William L. Rudkin Testamentary Trust U/W/O Henry A. Rudkin, Michael J. Knight, Trustee v. Commissioner , 124 T.C. No. 19 ( 2005 )

124 T.C. No. 19UNITED 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.
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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.
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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.
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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
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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
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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,
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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).
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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
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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
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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
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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
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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).
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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.