Scott v. U.S., CIV.A. 3:01CV177.

• Decision Date: 28 February 2002
• Docket Number: No. CIV.A. 3:01CV177.,CIV.A. 3:01CV177.
• Citation: 186 F.Supp.2d 664
• Court: U.S. District Court — Eastern District of Virginia
• Parties: J.H. SCOTT, et al., Plaintiffs, v. UNITED STATES of America, Defendant.

186 F.Supp.2d 664

J.H. SCOTT, et al., Plaintiffs, v. UNITED STATES of America, Defendant.

No. CIV.A. 3:01CV177.

United States District Court, E.D. Virginia, Richmond Division.

February 28, 2002.

Ronald D. Aucutt, McGuireWoods LLP, McLean, for plaintiff.

Craig Dennis Bell, McGuireWoods LLP, Richmond, for pla represented by Bell.

Tara Louise Casey, U.S. Attorney's Office, Richmond, for defendant.

Darren David Farfante, U.S. Department of Justice, Tax Division, Washington, DC, for defendant.

Elizabeth Butterworth Stutts, McGuireWoods LLP, Richmond, for plaintiff.

James J. Wilkinson, U.S. Department of Justice, Tax Division, Washington, DC, for defendant.

MEMORANDUM OPINION

LOWE, United States Magistrate Judge.

John Stuart Bryant, a resident of the City of Richmond, Virginia, died in 1945. Under the terms of his will, probated in the Circuit Court for the City of Richmond, Virginia, Bryant created a trust providing for income to certain beneficiaries, sequentially, with a remainder to others. The current beneficiaries are the fourth generation of income recipients. The trustees, who have no experience in managing large amounts of assets, are all individuals who would not serve in that capacity unless the services of a financial advisor were available to assist in financial planning for the trust. The trustees are authorized to invade principal if, in their discretion, it is necessary to meet the needs of the income beneficiaries.

Plaintiffs are the trustees and the income beneficiaries of the trust. For a number of years, the trust retained the services of a financial advisor to assist in financial planning. The trust deducted the full amount of the fees in 1996 and 1997 when computing federal income taxes. Following an audit, the Internal Revenue Service (IRS) held that the fees should have been treated as a "miscellaneous itemized deduction" and subjected to the two percent limitation provided in 26 U.S.C. § 67(a), (b) ("2% Rule"). As a result, the IRS assessed, and the trust paid, additional taxes due. Plaintiffs bring the current action seeking a refund of those taxes. Jurisdiction is appropriate pursuant to 26 U.S.C. § 7422 and 28 U.S.C. §§ 636(c) and 1346(a)(1). The matter is before the Court on cross motions for summary judgment.

The sole issue before the Court is whether the Plaintiffs (the trustees and the income beneficiaries) are entitled to deduct the full amount of fees paid to financial advisors from trust income for federal income tax purposes.¹ The IRS asserts that the fees are subject to the 2% Rule,² relying on Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed.Cir. 2001). The Plaintiffs assert the fees are fully deductible under 26 U.S.C. § 67(e), citing to O'Neill v. Commissioner, 994 F.2d 302 (6th Cir.1993).

Section 67(e) provides:

(e) Determination of adjusted gross income in case of estates and trusts. For the purpose of this section, the adjusted gross income of an estate or trust shall be computed in the same manner as 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.

26 U.S.C. § 67(e).

In O'Neill, co-trustees of a trust lacked expertise in the investment of large sums of money. Without the assistance of a financial advisor, they would not have been willing to serve as trustees. They engaged a financial advisor and deducted the full amount of the fees paid on the trust income tax return. In a subsequent audit, the IRS allowed the deduction only to the extent that it exceeded 2% of the trust income. The trustees appealed to the Tax Court, which sustained the Commissioner's ruling, holding that only costs which are unique to the administration of a trust may be deducted without application of the 2% Rule. The trustee appealed directly to the United States Court of Appeals for the Sixth Circuit. That court stressed, "A trustee is charged with the responsibility to invest and manage trust assets as `a prudent investor would manage his own assets.'" 994 F.2d at 303. The Sixth Circuit agreed that under § 67(e), costs must be "unique" to the administration of the trust to be fully deductible. However, because of the "prudent investor" rule applicable uniquely to fiduciaries, the court held that trustees were required to consult with a financial advisor to meet their obligation to manage the trust assets in accordance with the "prudent investor" standard, an obligation not imposed on an individual investor. The court recognized that individual investors routinely seek and pay for investment advice, but "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 have an obligation to the beneficiaries to exercise proper skill and care with assets to the trust." 994 F.2d at 304 (emphasis in original).

In the Mellon Bank case, the bank, acting as a trustee, sought a refund based on a deduction for fees paid to accountants, tax preparers and financial advisors, who had rendered services in administering the trust. The court held that such fees did not qualify for the 100% deduction under § 67(e). The court explained:

The second clause of section 67(e)(1) serves as a filter, allowing a full deduction only if such fees are costs that "would not have been incurred if the property were not held in such trust or estate." The requirement focuses not on the relationship between the trust and costs, but the type of costs, and whether those costs would have been incurred even if the assets were not held in trust. Therefore 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.

Investment advice and management fees are commonly incurred outside of trusts. An individual taxpayer, not bound by a fiduciary duty, is likely to incur these expenses when managing a large sum of money. Therefore, those costs are not exempt under section 67(e)(1) and are required to meet the two percent floor of section 67(a). 265 F.3d at 1280-81 (emphasis added). Thus, the court focused not on the need for a trustee to fulfill a fiduciary duty, but solely on whether the type of cost was different from the same type of cost incurred by an individual taxpayer administering a large sum of money.

Plaintiffs in the current case have urged the Court to reject the reasoning of Mellon Bank, and to follow the holding in O'Neill. Not surprisingly, the United States takes the contrary position. Here it is unnecessary to elect which precedent to follow, because, unlike the trustees in O'Neill, the Plaintiffs here cannot show that the trustees are required to seek investment advice in order to fulfill the fiduciary duties imposed by law.

In Virginia, the duties a fiduciary owed to beneficiaries in managing investments in 1996 and 1997 are set forth in Va.Code § 26-45.1 of 1992. The statute requires a fiduciary:

... shall exercise the judgment of care, skill, prudence and diligence under the circumstances prevailing from time to time, (including, but not limited to, general economic conditions, anticipated tax consequences, the duties of the fiduciary and the interests of all beneficiaries) that a prudent person familiar with such matters and acting in his own behalf would exercise under the circumstances in order to accomplish the purposes set forth in the controlling document. In investing pursuant to this standard, a fiduciary shall consider individual investments in the context of the investment portfolio as a whole and as part of the overall investment plan and shall have a duty to diversify investments unless, under the circumstances, it is prudent not to do so. Any determination of liability for investment performance shall consider not only the performance of a particular investment, but also the performance of the portfolio as a whole.

Va.Code Ann. § 26-45.1 (Michie 1992). Section 26-45.1 specifically excepts from liability fiduciaries who acquire, invest, exchange, retain, sell, or manage "... the securities described in § 26-40.01 and ... those investments authorized by § 26-40. ..." Id. Section 26-40 sets forth a list of stocks, bonds and securities in which a fiduciary may invest and that such investments "shall be conclusively presumed to have been prudent." Va.Code Ann. § 26-40 (Michie 1992). Section 26-40.01.B stresses that a fiduciary's immunity is limited by providing: "[E]xcept as provided in § 26-40, fiduciaries, whether individual or corporate, shall be conclusively presumed to have been prudent in investing funds held by them in a fiduciary capacity in only the following securities ...." Va.Code Ann. § 40.01.B (Michie 1992).

Thus, Virginia is one of the very few states, if not the only, that affords a fiduciary, whether individual or corporate, absolute immunity from claims that it did not follow the "prudent investor" rule in managing trust assets, provided the fiduciary invests in the assets specified by statute. See Va.Code Ann. §§ 26-40, 26-40.01 (Michie 1992). The Supreme Court of Virginia has decided three cases in which it discussed the predecessor to what is now § 26-40. While none of the decisions involved a suit against a trustee who had complied with the statute, the court made clear that the statute provides complete immunity to a trustee who chooses to invest in one of the statutorily approved investments.³

Thus, unlike the situation in O'Neill, a trustee in Virginia is not required to consult a financial advisor to fulfill his statutory obligations.⁴ As unfair as it may prove to be to the beneficiaries, a trustee in Virginia may...