The annual “wrap” fee paid by investors on their brokerage accounts must be treated as a miscellaneous itemized deduction, not as a capital cost for the account, at least according to a recent IRS Chief Counsel’s memo that has caused quite a stir.

A growing number of investors pay an annual flat fee, in lieu of paying commissions on each trade, on their brokerage accounts. The annual fee, referred to as a “wrap fee,” covers annual maintenance charges and brokerage commissions, among many other investment expenses.

In a recent advice memorandum, IRS Chief Counsel ruled that taxpayers must treat the annual “wrap” fee as a miscellaneous itemized deduction, not as a carrying charge that may be capitalized under Regulation §1.266-1(b). As a result, taxpayers are no longer able to include these fees in the basis of the securities held in their brokerage account. Adding fees to a stock’s basis reduces the capital gain tax eventually due on its sale or exchange.

The IRS’s position will impact a significant number of investors whose practice has been to capitalize these fees by adding them to stock basis.

Deduction treatment

Miscellaneous itemized deductions including wrap fees are permitted only to the extent that such deductions exceed two percent of the taxpayer’s adjusted gross income (AGI). As a result, if a taxpayer’s total amount of miscellaneous expenses is less than two percent of their adjusted gross income, the taxpayer cannot deduct any of their miscellaneous expenses, including the annual fee paid on their brokerage account. While a miscellaneous itemized deduction may offset ordinary income, it is usually difficult to get past the two percent AGI floor.

Now, many investors may not see any tax benefit from the payment of a wrap fee. Taxpayers may lose the benefit through the two percent floor, the phase-out of itemized deductions, or application of the AMT.

IRS reasoning

The IRS Chief Counsel stated that wrap fees do not fall into any of the categories of expenses that qualify for treatment as a “carrying charge.” The Chief Counsel determined that carrying charges are “expenses incurred when acquiring, financing, and holding property.” According to the Chief Counsel, a wrap fee charged to a brokerage account falls outside this definition because it is incurred independent of a taxpayer’s acquisition of property and is not a necessary expense of holding the property.

Uncertainty remains

As the result of the recent Chief Counsel’s memo, the IRS apparently wants investors to treat the annual fee as a miscellaneous itemized deduction. “Apparently” is used specifically, however, since it has not made its position “official guidance.”  A Chief Counsel’s memo is considered internal correspondence made public through Freedom of Information Act disclosure. 

Despite the IRS’s memorandum, no regulation or proposed regulation has been issued. Currently, a conflict looms among the circuit courts as to whether, under Code Sec. 67(e), investment-advice fees paid by a trust or estate may be deducted in full, or are subject to the two percent AGI floor. The Supreme Court may have its say on the issue, and if so, the result may affect the IRS’s new position applicable to investment fees on regular, individual accounts.

If you’d like further information on how your investment expenses may be affected by this new development, please do not hesitate to call this office for assistance.

(CCA 200721015)