The subject of the deductibility of investment advisory expenses generates confusion given its complex evolution, and is further complicated by new rules for corporate fiduciaries. In this article, the first in a series, we briefly set forth the historical position of Congress and the Internal Revenue Service on the deductibility of investment management expenses and outline the limitations for individuals (including grantor trusts), estates and non-grantor trusts. In future articles we will outline more specifically how these rules apply to estates and non-grantor trusts; illustrate the impact these limitations have on taxpayers with high adjusted gross income (AGI) or those subject to the alternative minimum tax (AMT); and suggest potential methodologies for fiduciaries in unbundling fiduciary and investment advisory expenses.
Background
The Internal Revenue Code imposes a tax on “taxable income” of both individuals and trusts. The calculation of taxable income begins with a determination of gross income, which includes “all income from whatever source derived.” Taxpayers may then reduce this number by taking various allowable deductions directly against it, such as for business or trade expenses (a list can be found on the first page of that year’s 1040 form). These are called “above the line deductions,” and generally face few restrictions. The new figure (now called AGI) can be further reduced, if the individual itemizes, by taking so-called “below the line” deductions, such as for investment advisory expenses, which are subject to far stricter rules and scrutiny. This article explains some below-the-line deductions and the limitations imposed on them.
Evolution of the Position of the IRS and Congress with Respect to the Deductibility of Investment Advisory Expenses
The IRS used to treat business expenses and other “profit-oriented” expenses (like investment advisory fees) as one and the same, and deductible. That changed with the Supreme Court case Higgins v. Commissioner in 1941, where the court ruled profit-oriented expenses weren’t, in fact, deductible.
The Internal Revenue Code was then retroactively changed to specifically include fees paid for non-business, profit oriented expenses, such as the management, conservation or maintenance of investment property, as deductible adjustments to AGI (Section 212).
Section 67: The 2 Percent Floor
Since these fees are, by default, characterized as miscellaneous itemized deductions, they are subject to a variety of limitations. For one, a taxpayer can only make miscellaneous itemized deductions to the extent they exceed 2 percent of their AGI (Section 67). This is frequently referred to as the “2 percent floor.” Investment advisory expenses are included as miscellaneous itemized deductions when calculating the 2 percent floor. Miscellaneous itemized deductions that cannot be taken are permanently lost.
Section 68: Overall Limit on Itemized Deductions
For individual taxpayers whose AGI exceeds a certain threshold, Section 68 further reduces a taxpayer’s itemized deductions by an amount equal to the lesser of either 3 percent of the excess AGI over the “applicable amount,” ($258,200 for a single taxpayer) or 80 percent of the amount of itemized deductions otherwise allowed. It’s important to note that this limitation does not apply to estates and non-grantor trusts.
Section 56: Exclusion from Alternative Minimum Tax Calculation
Unlike deductions for trade or business expenses, no deduction is allowed for financial advisory expenses for purposes of the AMT. As a result, any amount deducted from AGI for miscellaneous itemized deductions will be added back into the taxpayer’s AGI to compute the alternative minimum taxable income, thereby increasing any AMT expense.
Taxpayers should work with their financial advisors and tax professionals to determine what expenses are subject to the limitations, to monitor the impact of these limitations and to develop strategies to minimize such impact.