William L. Rudkin Testamentary Trust U/W/O Henry A. Rudkin, Michael J. Knight, Trustee v. Commissioner

124 T.C. No. 19

• Court: United States Tax Court
• Decided: June 27, 2005
• Docket: 3297-04
• Status: Unknown

Opinion

124 T.C. No. 19

UNITED STATES TAX COURT

WILLIAM L. RUDKIN TESTAMENTARY TRUST U/W/O HENRY A. RUDKIN, MICHAEL J. KNIGHT, TRUSTEE, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3297-04. Filed June 27, 2005.

T is a trust established in 1967. The trustee engaged an outside firm to provide investment management advice for T, and the firm was paid $22,241.31 for such services during the 2000 taxable year. On its Federal income tax return, T deducted these fees (rounded) in full.

Held: The investment advisory fees paid by T are not fully deductible under the exception provided in sec. 67(e)(1), I.R.C., and are deductible only to the extent that they exceed 2 percent of the T’s adjusted gross income pursuant to sec. 67(a), I.R.C.

Michael J. Knight (specially recognized), for petitioner.

Frank W. Louis, for respondent. - 2 -

WHERRY, Judge: Respondent determined a Federal income tax

deficiency in the amount of $4,448 with respect to the 2000

taxable year of the William L. Rudkin Testamentary Trust (the

trust). The sole issue for decision is whether investment

advisory fees paid by the trust are fully deductible under the

exception provided in section 67(e)(1) or whether the fees are

deductible only to the extent that they exceed 2 percent of the

trust’s adjusted gross income pursuant to section 67(a).1

FINDINGS OF FACT

The majority of the facts have been stipulated and are so

found. The stipulations of the parties, with accompanying

exhibits, are incorporated herein by this reference.

Michael J. Knight serves as trustee of the trust and provided an

address in Fairfield, Connecticut, at the time the petition in

this case was filed.

The trust was established under the will of Henry A. Rudkin

on April 14, 1967.2 Henry A. Rudkin’s family was involved in the

founding of Pepperidge Farm, a food products company. Pepperidge

Farm was sold to Campbell Soup Company in the 1960s, and the

1 Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the year in issue, and Rule references are to the Tax Court Rules of Practice and Procedure. 2 The will refers to the trust as the “William L. Rudkin Family Testamentary Trust”, but all other documents contained in the record omit “Family” from the name. The difference is not material. - 3 -

trust was initially funded primarily with proceeds from that

sale.

The will of Henry A. Rudkin referenced above sets forth the

governing provisions of the trust. In general, income and

principal of the trust were to be applied for the benefit of

Henry A. Rudkin’s son, William L. Rudkin, and the son’s spouse,

descendants, and spouses of descendants. Principal distributions

were also subject to a special power of appointment held by

William L. Rudkin. The trustee and other fiduciaries of Henry A.

Rudkin’s estate were provided with broad authority in the

management of property, including the authority “to invest and

reinvest the funds of my estate or of any trust created hereunder

in such manner as they may deem advisable without being

restricted to investments of the character authorized by law for

the investment of estate or trust funds” and “to employ such

agents, experts and counsel as they may deem advisable in

connection with the administration and management of my estate

and of any trust created hereunder, and to delegate discretionary

powers to or rely upon information or advice furnished by such

agents, experts and counsel”.

The trustee engaged Warfield Associates, Inc., to provide

investment management advice for the trust. During the taxable

year 2000, Warfield Associates, Inc., was paid $22,241.31 for its

services. - 4 -

A Form 1041, U.S. Income Tax Return for Estates and Trusts,

for the 2000 year was timely filed on behalf of the trust.

Thereon the trust reported total income of $624,816. The Form

1041 also reflected, among other things, a deduction of $22,241

on line 15a for “Other deductions not subject to the 2% floor”,

further described on an attached statement as “INVESTMENT

MANAGEMENT FEES”. No deduction was claimed on line 15b for

“Allowable miscellaneous itemized deductions subject to the 2%

floor”.

On December 5, 2003, respondent issued to the trust a

statutory notice of deficiency determining the aforementioned

$4,448 deficiency for the taxable year 2000. Respondent

disallowed full deduction of the $22,241 in investment fees and

instead permitted a deduction of $9,780, the amount by which

$22,241 exceeded 2 percent of adjusted gross income of $623,050

(i.e., $12,461).

The trustee filed the underlying petition in this case

disputing respondent’s determination on grounds that the

investment advisory fees should not be subject to the 2-percent

limitation. During trial preparations, the parties became aware

that the notice of deficiency contained an error in its

computation of adjusted gross income. The parties have now

stipulated that the correct adjusted gross income figure is

$613,263, for a corresponding deduction under respondent’s - 5 -

position of $9,976. However, on account of the alternative

minimum tax, the parties are in further agreement that the

resultant deficiency if respondent’s position is sustained

remains unchanged at $4,448.

OPINION

I. General Rules

As a general rule, the Internal Revenue Code imposes a

Federal tax on the taxable income of every individual and trust.

Sec. 1. Taxable income is defined as gross income less allowable

deductions. Sec. 63(a). Gross income broadly comprises “all

income from whatever source derived,” sec. 61(a), and allowable

deductions are calculated through application of a multi-tiered

process. First, certain enumerated deductions may be subtracted

from gross income to arrive at adjusted gross income. Sec.

62(a). Itemized deductions may then be subtracted from adjusted

gross income in arriving at taxable income. Sec. 63(d).

Itemized deductions, however, are further segregated into

two categories that impact on their deductibility. Section 67(b)

sets forth a list of itemized deductions allowed without further

limitation to the extent permitted under the appropriate

statutory section authorizing the deduction. For individual

taxpayers, the remaining itemized deductions are characterized as

“miscellaneous itemized deductions” and are allowed under section

67(a) only to the extent that they exceed 2 percent of adjusted - 6 -

gross income. For estates and trusts, section 67(e) mandates

application of the rule of section 67(a), with specified

modifications. Specifically, section 67 provides as follows in

relevant part:

SEC. 67. 2-PERCENT FLOOR ON MISCELLANEOUS ITEMIZED DEDUCTIONS.

(a) General Rule.--In the case of an individual, the 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.

* * * * * * *

(e) Determination of Adjusted Gross Income in Case of Estates and Trusts.--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, except that--

(1) the 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 * * *

shall be treated as allowable in arriving at adjusted gross income. * * *

Hence, the statutory text of section 67(e)(1) creates an

exception allowing for deduction of trust expenditures without

regard to the 2-percent floor where two requirements are

satisfied: (1) The costs are paid or incurred in connection with

administration of the trust, and (2) the costs would not have

been incurred if the property were not held in trust. Otherwise, - 7 -

deductibility is limited to the extent it would be for individual

taxpayers.

In that vein, regulations promulgated under section 67 list

examples of expenses that, in the context of individuals, are

subject to the 2-percent floor. Sec. 1.67-1T(a)(1), Temporary

Income Tax Regs., 53 Fed. Reg. 9875 (Mar. 28, 1988).3 Included

are expenses incurred “for the production or collection of income

for which a deduction is otherwise allowable under section 212(1)

and (2), such as investment advisory fees, subscriptions to

investment advisory publications, certain attorneys’ fees, and

the cost of safe deposit boxes”. Sec. 1.67-1T(a)(1)(ii),

Temporary Income Tax Regs., supra (emphasis added).

II. Contentions of the Parties

Against this backdrop, the trustee contends that the

investment management fees in dispute here are properly

deductible under the exception set forth in section 67(e)(1).

The trustee maintains that the fees were paid in connection with

administration of the trust and would not have been incurred if

the property were not held in trust. In reaching this

conclusion, the trustee relies largely on the fiduciary duties

imposed on trustees. According to the trustee, while an

3 Temporary regulations are entitled to the same weight and binding effect as final regulations. Peterson Marital Trust v. Commissioner, 102 T.C. 790, 797 (1994), affd. 78 F.3d 795 (2d Cir. 1996). - 8 -

individual may make a voluntary and personal choice to seek

investment advice, fiduciary duties render such professional

advice a necessary and “involuntary” component of trust

administration.

In contrast, it is respondent’s position that the section

67(e)(1) exception does not apply to the expenses at issue.

Respondent does not dispute the expenditures were made in

connection with the administration of the trust. However,

respondent alleges that because investment advisory fees are

commonly incurred by individual investors outside the context of

trust administration, the fees fail to satisfy the requirement

that they would not have been incurred if the assets were not

held in trust. It is also respondent’s view that neither State

law nor the governing trust instrument imposed a legal obligation

on the fiduciary to obtain professional investment management

services.

III. Analysis

The deductibility of investment advisory fees by a trust

under section 67(e)(1) is not a matter of first impression. This

Court and three Courts of Appeals have ruled on the question.

Scott v. United States, 328 F.3d 132 (4th Cir. 2003); Mellon

Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001);

O’Neill v. Commissioner, 994 F.2d 302 (6th Cir. 1993), revg. 98 - 9 -

T.C. 227 (1992). The result has been a split in authority on the

issue.

This Court in O’Neill v. Commissioner, 98 T.C. at 230-231,

held that investment advice costs were not deductible under

section 67(e), reasoning as follows:

We believe that the thrust of the language of section 67(e) is that only those costs which are unique to the administration of an estate or trust are to be deducted from gross income without being subject to the 2- percent floor on itemized deductions set forth at section 67(a). Examples of items unique to the administration of a trust or estate would be the fees paid to a trustee and trust accounting fees mandated by law or the trust agreement. Individual investors routinely incur costs for investment advice as an integral part of their investment activities. Consequently, it cannot be argued that such costs are somehow unique to the administration of an estate or trust simply because a fiduciary might feel compelled to incur such expenses in order to meet the prudent person standards imposed by State law.

The Court of Appeals for the Sixth Circuit reversed in O’Neill v.

Commissioner, 994 F.2d at 304-305. Although the Court of Appeals

concurred that “certain expenditures unique to trust

administration are excepted from the two percent floor”, the

Court disagreed with our analysis as to why the costs in dispute

were not unique. Id. at 303-304. Noting our statement that

individual investors routinely incur costs for investment advice,

the Court of Appeals opined: “Nevertheless, they are not

required to consult advisors and suffer no penalties or potential

liability if they act negligently for themselves. Therefore,

fiduciaries uniquely occupy a position of trust for others and - 10 -

have an obligation to the beneficiaries to exercise proper skill

and care with the assets of the trust.” Id. at 304.

Subsequently, the Courts of Appeals for the Federal and

Fourth Circuits in Mellon Bank, N.A. v. United States, supra, and

Scott v. United States, supra, respectively, diverged from the

position taken by the Court of Appeals for the Sixth Circuit.

These latter rulings were consistent in their rationale and

result, summarized as follows by the Court of Appeals for the

Fourth Circuit:

the second requirement of § 67(e)(1) does not ask whether costs are commonly incurred in the administration of trusts. Instead, it asks whether costs are commonly incurred outside the administration of trusts. As the Federal Circuit decided in Mellon Bank, investment-advice fees are commonly incurred outside the administration of trusts, and they are therefore subject to the 2% floor established by § 67(a). * * * [Scott v. United States, supra at 140.]

See also Mellon Bank, N.A. v. United States, supra at 1281 (“the

second requirement treats as fully deductible only those trust-

related administrative expenses that are unique to the

administration of a trust and not customarily incurred outside of

trusts”).

In construing section 67(e)(1), the Courts of Appeals for

both the Federal and Fourth Circuits emphasized the importance of

not interpreting the statute so as to render superfluous any

portion thereof. Scott v. United States, supra at 140; Mellon

Bank, N.A. v. United States, supra at 1280. Moreover, both - 11 -

courts explicitly rejected the taxpayers’ arguments premised on

fiduciary duties as running afoul of this principle of

construction. Scott v. United States, supra at 140; Mellon Bank,

N.A. v. United States, supra at 1280-1281. In the words of the

Court of Appeals for the Fourth Circuit:

we would, by holding that a trust’s investment-advice fees were fully deductible, render meaningless the second requirement of § 67(e)(1). All trust-related administrative expenses could be attributed to a trustee’s fiduciary duties, and the broad reading of § 67(e)(1) urged by the taxpayers would treat as fully deductible any costs associated with a trust. But the second clause of § 67(e)(1) specifically limits the applicability of § 67(e) to certain types of trust- related administrative expenses. To give effect to this limitation, we must hold that the investment- advice fees incurred by the Trust do not qualify for the exception created by § 67(e). Rather, they are subject to the 2% floor established by § 67(a). [Scott v. United States, supra at 140.]

The Court of Appeals for the Fourth Circuit characterized

the contrary analysis in this regard of the Court of Appeals for

the Sixth Circuit in O’Neill v. Commissioner, 994 F.2d at 304, as

containing “a fatal flaw”. Scott v. United States, supra at 140.

The Court of Appeals for the Federal Circuit similarly branded

the taxpayer’s attempts to bolster its interpretation through

legislative history as “unpersuasive.” Mellon Bank, N.A. v.

United States, supra at 1281. To wit, the Court of Appeals for

the Federal Circuit, tracing the genesis of section 67(e), noted

that to premise full deduction of all trust expenses on fiduciary

duties would run counter to - 12 -

legislative intent to equate the taxation of trusts with the taxation of individuals, limit the ability of sophisticated taxpayers to use trusts or other complex arrangements to lower their tax burden compared to similarly situated individuals, and to minimize the impact of the tax code on economic decision making. [Id.]

Having reviewed our initial construction of section 67(e)

and the ensuing judicial developments detailed above, this Court

concludes that the interpretation set forth in O’Neill v.

Commissioner, 98 T.C. at 230-231, and expressed by the Courts of

Appeals in Scott v. United States, 328 F.3d at 139-140, and

Mellon Bank, N.A. v. United States, 265 F.3d at 1280-1281,

remains sound. The trustee here, in support of full

deductibility, relies on concepts rejected in the foregoing

decisions. Appeal in the instant case, barring stipulation to

the contrary, would be to the Court of Appeals for the Second

Circuit, which has not ruled on the issue. See Golsen v.

Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th

Cir. 1971). The Court therefore holds that the investment

advisory fees paid by the trust are not fully deductible under

the exception provided in section 67(e)(1) and are deductible

only to the extent that they exceed 2 percent of the trust’s

adjusted gross income pursuant to section 67(a). - 13 -

To reflect the foregoing,

Decision will be entered

for respondent.

Reviewed by the Court.

GERBER, COHEN, SWIFT, WELLS, COLVIN, HALPERN, CHIECHI, LARO, FOLEY, VASQUEZ, GALE, THORNTON, MARVEL, HAINES, GOEKE, KROUPA, and HOLMES, JJ., agree with this opinion.