Executive Summary
While the tax code offers a deduction for investment management fees paid by an investor, it is a less than ideal tax deduction. Characterized as a miscellaneous itemized deduction subject to the 2%-of-AGI floor, in practice it is not deductible unless the taxpayer both itemizes deductions in the first place, and has enough miscellaneous itemized deductions in total to exceed the required threshold. In addition, all such miscellaneous itemized deductions are disallowed for AMT purposes - especially problematic since the AMT is somewhat more likely to affect those with sufficient income and assets to be paying such fees in the first place.
To avoid this tax result, some clients and their accountants have been going an alternate route: capitalizing the investment management fee into the cost basis of the assets being managed, which at least provides some tax benefit, by increasing the cost basis and reducing future capital gains (or increasing the losses). Unfortunately, though, the IRS has already responded to the strategy: Just Don't Do It.
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.
Capitalization Of Investment Management Fees
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."
Deduct Investment Expenses, But Don't Add Them To Basis
Accordingly, investment management fees should not be capitalized into the cost basis of investments. Advisor fees 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!)
This tax treatment seems particularly unfair to fee-only advisors. Commission based advisors can hide their advisory fee in a fund load to capitalize it.
Steven,
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).
Respectfully,
– Michael
I’m sure I’m missing something obvious here, but as an RIA, why can’t my advisory fees be treated the same way mutual fund RIA fees are treated (taken off before income is distributed to clients)?
Dave,
Because that treatment is specifically allowed under the tax structure for mutual funds, and not for RIAs. It’s that way because that’s how the tax code is written. (Generally because the rise of investment management fees paid by individuals outside of underlying expense ratios is a fairly recent phenomenon, and the tax code has not been otherwise modified to address this.)
Given the tax advantages of paying by commission and 12b1, is there a way for a dually-registered advisor to transact commission business, provide the client with the tax advantages stated above, and then offset or reduce advisory fees but the commissions received? This would seem to provide clients with the best of both worlds assuming commissions are arranged to not exceed the RIA fees.
Very insightful, Michael.
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.
Michael,
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. 🙂
Fondly,
Steve,
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,
– Michael
Michael,
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.)
Best regards,
Art Dicker
Art,
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.
Respectfully,
– Michael
I realize this is a 2012 article, but I had another twist on NQ annuity fees to run by you. I understand that advisory fees paid out of a NQ annuity are tax-deductible. Do those fees reduce taxable basis in this situation?
Michael,
I wonder if this might be worth revisiting in light of the fact that advisory fees are no longer expressly deductible.
Steve,
I agree that in light of the new 2018 tax laws eliminating the option to deduct advisory fees, investment fees should be allowed to be capitalized to adjust cost basis of mutual fund holdings.