Knight v. Commissioner

Background

Michael Knight is the trustee of the William L. Rudkin testamentary trust, created under Connecticut law. In 2000 the Trustee hired Warfield Associates to advise on investing roughly $2.9 million in trust assets and paid $22,241 in advisory fees. The Trust reported about $624,816 in income and deducted the advisory fees in full. The IRS allowed the fees only to the extent they exceeded the 2% miscellaneous deduction floor, creating a $4,448 deficiency. The Tax Court and the Second Circuit sided with the IRS, and other federal appeals courts were split on the question.

Reasoning

The Court read the tax statute’s exception to the 2% floor to ask whether a cost “would not have been incurred” if the property were owned by an individual. The Justices interpreted “would” to mean what is uncommon or unusual for an individual to incur. They rejected the Trustee’s argument that the statute asks only whether the expense was caused by trust duties, and they rejected the more demanding test the Second Circuit announced. Applying Connecticut’s “prudent investor” standard, the Court explained a prudent individual with the same objectives would likely seek investment advice. The Trustee had the burden to show these fees were unusual for individual investors, and the record did not show Warfield charged any special fiduciary-only fees.

Real world impact

Ordinary investment-adviser fees paid by trusts are generally subject to the 2% deduction floor. Trustees and beneficiaries cannot automatically deduct routine advisory fees in full; only truly unusual fiduciary-only charges or distinctive trust objectives might escape the floor. The decision resolves a split among appeals courts on this statutory question.