Clients are permitted to deduct the AUM fee of an investment manager, according to the Internal Revenue Code. 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 comprehensive wealth management, it is increasingly common for clients to pay a single bundled AUM fee that covers not only deductible investment management services but also non-deductible planning expenses. Technically, though, 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 planning services.
The issue is especially concerning when it comes to retirement accounts such as IRAs, where paying a personal financial planning fee with retirement assets could trigger a taxable deemed distribution, or even 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. In fact, unbundling is now required under new IRS regulations when it comes to investment management versus administration and other fees for estates and trusts.
Yet for some firms, unbundling fees can present challenges in communicating the value of their services.
Generally speaking, personal expenditures are not tax deductible unless they are specifically given preferential treatment under a section of the Internal Revenue Code. For example, IRC Section 219 allows the deduction of contributions to IRAs, and IRC Section 213 permits the deduction of some medical expenses.
When it comes to investment management fees, the tax code is also favorable. The codes Section 212 regarding expenses for the production of income provides 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 deductibility of such expenses as tax preparation, income and estate-tax planning advice, and as noted earlier ongoing investment management fees and payments for investment advice.
These expenses are generally claimed as miscellaneous itemized deductions subject to the 2%-of-AGI floor (which, unfortunately, also means they are adjusted out for AMT purposes).
However, since expenses are only deductible when there is a tax code section to specifically allow it, the cost of financial planning advice is not deductible unless it pertains to one of the categories of permissible Section 212 expenses. That means clients cannot deduct fees for advice regarding retirement planning and strategies, insurance, cash flow and budgeting, and various life planning services.
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.
Given that investment management fees are deductible but other financial planning fees are not, the process for a typical arrangement with a standalone investment manager is fairly straightforward: The fees are deductible.
However, a potential problem arises in the case of wealth management firms that provide a wide array of investment management and planning services for a single bundled AUM fee. The fact that the financial planning fee was charged as an AUM fee based on assets doesnt change the reality that its not normally a deductible expenditure if the fee was for non-deductible planning services.
The situation is especially dangerous in the context of an IRA. An IRA is expected to pay only for its own expenses. When an IRAs assets are used for non-IRA expenses, this is considered 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), it may be treated not just as a distribution but also as a prohibited transaction.
This would cause 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 services are just incidental, the IRS is not likely to intervene, as IRAs can pay for their own investment management expenses and the non-deductible/impermissible portion of the fee would be negligible.
PROBLEMS WITH TRUSTS
Nonetheless, when a similar situation arose several years ago in the context of trusts, the case of Knight v. Commissioner ultimately went all the way to the Supreme Court. The high court determined then 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.
And in the aftermath, the IRS issued new regulations requiring trust and estate AUM fees to be unbundled so the investment management and non-investment-management portions can be properly allocated for the appropriate tax treatment.
The Knight case and the subsequent regulations suggest that, while there is currently no requirement for wealth management firms to unbundle fees and no clear line at when the non-investment-management portion is material, the IRS may ultimately decide to apply a similar unbundling rule for firms.
In the case of Knight, the investment management fees received the less-favorable treatment. But for individuals it would be the non-investment-management portion that would be less favored with unbundling.
For advisors whose AUM fees truly are attributable to only investment management services, no concern is necessary. 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, the risk of an unfavorable action from the IRS is likely low.
In other words, the issue may not receive scrutiny any time soon, given that many advisory firms with bundled fees are still charging the same as investment-only firms (implying that the planning fees may not be material from a tax perspective).
For instance, if an AUM fee including planning was 2.5% in a world where most managers charged less than 1.5%, the additional 1% fee might raise questions. But when AUM fees with financial planning are directly in line with investment-only fees, the implication at least from the tax perspective is that the portion of the fee attributable to non-investment services cant 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 their marketing suggests a large portion of the fees are for services other than investment management.
For instance, a 1%-of-AUM fee that provides for investment management and financial planning services may not raise questions. Yet firms that proclaim in their own materials that 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 sweeps from the IRA at risk.
Obviously, this can create an implicit tension between the advisory firms efforts to demonstrate its value beyond just investment management 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, applying the tax rules is fairly straightforward. The AUM fee will be deductible, and the financial planning fees will generally not be.
Notably, in this context, its important that the clients IRA pay only the AUM fee and not any portion of the 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).
RETAINERS A CHALLENGE
Its also worth noting that not only is it problematic to bundle together investment management and financial planning services into a single AUM fee, its also problematic to bundle these services into a single retainer fee.
Ironically, in this context the challenge arises in determining how much of a retainer fee (which would otherwise not be deductible) actually is a deductible investment management and/or income and estate-tax planning fee. (For more on advisors charging retainers, see Bob Veres column.)
Advisors who wish to support their clients ability to deduct such fees may want to provide them with a more itemized invoice that provides some reasonable allocation of the fee to Section-212-related expenditures.
Ultimately, the challenge of the rules around the tax deductibility of advisor 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 marketing and communicating the advisors value proposition.
While completely unbundling fees at least provides the clearest course of action for tax purposes, charging separately for planning presents business challenges in getting clients to engage in the process.
And arguably, such separate fees are still less favorable from a business perspective than a bundled AUM fee that can reasonably 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. Then all related fees could be grouped together, whether attributable to investment management, tax planning or other services.
But for now, be cognizant of the complications that can arise as clients pay for investment management and financial planning services, especially when a bundled fee represents a broad range of deductible and non-deductible services.
Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of research at Pinnacle Advisory Group in Columbia, Md., and publisher of the planning industry blog Nerds Eye View. Follow him on Twitter at @MichaelKitces.
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