Knight v. Commissioner of Internal Revenue, No. 06-1286 (previously discussed in the June 25, 2007 docket report). In calculating a taxpayer's federal taxable income, the Internal Revenue Code permits all taxpayers, including trusts, to deduct certain "miscellaneous itemized deductions" from their adjusted gross income, to the extent that, in the aggregate, those deductions exceed two percent of the taxpayer's adjusted gross income. 26 U.S.C. § 67(a). Trusts, however, may deduct in full all "costs which are paid or incurred in connection with the administration of the * * * trust and which would not have been incurred if the property were not held in such trust." Id. § 67(e). In Knight, the Supreme Court held that a trust may deduct the fees it pays for investment advice only to the extent that they exceed two percent of the trust's adjusted gross income. The decision in Knight will be of significance to both trustees and the financial services industry, as well as wealthy individuals assessing alternative approaches to wealth management and estate planning.

In this case, the trustee of a testamentary trust sought the United States Tax Court's review of the IRS's determination that the trust could not deduct all of its investment advice fees. Relying upon a Sixth Circuit decision, the trustee argued that the entire amount was deductible under 26 U.S.C. § 67(e) because Connecticut law imposed upon trustees a fiduciary duty to employ investment advisory services. Siding with decisions of the Fourth and Federal Circuits, the Tax Court rejected that argument, reasoning that because individuals also commonly incur investment advisory fees, those fees are not unique to trusts and thus are not an expense that "would not have been incurred if the property were not held in such trust" under Section 67(e). Rudkin Testamentary Trust v. Commissioner, 124 T.C. 304, 309 (2005). The trustee appealed to the Second Circuit, which affirmed the Tax Court's judgment but adopted an even narrower interpretation of Section 67(e). Rather than holding that Section 67(e) permits the full deduction of an expense that merely is not "customarily" or "commonly" incurred by individuals, the Second Circuit held that Section 67(e) permits the full deduction of only those expenses that an individual could not incur at all. 467 F.3d 149, 155-56 (2d Cir. 2006).

In a unanimous decision authored by Chief Justice Roberts, the Supreme Court affirmed the judgment below but rejected the Second Circuit's interpretation of Section 67(e) in favor of the interpretation of the Fourth and Federal Circuits, holding that a trust may fully deduct an expense that an individual would not commonly incur. The Court explained that Congress's use of the word "would" in Section 67(e) necessarily entails a prediction of how the prudent investor would behave. Because a prudent individual investor would obtain investment advice and thus incur fees, Section 67(e) does not permit a trust to deduct fully the fees that it has incurred to obtain investment advice, even if the trust is, as a trust, legally required to retain an investment advisor.