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!)
