GainsKeeper Blog

Lost Knight--Supreme Court rules in favor of IRS and concludes that trust’s investment fees are not fully deductible

February 4, 2008

On January 16, 2008, the U.S. Supreme Court issued its opinion in Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner of Internal Revenue. This highly anticipated decision was a major disappointment to many because the Supreme Court ruled against the taxpayer and limited the deductibility of the trust’s investment related expenses. This is the “phantom income” issue discussed in two prior articles.

As previously discussed, the tax law provides that certain expenses of individuals (and trusts) are not always deductible because of the “2% floor.” Section 67 of the Internal Revenue Code provides that certain types of itemized deductions are only deductible to the extent that such deductions during the tax year exceed 2% of the taxpayer’s adjusted gross income. The non-deductibility of investment expenses under the 2% floor gives rise to phantom income. For example, assume you that you earn taxable income of $5 but pay a fee of $3. If the fee isn’t deductible, you’ve got phantom income of $3 because although you will report $5 of taxable income on your tax return, you only receive $2 in cash (net of the $3 nondeductible fee).

Because the 2% floor also applies to trusts, the issue was whether trustees had to break-out separately any portion of the trustee’s fees that were considered investment expenses. Trustees and trust companies argued that such a breakout was not appropriate or necessary. The IRS has disagreed. The IRS has litigated this issue against several taxpayers, which ultimately resulted in the Supreme Court’s recent decision in Knight. And last summer the IRS also issued proposed regulations that would require trustees to break-out investment or custody fees or portions of bundled fees and treat such fees or portions as subject to the 2% floor. The proposed regulations were discussed in the prior article titled “‘Phantom Income’ and Trusts: Recent Adverse IRS Proposed Regulations for Investment Management & Custody Fees.” Knight effectively puts to rest arguments raised by trustees, advisors and service providers challenging the proposed regulations.

Given the Supreme Court’s decision in Knight, trustees, trust advisors and trust companies will generally be required to break-out the portion of any expenses that are investment related. Such expenses will generally be subject to the 2% floor, and thereby likely result in phantom income to trusts. Breaking out the investment related portion of expenses could be burdensome, but unfortunately the Supreme Court’s recent decision means that this is required.


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