Executive Summary
Under the Internal Revenue Code, expenses for investment management are tax deductible. Accordingly, taxpayers are permitted to deduct the typical assets-under-management (AUM) fee of an investment manager. However, financial planning fees not specifically attributable to investment management (or tax planning) are non-deductible, treated instead as a personal expense.
With the rise of wealth management, though, it is increasingly common for consumers to pay a single “bundled” AUM fee, that covers not only (deductible) investment management services, but also (non-deductible) financial planning as well. Which means technically, those clients should probably only be deducting a portion of the AUM fee, not the entire amount – at least, where the AUM fee covers a “material” amount of financial planning services. And the issue is especially concerning when it comes to retirement accounts like IRAs, where paying a personal financial planning fee with retirement assets could trigger a (taxable) deemed distribution, or at worst disqualify the entire IRA as a prohibited transaction!
Ultimately, the easiest solution to the problem – at least from a tax perspective – is simply to unbundle the financial planning and investment management fees. And in fact, unbundling is now required under new IRS regulations when it comes to the investment management vs administration and other fees for estates and trusts. Yet for some firms, unbundling fees can present other business challenges about communicating the value of their services.
Fortunately, the issue may not receive scrutiny anytime soon, given that many advisory firms with bundled fees are still charging the same as investment-only firms (implying the financial planning fees may not be "material" from a tax perspective). Nonetheless, as long as the tax treatment is different for financial planning versus investment management fees, advisors should at least be cautious about how those various financial advisor fees are characterized by clients, especially when extracted directly from an IRA!
Can You Claim A Tax Deduction For Financial Planning Fees?
Generally speaking, our personal expenditures are not deductible for tax purposes, unless they are specifically given preferential tax treatment under a section of the Internal Revenue Code. Thus, for instance, IRC Section 219 allows us to deduct contributions to IRAs, IRC Section 213 lets us deduct medical expenses (subject to certain limits), but most of the ways we spend or save our cash have no tax benefits attached.
When it comes to the costs of financial planning advice, there is no specific section of the tax code that authorizes tax deductions for such expenditures, although when it comes to “expenses for the production of income” IRC Section 212 does provide that:
In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for the production of income; or
(3) in connection with the determination, collection, or refund of any tax.
These provisions of the tax code allow for the tax deductibility of such expenses as tax preparation, income and estate tax planning advice (though notably, the drafting of estate planning documents is not deductible), ongoing investment management fees, and payments for investment advice. The deductions are generally claimed as a miscellaneous itemized deduction subject to the 2%-of-AGI floor (which, unfortunately, also means they are adjusted out for AMT purposes).
Notably, though, the cost of financial planning advice not specifically pertaining to one of categories of permissible Section 212 expenses is not deductible. Thus, advice regarding retirement planning and strategies, insurance guidance, cash flow and budgeting, and various “life planning” services would not be tax deductible at all.
Given these regulations, the reality is that at best only a portion of a “comprehensive financial planning fee” would be tax deductible – the parts specifically allocable to investment management and advice, or tax planning. The remainder of any financial planning fee, associated with all the other types of personal financial advice, would be treated as a personal expense not eligible to be deducted.
The Tax Problem With Bundled AUM Fees
As noted earlier, Section 212 does allow a tax deduction for expenses for the management of property – including investment assets – and as a result, payments of investment management fees (e.g., AUM fees) can be deducted for tax purposes. For the typical arrangement with a standalone investment manager, this is a fairly straightforward process.
However, a potential problem arises in the case of “wealth management” firms that provide a wide array of investment management and financial planning services, for a single bundled AUM fee… because technically, only the portion of fee attributable to actual investment management should be deductible, and the remainder of the fee allocable to the financial planning services is not. The fact that the financial planning fee was charged as an AUM fee based on assets doesn’t change the reality that it’s not a deductible expenditure if the fee was for (non-deductible) financial planning services and not for (deductible) investment management services.
The situation is especially dangerous in the context of an IRA. While IRAs are allowed to pay their own expenses – thus why an investment management fee for an IRA can be deducted directly from that IRA without a taxable event – and doing so effectively makes the management fee pre-tax (since it was deducted directly from a pre-tax account), an IRA should only pay for its own expenses. When an IRA’s assets are used for other non-IRA expenses, it is deemed to be a distribution from the account. And when IRA assets are used in particular to pay personal expenses on behalf of a “disqualified person” (including the IRA owner themselves), it may be treated as a prohibited transaction under IRC Section 408(e)(2) and IRC Section 4975, which causes the entire account to lose its tax-qualified status and be deemed as distributed at the beginning of the tax year. Thus, using IRA assets to pay the personal financial planning expenses of the IRA owner would be a deemed distribution of that dollar amount at best, and at worst a prohibited transaction triggering distribution of the entire account.
Of course, to the extent that an AUM fee is almost entirely an investment management fee, and any ancillary (financial planning or other) services are just incidental, the IRS is not likely to intervene, as the non-deductible/impermissible portion of the fee would be “negligible” at that point. Nonetheless, when a similar situation arose several years ago in the context of trusts – where “bundled” AUM fees for a trust or estate may cover both investment management services and other non-investment-related expenses associated with administering the trust and settling an estate – the case of Knight v. Commissioner ultimately went all the way to the Supreme Court, which ultimately determined that the investment management portion of an AUM fee is subject to the 2%-of-AGI floor but other fees and expenses associated with administering an estate are fully deductible. In the aftermath, the IRS issued new Regulations that going forward will require trust and estate AUM fees to be “unbundled” so that the investment management and non-investment-management portions can be properly allocated for the appropriate (and different) tax treatment.
Thus, the Knight case and subsequent regulations do suggest that while there is no requirement to unbundle fees and no clear line at when the non-investment-management portion is “material” right now, ultimately the IRS may eventually decide to apply a similar unbundling rule for wealth management firms as well. Especially if/when/as a larger and larger portion of an AUM fee becomes attributable to non-investment-management services (which makes it a more substantive issue for the industry to address). Even though ironically, in the case of Knight the issue was that the investment management fees got the less favorable treatment, while for individuals it would be the non-investment-management portion that would be less favored with unbundling.
Tax Issues To Consider When Deducting Bundled AUM Or Retainer Fees
For advisors whose AUM fees truly are attributable to (just) investment management services, no concern is necessary – paying such fees and deducting them, or extracting them on a pre-tax basis directly from an IRA – fits squarely within the law as written.
For those where the AUM fee is at least “predominantly” attributable to investment management services, and any additional services provided are just “value-add” or ancillary benefits, from a practical perspective the risk of an unfavorable action from the IRS is likely low. Especially given that in today’s environment, investment managers already charge fees ranging from 0.25% to 2%+, so the fact that an “average” wealth manager charging around 1% provides some additional value-add (financial planning) services as a part of that 1% fee isn’t likely to draw any attention – as there’s no clear indication that the AUM fee has been “marked up” for clearly-non-deductible purposes.
By contrast, in the IRS guidance on unbundling investment management from other fees for trusts and estates, particular scrutiny was given to the difference between a trust’s AUM fee for “investment management and other services” versus what an individual might have paid for just investment management. The difference was presumed to be for separate/other services. In other words, if an AUM fee including financial planning was 2.5% in a world where most managers charged less than 2%, the additional 0.5% fee might raise questions; but when AUM-fees-with-financial-planning are directly in line with other fees that are investment only, the implication – at least from the tax perspective – is that the portion of the fee attributable to non-investment services can’t be all that material.
On the other hand, advisors may at least want to be cautious in how they communicate the value of their AUM fees in the first place, especially if the marketing suggests a large portion of the fees are for non-investment-management services. In other words, while in general a 1% AUM fee that provides for investment management and financial planning services may not raise questions (given that so many investment managers charge 1% for just investment management), a firm that proclaims in its own materials “half of this fee is for investment management and the other half is for financial planning” may be giving the IRS grounds to challenge their own clients’ tax deductions for the entire fee, and/or putting the fee deductions from the IRA at risk. Obviously, this can create an implicit tension between the advisory firm’s efforts to demonstrate its value beyond just investment management (by noting all the non-investment services provided as a part of the comprehensive fee), and its desire to bundle everything into a single fee that the client can conveniently and tax-efficiently deduct or pay from an IRA.
For advisors who already have unbundled their fees, charging a separate upfront or ongoing retainer (or both) for financial planning services, and a (lower) AUM fee for “just” the investment management, the tax rules are fairly straightforward to apply. The investment management (AUM) fee will be deductible, and the financial planning fees will not (though in theory the advisor could document that some portion of the financial planning fee is allocable to tax-deductible income and estate tax planning advice). Notably, in this context, it’s still important that the client’s IRA pay only the investment management (AUM) fee and not any portion of the financial planning fee (and further that, as always, the IRA should only pay its own investment management fee and not the AUM fees for any other accounts). Alternatively, advisors who are concerned about disqualifying the IRA can always pay the fees from an outside taxable account and claim a deduction for the portion attributable to investment management fees (for the IRA or taxable accounts).
It’s also worth noting that it’s not only problematic to bundle together investment management and financial planning services into a single AUM fee, it’s also problematic to bundle together investment management and financial planning services into a single retainer fee as well. Ironically, in this context the challenge arises in determining how much of otherwise-not-deductible retainer fee actually is a deductible investment management and/or income and estate tax planning fee – in other words, how much of the total bundled retainer fee really is for some type of Section 212 expense. Advisors who wish to support their clients’ ability to deduct some of their financial advisory fees may even wish to consider providing clients a more itemized invoice that provides some reasonable allocation of the fee to Section-212-related expenditures. And again, be cautious about having any portion of such a financial planning retainer fee paid from a retirement account, unless it is solely the portion genuinely attributable to the management of just that investment account.
Ultimately, the challenge of the rules around the tax deductibility of investment management (but not financial planning) fees is that what may be best for tax purposes (that most/all of the fee is attributable to investment management) may not necessarily be best for communicating marketing and the advisor’s value proposition (which is less and less investment-centric in today’s environment). Yet advisors must be cautious that their communication for marketing purposes not conflict with the advice that clients are given about fee deductibility for tax purposes (e.g., telling clients about all the non-investment services but encouraging them to fully deduct it as an investment management fee) – lest the IRS actually use the advisor’s marketing materials against the client to substantiate why portions of the fee were not deductible (or worse, why an IRA should be disqualified!). And while completely unbundling fees at least provides the clearest course of action for tax purposes – and unbundling may even be a rising trend in the future given the pressures of robo-advisors – charging separately for planning presents both business challenges in getting clients to engage in the process, and arguably is still less favorable than a bundled AUM fee that can “reasonable” be claimed as a fully deductible investment management expense anyway.
Perhaps at some point in the future, paying for financial planning services itself will become a permissible deduction under the tax code, and at that point all such fees can be grouped together, whether attributable to investment management, tax planning, or other financial planning services. But until that point, be cognizant of the complications that can arise as clients pay for investment management and financial planning services – and from what accounts those expenses are paid in the case of IRAs – especially when a bundled financial advisory fee represents a broad range of deductible and non-deductible services!
So what do you think? Do you bundle together financial planning services with your AUM fee? What is your guidance to clients about the deductibility of your fee? If you charge a retainer fee, do you itemize the portions that would be deductible for clients?
