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KNIGHT v. COMMISSIONER OF INTERNAL REVENUE

On appeal from the United States Court of Appeals for the Second Circuit

Who's Who?

Knight is a trustee for trust called William L. Rudkin Testamentary Trust. The Commissioner is who you'd expect - the head of the IRS.

What's a trust?

A trust is a way of putting aside money for a specific purpose. A more complete definition is that a beneficiary has an equitable right to property that a trustee holds for the beneficiary's benefit. Its a pretty complex area of the law. For example, there are approximately five pages in the entry for "trust" in Black's Law Dictionary 7th Edition.

Why not just give the property to the beneficiary and be done with it?

Taxes.

What's this case about?

Taxes.

Specifically, a special tax exemption that applies to trusts. Before we get to the exemption, let's talk about the rule that the exemption applies to.

When individuals (that's us) file tax returns, we use a pretty simple framework - it goes like this:

• Gross Income - "Above-the-Line" Deductions = Adjusted Gross Income.
• Adjusted Gross Income - "Itemized Deductions" (a.k.a. "Below-the-Line-Deductions") = Taxable Income.

Whether a deduction is Above-the-Line or Below-the-Line up depends the law - and that question is not important to this case. What's important is a rule relating to Itemized Deductions. Tax laws do not allow individuals to take all of our itemized deductions, just the deductions that exceed 2% of our Adjusted Gross Income. For everything less than 2%, we have the standardized deduction.

Now, let's talk about the exception that applies to trusts. Trusts normally apply the same rules as individuals. But the tax law excepts deductions for costs incurred in connection with the administration of the trust "which would not have been incurred if the property were not held" in trust. Those deductions are not subject to the 2% floor.

How did Knight get to the Supreme Court?

In 2000, Knight (as trustee) deducted all of the fees of an investment advisor to the trust. The Commissioner of Revenue audited Knight and concluded that Knight should have only deducted the amount above the 2% floor. Knight appealed to the Tax Court, and lost. Knight then appealed to the Second Circuit, and lost. Knight appealed to the Supreme Court.

Why, if Knight lost everywhere, did he end up in front of the Supreme Court?

There's only a couple of sure-fire ways to get the Supreme Court to take your case. One of the best is if the Circuit Courts of Appeal disagree on the law. This is case an example.

There were three different ways the appellate courts applied the law:

1. The Sixth Circuit had ruled that investment advisor expenses were always exempt.
2. The Fourth and Federal Circuits have found that investment advisor expenses that are "commonly" found outside trusts are exempt.
3. The Second Circuit held that trusts were not subject to the exemption if the expense could not have been taken by an individual.

So, the Supreme Court had three standards it could choose to resolve the conflict.

How did the Court decide?

It read the statute.

And the statute said this: For a cost to fit the exception it must be a cost that "would not have been incurred if the property were not held in" a trust.

So the Second Circuit and the Sixth Circuit were wrong in their formulations of the rule. Not all investment fees are allowed to be deducted by a trust; neither are all fees that could not be deducted by an individual. Instead the question is: Would an individual incur the fee if the property was his?

For those of you keeping track, this means that fees an individual might have can still be fully exempt from the 2% floor, so long as an individual would not have incurred them. Its a pretty fine distinction.

The fees in this case are commonly charged when managing big lumps of investments. So, a unanimous Supreme Court affirmed the Second Circuit Court of Appeals. (Although, the Supreme Court actually rejected the test the Second Circuit used)

Knight lost. 9-0. Again. Poor fella. He'll just have go home and manage the $2.9 million dollars of securities without taking the full deduction on the Trust's taxes.

Why was that so hard?

Double negatives. Reread the little bit of quoted text from the statute.

Congress wrote two "not"s within nine words of each other. As Strunk and White wrote, "Put statements in positive form." The word "not" fails to portray dynamic meaning. Readers (and courts) want to know what is, rather than what is not. Congress ought to make its commands positive, and leave the "not" at home. Courts make the language positive anyway.