The Deductibility of Trust Expenses
The Knight Decision is A First Step toward Resolving uncertainties about how to deduct trust expenses
Recently, the United States Supreme Court unanimously decided in Knight v. Commissioner that trust expenses are to be treated as "below-the-line" deductions, with the exception of those expenses that are not "commonly" or "customarily" incurred by individuals. 2006-1286, slip. op. (U.S. Jan. 16, 2008). The Court granted certiorari in Knight to resolve conflicting decisions among the circuits regarding the degree to which trust expenses can be deducted under I.R.C. § 67(e)(1). In most instances, "above-the-line" deductions (deducted from gross income to reach adjusted gross income) are more advantageous than below-the-line, resulting in a lower adjusted gross income and taken regardless of whether the taxpayer chooses the standard or itemized deductions. A lower adjusted gross income usually means that the percentage of deductibility of itemized deductions will increase, decreasing the amount of the ultimate taxable income. In contrast, below-the-line deductions (itemized deductions) can be phased out based on income and may be subject to other limitations.
Like individuals, trusts and estates are allowed to deduct some specific expenses as above-the-line. All remaining expenses, miscellaneous itemized deductions, are allowed only to the extent that the total exceeds 2% of adjusted gross income (I.R.C. § 67(a)). Through I.R.C. § 67(e), the 2% floor is also applied to deductions for trust and estate expenses, with two exceptions. One exception is for those deductions detailed in specific Code sections (§§ 642(b), 651 and 661), (I.R.C. 67(e)(2)). The second exception, the central issue in Knight, allows "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" (I.R.C. § 67(e)(1)). If an expense falls under either exception it may be deducted "above-the-line".
The meaning of "costs . . . which would not have been incurred if the property were not held in such trust or estate" had been disputed by trustees and the I.R.S leading up to Knight. The essence of the petitioner's argument was that the statute includes all expenses related to property held in trust as deductible above-the-line, regardless of whether or not an individual can or cannot make similar deductions. The IRS rejected this theory, instead maintaining that § 67(e)(1) applies only to expenses unique to trusts. With the issue being litigated in the courts, the IRS released Proposed Regulation 1.67-4 which stated that a trust expense is not deductible unless it "could not have been" incurred by an individual. In other words, any property related expense an individual could incur on their own would not receive special treatment under §67(e)(1) simply for being held in trust. The circuit courts came down with an array of interpretations, leading the Supreme Court to finally grant certiorari in Knight to resolve the issue and provide one clear explanation.
In Knight the court decided that §67(e)(1) applies only to those expenses incurred by a trust that would be uncommon or unusual for an individual to incur on their own. The Court acknowledged that its interpretation leaves room to prediction and uncertainty, but that in deciding whether or not an expense is one which is not "commonly" or "customarily" incurred by individuals, one should look to factors such as "custom, habit, or probability." This means that, in deciding if an expense should be treated as above-the-line, a trustee must consider whether the trust expense is one that an individual would unlikely incur on their own. If it is in fact an expense that a taxpayer usually incurs in their individual capacity, it will be subject to the 2% of adjusted gross income limitations. The Knight decision handedly rejects the "could not have been" test set forth by the IRS in Prop. Reg. 1.67-4. While the meaning of the Knight test is seemingly straightforward, its application will prove difficult. Many questions arise as to what exactly is, and is not, a common or customary expense for an individual.
The specific expense at issue in Knight was investment advisory fees. The trustee in Knight argued that, being required by law to act as a prudent investor, it was necessary to hire an investment advisor to handle the trust's assets and investments. The trustee's position was that having to act as a prudent investor was a unique requirement resulting from the property being held in trust, and thus, should have been considered an above-the-line expense. The Court rejected this argument, and applying its new test, determined that an individual too, acting as a prudent investor, would seek out an investment advisor. It pointed out that the prudent investor standard does not equate to what a prudent trustee would do, but, instead, requires a trustee to act in the same manner as they would with their own financial affairs. Because an individual will likely seek out investment advice themselves, a trustee doing the same for a trust does not incur an uncommon or unusual expense unique to trusts. Therefore, according to the Court, investment advisory fees for trusts do not meet the §67(e)(1) exception and are not deductible above-the-line.
Unfortunately, the Knight decision dealt only with one type of expense. The ruling does provide guidance for understanding §67(e)(1), but by analyzing only investment advisory fees, many questions remain unanswered. In addition, it is likely that the IRS will now issue new regulations to replace the existing Prop. Reg. 1.67-4. Despite being in direct conflict with the ruling in Knight, Prop. Reg. 1.67-4 still stands as the IRS' guidance for interpreting §67(e)(1). This conflict, as well as the likelihood of a new set of regulations, should lead to continuing questions and problems for trustees. While Knight is a positive step toward resolving the meaning of the statute, it seems unlikely that there will be a clear-cut definition in the near future. For now, when determining the correct treatment of deductions, trustees, must determine whether or not the expense is one "commonly" or "customarily" incurred by individuals or if it is an expense more commonly associated with a prudent trustee.
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