Trust Argues Investment Advisory Fees Not Subject to 2 Percent Floor

Knight filed a timely petition with the United States Tax Court on February 25, 2004. (Joint Appendix pp. 5-7). The case was originally submitted as a small tax case to Special Trial Judge Stanley J. Goldberg. On September 21, 2004, pursuant to Knight's oral motion to change the case to a regular tax case, Chief Judge Joel Gerber transferred the case to Judge Robert A. Wherry, Jr. (Joint Appendix p. 63). On June 27, 2005, Judge Wherry entered his decision that the investment management fees are deductible only to the extent they exceed 2-percent of the trust's adjusted gross income and do not qualify for the exemption for estates and trusts provided in IRC § 67(e)(1). (Joint Appendix p. 76). Knight filed a timely Notice of Appeal in this case on September 21, 2005. (Joint Appendix pp. 77- 78).

The trust terminates twenty-one years after the death of the last class member living at the time of Henry A. Rudkin's death. Id. Knight estimates the trust will terminate in 2065 based on the age of William's youngest son. (Joint Appendix pp. 60-61). On termination the trust distributes its assets to William L. Rudkin's living descendants, per stirpes. (Joint Appendix p.41). No spouses are included in the remainder class. Id. The Connecticut Probate Court appointed a guardian ad litem to represent the interests of the unborn beneficiaries and requires Knight to file detailed principal and income trust accounting with it every three years. (Joint Appendix, pp.58, 62).

The trust agreement imposes a heightened level of investment responsibility on Knight by removing all restrictions to any safe harbor investments authorized by law. (Joint Appendix pp. 43, 61). Specifically, it authorizes him "to invest and reinvest the funds of my estate or of any trust created hereunder in such manner as they may deem advisable without being restricted to investments of the character authorized by law for the investment of estate or trust funds." (Joint Appendix pp. 43.)

The will also authorizes the trustee "to employ such agents, experts and counsel as they may deem advisable in connection with the administration and management of my estate and of any trust created hereunder, and to delegate discretionary powers to or rely upon information or advice furnished by such agents, experts and counsel." (Joint Appendix p. 46).

Additionally, the Connecticut Uniform Prudent Investor Act (CUPIA) §§ 45a-451 became applicable to the Rudkin Trustee on October 1, 1997. (Joint Appendix pp. 61, 88). CUPIA applies unless the trust agreement specifically overrides it. (Joint Appendix pp. 80, 88). The Rudkin Trust does not override CUPIA, but is consistent with its heightened investment standard. (Joint Appendix pp. 61, 43, 81). CUPIA requires Knight to evaluate "investment and management decisions respecting individual assets" . . . "not in isolation, but in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust." (Joint Appendix, p. 81). In total, it mandates nine unique investment standards applicable only to trustees. (Joint Appendix, pp. 79-88).

These standards include the duty to invest impartially among all beneficiaries whether current, successive, or remainder and to consider the trust's purposes, terms, and ten other factors enumerated in the statute. (Joint Appendix pp. 81, 84). These factors include the general economic conditions, the effects of inflation and deflation, the expected tax consequences, the role that each investment plays within the overall trust portfolio, the expected total return from both income and principal, other resources of the beneficiaries, needs for liquidity, regularity of income, and preservation or appreciation of capital, and an asset's special relationship to the purposes of the trust or any one or more of the beneficiaries. (Joint Appendix p. 81).

If the trustee cannot meet these mandatory standards, CUPIA gives the trustee the power to delegate these duties to an agent who assumes full liability as a fiduciary under the Act. (Joint Appendix p. 86). Michael Knight, a CPA, engaged Warfield Associates, Inc. as agent and fiduciary to manage the trust assets because he needed professional help to manage the assets for multiple generations of beneficiaries, as mandated by the trust. (Joint Appendix pp. 6, 12, 58, 60-61). Warfield Associates, Inc., an SEC registered investment adviser in New York, invested the trust assets mostly in growth stocks. (Joint Appendix p. 39-30). Knight paid Warfield Associates, Inc., quarterly payments totaling $22,241.31 for these investment services based on .8 percent of the $2.8 million average portfolio value in 2000. (Joint Appendix p. 49-52).

Knight prepared the Trust's 2000 Form 1041 and deducted these fees from the trust's adjusted gross income pursuant to IRC § 67(e)(1). Upon audit, the IRS reclassified these fees as miscellaneous itemized deductions allowable only to the extent they exceeded 2-percent of the trust's adjusted gross income. (Joint Appendix p. 17). Knight petitioned the United States Tax Court, which agreed with the IRS's interpretation of IRC § 67(e)(1). (Joint Appendix pp. 5-7, 76).

The prong's plain meaning allows a full deduction for administrative costs necessitated by the trustee's duties. The Sixth Circuit in O'Neill v. Commissioner correctly applied the statute and allowed the trust a full deduction for its investment management fees. O'Neill, 994 F.2d 302. However, the Tax Court believed that under that interpretation, all administrative costs in prong one would meet the definition of prong two, rendering it superfluous. Id.

To give it a meaning that was not superfluous, the Tax Court rewrote the statute, adding "commonly" and subtracting "such." As rewritten by the Tax Court, the statute allows a full deduction only for costs that are not commonly incurred by individuals outside a trust administration. On that basis, the Tax Court disallowed a full deduction for the investment management fees Knight paid Warfield because it alleges that individuals commonly incur the same investment costs as trustees.

However, the Tax Court's redrafting of the statute has created, and will continue to create,results that are confusing, absurd and contrary to its plain meaning and legislative purpose. Further, its application relies on the false premise that individuals commonly incur the same investment costs as trustees.

Legislative Purpose

The Tax Court, and the Fourth and Federal Circuits upon which the Tax Court relied, all erred by changing the prong's plain meaning because they failed to understand its purpose as explained in its clear legislative history. At the time prong two was written, estates and trusts were frequent investors in pass-thru entities. Congress was concerned about tax shelters conducted through pass-thru entities. (Special Appendix pp. 90, 100a, 100e, 100g). Congress wanted to clarify whether trustee fees and administrative costs of pass-thru entities should be exempt from the 2-percent floor. (Special Appendix pp. 111, 116).

Consequently, it designed the second prong to exclude them from the exemption. (Special Appendix pp. 158, 204). Such costs would clearly not pass the test of costs "which would not have been incurred if the property were not held in such trust." Rather, they would have been incurred regardless of such trust's ownership because they were authorized and incurred because of the pass-thru entity.

The Tax Court's "Thrust"

Because the Tax Court did not understand the second prong's purpose and believed it superfluous under the Sixth Circuit's interpretation, Tax Court added and subtracted words to give it a "thrust" of their own. Rudkin, 124 T.C. 304, 309; O'Neill v. Commissioner, 98 T.C. 227, 230. It added "unique" and "commonly" and subtracted "such." It also misused "would not have been . . . if "to denote custom or habit rather than causation. Consequently, the Tax Court misinterpreted the statute as allowing a full deduction only for the types of costs that are unique to the administration of an estate or trust. That is, those not commonly incurred outside of a trust administration. Id.

However, giving effect to all the words of the statute and no more, its plain meaning allows a full deduction for the Warfield costs which would not have been incurred if the portfolio were not held in the Rudkin trust. Take away the Rudkin Trustee and the Warfield costs would not have been incurred because Michael J. Knight, Trustee alone authorized them. Take away Knight and the administrative costs of pass-thru entities would have been incurred regardless, because they were authorized by another entity. As such, they fail prong two. The Tax Court and the Fourth and Federal Circuit Courts of Appeal failed to see this application of the second prong. This application was its central purpose. (Special Appendix pp. 158, 204).

Absurdity

The Tax Court's interpretation of prong two results in absurdity. It allows a full deduction for trust accounting costs mandated by law, but disallows trust investing costs mandated by law. Rudkin, 124 T.C. 304, 309-310. This is a distinction without a difference. It also creates absurdity by allowing an unskilled trustee to fully deduct his trustee fees if he performs the investment services negligently, but disallows him a full deduction for costs he incurs to delegate those to a professional to avoid breaching his fiduciary duties. Id. Presumably the trustee in either case is entitled to fully deduct the legal fees to defend himself for breach of fiduciary duty because only trustees can be sued for breach of duty under the prudent investor statutes.

False Premise

Finally, assume we adopt the Tax Court's erroneous interpretation that the second prong requires costs to be unique (not commonly incurred outside of) to trust administration to be fully deductible. This requires us to accept that individuals (1) incur the same costs as trustees and (2) routinely incur them. The first assumption is false because no individual incurs costs to invest according to the strict and unique requirements of the Prudent Investor Act. It is only applicable to trustees. (Joint Appendix p. 93). The second assumption is contradicted by the experience of most tax practitioners and the IRS's own published statistics, which show that individuals do not routinely pay for professional investment advice. (Joint Appendix p. 57 and Special Appendix pp. 215, 223, 232).

The Tax Reform Act of 1986 added IRC § 67 to allow deductions for miscellaneous itemized deductions "only to the extent that the aggregate of such deductions exceeds 2-percent of adjusted gross income" ("the 2-percent floor"). The statute also contains numerous exceptions listed in IRC § 67(b)-(e).

The costs involved in this dispute are investment management fees that Knight paid to Warfield to invest the trust assets pursuant to Knight's state law duty under the Connecticut Uniform Prudent Investor Act (CUPIA). Such fees are miscellaneous itemized deductions, deductible under IRC § 212 as expenses incurred for producing income and managing property held for the production of income. Treas. Reg. § 1.212-1(g), (i). Unless specifically exempted under any subsection of IRC § 67, they are generally subject to the 2-percent floor. Temp. Treas. Reg. § 1.67- 1T(a)(1)(ii).

However, IRC § 67(e)(1) exempts administrative costs of estates and trusts from the 2-percent floor as follows:

There is no dispute that the investment management fees paid to Warfield in this case were paid or incurred "in connection with the administration of the . . . trust." Id. The issue presented here is whether the fees paid to Warfield meet the second prong's criteria. That is, they would not have been incurred if the property [investment portfolio] were not held in such [the Rudkin] trust. This court is called upon to interpret the meaning of the second prong of IRC § 67(e)(1).

II. The Holdings of the Circuit Courts of Appeal

The Tax Court relies solely on its own opinion in O'Neill v. Commissioner, 98 T.C. 227 (1992) and on the holdings of the Fourth and Federal Courts of Appeals in the Scott v. United States,, 328 F.3d 132, 139-140 and Mellon Bank, N.A. v. United States, 265 F.3d 1275, 1280-1281. Based on these holdings, the Tax Court finds that the "thrust" of prong two is to allow a full deduction for only the type of costs that are unique to the administration of an estate or trust. It defines unique as not commonly or routinely incurred outside of a trust administration. Rudkin, 124 T.C. 304, 309-310; O'Neill, 98 T.C. 227, 230. The Tax Court provides examples of such unique costs as fees paid to a trustee and trust accounting fees mandated by law or the trust agreement. Id.

The Tax Court also asserts that "individual investors routinely incur costs for investment advice . . . Consequently, it cannot be argued that such costs are somehow unique to the administration of an estate or trust simply because the fiduciary might feel compelled to incur such expenses in order to meet the prudent person standards imposed by law." Id.

However, these Courts all commit the same error by -- (1) adding and subtracting words that change the statute's plain meaning, and (2) reaching a result that is contrary to the statute's clear legislative purpose. In addition, their interpretation relies on the false premise that individuals routinely incur the same investment costs as trustees and causes divergent, confusing, and absurd results.

The Sixth Circuit rendered the first, and only correct, appellate decision on this issue when it reversed the Tax Court in O'Neill v. Commissioner, 994 F.2d 302 in 1993.

A. The Sixth Circuit in O'Neill

The Sixth Circuit had no trouble recognizing that the statute allows a full deduction for costs necessitated by the trustee's legally mandated duties and rejected the Tax Court's argument that costs must be unique to trusts. It held ". . . the investment advisory fees were necessary to the continued growth of the trust and were caused by the fiduciary duties of the co-trustees." O'Neill, 994 F.2d 302, 304. It also noted that individuals "suffer no penalties or potential liability if they act negligently for themselves" and that trustees "uniquely occupy a position of trust for others and have an obligation to the beneficiaries to exercise proper skill and care with the assets of the trust." Id.

Therefore, the Sixth Circuit found that "as the expenses for the investment management advice would not have been incurred if the property had not been held in trust, then these expenses meet the statutory requirement and are deductible in full from the Trust's adjusted gross income." Id. at 305. This interpretation renders each word of the statute significant, adds no words, and is consistent with the statute's legislative purpose.

B. The Federal Circuit in Mellon

The Federal Circuit rejected the Sixth Circuit's interpretation of prong two as consisting of all those costs necessitated by the trustee's fiduciary duties because it erroneously believed such an interpretation would render the second prong meaningless. Mellon, 265 F.3d 1275, 1280-1281. The Tax Court and the Fourth Circuit followed along with this faulty assumption. Rudkin, 124 T.C. 302, 310; Scott, 328 F.3d 132, 140. They believed that under this interpretation, all prong one trust administrative expenses would also qualify under prong two, rendering one of the prongs superfluous. Rudkin, 124 T.C. 302, 310; Scott, 328 F.3d 132, 140; Mellon, 265 F.3d 1275, 1280- 1281. Therefore, they added and subtracted words from the statute to give it a meaning of their own.

In concluding that prong two was superfluous without their changes, the Federal Circuit made three errors. First, they failed to realize that prong one contains costs that are distinct from prong two and neither prong is superfluous. Prong one consists of all administrative costs of the trust. These include costs necessitated by the trustee's duties as well as costs not caused by the trustee's duties. This latter group, for example, could include real estate property taxes and administrative costs from pass-thru entities that accrue regardless of the property's owner. The taxes are excepted from the 2-percent rule under IRC § 67(b)(2) as fully deductible under IRC § 164. But the administrative costs from pass-thru entities will not meet prong two because they would have been incurred regardless of the trust's ownership of the property.

Second, the Federal Circuit, followed by the Tax Court and Fourth Circuit, deleted "such" from the statute. Holding that the second prong excludes "the type of costs. . . that would have been incurred even if the assets were not held in a trust" impermissibly reads "such" right out of the statute. Mellon, 265 F.3d 1275, 1280-1281. This error completely changes the statute's meaning from 'costs incurred because of the trustee in question' to 'those that might be commonly incurred by another.'

Third, the Federal Circuit flatly misstated the second prong's legislative history by claiming that Congress sought to reduce the benefits of income-splitting between an estate or trust and its beneficiaries by applying the two percent floor:

Moreover, the Senate Report No. 99-313 directly contradicts the Federal Circuit's assertion that Congress used the 2-percent floor and not tax rate compression to achieve its goal of reducing the income-splitting benefits of estates and trusts. Senate Report No. 99-313 at 868 states instead that it achieved its purpose of reducing the income-splitting benefits for estates and trusts by compressing the tax brackets:

C. The Fourth Circuit in Scott

The Tax Court also relies on the Fourth Circuit's decision in Scott v. United States, 328 F.3d 132. In Scott, the Fourth Circuit makes the same errors as the Federal Circuit. It, too, fails to see that an interpretation of prong two premised on fiduciary duties does not render prong two superfluous. Therefore, like the Federal Circuit and the Tax Court, it adds and subtracts words of its own choosing, and refuses to "reference any of the statute's legislative history brought to [their] attention by the parties." Scott, 328 F.3d 132, 139.

Committing the first error, the Fourth Circuit holds:

Also like the Federal Circuit and the tax Court, the Fourth Circuit added and subtracted words from the statute to create its own meaning. By adding "commonly" and deleting "such," it created a second prong that "asks whether costs are commonly incurred outside the administration of trusts." Scott, 328 F.3d 132, 140. This reading, it felt, had meaning. However, the statute does not ask about commonly incurred costs. It asks "which costs that have actually been paid or incurred would not have been incurred without this trustee?" Thus, it seeks a causal connection between the administrative costs actually incurred and the trust in question.

The Fourth Circuit justifies inserting "commonly" into the statute by using the wrong meaning of "would." Webster's Ninth New Collegiate Dictionary offers ten different meanings of "would" depending on how it is used. (Special Appendix p. 214). The Fourth Circuit selected one that implies custom or habit. Scott, 328 F.3d 132, 139. For example, "we would often go to lunch." However, the Fourth Circuit picked the wrong use of "would."

"Would, as used in Section 67(e)(1) with a subjunctive clause starting with "if," expresses presumption or probability about a past event under a counterfactual condition. Id.; see also Bryan A. Garner, A Dictionary of Modern American Usage (Oxford Univ. Press 1998). Put simply, it seeks a causal connection between a hypothetical condition (the property is not held in such trust) and an event that has already happened (the Warfield costs were paid).

Applying these rules to our facts, the second prong asks "would the Warfield costs have been incurred if the property were not held in the Rudkin Trust?" The past event is that the Warfield costs were incurred. The counterfactual (hypothetical) condition is that the property in not held in the Rudkin Trust. Thus, the second prong plainly and simply asks whether the Warfield fees would have been incurred absent the Rudkin trustee and the answer is no. Therefore, the costs pass the test of prong two and are fully deductible as Congress intended.

III. Statutory Construction

Questions of statutory interpretation begin with the plain meaning of the law's text and, absent ambiguity, will generally end there. Collazos v. United States, 368 F.3d 190, 196 (2nd Cir. 2004). Courts should give effect to every provision and word in a statute if possible and avoid any interpretation that may render statutory terms meaningless or superfluous. Freytag v. Commissioner of Internal Revenue, 501 U.S. 868, 877 (1991). The Tax Court's gloss over the statute, adding and subtracting as it goes, violates these cannon of statutory construction.

A. Superfluity

The Tax Court and the Fourth and Federal Circuits rejected an interpretation of prong two premised on the fiduciary's duties. Under that construction, these Courts erroneously believed that "the second prerequisite of section 67(e)(1) would be rendered superfluous because any costs associated with a trust will always be deductible." Rudkin, 124 T.C. 304, 310; Scott, 328 F.3d 132, 140; Mellon, 265 F.3d 1275, 1281. They reasoned that under this construction, prongs one and two would define identical sets, rendering one of them superfluous. To fix the perceived problem, they created a meaning of their own.

All three Courts, however, failed to see the distinction between prong one and prong two. Prong one defines all administrative costs of an estate or trust whether attributable to such trustee's duties or not. Prong two contains only those costs that were incurred because of such trust.

Judge Andewelt of the Federal Claims Court used Venn diagrams in Mellon Bank v. United States to illustrate whether a proposed interpretation of a statute renders a particular provision superfluous. . ." Mellon Bank, N.A. v. United States, 47 Fed. C1. 186, 192, at note 4. "Each individual statutory requirement as interpreted by the party constitutes a distinct set and a circle is employed for that set to depict all possible situations that satisfy that requirement." Id.

"A set is a group of distinct elements which have common properties, for example, where all elements satisfy the same conditions or meet the same requirements. . . . The relationship between two sets is depicted by the position and overlap of two circles." Id. The circles will either intersect, completely overlap, or not overlap at all. If the sets each contain a distinct provision of the statute and the circles intersect, there is no superfluity. For example, assume Set I contains all red objects and Set II contains all automobiles. All red automobiles lie at the intersection of the circles and neither Set is superfluous. Id.

Judge Andewelt set up the circles representing the requirements of IRC § 67(e)(1) in Mellon as follows:

 

 

Judge Andewelt erroneously believed that Mellon Bank's interpretation of Prong II premised on fiduciary duties would render Set I and Set II identical. Id. He failed to see that Prong I costs includes trustee fees and administrative costs incurred by pass-thru entities owned by the trust, whereas Prong II includes only costs incurred because of such trustee. Thus, the sets are not identical. They intersect, rendering neither prong superfluous.

Fees paid to Warfield are Prong I administrative costs actually paid or incurred. They also satisfy the definition of Prong II costs because they would not have been incurred without such trustee, Michael Knight. Because they lie at the intersection of the two circles, they satisfy both criteria of nonidentical sets and are fully deductible.

Properly read, prong two asks which administrative costs that were actually "paid or incurred" (prong one costs) would not have been incurred if we remove "such trust." It does not ask about "a trust" or a "type of costs." Instead, the statute asks us to remove the Michael Knight and reexamine the administrative costs to see which would have been incurred without him.

Removing "such trust" removes the trustee's duties because trust and trust duties are synonymous. A trust is merely a relationship defined by a set of duties. Duties are the quintessential element of a trust, without which there is no trust. Moreover, investing is a fundamental trust duty. Treasury Regulations define a trust as "an arrangement created either by a will or by an intervivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts." Treas. Reg. § 301.7701-4. Probate courts define a trust as a "relationship with respect to property, subjecting the person by whom title to the property is held to equitable duties to deal with the property for the benefit of another person. . . ." Restatement, Second, Trusts § 2. Therefore, we can legitimately read prong two as allowing a full deduction for administrative costs "which would not have been incurred if the property were not subject to the trustee's duties."

Congress intended to allow a full deduction for administrative costs attributable to the fiduciary duties of "such trust," but not necessarily for those attributable to other entities owned by the trust. Prong two is the filter. Indeed, most of the administrative costs incurred by the trust would not have been incurred if we remove such trustee. This should come as no surprise, because it is consistent with Congress's well documented legislative intent to allow fiduciaries to fully deduct the costs of carrying out their legally mandated duties. Congress has never considered fiduciaries incurring costs to carry out their fiduciary duties as abusive.

The relative pronoun "which" appears twice in IRC § 67(e)(1). It begins a restrictive clause that is essential to the meaning of the sentence. Bryan A. Garner, The Redbook, A Manual on Legal Style 135 (West Group 2002). Neither the Senate nor House bill version of IRC § 67(e) contained the word "which." (Special Appendix pp. 30, 76). Congress added "which" to prong one when it added prong two in the adopted version of IRC § 67 in order to emphasize which costs it was focused on. (Special Appendix pp. 195). Congress added another "which" in the Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647). (Special Appendix pp. 210). The second "which" re-emphasizes Congress's focus on costs that have actually been incurred, and not other types of costs that might be commonly incurred.

To delete "such" and ignore "which" costs Congress is asking about completely and impermissibly changes the meaning of the second prong, contrary to its clear legislative purpose. This is what the Tax Court and the Fourth and Federal Circuits did.

B. Causation and the Subjunctive "Would"

The Tax Court and the Fourth and Federal Circuits rejected the Sixth Circuit's interpretation that prong two costs are those caused by the fiduciary duties of the trustee. Rudkin, 124 T.C. 304, 310; Scott, 328 F.3d 132, 140; Mellon, 265 F.3d 1275, 1280-1280. They did so because they could not see the purpose of prong two and therefore perceived it to be superfluous. Therefore, to avoid its perceived superfluity, they simply changed the meaning of the statute, contrary to its clear legislative purpose. Rudkin, 124 T.C. 304, 309; Scott, 328 F.3d 132, 139; Mellon, 265 F.3d 1275, 1281.

In addition to inserting "commonly" and deleting "such," these three Courts ignored the plain meaning of "would (not) have . . . if." When "would (not) have" is accompanied by a subjunctive clause starting with "if," it expresses probability or presumption of a past condition counter to fact. Bryan A. Garner, A Dictionary of Modern American Usage (Oxford Univ. Press 1998). For example, "I would have won if I had not tripped." Webster's Ninth New Collegiate Dictionary 1361; Special Appendix p. 214). "Would (not) have" standing alone makes no sense without the counterfactual condition that I did not trip. The clear implication is that tripping caused me to lose. Applying the correct use of "would" to IRC § 67(e)(1), we see that costs "which would not have been incurred if the property were not held in such trust" means "costs caused by such trust."

As used in the second prong, "if . . . were not" means "but for." Bryan A. Garner, A Dictionary of Modern Legal Usage 124 (Oxford University Press 2nd ed. 1995). That is, "if the property were not held" means "if not for the property being held" or "but for the property being held." Costs "which would not have been incurred if the property were not held in such trust" is equivalent to costs "which would not have been incurred but for such trust." The entire phrase focuses on something that has already happened (administrative costs) and tests for causation by removing the suspicious factor (such trust). It is pure "but for" causation.

A test for causation does not require the cost to be unique, although some causal factors may be unique. An interpretation that requires costs to be unique to trusts would read the entire exception for estates and trusts right out of the statute because no cost would pass this test. Not even fiduciary fees are unique to trusts. They occur in the context of guardians, agents under a power of attorney, general partners, corporate directors, and many other types of fiduciary relationships. Rather, the second prong of IRC § 67(e)(1) asks whether such trustee caused the costs to be incurred.

Section 67(e)(1) is no different. Costs "which would not have been incurred if the property were not held in such trust" does not ask whether similar costs are commonly incurred outside of a trust. It asks whether this trustee caused the costs to be incurred. The Tax Court refuses to read it this way because it believes that it renders prong two superfluous. Rudkin, 124 T.C. 304, 310.

Similarly, prong two asks what costs are incurred because of such trust. It asks us to remove such trust and see what costs would have been incurred without him. The true litmus test of causation is whether the costs would have been incurred after removing the suspicious agent. Fees paid to Warfield unequivocally would not have been incurred without Michael Knight. He alone authorized them. They do not accrue independently of him, like costs of pass-thru entities. As such, they are fully deductible as Congress intended.

C. The Tax Court Causes Absurd Results

A cardinal canon of statutory construction is that courts should avoid interpretations that lead to absurd results.Commissioner v. Brown, 380 U.S. 563, 571-572 (1965); United States v. Hendrickson, 26 F.3d 321 (2^nd Cir. 2000). The Tax Court's interpretation of IRC § 67(e)(1) violates this canon because it leads to absurdity. It allows a full deduction for investment services performed by an unskilled trustee, yet denies him a full deduction when he prudently delegates the duty to avoid a breach. Although he may not fully deduct the cost of avoiding breach by delegating, he may fully deduct his legal fees when he is sued for negligent investing because only trustees get sued for this. Individuals investing for their own account do not.

It is also absurd to allow costs for trustee fees, trust accountings, and trust tax return preparation that are mandated by law or the trust instrument, yet disallow trust investing costs that are also mandated by law or the trust instrument. Rudkin, 124 T.C. 304, 309; Scott, 328 F.3d 132, 140. This interpretation renders no distinction between the first group of fully deductible expenses and trust investing which the Tax Court arbitrarily subjects to the 2-percent floor.

Finally, the Tax Court's approach to the application of prong two requires the taxpayer to know what expenses are commonly incurred by a wealthy hypothetical investor who voluntarily engages an investment advisor to tailor a portfolio to his individual goals. This is not a one-size fits all hypothetical. It may vary by personality, region, time, custom, cost, taste, ethics, age, risk tolerance and many other factors to numerous to mention. Moreover, the Tax Court asks the taxpayer to measure a statistic that even the IRS Statistics of Income does not measure, either because it is impossible to measure or insignificant. (Special Appendix p. 223). It is doubtful whether such a statutory interpretation even passes Constitutional muster.

D. The Tax Court Relies on a False Premise

Assume we adopt the Tax Court's interpretation that trustee's investment management fees are subject to the 2-percent floor if individuals routinely incur the same costs outside of trust administration. There is no evidence in the record to establish that individuals incur the same costs as trustees or that they do so routinely.

First, no individual is subject to the Uniform Prudent Investor Act (UPIA). It uniquely applies to trustees.¹ (Joint Appendix p. 93). Connecticut adopted UPIA in 1997. It became effective for all Connecticut trusts existing on or after October 1, 1997 unless the trust instrument expressly overrides it. (Joint Appendix pp. 80-88). The provisions of the Connecticut Uniform Prudent Investor Act (CUPIA) are almost identical the Uniform Laws Commissioner Uniform Prudent Investor Act. (Joint Appendix pp. 79-88 (CUPIA) and pp. 89-110 (UPIA)).

UPIA and CUPIA require trustees to invest according to the "prudent investor rule." (Joint Appendix pp. 80, 94). Among other requirements, this requires trustees to invest impartially among current and successive beneficiaries, assume risk, diversify, and consider ten other factors enumerated therein. (Joint Appendix pp. 81, 82, 84, 95-100, 104). The trustee must also be loyal to the beneficiaries. (Joint Appendix pp. 83, 103). This means he is restricted as to the types of investments he can make. He must avoid conflicts of interest and may not engage in any form of "social investing." (Joint Appendix p. 103).

If a trustee is unable to fulfill these mandatory duties, he may delegate them to an agent who assumes full responsibility for the investment function as a fiduciary under UPIA. (Joint Appendix p. 86, 105-109). Put simply, the agent steps into the shoes of the fiduciary for the investment function. If the trustee delegates the investment duties, he must lower his trustee fee accordingly to avoid "double dipping" the beneficiaries. (Joint Appendix p. 109). If an unskilled trustee does not properly delegate and fails to meet the prudent investor standard, he may be liable for breach of his fiduciary duties under state law. (Joint Appendix p. 151).

Therefore, individuals seeking investment advice on their own account do not purchase the same services or incur the same costs as trustees fulfilling their duties under the prudent investor statutes.

Second, individuals do not routinely incur investment advice. The experience of tax practitioners is just the opposite. (Joint Appendix p. 57). They buy mutual funds or make their own investment decisions. This fact is supported by the IRS's own published Statistics of Income. Of the 129 million individuals who filed tax returns for tax year 2000, only about 10 million individuals (or 7.75 percent) deducted itemized deductions in excess of the 2-percent floor. (Special Appendix pp. 215, 223). Over 70 percent of the deductions subject to the 2-percent floor consisted of employee business expenses. (Special Appendix p. 231-232). Based on these statistics, it is reasonable to estimate that less than 3 percent of all individuals incur fees for professional investment advice.

Therefore, based on common practices substantiated by the IRS's own Statistics of Income, individuals do not commonly incur costs for investment management. Consequently, even under the Tax Court's flawed interpretation of IRC § 67(e)(1), the Rudkin Trust is entitled to a full deduction from adjusted gross income for investment management fees paid to Warfield in 2000.

IV. Legislative Purpose

In the absence of a conflict between a reasonably plain meaning and legislative history, the words of a statute must prevail. United States v. Koh, 199 F.3d 632, 637-638 (2d Cir. 1999). Michael Knight's interpretation of IRC § 67(e)(1) relies on its plain meaning and is consistent with the statute's legislative history. The Tax Court refuses to rely on the plain meaning because it believes that such an interpretation causes the second prong of IRC § 67(e)(1) to be superfluous. Therefore, it rewrites the statute by adding "commonly" and "deleting such" to give it meaning. However, The Tax Court's meaning is at odds with the statute's legislative purpose. Therefore, it is necessary to review this legislative purpose.

The 2-percent floor under IRC § 67 was added in 1986 by the Tax Reform Act of 1986 (P.L. 99-514). Both the House and Senate versions of H.R. 3838 to the Tax Reform Act of 1986 allowed estates and trusts to fully deduct their administrative costs, exempting all such costs from the 2-percent floor. (Special Appendix pp. 30, 76). The second prong did not exist. Consequently, neither the House Report 99-426 (Dec. 17, 1985) nor the Senate Report 99-313 (May 29, 1986) explains the prong's purpose.

Prong two was added because of a Senate amendment that added IRC § 67(c) to prohibit individuals from deducting costs of pass-thru entities that would be subject to the floor if paid or incurred directly by them. (Special Appendix pp. 101, 158, 204). Prong two was necessary to clarify whether an estate or trust's share of administrative costs from pass-thru entities under IRC § 67(c) would be fiduciary administrative costs exempt from the floor under IRC § 67(e). (Special Appendix pp. 111, 116, 158).

The Joint Conference Agreement and Conference Report both clearly explain that the second prong's purpose was to filter out administrative costs of pass-thru entities owned by an estate or trust. (Special Appendix pp. 158, 204). This purpose is consistent with the intent of both the House and Senate to allow estates and trusts to fully deduct all costs necessitated by their fiduciary duties. (Special Appendix pp. 30, 34, 76).

A. The Origin of Section 67(e)

The House Ways and Means Committee passed H.R. 3838 on December 17, 1985 containing the original version of IRC § 67(e). It proposed a 1-percent floor on miscellaneous itemized deductions with a full exclusion for administrative costs of estates and trusts. (Special Appendix p. 30). The Senate Finance Committee version of H.R. 3838 reported on May 29, 1986 and passed by the Senate on June 24, 1986 proposed to repeal all miscellaneous itemized deductions for individuals. (Special Appendix p. 102). However, it fully exempted administrative costs of estates and trusts from this rule. (Special Appendix p. 76).

The House and the Senate bill versions of IRC § 67(e) contained identical language allowing a full deduction from adjusted gross income for all administrative costs of an estate or trust for purposes of the 2-percent floor. They read as follows:

B. The Senate Adds Section 67(c) for Pass-Thru Entities

Following a series of congressional hearings in June 1986 on "Issues Related to Passthrough Entities" the Senate proposed an amendment to add IRC § 67(c) to avoid potential abuse by taxpayers who would invest in pass-thru entities in order to avoid the 2-percent floor. (Special Appendix pp. 100a, 100e, 100g, 101). Pass-thru entities could be used to masque expenses that would otherwise be subject to the floor. The proposed amendment directed Treasury to write regulations to accomplish the purposes of IRC § 67(c).

During the joint conferences, the House offered to increase the 1-percent floor in its bill version to 2-percent and proposed to exclude certain entities that did not lend themselves to abuse of the 2-percent rule. (Special Appendix pp. 111, 116). These included estates, trusts, cooperatives and real estate investment trusts (REITs). People do not "invest" in estates and trusts, live in co-ops, or form REITs requiring 100 or more investors to avoid the 2-percent floor on miscellaneous itemized deductions. As such, these situations did not lend themselves to potential abuse of the 2-percent floor and were excluded from the requirement to separately report miscellaneous itemized deductions to their beneficiaries, shareholders, and partners.

The House and Senate compromised on the following version of IRC § 67(c):

C. Coordinating Section 67(c) and 67(e)

However, one problem remained. Estates and trusts were exempt from the requirement to separately report to their beneficiaries costs that might be subject to the floor if incurred directly by them under IRC § 67(c). However, estates and trusts were themselves frequent investors in pass-thru entities such as regulated investment trusts (mutual funds), common trust funds, partnerships, S corporations, grantor trusts, real estate mortgage investment conduits, and others. The issue arose how a trust should treat its share of such separately stated costs reported to it by pass-thru entities in which it owned an interest. (Special Appendix pp. 111, 116).

Of particular concern was whether trustees' fees and administrative costs of such pass-thru entities owned by the trust were considered administration costs of the trust that should be excluded from the 2-percent floor under IRC § 67 (e). Id. The question needed to be answered because IRC § 67(e) exempted all administrative costs of estates and trusts from the floor. Without more, all of an estate or trust's share of administrative costs from pass-thru entities could be considered administrative costs of the estate or trust. Consequently, Congress needed to coordinate subsections 67(c) and 67(e) to clarify how trusts should treat their share of administrative costs from pass-thru entities.

D. The Joint Conferees' Fix -- Prong Two

The "fix" that the Conference Agreement settled on to coordinate these two sections was to add prong two to IRC § 67(e). Therefore, prong two appeared for the first time in the final version of H.R. 3838 agreed to in the Joint Conference Agreement on August 16, 1986. (Special Appendix pp. 116, 133, 158). The conferees added prong two to provide that the trust's administrative costs "paid or incurred" are exempt from the floor only if they "would not have been incurred" if the property were not held by "such trust." Prong two refers only to "incurred" costs because it focuses on indirect costs incurred by pass-thru entities owned by the estate or trust. Such costs can only be incurred, but not paid by such trust.

The evolution of the second prong is easily seen in the Addendum attached to this Brief summarizing the House and Senate bill versions, the addition of IRC § 67(c), the House Offer and Senate amendments, the Conference Agreement and the final adopted version of IRC § 67(e).

E. Architecture of Section 67 (c) and Prong Two

The architecture and word choice of IRC § 67(c) and prong two are intentionally similar. Section 67(c) disallows costs paid by the pass-thru entity "which" would be subject to the 2-percent floor "if paid or incurred" directly by an individual. Compare Section 67(e), which allows costs "paid or incurred" by the trust "which" would not have been incurred "if" the property were not owned by the trust.

Both subsections ask the reader to remove the property's true owner. Section 67(c) directs us to remove the pass-thru entity and prong two directs us to remove the trust(ee). Then both statutes ask us to test the costs absent the true owner. Section 67(c) asks whether the costs would have been deductible if incurred directly by the individual. If not, they are not deductible. IRC § 67(e)(1), on the other hand, asks if costs would have been incurred without the trustee. If not, they are fully deductible.

F. Treasury Regulations "Effectuate" Prong Two

The nexus between IRC § 67(c) and the second prong of 67(e)(1) are clear from their structural design and their evolution in the joint conferences. (see also attached Addendum -- Spreadsheet Summary of the Legislative History of IRC § 67). It is also clear from the explanations in both the Joint Conference Report No. 99-841 and the Blue Book General Explanation of the Tax Reform Act. (Special Appendix pp. 158, 204). Both the Conference Report and the Blue Book explain that the purpose of IRC § 67(e) is to apply "the floor with respect to indirect deductions through certain pass-through entities" and that the Treasury Department's regulations under IRC § 67(c) will "effectuate this provision." Id.

Although the Conference Report and the Blue Book have different paragraph breaks, their identical meaning is only reinforced by obtaining the same meaning regardless of where the paragraph break occurs. (Special Appendix pp. 158, 204). The Blue Book explains the purpose of IRC § 67(e) as follows:

Treasury promulgated regulations effectuating the second prong's purpose in March 1988 as Temporary Regulation § 1.67-2T. (Special Appendix pp. 13-24). At that time, Treasury Decision 8189 announced that guidance for estates and trusts regarding matters pending in the Technical and Miscellaneous Revenue Act of 1988 would be published separately. (Special Appendix p. 10). Temp. Reg. 1.67-4T was reserved for that purpose. Those technical corrections were to clarify that estates and trusts could deduct charitable contributions under IRC § 642(c) and distribution deductions under IRC §§ 651 and 661 from their adjusted gross income for purposes of the 2-percent rule. (Special Appendix p. 207, 208, 210). They had nothing to do, however, with the meaning of the second prong. These anticipated technical corrections were one of many needed to correct Congressional oversights in the Tax Reform Act of 1986.

In the meantime, Temporary Regulation 1.67-2T took care of the application of prong two. It includes a very instructive example of a trust investor in a pass-thru entity reporting its share of deductions subject to the 2-percent rule (Special Appendix p. 14):

G. Could Congress Have Said it Any Better?

The question arises whether Congress could have expressed its intent more clearly and why it used a double negative in the passive voice. The answer becomes obvious when one attempts to improve on Congress' handiwork. The double negative is used to avoid a statute containing an exception to an exception. The passive voice is necessary because the prong is referring to indirect costs that the trust has incurred from another entity.

Perhaps Congress could have said: "Trusts are subject to the floor, except for administrative costs paid or incurred, except for those incurred by pass-thru entities." This structure contains an exception to the exception. Besides being awkward, it could be construed too broadly to exclude legitimate trust administrative costs necessitated by the duties of trustees that form pass-thru entities as part of their overall investment strategy. For example, a trustee is often the general partner in a family partnership containing professionally managed securities. In such a case, the administrative costs of the family partnership could be attributable to the trustee's duties,, depending on the facts and circumstances. A "with and without" test like the statute contains would be the true determinant of any such attribution.

Alternatively, Congress could have said: "Trusts are subject to the 2-percent floor, except for administrative costs paid or incurred which are necessitated by such trustee's duties." Perhaps this would have been a good choice. But instead, Congress chose the typical "would not have been . . . if' language that so many other tax code sections employ to test for causation. This would filter out most administrative costs not attributable to the trustee's duties without being overly inclusive or exclusive. Moreover, Congress intentionally left it up to Treasury to write regulations under IRC § 67(c) to effectuate the second prong and Treasury did so in Temp. Reg. § 1.67-2T.

Consequently, the prong accomplished its intended purpose. Its purpose is obvious to trustees that own an interest in a pass-thru entity and to tax practitioners who see its impact on tax returns every day. To others, its purpose may seem obscure. Nonetheless, it does not justify rewriting the statute as did the Tax Court and the Federal and Fourth Circuits.

V. Chevron Deference

Courts will generally give deference to an agency's regulatory interpretation of a federal statute when the statute is ambiguous and there is no legislative history. Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc. et. al., 467 U.S. 837 (1984). In this case, however, the language of the statute is clear and unambiguous. Mellon, 265 F.3d 1275, 1280; Scott, 328 F.3d 132, 139. There is also clear legislative history consistent with Knight's position. Moreover, the IRS promulgated regulations effectuating prong two shortly after Congress directed them to. Temp. Reg. § 1.67-2T.

The IRS now seeks to advance a different and erroneously crafted judicial interpretation. Their arguments in this case conflict with the plain language of the statute, the clear legislative history, and their own regulations published shortly after the statute's enactment. Moreover, their arguments defy common sense based on inescapable conclusions drawn from their own published statistics. Consequently, the agency should not be entitled to Chevron deference.

This interpretation is supported by a plain reading of the statute and its clearly expressed legislative purpose. It also eliminates the absurd debates over whether wealthy hypothetical investors routinely incur the same or generally similar costs, whether trustees should label all their services as "trustees fees" in order to achieve full deductibility under the Tax Court's rationale, and whether the deductibility of costs incurred for prudent delegation of these duties should be on a par with the same services performed by the trustee. Most importantly, it achieves the original purpose of the second prong.

The Sixth Circuit Court of Appeals in O'Neill v. Commissioner, ruled in favor of the position advanced by Michael J. Knight, Trustee of the Rudkin Testamentary Trust. The Sixth Circuit correctly interpreted the statute based on its plain meaning to allow a full deduction for costs caused by the trustee's duties.

The Tax Court, relying on the Fourth and Federal Circuit Courts of Appeal in Scott and Mellon and its own decision in O'Neill, misconstrued the statute to require such costs to be unique to trusts and disallowed the deductions on the theory that they were not unique to trusts because they are commonly incurred by individuals outside of a trust administration. This interpretation is contrary to the statute's plain meaning and its clearly expressed legislative history. It also rests on a fact not in evidence and causes absurd results.

Accordingly, Michael J. Knight, Trustee respectfully requests this Court to reverse the decision of the Tax Court and enter final judgment on behalf of the Rudkin Testamentary Trust.