Since the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), there has been a lot of concern about the deductibility of investment advisory fees. The TCJA repealed the miscellaneous itemized deductions for individual taxpayers’ investment advisory fees for tax years 2018 through 2025.
Practically speaking, this change had little impact on many individual taxpayers, as the deductions were limited to expenses exceeding 2% of a taxpayer’s adjusted gross income and were not deductible for alternative minimum tax purposes. However, this change did draw the attention of investors and advisers who were surprised by the lack of deductibility. The issue may be an even bigger problem for advisers who charge a performance or incentive fee to these investors. Investment partnerships may be a solution to consider.
Let’s look at an example of the potential issue we’re trying to resolve:
An adviser manages a separately managed account (SMA) for an individual taxpayer with $1 million of original value. The advisory firm charges clients a 1% management fee plus a 20% performance fee for this strategy. Before the performance fee, the account earns the $110,000 of long-term capital gains and has $10,000 of investment advisory fees. Based upon the performance, the adviser also receives an incentive fee of $20,000.
In this example, on the $80,000 of economic return, the investor has taxable income on $110,000 of long-term capital gains and $30,000 of nondeductible expenses. However, the adviser picks up the $30,000 of income on its tax return. Because of this tax treatment, the $80,000 of economic return to the investor creates $110,000 of income that is taxed to both the investor and the adviser. Furthermore, the adviser is taxed on the management fees and incentive fee income at ordinary tax rates and may be subject to self-employment tax on these amounts.
The good news is there are ways to set up investment partnerships, or hedge funds, to help reduce the impact. Instead of managing these types of SMAs for each investor, the adviser can pool investors who will then invest in the exact same portfolio through a hedge fund. The adviser charges a 1% management fee and has an incentive allocation, or carried interest, on 20% of the profits allocated to the investor(s). In this case, the management fee expense may still be nondeductible, depending on the activities of the partnership, but the incentive allocation would reduce the amount of short-term capital gain allocated to the investor.
Specifically, in our example the $80,000 of economic income would be allocated as follows:
|
|
Investor |
General Partner/Adviser |
Total |
|
Long-Term Capital Gains |
88,000 |
22,000 |
110,000 |
|
Management Fee Expense |
(8,000) |
(2,000) |
(10,000) |
|
Total Income |
80,000 |
20,000 |
100,000 |
In addition, the adviser would have management fee income on the $10,000 of fees. As you can see, this allocation may create a win/win for the investor and the adviser by creating tax efficiencies for both parties.
There are many other factors to evaluate when deciding if an investment partnership makes sense, beyond the tax treatment of nondeductible expenses.
The adviser and the investor(s) should consider the start-up and operational costs of a fund, including legal, administration, and audit and tax services that may be needed to organize and provide ongoing services to the fund. The specific nature of the operations of the fund may result in different tax treatment of these expenses.
The investor may not have the level of transparency they might have had historically in a separate account. For instance, investors will receive a Schedule K-1 instead of a 1099 to report their income. The investor also may be giving up control over the account by moving into an investment partnership.
Advisers should consider the impact of the carried interest provisions of IRC Section 1061 that may recast some long-term capital gains to short-term capital gains, as well as potential tax proposals that may further limit the tax benefits of an investment partnership.
Using an investment partnership structure can be effective in increasing the after-tax return to investors, with a possible tax benefit to the adviser as well.
Contact Rob Velotta at rvelotta@cohencpa.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.