The IRS has put a damper on a tax saving strategy that has been used by some investors with fee-based accounts.
CHICAGO — The IRS has put a damper on a tax saving strategy that has been used by some investors with fee-based accounts.
In a recently released memo of guidance aimed at helping its agents, the Internal Revenue Service stated that fees charged in fee-based accounts should not be considered carrying charges and should not be capitalized into the cost of the securities in these accounts. Instead, the fees should be considered expenses, according to the memo.
In the past, some financial advisers and certified public accountants encouraged their clients to add the fees to the cost basis of their holdings, which would serve to reduce potential capital gains and taxes.
“Now you have to treat these fees as miscellaneous itemized deductions, and you won’t get a tax deduction,” said Robert Willens, a tax analyst at Lehman Brothers Inc. in New York, who recently published a report on the IRS memo.
He said that an investor will be able to earn a miscellaneous itemized deduction on account fees only if the amount of miscellaneous charges exceeds 2% of adjusted gross income — not an easy feat for many high-net-worth investors.
With account fees often as high as 3%, adding the fees to an account’s cost basis saved some investors thousands of dollars in taxes, Mr. Willens said.
It isn’t clear how many advisers and CPAs currently recommend this strategy to their clients. But this guidance comes as more advisers charge fees rather than commissions.
Research from Tiburon (Calif.) Strategic Advisors LLC in January showed that assets worth $1.5 trillion were held in fee-based accounts last year while assets worth $4.7 trillion were held in commission accounts.
According to Tiburon, fee-based account assets stood at $180 million in 1996 and grew to $1.2 trillion in 2005.
Bucking the IRS?
Investors still can try to add the fees to the cost basis of the stocks despite the IRS guidance, but that probably isn’t wise, Mr. Willens said.
“I don’t think a lot of CPAs are going to recommend that taxpayers buck the IRS on this,” he said.
“I’m willing to disagree with the IRS, but in this case, I think they have the better argument,” Mr. Willens added. “I’m recommending people follow the IRS.”
Despite the guidance from the IRS, Diane Park, a CPA in Minneapolis with Wade Financial Group Inc., said she still will recommend the capitalization strategy to clients.
Her firm helped one client reduce his 2006 federal taxes by $7,000 by adding fees to the cost basis of the investments, she said.
“Just because the IRS gives guidance doesn’t mean it’s a done deal,” Ms. Park said. “We could get down the road, and it gets taken to tax court.”
But Ms. Park conceded that not all of her clients would be comfortable taking the risk.
“If you’re ultraconservative and don’t want to receive a letter from the IRS, we don’t recommend this for you,” she said.
It also is possible some taxpayers will argue that a certain portion of the account fees should be added to the cost basis, said Steven Rosenthal, a partner at Washington-based law firm Miller & Chevalier Chartered.
The guidelines for how taxpayers handle this issue can vary depending on whether the account is taxable or non-taxable, he said.
“Taxpayers really need to think about their tax position and how best to optimize their tax situation,” Mr. Rosenthal said.
Mark Briggs, a CPA and certified financial planner with Briggs Wealth Management LLC in Glastonbury, Conn., said he actually is relieved the IRS issued guidance on this complex issue.
He has done tax returns for a client whose former accounting firm had used the strategy and passed along the worksheets. Mr. Briggs said he continued capitalizing account fees — and saving the client thousands of dollars — but always worried that the strategy wouldn’t pass muster with the IRS.
“It was just a crazy interpretation, and I felt it was a stretch,” Mr. Briggs said. “I wasn’t completely comfortable that this would withstand a true audit.”
Ceasing and desisting
Mr. Briggs said he already has contacted his client, who agreed to not use the strategy again.
“If people will continue to use it, it’ll be interesting to see what will happen, because [the IRS has] already warned you about it,” he said.
About 2% to 3% of Marc B. Schindler’s clients have utilized the strategy. Mr. Schindler, a CFP with Pivot Point Advisors LLC in Bellaire, Texas, said it was helpful in the few cases in which he used it.
The strategy always seemed too risky to Mark Farrell, director of advanced planning at McLean (Va.) Asset Management Corp.
Mr. Farrell said he has advised clients to pay wrap fees by taking a distribution from their individual retirement account, because that distribution isn’t taxable if it is used for adviser fees.
“If they can’t deduct the fee, maybe we should take tax-free distributions from the IRA,” he said. “For some of our clients, they may not necessarily need the IRA.”
