Knight v. Commissioner
The Supreme Court ruled that trusts, like individuals, generally must subject investment advisory fees to a 2%-of-income floor before deducting them on their taxes.
The unanimous decision rejects a broader reading that would have let trusts deduct such fees in full simply because a trustee's legal duties required hiring an adviser, keeping the tax treatment of trusts and individuals closely aligned.
“The fact that an individual could not do something is one reason he would not, but not the only possible reason.”
Explaining why the Court rejected the lower court's 'could not have been incurred' test.
How it got here: The Tax Court and the Second Circuit both sided with the IRS; the trustee asked the Supreme Court to resolve a split among the circuits.
The Case in Depth
What happened
A Connecticut trust hired an investment advisory firm to manage roughly $2.9 million in securities and paid about $22,000 in advisory fees, which it deducted in full on its tax return. The IRS said the fees were subject to the usual 2%-of-income floor that limits how much individuals can deduct for such costs, creating a tax shortfall the trustee disputed.
The question before the Court
When a trust pays investment advisory fees, does it have to follow the same 2%-of-income deduction limit that individuals face?
The Court's answer
Yes — the Court ruled that investment advisory fees paid by a trust are generally subject to the same 2%-of-income deduction floor that applies to individuals. The tax law's exception for trust administration costs only covers expenses that would be unusual or uncommon for an individual to incur, and hiring an investment adviser is a common thing individuals do with their own money.
The Court rejected the trustee's argument that the fees should be fully deductible just because Connecticut law required the trustee to seek investment advice, noting that Connecticut's 'prudent investor' standard is itself modeled on what an ordinary prudent individual investor would do. Because nothing showed the trust's adviser charged more than it would charge an individual with similar goals, the fees counted as an ordinary, commonly incurred cost — not one unique to trusts.
Curious how the Court got there? See the step-by-step legal reasoning →
Why it matters
Trustees managing trusts and estates will generally have to treat investment advisory fees the same way individual taxpayers do, limiting how much they can deduct. The ruling also clarifies, for accountants and trust administrators nationwide, exactly what kind of trust expense counts as unique enough to escape the 2% deduction limit.
What changes now
This is a final merits decision resolving a split among the federal appeals courts, so there is no remand or further proceeding needed. The trust's tax deficiency stands as assessed. Going forward, trusts and their advisers must evaluate whether a particular administrative expense is one individuals commonly incur to determine whether it is subject to the 2% deduction floor, though the Court left open that unusually distinctive trust expenses might still escape the floor.
What this does not decide
The Court left open that some trust-related investment advisory fees could still be fully deductible — for instance, if an adviser charged a special extra fee just for handling fiduciary accounts, or if a trust's investment goals were so unusual that comparing it to an individual investor would not make sense.
How the Court got there
The legal reasoning, step by step
- The Court read the tax law's exception for trust expenses as asking a hypothetical question: would this type of cost have been incurred if the property were owned by an individual instead of a trust? A cost only escapes the usual 2% deduction limit if it would be unusual or uncommon for an individual to incur it.
- The Court rejected the Second Circuit's stricter test, which asked only whether an individual 'could' have incurred the cost, because that standard ignored costs individuals commonly do incur even though they are theoretically capable of it — Congress used 'would,' not 'could.'
- The Court also rejected the trustee's proposed causation test, which would have made any expense fully deductible simply because a trustee's fiduciary duty required incurring it, reasoning that nearly every trust expense is incurred because of some fiduciary duty, so that reading would swallow the general rule requiring trusts to follow the same 2% limit as individuals.
- Applying its 'customarily incurred' standard, the Court found that hiring an investment adviser is a common practice among individual investors generally, not something unique to trusts, particularly since Connecticut's prudent-investor rule for trustees is itself modeled on what a prudent individual investor would do with his own money.
- Because the record showed no evidence that the advisory firm charged the trust anything different from what it would charge an individual with similar investment goals, the Court concluded the fees were the ordinary kind individuals commonly pay and therefore fell under the 2% floor.