In a decision handed down on Jan. 16, 2008, the United States Supreme Court in Knight v. Commissioner ruled that the income tax deduction for trust investment advisory fees is subject to the 2 percent floor limitation applicable to all miscellaneous itemized deductions. The Knight ruling means that a trust may only deduct its investment advisory fees to the extent that such fees, in addition to all other miscellaneous itemized deductions, exceed 2 percent of the trust's adjusted gross income. Although the Knight opinion generally refers only to trusts, the Court noted that its analysis also applies to estates.
This decision represents a change of law for taxpayers residing in Kentucky, Michigan, Ohio, and Tennessee who previously relied upon the ruling of the Sixth Circuit Court of Appeals in O'Neill v. Commissioner that the 2 percent floor limitation did not apply to trust investment advisory fees. For taxpayers located in many other states, the decision is simply an affirmation that the 2 percent floor limitation applies. The Knight decision will apply to all non-grantor trusts and estates for purposes of preparing their 2007 income tax returns.
In Knight, the Supreme Court essentially found that expenditures for investment advisory fees are not unique to trusts and therefore, trusts are generally subject to the 2 percent floor limitation in the same manner as individual taxpayers. The Court did, however, leave open the possibility that expenses for certain types of specialized investment advice might not be subject to the 2 percent floor limitation. Examples would include situations where the trust has an unusual investment objective or if there is a need to carefully balance competing interests in the trust and these needs result in a special or additional charge.
The Internal Revenue Service issued proposed treasury regulations last summer concerning the application of the 2 percent floor limitation to various trust expenses in anticipation of the ruling in Knight. The IRS is likely to fast track issuing the final version of these regulations. In addition to specifying the types of expenses that are unique to trusts and those that are not for purposes of applying the 2 percent floor limitation, the proposed regulations address the issue of bundled fees. Bundled fees are flat fees charged by advisors for a variety of services, including legal, accounting, investment advisory, and appraisal services. The proposed regulations require that a taxpayer use a reasonable method to allocate bundled fees between the expenses that are unique to a trust and those that are not. In anticipation of the issuance of final regulations requiring this type of allocation, trust advisors who currently provide a variety of services under a bundled fee arrangement will need to evaluate whether to implement a methodology that will allow trust taxpayers to determine what portion of the bundled fee is subject to the 2 percent floor limitation.
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