Oops! Unintended consequences of tax-law changes

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.