The deductibility of investment management fees is a significant issue for many wealthy clients. The Supreme Court recently reached a rather unfavorable decision on this issue in Knight vs.Commissioner that effectively puts the kibosh on the ability of most trusts and estates to deduct investment management fees. It is vital to understand the rules so you can help clients maximize the deductions they might qualify for.

Some Background

Individual taxpayers can deduct certain miscellaneous itemized expenses on their personal tax return, Form 1040, Schedule A, such as investment-related expenses like custodian fees, investment counsel fees, tax preparation fees, legal fees relating to the production of income or protection of income-producing property and so on.

The IRS and Congress became concerned about abuse of these deductions and, in reaction, Congress modified the law to mandate that the total of these expenses must be reduced by 2% of a taxpayer's adjusted gross income (AGI). For example, if a client's total AGI is $200,000, and she paid her accountant $2,000 for tax preparation and incurred $3,000 of deductible investment expenses, she would have $5,000 of total miscellaneous itemized deductions. This figure must first be reduced by $4,000 (2% x $200,000 AGI), so only $1,000 would be deductible. Trusts and estates are subject to the same rules, since the approach used to tax them is generally the same.

The Fee Controversy

Tax law includes a rule governing what miscellaneous itemized deductions trusts and estates can claim. These deductions are generally the same as for individuals, except that "...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...[are not subject to the 2% reduction]." This last phrase has spawned much confusion.

For trusts and estates, a major annual cost is the investment management fee paid to advisors. Many taxpayers have deducted this fee, generating controversy over whether the 2% reduction applies. Trustees and executors have a fiduciary duty to invest properly, mandated by the Prudent Investor Act in most states, making it natural for them to seek out professional investment and wealth management services. The Prudent Investor Act does not apply to clients investing their own assets, who can be as imprudent as they want! The Supreme Court was not swayed by this distinction.

Tax stakes are high for trust and estate clients. Expenses subject to the 2% reduction are limited for income tax purposes. They are also subject to the alternative minimum tax (AMT), which substantially reduces or even eliminates any deduction for advisor fees for many estate and trust clients.

It is difficult to determine which trust and estate expenses are subject to this rule. You need to understand this, since how you bill your clients will directly affect what they can deduct. There are now two sources of information on this issue.

The Supreme Court's Say

In Knight vs.Commissioner, the Court said costs that "would customarily" be incurred by an individual are subject to the 2% reduction. The trustee or executor should consider custom, habit, natural disposition or probability of an individual incurring the particular cost. If it would be uncommon or unusual for an individual to incur, the trust or estate can deduct it fully.

If a trustee or executor can demonstrate that the cost exceeds what an individual would customarily incur, the excess can be deducted fully. For example, if your firm charges a supplemental fee for investment management services to a trust or estate, that incremental amount is fully deductible. Also, if a trust or estate has an unusual investment objective or requires a special balancing of the interests of various parties such that a reasonable comparison with individual investors would be improper, that portion of the advisory fee is fully deductable.

One approach for advisors to help their clients is to provide an analysis that breaks out certain aggregate fees and costs into their component parts, so they can be properly deducted.

The IRS's Word

The Treasury Department had issued proposed regulations, which now must be modified to reflect the Supreme Court's opinion in Knight. According to the IRS, costs not "unique" to a trust or estate are subject to the 2% floor. "Unique" costs cannot have been incurred by an individual investment client. In short, the IRS view requires trustees and executors to unbundle aggregated fees.

For example, assume a trustee meets annually with an attorney who bills hourly for a two-hour appointment to review trust matters. The lawyer must give the trustee a breakdown of what portion of the meeting addressed "unique" trust matters, such as interpreting the trust document and communicating with beneficiaries, which would be deductible in full. The trust client may only deduct the remainder of the lawyer's bill, which covers matters not unique to a trust, such as discussing the investment policy statement, after a 2% of AGI reduction.