Can You Deduct Management and Investment Advisory Fees after Tax Reform?

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The short answer to whether or not people can deduct management and investment advisory fees (such as asset management fees for an investment into an real estate partnership) is well, kind of. To put it simply—you can’t deduct investment advisory fees if they are paid directly out of the individual taxpayer’s pocket, but they can be if they are paid out of the entity whom you’ve made an investment with. Its not the perfect answer, but at least there is a way to get to our desired result—being able to deduct those fees.

 

Prior to the passage of the TCJA, individuals could take management and investment advisory fees as an itemized deduction that were paid out of the individuals’ pocket. However, after the passage of the TCJA, this itemized deduction was completely eliminated for individuals.

 

But the TCJA did not eliminate the ability to deduct management and investment advisory fees that are paid out at the entity level in which the individual is an investor and owner. So if an entity pays out management and/or investment advisory fees from its investment’s gross profit and prior to making distributions to its investors, then the deduction is allowed because the expense/deduction is incurred by the entity and the investors take such profit already net of the management and/or investment advisory fee and are only taxable on that net amount received.

 

For example, Taxpayer 1 and Taxpayer 2 each invest $50 (for a total of $100) into an limited partnership (the “LP”) that specializes in real estate investments. The manager of the LP is entitled to an 1% fee for total assets under management (“AUM”). Thus, for our example, the manager would be entitled to a total $1 of compensation based upon the AUM fee agreed too. Additionally, lets say that the LP makes a 10% return on its AUM, for a total gross profit of $10 made in the year.

 

Consequences if LP Distributes Profit to Taxpayers, and Taxpayers Pay Investment Fee. In this first case, if the LP distributes the gross $10 of profit to Taxpayer 1 and Taxpayer 2 ($5 each), and each of the taxpayers pay their AUM fee to the manager thereafter (.50 cents each), then neither taxpayer would be entitled to a deduction equal to .50 cents as it would be payment for management and/or investment advisory fee for which a deduction is no longer allowed at the individual level. Both taxpayer’s would be taxable on the whole $5 of profit they were distributed.

 

Consequences if LP Pays Investment Fee to Manager from Profit, and LP Distributes Net Profit to Taxpayers Thereafter. In this second case, if the LP pays the total $1 AUM fee to the manager from the $10 of gross profit it made in the year, and then distributes the net profit of $9 to the taxpayers ($4.5 each), the taxpayers already take their respective profits of $4.5 net of the management and/or investment advisory fee. Each taxpayer is only taxable on the net $4.5 of profit that they were distributed, and the AUM fee is respected as a deduction as it was paid out by the entity.

So in the end, any investment management and/or advisory fee should be paid by the investment entity prior to making distributions of profit to its ultimate investors. No individual investor should be making direct payments of investment management and/or advisory fees, and if they do, they are not entitled to a deduction for such payment.

For a fuller discussion on all of the changes to the tax law after passage of the TCJA, see Alton’s other post discussing these changes in general.

For the governments discussion on how asset management fees are no longer deductible, please see IRS Publication 529 for a broader discussion on this topic as well as other miscellaneous itemized deductions.