Deducting Investment Advice Fees
Burt, Charles J., II, Sprohge, Hans, Journal of Accountancy
Since the Tax Reform Act of 1986 there has been uncertainty about the tax treatment of fees for investment advice paid by estates and trusts. The language of Internal Revenue Code sections 67(a) and 67(e) has been construed as either allowing a full deduction for such fees or imposing a 2% of adjusted gross income (AGI) floor before fees are deductible. This article describes a court case that ends the uncertainty for some taxpayers.
In William J. O'Neill, Jr., Irrevocable Trust v. CIR, y; 98 T.C. 227 (1992), the Tax Court held that investment advice fees were subject to a 2% floor. The Sixth Circuit Court of Appeals reversed that decision, allowing the fees to be deducted in their entirety (William J. O'Neill, Jr., Irrevocable Trust v. CIR, 994 F2d 302 [6th Cir. 1993]).
In a 1994 action on decision, the Internal Revenue Service said it did not acquiesce to the Sixth Circuit's decision. Consequently, investment advice fees are fully deductible for estates and trusts within the Sixth Circuit, which includes Kentucky, Michigan, Ohio and Tennessee. CPA practitioners in the Sixth Circuit therefore should consider amending the estates and trusts tax returns for 1994, 1995 and 1996 that limit deductions for investment advice fees to amounts above 2% of AGI. Taxpayers outside the Sixth Circuit may rely on the court's O'Neill decision. However, since the Tax Court is not formally bound by the decision outside the Sixth Circuit, outside taxpayers may want to evaluate whether substantial authority exists before making a challenge.
JUST THE FACTS
The William J. O'Neill, Jr., Trust was formed in 1965 under Ohio law. None of the trustees was an investment expert or willing to serve unless an investment adviser was hired. From 1979 to 1991, the trustees received investment advice from a professional investment management company. On its 1987 Form 1041, U.S. Fiduciary Income Tax Return, the trust deducted in full the investment fees it had paid. The trustees declined compensation for their services.
During an audit of the trust's 1987 return, the IRS allowed the deduction for the fees only to the extent they exceeded 2% of the trust's AGI. The trust challenged the IRS decision in Tax Court.
The deductibility question arose because section 67(e) generally requires the AGI of an estate or trust to be "computed in the same manner as in the case of an individual." Under section 67(a), investment fees for individuals are miscellaneous itemized deductions subject to a 2% floor. A trust or estate's administrative expenses, "costs... which would not have been incurred if the property were not held in such trust or estate," are fully deductible for purposes of determining AGI. The investment advice fees were construed by the IRS to be subject to the 2% floor and by the trust to be a fully deductible administrative expense.
THE TAX COURT DECISION
In Tax Court, the trust advanced two arguments to support its position.
Role of local law. In the absence of Treasury regulations and little legislative history on section 67(e), local law determines what constitutes an administrative expenditure. Ohio statutes require trustees to invest trust assets and prescribe the type and quality of investments they can make. As with most states, Ohio law holds trustees to the "prudent person" standard of care, under which trustees' investment decisions are evaluated in light of all circumstances to determine whether they acted honestly, in good faith and with the degree of care and prudence ordinary persons would exercise in transacting their affairs. The trust argued that Ohio trustees must seek investment advice if they are to fulfill their fiduciary obligations. Hence, investment advice fees are fully deductible trust administration expenses.
Source of payments. The other argument was that investment advice payments should be given the same tax treatment regardless of whether they are paid from the trust or directly by the trustees. …