Knight v. Commissioner
| Knight v. Commissioner | |
|---|---|
|
| |
| Argued November 27, 2007 Decided January 16, 2008 | |
| Full case name | Michael J. Knight, Trustee of the William L. Rudkin Testamentary Trust, Petitioner v. Commissioner of Internal Revenue |
| Citations |
128 S. Ct. 782; 169 L. Ed. 2d 652; 2008 U.S. LEXIS 1096; 76 U.S.L.W. 4048; 2008-1 U.S. Tax Cas. (CCH) P50,132; 101 A.F.T.R.2d (RIA) 544; 21 Fla. L. Weekly Fed. S 39 |
| Court membership | |
| Case opinions | |
| Majority | Roberts, joined by unanimous |
Knight v. Commissioner, 552 U.S. 181 (2008), was a United States Supreme Court case that addressed the tax deductibility of investment advisory fees paid by a trust.
Background
Tax law context
When trusts deduct their expenses, most expenses are deductible in full, but there is an exception for certain expenses: miscellaneous itemized deductions are only partly deductible, i.e. only to the extent they exceed two percent (2%) of the taxpayer’s adjusted gross income (this 2% limitation is referred to as the “2% floor”). The tax law includes “investment advisory fees" in this category. However, a further exception provides that the 2% floor does not apply to miscellaneous itemized deductions such as investment advisory fees incurred by a trust “which would not have been incurred if the property were not held in such trust.” Thus, a trust may deduct an investment advisory fee in full if the fee would not have been incurred were the property not held in trust -- i.e., if an individual would not incur such costs. If it is common or expected that an individual would pay for investment advisory fees, then such fees are subject to the 2% floor when incurred by a trust. However, if individuals would only rarely, if ever, incur such fees, then such fees would not be subject to the 2% floor.
Facts
In Knight v. Commissioner, the question was whether the investment advisory fees incurred by the trust in that case were subject to the 2% floor. Michael J. Knight, as trustee of the William L. Rudkin Testamentary Trust, hired an advisor for assistance in investing the trust's assets. The trust had approximately $2,900,000 in marketable securities, and it paid the advisor $22,241 in investment advisory fees for the 2000 taxable year, which it deducted in full from the $624,816 it reported in income on its 2000 fiduciary income tax return.
On audit, the IRS determined that this fee was a miscellaneous itemized deduction and subject to the 2% floor. The IRS permitted the trust to deduct the advisory fees only to the extent that they exceeded 2% of the trust's adjusted gross income. The discrepancy resulted in a tax owed by the trust of $4,448. The trustee appealed the IRS determination. It lost in the lower courts.
The Supreme Court agreed to hear the case to resolve a split among the lower courts. Although most lower courts had held that investment advisory fees incurred by a trust were subject to the 2% floor, at least one held that under certain circumstances, such fees were not.
Opinion of the court
The Supreme Court framed the issue of deductibility of investment advisory fees by a trust as a prediction as to whether an individual would incur such investment advisory fees. If the facts were changed and the funds were instead held by an individual, would the individual incur such fees? If individuals commonly incur such expenses (and therefore would likely incur the advisory fee), then the expense was subject to the 2% floor.
The Court rejected any other reading of the statute. According to one such argument, because trusts were unique and had to incur investment advisory fees to satisfy the trustee’s fiduciary duty to invest prudently on behalf of all beneficiaries, those fees would not be incurred by individuals; thus, holding funds in a trust effectively mandated the use of an investment advisor and payment of fees. In contrast, an individual does not have to hire an investment advisor, and does not have a fiduciary duty to invest prudently. In rejecting this argument, the Court noted that, under the “prudent investor rule”, trustees are required to invest in the manner that intelligent people invest. There is no additional standard specially imposed on a trustee. Accordingly, since an individual would probably have incurred such fees (so as to invest in a prudent manner), the expense was subject to the 2% floor.
The Court acknowledged that making the prediction as to what expense an individual would commonly incur made the administration of the 2% floor difficult to administer. In each case, the trustee will have to inquire whether an individual would likely incur an expense to determine whether the expense is subject to the 2% floor. However, the Court noted that such difficult tests were common in the tax law, and the Court’s test must be applied to comply with the language of the Internal Revenue Code.
The Court noted that the “commonality” test (i.e., if costs are commonly incurred by an individual, they are subject to the 2% floor) did leave open the door for trusts to deduct fees paid to an investment advisor for “specialized advice” applicable only to trusts. According to the Court, if a trust had an unusual investment objective, or required a specialized balancing of the interests of the beneficiaries, then the incremental cost of expert advice beyond what would normally be required for the ordinary taxpayer would not be subject to the 2% floor.