Oops! Unintended consequences of tax-law changes
Will clients become more interested in paying commissions? Will the new tax law steer more financial advisers toward independent channels? It could.
The Republican tax bill, signed into law on Dec. 22, has a few unintended consequences for financial advisers.
Despite the steady shift from commissions to fee-based accounts, the former could now be slightly more attractive to clients. That’s due to a mismatch — the new law eliminates the tax deduction for clients’ investment advisory fees, due to the law’s repeal of miscellaneous itemized deductions, but it doesn’t eliminate a standing tax advantage for commissions.
“People really concerned about losing the deduction for their [advisory] fees might be more interested in paying commissions instead,” Baird’s Mr. Steffen said of clients.
Paying a commission dilutes an investor’s capital gains tax. Imagine an investor buys a $100 stock that carries a $2 commission. When sold, for $110, there’s another $2 commission. The net result would be a $6 gain, not $10, Mr. Steffen said.
Mr. Kitces of Pinnacle believes the tax benefit may cause some large advisory firms to launch their existing managed-account models and strategies in mutual funds or exchange-traded funds that are fully managed by the firm. The firm’s fees would be assessed as a commission, rather than as a direct, nondeductible advisory fee from the client.
Further, the tax law’s provision on pass-through businesses creates some “distorted incentives” for advisers, Mr. Kitces added.
Pass-through entities like sole proprietorships get a 20% deduction on their taxable income if their income falls under a certain threshold. The benefit fully phases out for many service businesses, including advisory firms, after $207,500 for single filers and $415,000 for married couples filing jointly.
(More: Tax law’s pass-through provision could harm 401(k) plans)
Advisers at employee broker-dealers — for example, wirehouse brokerages and captive channels at firms like Ameriprise Financial and Raymond James — “will want to go to independent channels” and convert to a pass-through business to get the deduction, Mr. Kitces said, especially if their incomes were low enough to qualify for the 20% tax break.
Further, “junior” next-generation partners in advisory firms already structured as pass-throughs — those partners who have limited shares in the business and lower incomes — may, ironically, qualify for the 20% deduction while the founders likely wouldn’t, Mr. Kitces added.
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