Tax Court: Estate of Helen Christiansen, Deceased, Christine Christiansen Hamilton, Personal Representative v. Commissioner of Internal Revenue, 130 T.C. No. 1, January 24, 2008.

On February 4, the U.S. Tax Court ruled in Estate of Farnam v. C.I.R., 130 T.C. No. 2, 2008 WL 298862 (2008), 2/4/08) that the deceased couple's loans to a family-owned corporation were not interests in the corporation for purposes of the 50 percent liquidity test under I.R.C. § 2057(b)(1)(C). Although Mr. Farnam died in 2001 and his spouse in 2003, Code provisions relevant to the case are in all material respects the same for both years.

At the time of Mr. Farnam's death, he and his spouse each owned 50 percent of the outstanding voting common stock in a corporation and their son owned all of the corporation's non-voting stock. In addition, the decedent owned a 99-percent capital interest in a limited partnership he had formed, and the couple's son owned a 1-percent capital interest in the LP. At the time of Mrs. Farnam's death, she and her son each owned 50 percent of the outstanding voting common stock in the corporation with the son continuing to own all of the outstanding shares of nonvoting common stock. In addition, at the time of her death, Mrs. Farnam owned a 92.72-percent capital interest in a limited partnership she had formed, and the son, his wife and children owned the remaining 7.28-percent capital interest.

Prior to their deaths, decedents had lent funds to the corporation for use in its business operations. The corporation, in turn, issued unsecured promissory notes subordinated to claims by the corporation's outside creditors. Payments on the loans were made in accordance with tax law. At the time decedents formed the two limited partnerships, they contributed their ownership interests in several buildings used by the corporation and in several of the outstanding promissory notes.

On the decedents' federal estate tax returns, each estate claimed qualified family-owned business interest (QFOBI) deductions under I.R.C. § 2057 of $625,000 and $675,000, respectively, On each return, the common stock in the corporation and the notes decedents owned at the times of their deaths (directly and through their controlled partnerships) were included in their respective estates and in the calculation of the QFOBI 50-percent liquidity test under I.R.C. § 2057(b)(1)(C).

Subsequently, the Internal Revenue Service issued statutory notices of deficiency for $763,131 and $1,491,616 in the estate taxes paid by the estates, disallowing the claimed QFOBI deductions. The Service contended that for purposes of meeting the 50 percent liquidity test, an interest in a family corporation or partnership does not include a loan interest in the family corporation. The estates argued that for purposes of meeting the 50 percent liquidity test an interest in a family corporation or partnership could include not only equity ownership interests but loan interests as well, as long as the family ownership test under I.R.C. § 2057(e)(1)(B)(i) and (ii) was met.

The court noted that the issue presented a question of statutory interpretation, centering primary on "language from section 2057(e)(1)(B)-namely, 'an interest in an entity' carrying on a trade or business," and concluded that the loan interests held by decedents (directly and indirectly through their controlled partnerships) were not to be treated as QFOBIs for purposes of section 2057. Thus the claimed QFOBI deductions were not allowable.

"Our holding herein is based largely on the close proximity of the language "interest in an entity" in section 2057(e)(1)(B) to the explicit equity ownership language of section 2057(e)(1)(B)(i) and (ii). We find it illogical to divorce the equity ownership requirements of section 2057(e)(1)(B)(i) and (ii) from the immediately preceding language. As we read the statute, the "interest in an entity" language of section 2057(e)(1)(B) encompasses, or embraces, or is limited to, only the type of interests (i.e., to equity ownership interests) that is described in the rest of the very same sentence (i.e., in the immediately following clauses of section 2057(e)(1)(B))."

Source: Westlaw: Estate of Farnam v. C.I.R., 130 T.C. No. 2, 2008 WL 298862 (2008), ; United States Tax Court: Estate of Duane B. Farman, Deceased, Mark D. Farnam, Personal Representative, and Estate of Lois L. Farnam, Deceased, Mark D. Farman, Personal Representative, v. Commissioner of Internal Revenue Service, 130 T.C. No. 2 (February 4, 2008).

According to Aileen Condon, Chief of the Small Business/Self-employed Division of the Estate and Gift Tax Program for the IRS, the Service is maintaining "audit coverage" similar to past years, despite 2007 staff reductions of 81 estate and gift tax attorneys. Condon told attendees of the Heckerling Institute on Estate Planning conference last month that a "national workload" concept, in which government attorneys do not conduct examinations in face-to-face meetings but rather deal long-distance with taxpayers and their representatives, has proven successful.

The latest IRS SOI Tax Stats, which are available on the IRS website, report that estate tax revenue reached just over $26.7 billion in fiscal year 2006, surpassing the previous year's $23.56 billion and the high of $25.6 billion in fiscal year 2000. Revenues collected for gift taxes in fiscal year 2006 were $1.97 billion, down slightly from the prior year's $2 billion and the high of nearly $4.7 billion in fiscal year 1999.

"It is still critically important to the service that we have an appropriate enforcement presence and an audit coverage to deal with determining compliance levels and dealing with the noncompliance," Condon said in a panel discussion at Heckerling. "And, frankly, we are able to maintain an audit coverage similar to past years even with this reduced staffing."

Source: Westlaw: Tax Audits: Despite Staffing Cuts, Estate Tax Audits On Par With Prior Years, IRS Official Says, 012 DTR G-2, 2008; Internal Revenue Service:: Table 6. Internal Revenue Gross Collections, by Type of Tax, Fiscal Years 1960-2006, SOI Tax Stats - Collecting Revenue

Period for Compounding

	Annual	Semiannual	Quarterly	Monthly
Short-term
AFR	3.11%	3.09%	3.08%	3.07%
110% AFR	3.43%	3.40%	3.39%	3.38%
120% AFR	3.74%	3.71%	3.69%	3.68%
130% AFR	4.06%	4.02%	4.00%	3.99%
Mid-term
AFR	3.51%	3.48%	3.46%	3.46%
110% AFR	3.87%	3.83%	3.81%	3.80%
120% AFR	4.22%	4.18%	4.16%	4.14%
130% AFR	4.57%	4.52%	4.49%	4.48%
150% AFR	5.29%	5.22%	5.19%	5.16%
175% AFR	6.18%	6.09%	6.04%	6.01%
Long-term
AFR	4.46%	4.41%	4.39%	4.37%
110% AFR	4.91%	4.85%	4.82%	4.80%
120% AFR	5.36%	5.29%	5.26%	5.23%
130% AFR	5.81%	5.73%	5.69%	5.66%

Period for Compounding

Source: Westlaw: Federal Rates; Adjusted Federal Rates; Adjusted Federal Long-Term Rate And The Long-Term Exempt Rate, Rev. Rul. 2008-9, 2008 WL 279204 (2008); Internal Revenue Service: Rev. Rul. 2008-9, 2008-5 I.R.B. 342 (published February 4, 2008).