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Tax Deductions for Financial Advisor Fees

US News & World Report - Money 12/16/2021 Coryanne Hicks
Shot of a young woman using a laptop and going through paperwork while working from home © (Getty Images) Shot of a young woman using a laptop and going through paperwork while working from home

The Tax Cuts and Jobs Act of 2017, commonly referred to as TCJA, eliminated the deductibility of financial advisor fees from 2018 through 2025.

And while advisors and clients have had a few years to get used to the change, they may be eyeing it with renewed interest after the long bull market that's persisted even through the coronavirus pandemic.

"Investment returns have been so strong in 2021 that many fees are increasing enough for clients to really notice," says Ken Robinson, a certified financial planner and the founder of Practical Financial Planning in Rocky River, Ohio, and a member of the Alliance of Comprehensive Planners. "Whether markets are up or down, clients can really benefit by paying with pretax dollars by having appropriate amounts of their fees pulled from their IRAs."

While the TCJA limits the tax-saving options available to investors, there are still ways to increase the tax deductibility of your clients' fees, such as using loaded, commission-based investments and billing traditional individual retirement accounts, trusts and business accounts directly.

Section 212 Deductibility Eliminated, But Some Benefits Remain

Before TCJA, Internal Revenue Code Section 212 allowed individuals to deduct expenses incurred in the production of income, including fees paid for investment advice.

"These expenses were available as deductions when you itemized if they exceeded 2% of your adjusted gross income," says Kevin Martin, a principal tax research analyst with H&R Block's Tax Institute in Kansas City, Missouri. "The TCJA eliminated all of these 'subject to 2%' expenses for tax years through 2025."

Some deductions do remain: Investors can still deduct the interest they pay on investment assets, for instance, Martin says.

Perhaps of greater benefit is that investment fees such as mutual fund expense ratios are technically made on a pretax basis. The expense ratio is deducted from a fund's income before that income is distributed to shareholders. Since shareholders only pay taxes on the income they receive, their expense ratios are still made with pretax funds. The same holds true of any sales load or commission to the advisor.

"For individuals who are currently paying large investment management fees and are truly obsessed with finding a way to make the investment fees tax-deductible, a renewed consideration should be given to investing in loaded, commission-based, actively managed mutual funds," says Michael Zovistoski, managing director at UHY Advisors in Albany, New York.

"When the mutual fund is ultimately sold, the commission is included in the cost basis, which in turn reduces the gain on the sale, again indirectly making the sales commission deductible," he says.

Bill Traditional IRAs Separately

Another tax-saving strategy some advisors use is to bill their clients' traditional IRAs directly for the hours spent advising on the IRA.

"The advantage to the client is that a limited, appropriate portion of the fee could be taken directly from the IRA," Robinson says. This allows them to pay at least a portion of their advisory fee with pretax dollars.

Billing clients' IRAs directly should be done with care, however.

"There can be issues with pulling fees from IRAs if the fees don't represent actual time spent advising on the IRA," says Chris Wentzien, a certified public accountant and certified financial planner at Natural Bridges Financial Advisors and board member of the Alliance of Comprehensive Planners.

Sometimes clients want their entire fee pulled from an IRA, but doing so could result in the IRA being "disqualified if you are providing comprehensive financial planning services and running the whole fee through the IRA," he says.

Be careful to bill the IRA only for the number of hours spent advising on the IRA account specifically, advisors say.

Other experts advise against the practice of billing IRAs directly.

"We would still recommend not using retirement account assets to pay fees for other accounts," says financial advisor Ken Van Leeuwen, managing director and founder of Van Leeuwen & Co. based in Princeton, New Jersey. "One of the most powerful retirement tools is an account that grows tax-deferred, and we would not want to interfere with that compounded growth."

Trusts and Business Accounts Retain Some Deductibility

While an individual cannot take miscellaneous itemized deductions like those on IRC 212, trusts still can to a degree.

The tax code has a special rule that allows trusts to deduct these expenses in full, provided the expense is unique to the trust and would not be commonly or customarily incurred by an individual, says Sean Weissbart, a partner at Blank Rome and an adjunct professor of law at New York University School of Law.

If an advisor provides specialized advice to the trust that goes above and beyond what is traditionally provided to individuals, this extra portion may be deductible to the trust, he says.

"For example, if a trustee can articulate an unusual investment objective or specialized need to balance certain interests of the parties, it may be possible to deduct this excess expense even before the current law expires," he says. However, the regulations are clear that the balancing must be for services "beyond the usual balancing of the varying interests of current beneficiaries and remaindermen," to the point that it wouldn't make sense to compare these to the needs of an individual investor.

In such cases, if you'd charge a $10 fee to an individual but charge the trust $15, the trust can deduct the $5 difference, Martin says.

To do this, you must ensure the trust is considered a nongrantor trust, meaning it's treated as a separate tax-paying entity, Weissbart says. With grantor trusts, the creator of the trust is responsible for paying taxes on the trust's annual income and the special rule would no longer apply.

"It is possible for a trust that is currently classified as a grantor trust to be reclassified as a nongrantor trust by eliminating the powers in the trust document that caused the initial grantor trust classification," he says.

Then, as with an IRA, carefully divide your fee and identify the portion that is above what would be charged to an individual.

"Fiduciaries taking these positions should keep meticulous records in case it becomes necessary to justify that these expenses are outside of those that would be incurred by an individual investor," Weissbart says.

Business accounts also get an exception to the rule.

"To the extent investment fees relate to business assets or a business purpose and are paid by the business, those fees continue to be deductible by the business," Zovistoski says.

Likewise, if you help a business owner address specific business issues, such as succession planning, "those fees can be invoiced separately and paid by the business," which can deduct the fees, he says.

Wentzien provides a similar benefit to his self-employed clients.

"Since we are comprehensive financial planners, not just investment advisors, a portion of our fees can be taken from Schedule C (self-employed) and Schedule E (rental properties) for advice given in these areas," he says.

As with advising on IRAs, he carefully tracks the time he allocates to these areas and charges them separately.

Don't Change Your Billing Practices for the Sake of Taxes

The deductibility of Section 212 expenses was a nice benefit, but it should not define how you charge clients.

Rather than altering your billing practices, it's best to focus on "ways to minimize taxes on clients' overall investments through selecting investments that provide tax-free income, long-term capital gains or income from qualified dividends, which is taxed more favorably than ordinary income such as interest income, ordinary dividends or short-term capital gains," says James Beam, head of investment management, brokerage, planning, retirement and strategy for U.S. Wealth at TD Bank.

To your clients, it's more important that their investments match their objectives and the recommendations you provide align with those goals.

If the deductibility of your fees becomes a deal breaker for a client, Wentzien adds, that client likely isn't someone you'd want to retain over the long haul anyway.

Copyright 2022 U.S. News & World Report

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