In October 2006, in Rudkin (William L. Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006)), a two-judge panel of the Second Circuit Court of Appeals declared that "would" means "could" in Sec. 67(e). If this interpretation remains, it virtually eliminates the Sec. 67(e) exception to the two percent rule for estates and trusts and puts the Second Circuit in conflict with every other circuit that has interpreted this statute.

The Second Circuit held that Sec. 67(e) grants an estate or trust an exception from the two percent reduction in itemized deductions only for "costs of a type" that "individuals are incapable of incurring." On the surface, the court appeared to create a narrow window for an estate or trust to claim a full deduction for its administrative costs. In reality, however, it potentially eliminates a full deduction for any administrative cost of an estate or trust.

The court endorsed only three costs as fully deductible, because "individuals are incapable of incurring" them — "fees paid to trustees, expenses associated with judicial accountings, and the costs of preparing and filing fiduciary income tax returns." However, one could argue that even these do not pass muster under the Second Circuit's strict interpretation, because individuals are fully capable of incurring these costs. It makes sense that they would, because trustees are nothing more than titleholders for property beneficially owned by an individual. Thus, it is nearly impossible to conceive of a cost that trustees can incur with respect to property that an individual cannot.

This article examines how the Second Circuit reached its decision and how trustees and practitioners should respond to this questionable ruling.

The Controversy

Dozens of law reviews and journals have discussed the interpretation of Sec. 67(e) since the controversy first arose in O'Neill (William J. O'Neill, 994 F2d 302 (6th Cir. 1993), aff'g 98 TC 227 (1992), nonacq., 1994-2 CB 1). So far, none has urged the interpretation adopted by the Second Circuit. Indeed, the panel's interpretation even conflicts with IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, and most state fiduciary income tax forms, which allow a full deduction for legal and accounting fees. Under the court's definition, legal and accounting fees should not be fully deductible (at least in the Second Circuit), because individuals are capable of incurring them. Thus, the court's interpretation is bound to foster confusion and noncompliance.

While the $4,448 deficiency in Rudkin is undoubtedly small, the Second Circuit's position has serious implications. Its endorsement and application will create a substantial tax debt for trustees who must incur costs to comply with their legally mandated duties, such as those imposed under the Uniform Prudent Investor Act. It will also generate substantial litigation over a basic deduction that Congress intended for trustees carrying out such duties, all based on a questionable interpretation.

The Case
Two-Prong Test

The question before the Second Circuit was whether Sec. 67(e) exempted $22,241 of investment advisory fees paid by the Rudkin Trust from the "two percent rule" in Sec. 67(a), or required the fees to be reduced by two percent of the trust's adjusted gross income (AGI). Sec. 67(a) allows individuals to deduct miscellaneous itemized deductions only to the extent that they exceed two percent of AGI. Estates and trusts are generally subject to the same rules for determining income and deductions as individuals, except when specifically provided otherwise in numerous other Code sections. Sec. 67(e) is one of these many exceptions. It allows estates and trusts a full deduction for miscellaneous itemized deductions "paid or incurred in connection with the administration of the estate or trust ... which would not have been incurred if the property were not held in such trust or estate."

The exception is structured as a two-prong test. First, costs must be "paid or incurred in connection with the administration of the estate or trust." Second, those costs "would not have been incurred if the property were not held in such trust or estate." While the first prong is not in contention, no one can agree on what the second prong means.

"Would" Means "Could"

Despite Congress's deliberate choice of "would" in the second clause of Sec. 67(e), the Second Circuit's analysis interpreted "would" as "could." In doing so, it changed the statute from one that allows a full deduction for costs that would not have been incurred without the trust, to one that only allows costs that could not be incurred without a trust. One cannot help but question the court's justification for this change, because "would" does not mean the same as "could." "Would" expresses probability or presumption, whereas "could" denotes capability. These words are not ordinarily interchangeable.

Further, the court held that "such trust" means "a generic trust." This is also questionable, because "such" is a pointing word with a clear antecedent — the trust that paid or incurred the cost. Changing "such trust" to "a generic trust" changes the statute from a particularized inquiry about whether the costs were incurred because of such trust, to a general inquiry about whether the costs can be incurred outside of a trust at all. Indeed, it guts the very exception that Congress intended for administrative costs of estates and trusts, because there is arguably no cost that trustees can incur that "individuals are incapable of incurring."

Finally, and without explanation, the Rudkin court concluded that the statute "logically directs the inquiry away from the trust and back toward the hypothetical ownership of the property by an individual." Yet the statute says nothing about an individual property owner; rather, Sec. 67(e) specifically focuses on "costs which are paid or incurred in connection with the administration of the estate or trust" — not those that might be incurred by an individual.

Ruling's Effect

The Rudkin ruling potentially affects the four million estates and trusts that file tax returns with the IRS each year. Moreover, because estates and trusts report over $85 billion of AGI, there is an enormous amount at stake. Estates and trusts pay $9.8 billion a year for legal, accounting, tax reporting, asset management and other costs that are now subject to partial disallowance under the court's ruling. They also pay trustees $3.9 billion a year to perform these services. This decision is especially hard on fiduciaries and beneficiaries in New York, Connecticut and Vermont, because the Tax Court is bound to follow the Second Circuit's ruling in cases involving those residents. Approximately 10 percent of all estates and trusts reside in the Second Circuit.

How will executors and trustees react to the court's interpretation? Some will undoubtedly ignore it as an aberration. Others may simply avoid seeking any form of professional advice because it is not tax deductible, and, thus, not cost-effective to do so. To the extreme, some trusts may relocate outside the Second Circuit to a more favorable jurisdiction. Regardless, none of these reactions squares with sound tax policy or Congress's original intent to allow estates and trusts a full deduction for administrative costs incurred because of their legally mandated duties.

Millions of beneficiaries will also be affected by the court's decision. On audit, the Service will treat beneficiaries in the Second Circuit differently from all others, even in the same trust. They will owe a tax on "phantom income," to the extent they receive distributions from a trust that have been reduced by any costs that individuals

"are capable of incurring" and for which the trust has been denied a deduction. This deviation from the standard employed elsewhere will have broad economic and policy implications for all trustees and beneficiaries.

The Second Circuit's interpretation also conflicts with the IRS's interpretation of Sec. 67(e).In briefs before the Second Circuit and at oral argument, the government supported the position maintained by the Fourth and Federal Circuits (i.e., the second prong allows a full deduction only for costs that individuals do not "commonly incur"). But, more recently, the government took a different position. In CCA 200630016, the Service held that a bankruptcy estate is a "trust or estate" within the meaning of Sec. 67(e):

Therefore, applying § 67(e) to a debtor's estate in bankruptcy, the deduction for expenses paid or incurred in connection with administration of an estate in bankruptcy that would not have been incurred had the property not been held in such estate is treated as allowable in arriving at adjusted gross income.

The CCA expressly follows In re: Miller (In re: Miller, 252 B.R. 110 (Bankr. ED TX 2000)), which allowed a debtor's estate in bankruptcy a full deduction for telephone, postage, mileage, copies, legal and accounting fees and other expenses "paid or incurred in connection with administration of an estate in bankruptcy that would not have been incurred had the property not been held in such estate." Such costs are frequently incurred outside of bankruptcy. The government's position in the CCA is certainly not the position it maintained before the Second Circuit in Rudkin.

Hence, the Second Circuit's opinion conflicts with the Service's own interpretation of Sec. 67(e), with the decisions of all the other circuit courts, with every legal scholar who has written on this topic, and with all state and Federal fiduciary income tax forms. Thus, it has grave financial implications for estates and trusts and their beneficiaries, especially in the Second Circuit, and will affect all fiduciaries and beneficiaries if the IRS chooses to adopt the court's holding. Hopefully, this unusual decision will not be the final word on the issue.

Conclusion

This issue has traveled a long and bumpy road since it was first litigated in 1992 in O'Neill. Four circuits have sifted out three different meanings for this "plain and unambiguous" statute, the IRS has maintained inconsistent positions and trustees and tax preparers beg for guidance. Hopefully, the Supreme Court will deem the case worthy of review this fall.

Carol A. Cantrell, J.D., CPA, is a writer for The Tax Adviser. She is a shareholder at Briggs & Veselka Co., Bellaire, TX. Ms. Cantrell is a member of the AICPA Tax Division's Trust, Estate & Gift Tax Technical Resource Panel's Trust Accounting Income Task Force. Her views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.