We recently came across an article written by Michael Kitces, CFP, that discusses possible tax issues associated with AUM (asset under management) fees charged by financial planners. While the article does not raise any new issues, it does serve as a valuable reminder that our tax system is complex and why working with an experienced tax professional before making financial decisions is so important.
Mr. Kitces discussed that 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, he says that 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. He notes that financial planning fees not specifically attributable to investment management or tax planning are non-deductible, and are treated as a personal non-tax deductible expense.
Mr. Kitces states that 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.
The way the Internal Revenue Code (IRC) is written, all income is considered taxable to an individual unless specifically exempted by the IRC; and no expenditures are tax deductible unless specifically allowed as an expense by the IRC. You are allowed to deduct medical expenses because Sec. 213 of the IRC says you can. You cannot deduct the cost of homeowner’s insurance because there is no code section that allows this expense as a tax deduction. With respect to investment management fees, IRC Sec. 212 allows as a tax deduction all the ordinary and necessary expenses for the production or collection of income; for the management, conservation or maintenance of property held for the production of income; or expenses associated with the determination, collection or refund of any tax. Thus a taxpayer can deduct tax preparation fees, income and estate planning advice, and investment management fees and payments for investment advice. Since these expenses are generally claimed as a miscellaneous itemized deduction subject to the 2% AGI (adjusted gross income) floor, and are not considered for AMT (alternative minimum tax) tax purposes, these expenses, while tax deductible, may result in zero or insignificant tax savings.
Mr. Kitces says that taxpayers cannot deduct fees for advice regarding retirement planning and strategies, insurance, cash flow and budgeting, and various “life planning” services. He notes that in the case of wealth management firms that provide a wide array of investment management and planning services for a single bundled AUM fee, a portion of that fee may not be tax deductible. It’s not normally a deductible expenditure if the fee was for a non-deductible planning service. The most interesting part of Mr. Kitces’ comments is his discussion of a potential very “DANGEROUS SITUATION” in the context of an IRA. An IRA is expected to pay only for its own expenses. When an IRA’s assets are used for non-IRA expenses, this is considered a distribution from the account. Distributions can be a problem for some IRA holders. Those not yet age 59 ½ would find themselves subject to the 10% early withdrawal penalty, and all others would find themselves having to recognize a taxable distribution from their IRA. The real danger is that when IRA assets are used to pay personal expenses on behalf of a “disqualified person” (including the IRA owner), the taxable distribution and early withdrawal penalty may be the least of the IRA holder’s tax problems. The IRA holder may have entered into a prohibited transaction. In short, a prohibited transaction is considered self-dealing and qualified retirement plans have special rules that prohibit self-dealing. A prohibited transaction would cause the entire account to lose its tax-qualified status and be deemed as distributed at the beginning of the tax year.
Currently, to the best of our knowledge, the IRS is not focusing its audits on AUM fees. Mr. Kitces has perhaps suggested that sometime in the future the IRS may be inclined to require that these fees be broken out as the IRS did when it issued new regulations requiring trust and estate AUM fees to be unbundled. He did recommend that advisors may want to be cautious in how they communicate the value of their AUM fees, especially if their marketing suggests a large portion of the fees are for services other than investment management. His takeaway is that the IRA should only pay its own investment management fee and not the AUM fees for any other accounts.
If you want to learn more about tax preparation services or tax planning strategies, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
