Sotomayor, Roberts Agree on Taxes (Sort Of)

A couple of years ago, I was speaking about fiduciary taxes at a CLE when I was passed a note. It said, “Trust investment advisory fees subject to the 2% floor. Knight vs. Commissioner.” Whoa. This, you see, was a fairly significant development in the world of fiduciary income tax. It later went on to be only one of a handful of tax-related cases heard at the US Supreme Court last year.

Here are the facts in the case: Trustee (Michael J. Knight, and no, not of Knightrider fame which is I’m sure what popped into your head) hired an investment advisor to manage a trust portfolio worth about $3 million. In 2000, the advisor charged the trust about $20,000 in fees, which the trust deducted in full on its tax return.

On audit, the IRS said that the fees were not completely deductible. Instead, the IRS said that the fees were considered a “miscellaneous itemized deduction” and subject to the 2% floor. You might remember seeing that line on your personal income tax on Schedule A. If so, you know that miscellaneous itemized deductions are deductible only to the extent they exceed 2% of your AGI (adjusted gross income). The law says that “investment advisory fees” are subject to the 2% floor unless, in the case of a trust, the expenses “would not have been incurred if the property were not held in such trust.” The trustee in Knight argued that the fees were directly attributable to the fact that the money was in the trust and therefore met the exception (which would have made the fees fully deductible).

The trustee lost at the lower level and appealed on behalf of the trust – and lost again. And who wrote the opinion for the Second Circuit? Supreme Court Justice nominee Sonia Sotomayor.

There was a split among the lower courts with respect to the decision, with one court ruling in favor of the trustee. The case was further appealed to the US Supreme Court, which agreed to hear the case. The Supreme Court upheld Sotomayor’s decision in 2008 but Chief Justice Roberts wrote (downloadable as a pdf) that her decision “flies in the face of the statutory language.”

Same bottom line, different way of getting there. Expect to hear more about this case as Sotomayor goes to confirmation hearings – the “Knight case” is often referred to as the “Rudkin case” because the decedent in the matter was named Rudkin. Don’t be confused, same case.

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