Trust clients expecting to deduct bundled fees to the limit of the law may need to find providers who can break down fees as the IRS requires.

Two years ago, the US Supreme Court in Knight v. Commissioner held to be eligible to deduct investment management fees in a trust, they cannot be grouped together or bundled with trustee fees in one bill. As a result of this famous case, trust firms in the US are now getting ready to comply with an IRS directive requiring trustee and IM fees to be billed separately for a taxpayer to gain a deduction. 

A decade ago, Michael Knight was under the impression that investment management fees for trusts were fully deductible. After all, hiring the best possible advice was part of his fiduciary duty as trustee for a $2.8 million Pepperidge Farm family trust.

He was surprised when the IRS bounced most of the deduction back, leaving the trust with a $4,000 tax bill and gnawing questions about how to account for pure trust expenses (which are fully deductible) versus investment expenses going forward. He took the case all the way to the Supreme Court, only to lose in 2008.

The Supreme Court ordered trustees to split or “unbundle” pure trust expenses from everything else if they want to make sure their accounts get all the deductions they deserve. Two years later, Knight and everyone else in the trust business is still trying to figure out how to obey that order as the IRS delays issuing firm guidance on more than a year-to-year basis.

“You know they just extended the review process again a few weeks ago,” Knight told me. “That means they’ve deferred yet again on making a decision on unbundling. At this point, I wonder if I lost the battle only to win the war,” he added.

“A real pain”

If and when the IRS makes up its mind, trust companies that currently don’t break out their expenses are looking at headaches ahead.

“The Supreme Court ruled in their favor, but I agree that if that’s what’s going to happen, it’s going to be a real pain,” Douglas Blattmachr of Alaska Trust told me.

Other trust companies are steeled for what they see as inevitable. Reno-based Dunham Trust has the accounting systems in place to unbundle its fees as soon as the government tells it to push the button, Tommy Tucker, the company’s president, told me.

“When I checked into it, my operational people said we’re ready to go,” he says.

In fact, there are software fixes out there, says Les Revzon, president of Advisors Institutional, a firm that helps trust companies form in South Dakota and provides back office support for about a dozen trust company clients.

“Most trust accounting systems like SEI, Sungard, Infovisa and HWA can easily break fees down any way the trust company wants,” he says.

While the technology may not be a hurdle, figuring out where to assign every basis point of a previously unified fee may cause some consternation. Firms like Alaska Trust simply charge one all-in fee based on assets and service level, and so, Blattmachr tells me, they’re still working on what an itemized fee breakdown would look like.

Even asking trust companies to do this is pointless, as far as Texas lawyer Carol Cantrell, who argued Knight’s case against the IRS, is concerned.

“I am not sure it can even be done,” she told me. “It would be like asking a real estate broker to unbundle his real estate commission among the various duties he performed,” she added, noting the complexity of all the unique variables involved.

“No two trusts are alike”

Cantrell points to another serious issue: What happens when trust companies disagree in how they split up the basis points, even as far as trusts administered by the same company are concerned?

On the one hand, every trust and every trust company is different, but ultimately the line-item approach will force fee allocations to converge throughout the industry, Cantrell says. That could lead to a competitive race to the bottom, but it’s not likely to happen any time soon.

As things currently stand, there’s no need to unbundle unless the IRS mandates it. The Supreme Court’s issue was not so much with fee transparency but with whether bundled fees are fully deductible. Theoretically, any trust officer could simply charge a wrap fee and accept potentially less favorable tax treatment.

In the meantime, Dunham Trust, for example, is still treating all of its fees—trust and investment management alike—as deductible. However, Tommy Tucker has talked to colleagues who are being told to unbundle and not write off a cent of their investment fees.

Michael Knight originally argued that making sure his accounts were invested in the best possible way was part of his fiduciary duty, and so investment management necessarily qualifies as a fiducuary expense. It’s a great point, and there are efforts in Congress to change the law to accommodate it.

Whether that happens this year is anybody’s guess, given Washington’s distracted and fractious mood. Nobody I talked to expects anything to shake out before the November elections, and even when it does, there could probably be a long wait before new rules go into effect.

As for Knight, he told me he’s really just scratching his head when it comes to the Supreme Court decision.

“The lack of focus on the fiduciary relationship was disconcerting to me,” he says. “Some of these judges have been in private practice. I guess they didn’t do a lot of trustee work.”

Scott Martin, contributing editor, The Trust Advisor Blog. Steven Maimes contributed to the research.

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