The tax treatment of investment advisory fees paid by trusts has become a hotly debated topic in recent years.
The conflicting decisions of various circuit courts of appeals have led to discrepancies in tax treatment across different jurisdictions. While some courts have ruled that investment advisory fees paid by trusts are subject to the same tax treatment as individual taxpayers, others have reached the opposite conclusion.
This article addresses the circuit court split, referencing relevant tax law and cases where possible, and explores the practical implications of these varying rulings. These rules impact all trusts, including revocable trusts to more complex charitable remainder trusts.
About Investment Advisor Fees
An investment advisor fee is a fee charged by a financial professional or firm for providing investment advice and managing investment portfolios. Investment advisors can help individuals and institutions create investment strategies, select appropriate investments, and manage investment portfolios based on their goals, risk tolerance, and investment preferences.
The fee structure for investment advisors can vary depending on the type of services provided and the investment advisor’s business model. Some investment advisors charge a percentage of the assets under management (“AUM”) as their fee, while others charge a fixed fee or hourly rate. The fee may also depend on the complexity of the portfolio and the level of service required.
Are Investment Advisor Fees Tax Deductible?
Investment advisor fees may be deductible either as a reduction to gross receipts or, alternatively, an itemized deduction subject to the 2 percent floor. The IRS has long taken the position that they are subject to the 2 percent floor.
This distinction is now even more critical as, beginning in 2018, the Tax Cuts and Jobs Act (“TCJA”) suspended the deduction for miscellaneous itemized deductions, including investment advisor fees, for tax years 2018 through 2025.
Even then, there are some exceptions to the TCJA suspension of miscellaneous itemized deductions. Investment advisor fees may still be deductible if they are paid in connection with the production of income that is taxable, such as fees paid for managing investments in a taxable brokerage account.
Investment advisor fees paid for managing tax-deferred accounts, such as traditional IRAs, 401(k) plans, and other qualified retirement plans, are generally not deductible as they are already receiving tax-deferred treatment. However, investment advisory fees paid for managing a self-directed individual retirement account (“IRA”) may be deductible as a miscellaneous itemized deduction, subject to the limitations mentioned above.
So suffice it to say that the tax deductibility of investment advisor fees depends on the specific circumstances of the individual taxpayer and the type of account in which the fees are paid.
But what about deductions for trusts? Adding in a trust can muddy the analysis a bit. This is consistent with other tax issues involving trusts. Trusts have long stymied the IRS.
The Circuit Court Split
There is a split of authority on whether trusts can deduct investment advisor fees.
In William Rudkin Testamentary Trust v. Commissioner, 467 F.3d 149 (2d Cir. 2006), the Second Circuit Court of Appeals ruled that investment advisory fees paid by trusts are subject to the Section 67 two percent floor imposed on miscellaneous Schedule A itemized deductions. This decision means that trusts in New York, Vermont, and Connecticut must adhere to the two percent floor when deducting investment advisory fees.
In contrast, in O’Neill v. Commissioner, 994 F.2d 302 (6th Cir. 1993), the Sixth Circuit Court of Appeals held that the two percent floor does not apply to investment advisory fees paid by trusts. Consequently, trusts in Michigan, Kentucky, Ohio, and Tennessee are not subject to the two percent floor when deducting investment advisory fees.
Both the Federal Circuit and the Fourth Circuit Courts of Appeals have ruled in line with the Second Circuit. stating that the two percent floor does apply to investment advisory fees paid by trusts. This is from the Scott v. United States, 328 F.3d 132 (4th Cir. 2003) and the Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001) cases. These decisions affect trusts in Virginia, West Virginia, Maryland, North Carolina, South Carolina, and the District of Columbia.
Implications for Trusts and Other Taxpayers
Given the circuit court split, taxpayers should closely monitor the jurisdiction in which a trust operates to ensure compliance with the applicable ruling on investment advisory fees. This requires careful tax planning and a thorough understanding of the relevant circuit court decisions.
As the circuit split continues to create inconsistencies in the tax treatment of investment advisory fees paid by trusts, there is an increasing likelihood that the Supreme Court may eventually step in to resolve the issue. Taxpayers should stay up-to-date with any developments in this area.
The deductibility of investment advisory fees paid by trusts has become a complex issue due to the split in circuit court rulings. Taxpayers must be aware of the relevant rulings in their jurisdiction and advise clients accordingly. Proactive tax planning is advisable in this area.