The Wall Street Journal-20080123-Tax Report- Trust-Fees Ruling Causes Pain- Justices Decision Limits Deductions For Tax Purposes
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Tax Report: Trust-Fees Ruling Causes Pain; Justices Decision Limits Deductions For Tax Purposes
The Supreme Court handed down a painful decision last week for many people who rely on trusts for income.
In a unanimous opinion written by Chief Justice John Roberts, the court ruled that investment advisory fees paid by a trust can't be deducted in full for income-tax purposes. Instead, the court said, deductibility of those fees generally is limited by what's known as the 2% floor on miscellaneous itemized deductions.
The decision means those fees typically are deductible only to the extent that their total, along with certain other miscellaneous deductions, exceeds 2% of the trust's adjusted gross income.
If the Supreme Court had ruled the other way and allowed the deductions in full, many trusts, estates and their beneficiaries could have saved large amounts of money in taxes, says Jonathan Rikoon, a partner at Debevoise & Plimpton LLP in New York. Greg Rosica, a tax partner at Ernst & Young in Tampa, says the decision is especially significant for big trusts and estates that routinely spend hefty amounts on investment-advisory fees.
The Supreme Court took the case to resolve a long-running conflict among federal appeals courts. The Sixth Circuit Court of Appeals had said investment advisory fees were fully deductible. But several other appeals courts disagreed -- which meant, until the Supreme Court weighed in, that the law of the land could depend on where you live.
The case has drawn especially close attention because trusts -- and the amount of assets they hold under management -- have proliferated rapidly in recent decades as Americans have grown increasingly prosperous. There are many different types of trusts. In their simplest form, they typically involve an agreement to transfer what you own, such as money and property, to people you choose, known as trustees, who look after those assets on behalf of the designated beneficiaries.
There are nearly four million estates and trusts that outsource $10.2 billion a year for legal, accounting, tax reporting and asset management, and that pay trustees an additional $4 billion for their asset-management services, according to Eileen Sherr, tax technical manager at the American Institute of Certified Public Accountants in Washington.
Trusts serve a wide variety of purposes, such as reducing taxes, providing money for family members or people who can't look after themselves, supporting charities and shielding assets from creditors. Many trustees hire investment-advisory professionals for their expertise in managing money.
The case the Supreme Court heard is generally known as "Rudkin" since it involves a trust set up in 1967 in Connecticut under the will of Henry A. Rudkin, who, with his wife, founded food company Pepperidge Farm. It's also known as the "Knight" case after Michael J. Knight, trustee of the Rudkin trust.
In 2000, the trustee hired an outside firm to provide advice on investing the trust's assets. At the beginning of the tax year, the trust had about $2.9 million in marketable securities, and it paid the firm $22,241 in investment-advisory fees for the year, according to the Supreme Court's summary of the case. The trust deducted all those fees. But the Internal Revenue Service said the fees must be limited by the 2% floor. The result: The IRS said the trust owed an additional $4,448 in taxes.
The trust had argued that the trustee's fiduciary duty to act as a "prudent investor" under Connecticut law required the trustee to hire an investment pro. Thus, the trust said, the fees are unique to trusts and should be fully deductible.
The Supreme Court disagreed, although it arrived at its conclusion for different reasons than those given by the Second Circuit Court of Appeals.
Moreover, the Supreme Court "did leave the door slightly ajar," says Robert Willens, president of a New York tax and accounting consulting firm bearing his name. The justices left open the possibility that some fees might be deductible in certain cases -- such as if a trust "may have an unusual investment objective, or may require a specialized balancing of the interests of various parties."
In such cases, the extra cost of expert advice beyond what would normally be required for an ordinary taxpayer wouldn't be subject to the 2% floor, the court said.
The Supreme Court also said that costs incurred in administering a trust that wouldn't have been incurred if the property weren't held by a trust may be deducted without regard to the floor. Last year, the IRS issued proposed regulations that broke down various types of costs into those it considered unique to an estate or trust and those that aren't.
As a result of the ruling, trust companies may have to make changes in the way they bill clients. Many trust companies don't break out their investment-fee charge from other fees but bundle them into a single fee instead. Under the IRS regulations, if an estate or trust pays a single bundled fee, it has to figure out how much of the fee would be fully deductible and how much wouldn't be.
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DUMPING LOSERS can help save you money on taxes.
With stock prices tumbling so far this year, consider reviewing your holdings with an eye on your tax bill. For example, if you sell some poorly performing stocks, mutual-fund shares or other securities that now are worth considerably less than you paid for them, you typically can use your losses to cut your taxes.
You can use capital losses to soak up capital gains on a dollar-for- dollar basis, with no limit. If your losses exceed your gains, or if you have no gains at all, you can deduct as much as $3,000 a year of net losses ($1,500 if you're married and filing separately) from wages and other ordinary income. Excess losses get carried over into future years.
A few caveats: First, if you sell something at a loss, watch out for the "wash-sale rule." Don't buy the same investment, or something substantially identical, within 30 days of the sale. That means 30 days before or after the sale. If you violate this rule, you can't deduct your loss. Instead, you would add the disallowed loss to the cost of the new securities, and the result is your basis in the new securities.
Second, don't make the mistake of donating investment losers to charity. Instead, sell those losers, use the losses to save taxes. Then consider donating the proceeds.
For more details, see IRS Publication 17, "Your Federal Income Tax," on the IRS Web site (www.irs.gov).
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THE IRS OFFERS more detail on "frivolous" arguments.
Think twice before you claim there's no law requiring you to pay federal income tax or file a return. Congress has raised the penalty for frivolous arguments to as much as $5,000 from $500 previously.
The IRS recently updated its list of what constitutes a frivolous argument on its Web site.
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