One of the many changes made by the Tax Cuts and Jobs Act of 2017 was the repeal of miscellaneous itemized deductions through 2025… which was especially concerning to many financial advisors, as it included the elimination of the deduction for investment advisory fees! Of course, the reality is that not all taxpayers were eligible to claim a deduction for advisory fees in the first place, as not only did it require the taxpayer to itemize, and exceed 2% of the taxpayer’s AGI along with other miscellaneous itemized deductions… but even then, could be lost to the alternative minimum tax (AMT). Still, though, many clients of advisors have been impacted by the loss of the deduction for advisory fees… and are now looking for any opportunity they can find to reduce the repeal’s impact and still get at least some tax benefit for advisory fees paid.
One “simple” way to help clients retain the pre-tax nature of advisory fees is to find a bona fide way to continue deducting the expenses. For instance, although advisory fees are no longer deductible as miscellaneous itemized deductions, ordinary and necessary expenses of a business continue to be deductible under IRC Section 162. Thus, for clients who are small business owners, a portion of the total advisory fee may be deductible as a business expense, at least to the extent that business-related advice (i.e., succession planning, retirement plan services, business-related tax strategies, etc.) has been provided. Though notably, only payments made from taxable accounts (i.e., not retirement accounts) could potentially qualify for this treatment, and deducting advisory fees from the business may be even more complex for those who are not sole proprietors, and must logistically manage to pay the advisory fee (or a portion thereof) from a business account and not the owner’s individual investment account.
Another way that advisors can help clients mitigate the impact of the loss of the deduction for advisory fees is to help client’s pay fees from the most efficient source. As fortunately, AUM-style investment advisory fees for a client’s retirement account (i.e., a traditional IRA or a Roth IRA) can actually be “pulled” directly from the applicable retirement account, allowing the expense to continue to be paid with pre-tax dollars (at least when pulled from a pre-tax retirement account in the first place).
Hybrid advisors (i.e., those with both an RIA and broker/dealer affiliation) may also wish to reevaluate when it is in a client’s best interest to have them pay for the advisor’s services with advisory fees, as opposed to commissions. As ironically, while the financial “advice” industry has steadily been moving away from commissions and towards fees, the Tax Cuts and Jobs Act gives a distinct tax preference paying advisors via commissions over fees! Because while commissions are not deductible, per se, they can add to the cost basis of a position (such as a commission paid for the purchase of an individual security), reduce the proceeds of a sale (such as a commission paid for the sale of an individual security), or reduce the amount of taxable income produced by an investment (such as the 12b-1 fee commission paid by mutual funds) before the income is in turn passed through to the investor. All of which are more tax-efficient means of compensating a financial professional than advisory fees.
And when it comes to standalone RIAs, while they cannot receive commissions for the sale of securities (to get pre-tax treatment for their clients), RIAs may still benefit from the use of mutual funds or ETFs, by turning their investment models into such funds. By doing so, RIAs can bill their advisory fees as a management fee to the fund itself, which means clients effectively pay the RIA’s fee via the mutual fund/ETF’s expense ratio on a pre-tax basis. Unfortunately, though, the creation and maintenance of a mutual fund or ETF – and potentially multiple funds for multiple advisor model portfolios – can add a significant level of operational overhead to a firm. And even for larger firms that may be able to absorb such costs, there are still other issues to contend with, including up-ending the firm’s entire business model, and the fact that packaged funds, when held in taxable accounts, are generally not as tax-efficient as separately-managed accounts holding identical positions (from a tax loss harvesting perspective).
Alternatively, some advisory firms may look to limited partnerships as another potential method of mitigating the loss of the deduction for advisory fees, by again trying to claim the RIA’s fees as a “management fee” for the business, rather than a pass-through expense of the investment partnership. Though whether or not such a partnership would qualify as a true business – as opposed to an investment – would be of the utmost importance (as absent business status, expenses of the partnership would again be deemed non-deductible personal investment expenses), and is unfortunately a very grey area. A clearer path would be for advisory firms to instead opt to be compensated via a “carried interest” as a general partner, which is effectively treated on a pre-tax basis for the client… except even in the best of circumstances, such partnerships would likely be operated as private securities (limiting their availability to primarily high-net-worth and other accredited investors), and by definition a carried interest payment is a performance-based fee (that most advisory firms wouldn’t want to operate by in the first place?).
The bottom line, though, is that while the loss of the deduction for investment advisory fees may be painful for many, there are still at least some ways that financial advisors and institutions can help their clients pay investment related expenses in a tax-efficient (pre-tax) manner!
source https://www.kitces.com/blog/investment-advisory-fee-deduction-post-tcja-ira-expense-ratio-etf-limited-partnership/
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