## Facts

- August J. Fabens maintained a trust (1953–1969) holding both tax-exempt municipal bonds and taxable securities, producing tax-exempt interest, taxable income, and realized capital gains and losses.
- When the trust terminated in 1969, the corpus included substantial unrealized appreciation in the taxable securities portfolio.
- Under state law, fiduciary commissions (annual commissions and termination “receiving and paying” commissions) were computed as a percentage of the current market value of all trust assets, including unrealized appreciation.
- Fabens deducted the full commissions as expenses for the production of income under I.R.C. § 212.
- The Commissioner disallowed a portion of the deductions under I.R.C. § 265(1) as expenses allocable to tax-exempt income, using an allocation based on the ratio of tax-exempt income to total income.
- For termination commissions of $50,695, the Commissioner used a lifetime ratio (tax-exempt income $211,443 ÷ total income $740,093 = 28.57%), disallowing $14,484.
- For 1969 annual commissions of $3,241, the Commissioner used the 1969 ratio (tax-exempt income $9,028 ÷ total income $24,743 = 36.49%), disallowing $1,183.
- The Tax Court upheld the Commissioner’s allocation; Fabens appealed, arguing the termination-fee allocation was distorted because the fee level was driven largely by unrealized appreciation in taxable assets.

## Issues

1. Whether § 265(1) permits the Commissioner to allocate mixed fiduciary fees to tax-exempt income using an income-ratio formula.
2. Whether the Commissioner’s year-specific income-ratio allocation was reasonable as applied to annual fiduciary commissions.
3. Whether the Commissioner’s lifetime income-ratio allocation was reasonable as applied to termination commissions calculated on corpus market value that included substantial unrealized appreciation in taxable securities.

## Decision

- The First Circuit affirmed the allocation for annual commissions, holding the Commissioner’s year-by-year income ratio was reasonable for ongoing management fees.
- The court reversed the allocation for termination commissions, holding the lifetime income ratio was unreasonable because it failed to account for the extent to which termination fees were driven by corpus value and unrealized appreciation in taxable assets.
- The case was remanded for a more reasonable allocation of the termination commissions consistent with the court’s analysis.

## Legal Principles

- I.R.C. § 212 allows deductions for ordinary and necessary expenses incurred for the production or collection of income.
- I.R.C. § 265(1) disallows otherwise allowable deductions to the extent they are allocable to tax-exempt income.
- Where an expense relates to both taxable and tax-exempt income, § 265(1) requires a reasonable allocation based on the facts and circumstances.
- The Commissioner may use allocation formulas, but courts may reject an allocation that is arbitrary or clearly unreasonable in light of economic reality.
- An income-ratio method may be reasonable for annual fiduciary fees tied to current income production, but it may be unreasonable for corpus-based termination fees materially affected by unrealized appreciation in taxable assets.

## Conclusion

The First Circuit held that § 265(1) requires a reasonable, fact-sensitive allocation of mixed fiduciary expenses: it sustained the Commissioner’s income-ratio allocation for annual trust commissions but rejected the same approach for termination commissions computed on corpus market value heavily influenced by unrealized appreciation in taxable securities, remanding for a revised allocation.


Fabens v. Comm’r, 519 F.2d 1310 (1st Cir. 1975)