Recent changes in the tax law have raised some interesting questions about compensation, and clients are taking notice.
Specifically, what are the implications on deductions if an advisor charges fees or commissions?
Internal Revenue Code Section 212 permits individuals to deduct any expenses associated with the production of income or the management of such property — including fees for investment advice. However, the new tax codes eliminated the ability of individuals to deduct Section 212 expenses.
The legislation also made payments to advisors compensated via commission payable on a pre-tax basis, while advisory fees paid directly to advisors became ineligible for deduction. It’s a rich irony, given the current legislative and regulatory push toward more fee-based advice.
While some savings strategies remain, advisors need to account for this shift, while still emphasizing the very real tax benefits that exist for some clients — particularly those in higher tax brackets.
A long-recognized principle of tax law holds that income should be reduced by any expenses that were necessary to produce it. Thus, businesses only pay taxes on their net income after expenses under IRC Section 162. The rule applies for individuals as well, and while personal expenditures are not deductible, IRC Section 212 allows any individual to deduct expenses not associated with a business as long as they are still directly associated with the production of income.
This means that investment management fees charged by an RIA are deductible as a Section 212 expense, along with subscriptions to investment newsletters and similar publications, plus any service charges for investment platforms — e.g., custodial fees, dividend reinvestment plan fees or any other form of investment counsel as defined under Treasury Regulation 1.212-1(g). Similarly, tax preparation fees are deductible, along with any income tax or estate tax planning advice, as they’re associated with the determination or collection of a tax.
On the other hand, not all fees to advisors are tax-deductible under IRC Section 212. Given deductions are permitted only for expenses directly associated with the production of income, planning fees on their own are not deductible. Further, while tax planning advice and tax preparation fees are deductible, the preparation of estate planning documents that implement tax strategies — e.g., creating a will or revocable living trust with a bypass trust, or a GST trust — is not. And at best, only the planning portion of the attorney’s fee would be.
The caveat to deducting Section 212 expenses came in how they were deducted. Specifically, IRC Section 67 required that Section 212 expenses could only be deducted to the extent they, along with any other miscellaneous itemized deductions exceed 2% of adjusted gross income. In turn, IRC Section 55(b)(1)(A)(i) didn’t allow miscellaneous itemized deductions to be deducted at all for AMT purposes.
In practice, this meant that Section 212 expenses, including fees for advisors, were only deductible to the extent they exceeded 2% of AGI and the individual was not subject to AMT. Fortunately though, given advisors tend to work with fairly sizable portfolios — and the median AUM fee on a $1 million portfolio is 1% — the 2%-of-AGI threshold was often feasible to achieve, and thus many clients were able to deduct their advisory fees. Those days are, for the time being, over.
As a part of the recent tax law change, Congress substantially increased the standard deduction and curtailed a number of itemized expenses, including the entire category of miscellaneous itemized deductions subject to the 2%-of-AGI floor.
Technically, Section 67 expenses are just suspended for eight years (from 2018 through the end of 2025, when the law sunsets) under the new IRC Section 67(g). Nonetheless, the point remains: With no deduction for any miscellaneous itemized deductions under IRC Section 67 starting in 2018, no Section 212 expenses can be deducted at all. This means individuals lose the ability to deduct any form of advisor fees, regardless of whether they are subject to the AMT or not. Consequently, all advisor fees must be paid with after-tax dollars.
There are some exceptions. Under Treasury Regulation 1.404(a)-3(d), a retirement plan can pay its own Section 212 expenses without the cost being a deemed contribution to, or taxable distribution from, the retirement account. And since a traditional IRA or other traditional employer retirement plan is a pre-tax account, by definition the payment of the advisory fee directly from the account is considered a pre-tax payment.
Example 1. Charlie’s $250,000 traditional IRA is subject to a 1.2% annual advisory fee. His advisor can either bill the IRA directly to pay the $3,000 fee, or draw on Charlie’s separate/outside taxable account — which under PLR 201104061 is permissible and will not be treated as a constructive contribution to the account.
Yet given the recent changes, if Charlie pays the $3,000 advisory fee from his outside account, it will be an entirely after-tax payment, as no portion of the Section 212 expense will be deductible in 2018 and beyond. By contrast, if he pays the fee from his traditional IRA, his $250,000 taxable-in-the-future account will be reduced to $247,000, implicitly reducing his future taxable income by $3,000 and saving $750 in future taxes, assuming a 25% tax rate.
Simply put, the virtue of allowing the traditional IRA to pay its own way and cover its traditional advisory fees directly from the account is the ability to pay with pre-tax dollars. Viewed another way, if Charlie had waited to spend the $3,000 from the IRA in the future, he would have owed $750 in taxes and only been able to spend $2,250. By paying the advisory fee directly from the IRA, he satisfied the entire $3,000 bill with only $2,250 of after-tax dollars.
What’s more, IRAs aren’t the only type of investment vehicle capable of implicitly paying their own expenses on a pre-tax basis.
The virtue of mutual funds, including ETFs, is that investors can more rapidly gain economies of scale in the trading and execution of stocks and bonds than they could as individual investors. From a tax perspective, the additional good news is that mechanically, any internal expenses of the pooled vehicle are subtracted from the income of the fund, before the remainder is distributed through to the underlying shareholders on a pro-rata basis.
Example 2. Jessica invests $1 million into a $99 million mutual fund that invests in large-cap stocks, in which she now owns 1% of the total $100 million of value. Over the next year, the fund generates a 2.5% dividend from its underlying stock holdings, for a total of $2.5 million in dividends, which at the end of the year will be distributed to shareholders — of which Jessica will receive $25,000 as the holder of 1% of the outstanding mutual fund shares.
However, the direct-to-consumer mutual fund has an internal expense ratio of 0.60%, which amounts to $600,000 in fees. Accordingly, of the $2.5 million of accumulated dividends in the fund, $600,000 will be used to pay the expenses of the fund, and only the remaining $1.9 million will be distributed to shareholders, leaving Jessica with a dividend distribution of $19,000. Stated more simply, Jessica’s net distribution is 2.5% (dividend) - 0.6% (expense ratio) = 1.9% (net dividend that is taxable).
The end result is that while Jessica’s investments produced $25,000 of actual dividend income, the fund distributed only $19,000, as the rest was used to pay the expenses of the fund. This means Jessica only pays taxes on the net $19,000 of income. Viewed another way, Jessica managed to pay the entire $6,000 expense ratio with pre-tax dollars — literally $6,000 of dividend income that she was never taxed on.
That’s significant, because if Jessica had simply owned those same $1 million of stocks directly, earned the same $25,000 of dividends herself and paid a $6,000 management fee to an advisor to manage the same portfolio, she would have had to pay taxes on all $25,000 of dividends. In other words, the mutual fund or ETF structure actually turned non-deductible investment management fees into pre-tax payments via the expense ratio of the fund.
In addition, a commission payment to a broker who sells a mutual fund is treated as a distribution charge of the fund — i.e., an expense of the fund itself, to sell its shares to investors — that is included in the expense ratio. This means a mutual fund commission is effectively treated as a pre-tax expense for the investor.
Example 2a. Assume instead that Jessica purchased the mutual fund investment through her broker, who recommended a C-share class with an expense ratio of 1.6%, including an additional 1%/year trail expense that would be paid to her broker for the upfront and ongoing service.
In this case, the total expenses of her $1 million investment into the fund will be 1.6%, or $16,000, which will be subtracted from her $25,000 share of the dividend income. As a result, her end-of-year dividend distribution will be only $9,000, effectively allowing her to avoid ever paying income taxes on the $16,000 of dividends that were used to pay the fund’s expenses, including compensation to the broker.
Ironically, Jessica’s broker is paid a 1%/year fee entirely before tax, even though if Jessica hired an RIA to manage the portfolio directly — with the same investment strategy, the same portfolio and the same 1% fee — the RIA’s 1%/year fee would no longer be deductible. This occurs as long as the fund has any level of income to distribute, which may be dividends as shown in the earlier example, or interest or capital gains.
Granted, it does not appear that the new, less favorable treatment for advisory fees compared to commissions was directly intended, nor did it have any relationship to the Department of Labor’s fiduciary rule. Instead, it seems simply a byproduct of the removal of IRC Section 67’s miscellaneous itemized deductions, which impacted dozens of individual deductions —including the deduction for investment advisory fees.
Given the current regulatory environment, with both the Labor Department and various states rolling out fiduciary rules that are expected to reduce commissions and accelerate the shift toward advisory fees — along with a potential SEC fiduciary rule proposal in the coming year — the sudden differential between the tax treatment of advisory fees versus commissions raises substantial questions for advisors.
Of course, not all advisory fees were actually deductible in the past — due both to the 2%-of-AGI threshold for miscellaneous itemized deductions and the impact of AMT — and advisory fees are still implicitly deductible if paid directly from a pre-tax retirement account. Nonetheless, for a wide swath of clients, investment management fees that were previously paid pre-tax will no longer be pre-tax if actually paid as a fee rather than a commission.
Given the apparently unintended deduction distinction between fees and commissions, it’s entirely possible that subsequent legislation from Congress will reinstate the deduction. After all, investment interest expenses remain deductible under IRC Section 163(d) to the extent that they exceed net investment income. Accordingly, the investment advisory fee and other Section 212 expenses might similarly be reinstated, to the extent they exceed net investment income — at least for those whose itemized deductions can still exceed the higher standard deduction implemented under TCJA.
Unfortunately, one of the most straightforward ways to at least partially preserve favorable tax treatment of advisory fees — to simply add them to the basis of the investment, akin to how transaction costs like trading charges can be added to basis — is not permitted. Under Chief Counsel Memorandum 200721015, the IRS definitively declared that investment advisory fees could not be treated as carrying charges that add to basis under Treasury Regulation 1.266-1(b)(1).
This means that advisory fees may be deducted or not, but cannot be capitalized by adding them to basis as a means to reduce capital gains taxes in the future.
Nonetheless, there are at least a few options available to advisors — particularly those who charge now-less-favorable advisory fees — who want to maximize the favorable tax treatment of their costs to clients, including:
– Switching from fees to commissions
– Converting from separately managed accounts to pooled investment vehicles
– Allocating fees to pre-tax accounts (e.g., IRAs) where feasible
MAKING THE SWITCH
For the past decade, advisors from all channels have been converging on a price point of 1%/year as compensation to the advisor themselves for ongoing advice, regardless of whether it is paid in the form of a 1% AUM fee for an RIA or a 1% commission trail — e.g., via a C-share mutual fund.
Of course, once a broker actually gives ongoing advice that is more than solely incidental to the sale of brokerage services, and/or receives special compensation (e.g., a fee for advice), the broker must register as an investment advisor and collect compensation as an advisory fee anyway. This is why the industry shift to 1%/year compensation for ongoing advice, and not just the sale of products, has led to an explosion of broker-dealers launching corporate RIAs, so their brokers can switch from commissions to advisory fees.
Given these regulatory constraints, it may not often be feasible for dual-registered or hybrid advisors to switch their current clients from advisory fee accounts back to commission-based accounts, especially for those who have left the broker-dealer world entirely and are solely independent RIAs with no access to commission-based products.
Still, for those with a hybrid or dual-registered status, there is at least some appeal now to shift tax-sensitive clients into C-share commission-based funds, rather than using institutional share classes or ETFs in an advisory account.
It’s also important to note that many broker-dealers have a lower payout on mutual funds than what an advisor keeps on their RIA advisory fees, and it’s not always possible to find a mutual fund that is exactly 1% more expensive solely to convert the advisor’s compensation from an advisory fee to a trail commission. Furthermore, some clients may already have embedded capital gains in their current investments and not be interested in switching. That’s saying nothing of the risk that Congress might reinstate the investment advisory fee deduction in the future, thereby introducing additional costs for clients who want to switch back.
Nonetheless, for dual-registered or hybrid advisors who do have a choice about whether to receive compensation from clients via advisory fees versus commissions, there is some incentive for tax-sensitive clients to use commission-based trail products — at least in taxable accounts where the distinction matters; as previously noted, even traditional advisory fees within an IRA are being paid from pre-tax funds anyway.
THE POOLING STRATEGY
For very large advisory firms, another option to consider is to turn their investment strategies for clients into a pooled mutual fund or ETF, such that clients of the firm will be invested not via separate individual accounts that the firm manages, but instead into a single or series of mutual funds created by the firm. The firm’s 1% advisory fee may not be deductible, but its 1% investment management fee to operate the mutual fund would be.
Unfortunately, this approach also comes with significant challenges. Apart from overcoming the client’s potential objection to holding what appears to just be one mutual fund, the firm loses its ability to customize client portfolios beyond standardized models used for each of their new mutual funds. It also necessitates a purely model-based implementation of the firm’s investment strategies, given it’s no longer feasible to implement cross-account asset location strategies. And there are the non-trivial costs of creating a mutual fund or ETF, for which the proprietary-fund-for-tax-savings strategy is again only relevant for taxable accounts.
Yet for the largest independent advisory firms, creating a mutual fund or ETF version of their investment offering — if only to be made available for the subset of clients who are most tax-sensitive, and have large holdings in taxable accounts where the difference in tax treatment matters — may be appealing.
THE IRA STRATEGY
For advisors who don’t want to or can’t feasibly revert clients to commission-based accounts or launch their own proprietary funds, the most straightforward way to handle the loss of tax deductibility for advisor fees is simply to have them be payed from eligible retirement accounts.
This means that advisory firms will need to bill each account for its pro-rata share of the total advisory fees, given IRAs should only pay advisory fees for their own account holdings and not for outside accounts — which can be deemed a prohibited transaction that disqualifies the entire IRA. In addition, an IRA can only pay an investment management fee from the account, and not planning fees for anything beyond the investment-advice-on-the-IRA portion. This limits the ability to bill planning fees to IRAs, and even raises concerns for so-called bundled AUM fees that include a significant financial planning component. And of course, it’s only desirable to bill pre-tax traditional IRAs, and not Roth-style accounts, the fees for which should still be paid from outside accounts.
It’s worth recognizing though that the IRA would have grown tax-deferred in the long run, while a taxable brokerage account is subject to ongoing taxation on interest, dividends and capital gains. This means that eventually, giving up tax-deferred growth in the IRA on the advisory fee may cost more than trying to preserve the pre-tax treatment of the fee in the first place.
The chart below shows how many years an IRA would have to grow on a tax-deferred basis, without being liquidated, to overcome the loss of the tax deduction that comes from paying the advisory fee on a non-deductible basis.
As the results reveal, at modest growth rates it is a multi-decade time horizon, at best, to recover the lost tax value of paying for an advisory fee with pre-tax dollars. And the higher the income level of the client, the more valuable it is to pay the advisory fee from the IRA, as the implicit value of the tax deduction becomes even higher. Nonetheless, at least some clients — especially those at lower income levels, with more optimistic growth rates, and very long time horizons — may at least consider paying advisory fees with outside dollars and simply eschewing the tax benefits of paying directly from the IRA.
In the end, when the typical advisory fee is just 1%, the ability to deduct the advisory fee only saves a portion of the fee, and the alternatives to preserving the pre-tax treatment of the fee have other costs — whether it’s the expense of using a broker-dealer, the cost of creating a proprietary mutual fund or ETF, or the loss of long-term tax-deferred growth inside of an IRA. Consequently, in many or even most cases, clients may simply continue to pay their fees with their available dollars — especially since the increasingly relevant planning portion of the fee isn’t deductible anyway.
But for more affluent clients in higher tax brackets, the ability to deduct advisory fees can save one-quarter to one-third of the total fee of the advisor, or even more for those in high-tax-rate states, which is a non-trivial total cost savings. Hopefully, Congress will intervene and restore the tax parity between advisors who are paid via commission, versus those who are paid advisory fees. For the time being though, the disparity remains, which ironically has made tax planning for advisory fees itself a compelling tax planning strategy for advisors.
So what do you think? Are you maximizing billing traditional IRA advisory fees directly to those accounts after the TCJA? Will larger firms creating proprietary mutual funds or ETFs to preserve pre-tax treatment for clients? Will Congress ultimately intervene and restore parity between commission- and fee-based compensation models for advisors? Please share your thoughts in the comments below.