Rudkin v. Comm'r of Internal Revenue

• Decision Date: 27 June 2005
• Docket Number: No. 3297–04.,3297–04.
• Citation: Rudkin v. Comm'r of Internal Revenue, 124 T.C. 304, 124 T.C. No. 19 (T.C. 2005)
• Parties: William L. RUDKIN TESTAMENTARY TRUST u/w/o Henry A. Rudkin, Michael J. Knight, Trustee, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

124 T.C. 304

124 T.C. No. 19

William L. RUDKIN TESTAMENTARY TRUST u/w/o Henry A. Rudkin, Michael J. Knight, Trustee, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 3297–04.

United States Tax Court.

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.

WHERRY, J.

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, 1967.²Henry 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 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.

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 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 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, 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 TaxRegs., 53 Fed.Reg. 9875(Mar. 28, 1988).³Included 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 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 T.C. 227, 1992 WL 37354(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...