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Allocating portfolio management fees.

The adage, "You can't have your cake and eat it too," indeed applies to federal income taxation at the individual level and tax-exempt income and investment expenses. The Internal Revenue Code (IRC), Treasury Regulations, and various IRS publications preclude the deduction of investment expenses incurred to produce tax-exempt income. Of particular interest to investment advisors is the specific investment-related expense of portfolio management fees and the allocation of such fees between taxable income and tax-exempt income.

Relevant Code Sections and Regulations

IRC section 103 specifically exempts from federal income taxation the interest income from state and local government obligations; thus, the interest income on municipal bonds is tax-exempt at the federal level. This exclusion from gross income is a win-win situation for taxpayers and state and local governments. As a result, the cost of borrowing is reduced for these governmental units. Keep in mind that the exemption does not apply to capital gains on the disposition (e.g., sale or call) of tax-exempt securities like municipal bonds. Taxpayers must report all tax-exempt interest on Form 1040 Schedule B, Interest and Ordinary Dividends, although the amounts are not included in taxable income.

IRC section 212 deals with income-producing property. It allows taxpayers to legally deduct ordinary and necessary expenses--including portfolio management fees--reasonably and proximately related to the expenses paid regarding the collection, determination, or refund of taxes; the collection or production of income; and the conservation, maintenance, or management of property held with the intention of producing income.

Treasury Regulations section 1.212 provides for the deduction of investment-related expenses (e.g., investment supervisory services) as itemized deductions on Form 1040 Schedule A, Itemized Deductions, line 23, attributable to taxable investment income (e.g., dividends, interest, capital gains); therefore, these fees for services of investment counsel, as well as custodial fees, represent deductions from adjusted gross income (AGI).

IRC section 67 limits the deductible amount of an individual taxpayer's miscellaneous itemized deductions to the extent that the aggregate amount exceeds 2% of AGI. Expenses falling in the broad category of miscellaneous itemized deductions are reported on Form 1040 Schedule A, Itemized Deductions, lines 21-23; thus, they are deductions from AGI.

Treasury Regulations section 1.67 includes investment expenses that are deductible under IRC section 212. Investment advisory fees are specifically listed in this regulation. These are referred to as "below-the-line" deductions.

IRC section 265 precludes any deduction for expenses (e.g., portfolio management fees) related to tax-free investments. This management fee deduction disallowance provision simply prevents a taxpayer from being enriched at the government's expense by excluding interest income on municipal bonds and deducting the related management fees--one cannot have the best of both worlds, in other words. The tax code specifically disallows deductions for expenses of generating tax-exempt income.

Treasury Regulations section 1.265 covers the allocation of expenses (e.g., portfolio management fees) between taxable and tax-exempt income. The portion directly allocable to taxable income should be allocated to such, and the portion directly allocable to tax-exempt income should be allocated to such. When the expense is indirectly allocable to both (taxable and tax-exempt) sources of income, a reasonable portion should be allocated to each based upon a determination considering the specific facts and circumstances of the issue. The taxpayer's tax return (Form 1040) must include an attached statement reflecting the following items: relevant taxable and tax-exempt income; total expense in question; portion of expense allocated to taxable and tax-exempt income; and the basis of the allocation. The taxpayer should retain all records supporting the allocation.

Relevant IRS Publications

IRS Publication 550, Investment Income and Expenses, provides guidance regarding the allocation of investment counsel and advice expenses (including the costs of investment advisory services) between taxable and tax-exempt investment income. Management fees directly related to taxable or tax-exempt investment income are a straightforward allocation. But management fees indirectly allocable to taxable and tax-exempt investment income require a reasonable allocation. An acceptable allocation methodology considers the total management fees and the total investment income related to the fees. The fees are allocated in the same proportion as the two sources of investment income. If the management fees relate to capital gains and losses, the gains are included but the losses are excluded when investment income is computed for allocation purposes.

Publication 550 contains a simple example of this acceptable method of allocation. In the scenario, a taxpayer receives total interest income of $6,000 in a year, consisting of $4,800 of tax-exempt interest and $1,200 of taxable interest. In addition, the taxpayer incurs expenses of $500 in earning the interest during the year. Yet, the taxpayer is unable to specifically identify the amount of the $500 attributable to tax-exempt and taxable amounts. The taxpayer should thus allocate 80% ($4,800 / $6,000) of the investment-related expenses to the tax-exempt income and 20% ($1,200 / $6,000) to the taxable income. The taxpayer can deduct $100 ($500 x 20%) of the expense; the remaining $400 ($500 x 80%) is not deductible.

Example of Diversified Portfolio

Consider Tex Peyor, a cash-basis taxpayer filing individually who resides in Luling, Louisiana. Years ago, a brokerage firm helped him establish a diversified portfolio based on his finances, investment goals, and risk tolerance. Peyor desired customized, individualized, and professional portfolio management.

It was decided that Peyor's diversified portfolio should consist of six separate accounts, with five of them set up as separately managed accounts with different managers. Each account would hold positions in different types of taxable equities and taxable debt securities: account 1, international companies; account 2, real estate investment trusts (REIT); account 3, energy and utility companies; account 4, private equity and corporate debt; and account 5, core equities and master limited partnerships (MLP). Each account would contain a taxable money market cash fund.

From its list of participating financial managers, the brokerage firm (qualified custodian) recommended five outside professionals to manage these five accounts in the portfolio; thus, each account would have a different manager. Each manager would handle the trading by making the buy and sell decisions for the specific account. The individual managers would charge a quarterly wrap fee, covering all administrative and management costs, based upon a percentage of the account's value. This wrap fee would be divided between the particular manager and the brokerage firm. Annual wrap fees ranged from 1% to 1.8%.

Account 6, holding laddered municipal bonds and a tax-exempt money market cash fund, would be a nonmanaged account. The brokerage firm would handle the trading and administrative duties of this account without any quarterly or annual management fees.

Peyor concurred with all of the brokerage firm's suggestions, terms, and conditions regarding the arrangements. The brokerage firm evaluated the performance of the five managers each quarter, and then met with Peyor to discuss the portfolio. Near each calendar year-end, the brokerage firm and Peyor would meet for the purpose of tax planning.

Diversified Portfolio Tax Implication

For the most current tax year, Peyor received six Form 1099s from his brokerage firm, one for each account in his portfolio. The five managed accounts reflected the following totals: $9,127 of gross taxable interest income; $955 of accrued taxable interest paid on purchases; $37,677 of taxable ordinary dividend income; $1,272 of capital gain distributions; $2,941 of short-term capital gains; $21,624 of short-term capital losses; $107,706 of long-term capital gains; $4,564 of long-term capital losses; and $28,385 of management (wrap) fees. The nonmanaged account reported the following: $67,397 of municipal bond and other tax-exempt interest income (net of accrued interest paid on purchases), $2,420 of long-term capital gains, and no management fees.

Given this particular set of facts and circumstances, Peyor may deduct the $28,385 of management fees for investment advisory services on Schedule A, line 23, subject to IRC section 67 limitations (2% of AGI). In addition, the $28,385 (subject to the section 67 limitations) will be included in the computation on line 9c of Form 8960 (Form 1040), Net Investment Income Tax, a new form.

Modified Diversified Portfolio

Now assume that Peyor's entire portfolio consisted of just one single account containing all of the various securities mentioned earlier; further assume that it was a managed account requiring an outside manager. The dollar amounts reported on the Form 1099s would be the same; they are reflected merely on one Form 1099.

Given this modified scenario, the $28,385 of management fees will have to be bifurcated, based on the relevant tax laws covered earlier, between taxable income and tax-exempt income. The computations in the Exhibit capture the allocation of the $28,385 into a deductible amount and a nondeductible amount. Thus, $19,870 of the $28,385 can go on Schedule A and Form 8960 (subject to the section 67 limitations). But $8,515 would be deemed nondeductible and not part of Schedule A or Form 8960 in any fashion.

Other Investment-Related Expenses

In addition to portfolio management fees (i.e., investment advisory fees, custodial fees, fees for services of investment counsel and advice), the federal tax laws allow deductions for other investment-related expenses attributable to the production of taxable investment income. Treasury Regulations section 1.67, section 1.212, and Publication 550 provide the legal authority for deducting subscriptions to investment advisory publications, certain legal and accounting fees (e.g., tax advice, planning and preparation), and the rental of safe deposit boxes. But the investor expenses of attending stockholders' meetings and investment-related seminars are generally not deductible. IRC section 265 precludes any deductions for the interest expense on debt incurred to acquire or carry tax-free investments, but the interest expense on funds borrowed regarding taxable investment income is deductible, within certain limitations.

Deductibility of IRA Fees

A closely related issue to portfolio management fees involves the specific case of IRAs (traditional and Roth). The investment management fee incurred each year by an IRA may be in the form of an annual maintenance fee (e.g., $150) or a percent-of-asset value fee (e.g., 1.5%). Thus, a wrap fee arrangement may be a flat rate per period or a percentage of the account's market value.

IRS Publication 529, Miscellaneous Deductions, provides a deduction for the trustee's administrative fees of an IRA, if such fees are billed separately and paid by the taxpayer from an outside (of the IRA) source of taxable income (e.g., check or credit card). In addition, private letter ruling 201104061 affirmed that wrap fees and investment advisory fees for IRAs that are paid with outside taxable funds to the manager or trustee are deductible. These deductions are subject to the same limitations discussed earlier for portfolio management fees; however, such fees paid directly with IRA dollars (within the account) are not deductible, because such payments are coming from pretax dollars.

Vigilance Is Needed

Tax advisors must be aware of those tax laws related to the allocation of portfolio management fees. The issue should be covered with taxpayers during the client interview prior to preparing the tax return. In addition, advisors should be vigilant of all of the information reported on the Form 1099s, and the type of investment account (managed versus nonmanaged), as well as the composition of the income (taxable versus tax-exempt) in order to follow the appropriate reporting guidelines and record-keeping requirements.

Andrew D. Sharp, PhD, CPA, is a professor of accounting at Spring Hill College, business division, Mobile, Ala. Taylor A. Webre is a research assistant and accounting honors student, also at Spring Hill College.

Allocation of Portfolio Management Fees

Total portfolio management fees                           $28,385

Gross taxable interest income                              $9,127
Accrued taxable interest paid on purchases                  (955)
Taxable ordinary dividend income                           37,677
Capital gain distributions                                  1,272
Short-term capital gains                                    2,941
Long-term capital gains                                   110,126
    Taxable income                                       $160,188
Taxable income                                           $160,188
Municipal bond and other tax-exempt interest income *      67,397
    Total income                                         $227,585

$160,188 / $227,585 = 70% Deductible
$67,397 / $227,585 = 30% Nondeductible

$28,385 x 70% = $19,870 Deductible
$28,385 x 30% = $8,515 Nondeductible

* Net of accrued interest paid on purchases
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Title Annotation:Finance: personal financial planning
Author:Sharp, Andrew D.; Webre, Taylor A.
Publication:The CPA Journal
Date:Sep 1, 2014
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