Supreme Court Decision Limits Trust Tax Deductions

A recent Supreme Court decision limits the amount a trust can deduct from its federal taxes for fees paid to firms that advise on how to invest the trust's assets. The court found that a trust can deduct investment advisory fees only if the fees exceed 2 percent of the trust's adjusted gross income. Previously, federal courts had disagreed whether such fees would be limited by the 2 percent floor.

The case, Knight v. Commissioner (U.S. No. 06-1286, Jan. 16, 2008), involved a trust set up by Henry Rudkin, who was one of the founders of the Pepperidge Farm Company. The trustee, Henry Knight, hired an outside investment firm to advise him on investing the trust assets. The trust deducted all of the fees on its federal income tax return, but the IRS claimed the fees were subject to the 2 percent floor. This meant the trust owed an additional $4,448 in taxes.

Under federal tax rules, individuals and trusts can claim itemized deductions as long as the deductions are more than 2 percent of their adjusted gross income. In the case of a trust, there is in an exception to the 2 percent floor if the trust deducts costs that would not have been incurred if the property was not held by a trust or an estate.

The Supreme Court ruled that this exception does not apply to investment advisor fees. According to the Court, it is common for individuals to hire investment advisors, so it is not an expense that only a trust would incur. The ruling will not be a major issue for most trusts, but in the case of larger trusts, the trustee may have to file larger estimated tax payments to avoid penalties.

To read the Supreme Court's decision, click here.