Thursday, January 5. 2012
The inspiration for today's blog post comes from an email I received from a financial planner, who read this month's issue of The Kitces Report on the new cost basis reporting rules, and asked how the custodian would know that cost basis needed to be updated for clients who choose to capitalize their investment management fees, instead of deducting them as a current expense.
The strategy to capitalize investment management fees, instead of deducting them, has been increasingly popular over the past decade, as the AMT has expanded its reach, resulting in no effective deduction for such fees for a large number of financial services clientele. Unfortunately, though, the IRS responded to the strategy in 2007 with Chief Counsel Memorandum 200721015, which explicitly tackled the issue - and said that investment management fees are not eligible to be capitalized.
The ruling was relatively straightforward. The taxpayer paid a flat quarterly fee for investment management, which covered the cost of transactions, and compensation to the financial consultant and investment manager. The taxpayer wanted to know if such fees could be treated as "carrying charges" that may be added to cost basis, instead of deducted as current expenses.
The Treasury Regulations under 1.266-1(b)(1) highlight several types of expenses that would be carrying charges, such as taxes on various types of property, loan interest used to finance property, or the costs to construct or improve property (or to store it in the case of personal property). The IRS contrasted this with an investment management fee, which is generally for the management of property, not for its acquisition, financing, or holding/storage. As the IRS put it: "Consulting and advisory fees are not carrying charges because they are not incurred independent of a taxpayer's acquiring property and because they are not a necessary expense of holding property. Stated differently, consulting and advisory fees are not closely analogous to common carrying costs, such as insurance, storage, and transportation."
Accordingly, investment management fees should not be capitalized into the cost basis of investments. They can be deducted, or not, as investment expenses, and the taxpayer will receive whatever benefits are possible in light of the 2%-of-AGI floor for miscellaneous itemized deductions, and the AMT ramifications. But if the advisor wants a better outcome for the tax treatment of a client's AUM fee, it's up to Congress to change the rules.
(Editor's Note: Notably, while directly paid investment management fees cannot be capitalized, investment fees paid to registered representatives via a 12b-1 fee - which is deducted directly from the assets of a fund - are effectively capitalized, as the removal of the fee directly reduces any gains or increases losses. Thus, in practice, the regulatory difference in how the fee is paid - directly, as an AUM fee, vs indirectly as a 12b-1 commission - actually affects the tax outcome!)
Indeed, it is a reality of how different regulatory structure has led to a different tax treatment for fees. I wrote about this in my January 2009 issue of The Kitces Report on the deductibility of various types of financial planning fees.
The upshot for the fee-only advisor is that the deduction can be against ordinary income rates (as opposed to capital gains rates). The downside is that the fee-only advisor is constrained by miscellaneous itemized deductions and the AMT, whereas the fee-via-a-12b1 structure guarantees that the fees will reduce gains or increase losses (at a "cost" of only applying at capital gains rates, unless it's short-term).
Michael, I looked in the archives at the January 2009 issue and saw 2 topics--neither of which pertained to this. How do I find this article?
In the January 2009 issue, I covered the tax differences from the regulatory structures in the sidebar on page 5, and the general issue of capitalizing investment management fees in the last paragraph of that same page and continued onto page 6.
I hope that helps a little!
With warm regards,
One more aspect that your write up made me think is the fund expenses. Typical RIA pays lower fund expenses by buying institutional class shares. A part of RIA planer fees reflects the wholesale discount they have negotiated with the funds. Since the RIA planner fees is not deducted, where as the fund expenses for retail class shares is deducted from the fund's NAV and hence goes from capital gain, that's another way RIA fee based structure is getting less friendly treatment in taxes.
The laws have to evolve with the evolution of the industry.
For months on end this blog has had nothing but high level, deep, philosophical discussions related to our profession.
This particular post is jarringly nuts and bolts.
Indeed, I thought I would try to mix it up a bit more. For those poor souls who don't want to discuss high level, deep philosophical discussions in EVERY blog post.
With warm regards,
Clients who pay an investment management fee directly from a traditional IRA account enjoy a tax advantage of sorts. Payment of the fee is not treated as a distribution, so it is not subject to tax. (Of course, they cannot deduct it too.)
Indeed, that is true, but it's important to bear in mind that can only be done for fees pertaining directly to that IRA.
Using the IRA to pay investment management fees attributable to a taxable account's assets would be disastrous. At BEST, it's a taxable distribution for the amount of the fee. At worst, it's a prohibited transaction on behalf of the IRA, disqualifying the entire account.
Paying IRA investment management fees directly from the IRA makes sense, unless the taxpayer truly can fully deduct all fees paid with outside dollars (despite the limitations of micsellaneous itemized deductions and the AMT), but in practice we find the latter is a pretty rare scenario.