A Knight's Tale

Also: The Zero Percent Capital Gains Rate

Reprinted from The Estate Analyst, February 2008

By Robert L. Moshman, Esq.

ike a knight's quest from days of yore, the trustee of the William J. Rudkin Testamentary Trust has battled the Commissioner of the IRS from the Tax Court to the Second Circuit Court of Appeals and on to the highest court in the land.

The United States Supreme Court has ruled that the investment advice received by a trust is subject to the 2% threshold to be deductible.

The trustee's name was Knight, and the case of Knight v. Commissioner has come to an end.

What is significant about this case? Aside from clarifying the application of the 2% rule to trusts, this case has established the specific tests of deductibility, revealed some of the judicial philosophies of the current Supreme Court and set the stage for new IRS regulations.

A Brief History of Knights

Knights have long taken up lance and shield against dragons of our tax system.

In, Knight v. Commissioner, 6 T.C. 90 (1946), petitioners were beneficiaries of well-drafted trusts set up in 1918 in which assets were to remain in trust until beneficiaries reached age 35. However, there were limited elections that allowed beneficiaries to "test their wings" and receive portions of income at age 22 and age 25. Arguing that beneficiaries should not be taxed on trust income for years in which they had no access to the funds, these Knights prevailed over the IRS.

In, Knight v. Commissioner, 92 T.C. 199 (1989), the Commissioner determined deficiencies in a licensed minister's 1984 and 1985 self-employment tax in the amounts of $798 and $1,112.85, respectively. The IRS prevailed.

In, Knight v. Commissioner, 115 T.C. 506 (2000), taxpayers owning $10 million of stock in Luby's Cafeterias had set up a family limited partnership. This case established that the FLP had economic substance for gift tax purposes.

A New Knight

Our current Knight's tale began in 1967 when a testamentary trust arose from the will of Henry A. Rudkin. The Rudkin family had founded the Pepperidge Farms company, which was sold to Campbell Soup Company in the 1960s. The proceeds of that sale funded the Henry A. Rudkin Testamentary Trust and later passed through the estate of his son and into the William L. Rudkin Testamentary Trust.

In 2000, the Trust had assets of $2.9 million. The trustee paid $22,241 for investment advice concerning these assets. On the Trust's fiduciary return for 2000, total income of $624,816 was reported and all of those advisory fees were deducted.

The IRS found that the fees were subject to the 2% floor and therefore were only deductible to the extent they exceeded 2% of the Trust's adjusted gross income. Only $9,780 could be deducted. This resulted in a tax deficiency of $4,448.

This set the stage for a new Knight in shining armor, so to speak, and Michael J. Knight as trustee of the Rudkin trust initiated a legal action before the Tax Court to contest the Commissioner's ruling that the 2% floor was applicable to the trust investment advice.

The heart of this matter is the distinction between those expenses that apply to any individual and those which are unique to a trust.

Individuals may subtract from their federal taxable income certain itemized deductions under 26 U. S. C. §63(d), but only to the extent the deductions exceed a 2% "floor" of adjusted gross income as per §67(a).

Similarly, a trust may also take such itemized deductions subject to the 2% floor specified in §67(e). However, when the relevant cost incurred by a trust is in connection with the administration of the . . . trust and "would not have been incurred if the property were not held in such trust," the cost may be deducted without regard to the floor, §67(e)(1).

What About Investment Advice?

For individuals, investment advice falls into the general category of itemizable deductions that are subject to the 2% floor. The combined total of investment advice expenses and other expenses is deductible only to the extent that it exceeds 2% of the taxpayer's adjusted gross income.

Trustee Knight argued that while an individual may make a voluntary and personal choice to seek investment advice, fiduciary duties render such professional advice a necessary and "involuntary" component of trust administration. It argued that the Trustee had a fiduciary duty to act as a "prudent investor" under the Connecticut Uniform Prudent Investor Act.

The Commissioner countered with the argument that investment advisory fees are commonly incurred by individual investors outside the context of trust administration. In, Rudkin Testamentary Trust v. Commissioner, 124 T.C. 304 (2005), the Tax Court agreed and the Second Circuit applied similar logic in, Rudkin Testamentary Trust v. Commissioner, 467 F.3d 149 (2nd Cir. 2006).

This followed the reasoning of the Federal Circuit in, Mellon Bank, N.A. v. United States, 265 F.3d 1275 (Fed. Cir. 2001), which held that IRC section 67(e) does not permit the full deduction of investment advice fees because those fees are commonly incurred outside of the trust context.

Those cases represent a split among the circuits because the U.S. Court of Appeals for the Sixth Circuit, contrary to the 2nd, 4th, and Federal Circuits, interpreted section 67(e) as allowing trusts and estates to fully deduct investment advisory fees. O'Neill v. Commissioner, 994 F.2d 302 (1993).

Knight v. Commissioner, 502 U.S. ____ (2008), which arrived on January 16, 2008, represents the final word in this case, but not on the issue in general. Although the Supreme Court affirmed the same outcome as the Second Circuit Court of Appeals, the Tax Court, and the Commissioner, the reasoning that was applied took an unexpected detour.

"Would Have" Not, "Could Have

Writing for the unanimous Court, Justice Roberts focused on the language of the IRS Code:

"In applying the statute, the Court of Appeals below asked whether the cost at issue could have been incurred by an individual. This approach flies in the face of the statutory language. The provision at issue asks whether the costs "would not have been incurred if the property were not held" in trust, ibid., not, as the Court of Appeals would have it, whether the costs "could not have been incurred" in such a case, 467 F. 3d, at 156. The fact that an individual could not do something is one reason he would not, but not the only possible reason. If Congress had intended the Court of Appeals' reading, it easily could have replaced "would" in the statute with "could," and presumably would have. The fact that it did not adopt this readily available and apparent alternative strongly supports rejecting the Court of Appeals' reading."

A small window of hope was left open, however. The Court noted that a trust could have some unique investment objective or some investment advisors might have some special surcharge that is applicable only to fiduciary accounts. It may only be a small and hypothetical loophole at this point, but we shall surely see some good Knight of the realm attempt to drive through it with a tractor trailer filled with deductible investment advisory fees.

The Final Frontier

The Supreme Court distinguished "would have" and "could have" in this case, which has introduced new semantic analysis to tax cases. Can analysis involving "should have" be far behind?

Newly proposed regulations from the IRS were based on the language used in the analysis by the Second Circuit Court of Appeals in, Rudkin v. Commissioner. Analysts have predicted that the Service will have to re-introduce proposed regulations that modify such language to comport with the reasoning of the Supreme Court, which rejected the "could have" test applied by the Second Circuit.

The bundling of services within a single fee also appears to be a potential battleground in the future. The regulations proposed by the IRS after the Second Circuit's decision in Rudkin require trust administration fees to be broken down into separate categories for administration, investment advice, and tax preparation.

The purpose of this unbundling requirement is clearly to prevent trusts from getting around the 2% deduction floor by setting up "administrative fees" as a Trojan horse filled with items that are supposed to comply with the 2% threshold. Since the Supreme Court did not address bundling issues, that aspect of the new proposed regulations is likely to remain.

A Valiant Effort

Good night, good Knight. Sadly, you did not recover the $4,400. But it was a valiant crusade and sets an example for the next brave Knight who takes on the Commissioner of the IRS.

The Zero Percent Capital Gains Tax Rate

There is something very likable about the newest tax bracket to join the IRS Code. In fact, the new capital gains tax bracket is certain to be so popular that every investor will hope to qualify. "Zero is the bracket that works for me," investors must be thinking. "Count me in!"

But before selling off appreciated assets with wild abandon, a little more perspective is needed. Many people currently take advantage of the capital gains exemption for the sale of a personal residence. Others leave appreciated assets in their estate so that it can be transferred at death with a stepped-up basis. And those investors with significant capital gains typically would not be in the right income tax bracket to qualify for the new zero percent tax bracket on capital gains. So who does qualify for this new tax niche? And more significantly, what new long-term strategies can exploit the zero tax rate?

The New Zero Bracket

These days, tax reforms are like time-release pills; the relief comes years after the legislation. The zero percent tax bracket of 2008 originated with the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) and was scheduled only for one year, 2008. Then the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) extended the zero bracket to include 2009 and 2010 as well.

However, JGTRRA '03 did provide some relief up front by lowering the 20% tax on long-term capital gains to 15% for those in higher tax brackets and 5% for those in the lowest two income tax brackets of 10% and 15%.

The zero bracket applies only to taxpayers who are in the two lowest federal income tax brackets of 10% and 15%. The favorable zero bracket covers long-term capital gains (after being offset by net short-term losses). Qualified dividend income is also covered.

Thus, a married couple filing joint returns for 2008 with taxable income of less than $65,100, or a single person with less than $32,550 of taxable income, can take advantage of the new rate.

Many taxpayers in the 15% tax bracket have a fairly small amount of net long-term capital gains to begin with; even assuming a $10,000 gain, such a taxpayer would have faced a 5% tax of $500 in 2007 and now can realize that gain for free. But retirees could be in a position to benefit.

The next inquiry is whether someone wealthier and in a higher income tax bracket for which a 15% capital gain tax rate currently applies-such as someone with a $100,000 gain and a $15,000 potential tax liability can transfer those gains to someone in a lower tax bracket, such as a child?

Anticipating this move, Congress imposed a partial limit on such transfers by expanding the "kiddie tax" rules that tax a child's unearned income at a parent's tax rates to children up to the ages of 19 and, for full-time students or dependents, age 23. That still leaves open the potential for parents to gift appreciated assets to any of their adult children who are in 15% or lower income tax brackets. Reverse generational gifting from child to parent can also work effectively.

Caveats: Shifting income has potential unwanted consequences such as causing ineligibility for college aid to a young person, ineligibility for Medicaid to an older person, or the taxation of Social Security benefits.

Another strategy is to defer income to a future tax year or divert it to a retirement plan so as to create a year when income falls into the 15% income tax bracket and take advantage of that window of time to sell appreciated assets.

Old Reliable Strategies?

Second guessing these decisions is inevitable because the fate of the stepped-up basis for assets transferred at death remains uncertain. An estate tax repeal with a carryover basis is still possible, so taking advantage of current temporary techniques to avoid capital gains is somewhat tempting.

The future application of other capital gains strategies will influence what appreciated assets are to be sold currently. Some assets will remain in the family. Others can be qualified as primary residences prior to future sale. Those who already intend to make charitable gifts can do so using appreciated assets.

© KS 2008.2