Argument preview: Knight v. CIR
On November 27, 2007, the Supreme Court will hear Knight v. CIR. The case asks whether investment-advice fees incurred by a trust are deductible from adjusted gross income to the same extent as an individual's investment-advice fees or are instead fully deductible under Section 67(e) of Revenue Code, which allows a trust to deduct in full "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."
Petitioner Michael Knight is the trustee of the William L. Rudkin Testamentary Trust, a family trust funded with proceeds from the sale of Pepperidge Farm to the Campbell Soup Company. Knight says that he lacks the skills and training necessary to make investment decisions required by his fiduciary obligations and thus sought investment advice at an annual fee of 0.8% of the trust's assets. He deducted those fees in full on the trust's income tax return.
The IRS disallowed the full deduction. Instead, it permitted the trust to deduct the fees only to the extent that an individual would be able to do so "“ i.e., only the portion that exceeded 2% of the trust's income. Knight petitioned the Tax Court, which sustained the Commissioner's position. Consistent with decisions of the Fourth and Federal Circuits, the Tax Court held that only costs which are not "customarily" or "commonly" incurred by individuals are fully deductible by trusts and estates. Knight then appealed to the Second Circuit, which affirmed with a rule even more unfavorable to taxpayer trusts. The court of appeals held that costs that could be incurred if the property were held individually rather than in trust were not deductible under Section 67(e). The Supreme Court granted certiorari to determine whether the investment-advice fees, which are one of the major expenses of trusts, are costs "which would not have been incurred if the property were not held in such trust" within the meaning of Section 67(e).
After the Court granted certiorari, the Commissioner issued a proposed regulation interpreting Section 67(e) that essentially adopts the Second Circuit's position. It says that only costs which are "unique" to trusts and estates are fully deductible, and it defines a cost as "unique" to a trust "if an individual could not have incurred that cost" in connection with property not held in trust.
The petitioner trustee argues that Section 67(e) imposes a straightforward causation test: the costs of a trust are fully deductible if they "would not have been incurred if the property were not held in such trust or estate." He argues that investment advice fees are incurred to fulfill trustees' fiduciary obligations, which prevent them from investing trust assets as an individual would, and are tailored to those unique obligations. According to the petitioner, such advice is different in kind from the investment advice sought by individuals and is therefore fully deductible. The petitioner argues that this approach is consistent with the plain meaning, broad policy concerns, and legislative history of the statute, which was intended to subject expenses with a personal or voluntary aspect to the 2% floor. Investment advice sought by a trustee, he argues, is not subject to those concerns.
On behalf of the Commissioner, the United States argues that Section 67(e) is an exception to the general rule of taxability and therefore must be narrowly construed. It argues that there are two linguistically permissible, workable interpretations of the phrase "costs . . . which would not have been incurred if the property were not held in such trust." First, consistent with the position of the Second Circuit, it could mean only those costs that individuals do not incur absent a trust. Second, consistent with the Fourth and Federal Circuits, it could mean those costs that individuals do not customarily or commonly incur. The United States argues that investment advice fees are not covered under either of these possible definitions because they can be "“ and commonly are "“ incurred by individuals, but also that the Second Circuit's interpretation is more administrable and therefore preferable. The United States adds that if the proposed Treasury regulation adopting the position of the Second Circuit is adopted as a final regulation, that interpretation would be upheld under the deferential Chevron review afforded to administrative interpretations of the Internal Revenue Code.