Although we often think of the IRA as simply another account, the tax law generally regards it as a quasi-entity that is separate from the individual who owns it. Both the individual and the IRA have their own separate tax rules that apply; intermingling money is not allowed (due to contribution limits), and even paying each others’ costs can get a client into some hot water. Accordingly, clients must be very careful when they use their own "outside" dollars to pay any form of expenses that are associated with the IRA itself. Fortunately, in a recent private letter ruling, the IRS did (re-)affirm that an IRA’s wrap fee expenses are an acceptable cost to pay on behalf of an IRA with outside dollars, while not running afoul of the IRA rules and limitations.
The private letter ruling, 201104061, looked at several different types of "typical" account arrangements where a wrap fee was charged as a percentage of the assets in the IRA. In all cases, the wrap fees covered any transaction costs, broker’s fees, and commissions, although in several cases the wrap fees also covered costs associated with ancillary financial planning, investment advice, or even discretionary investment account management.
In the IRS’ view, these expenses can be considered "ordinary and necessary" expenses of the IRA, and are more analogous to paying the IRA trustee’s fees (which are deductible under Revenue Ruling 84-146) than paying brokerage transaction trading costs (which normally must be capitalized into the cost of the security, rather than claimed as a deductible expense, under Revenue Ruling 86-142). Since the expenses are ordinary and necessary, and are incurred on behalf of the IRA, but are not provided for already via contributions to the plan, under Treasury Regulation 1.404(a)-3(d) they can be treated as IRC Section 212 expenses ("expenses for the production of income") and are not deemed contributions. Without this ruling, the risk would have been that an expense paid on behalf of the IRA with outside dollars might be treated as the equivalent of having made a contribution to the IRA, which the IRA then used to pay its own expenses – which is problematic, given IRA contribution limits. Fortunately, the ruling affirms that such payments on behalf of the IRA (or Roth IRA) with outside dollars are not treated as a deemed contribution, consistent with the IRS’ earlier view on this issue reported in Private Letter Ruling 200507021 from several years ago.
Given that the IRS views such payments of Section 212 ordinary and necessary expenses – which is why they are not deemed contributions to the IRA – it would appear that the ruling also re-affirms the view that such payments should be deductible for the taxpayer on his/her own individual tax return, where the costs are paid with outside dollars. Such deductions are not necessarily eligible for the most favorable – as a miscellaneous itemized deduction subject to the 2%-of-AGI floor, and an AMT adjustment as well – but if there is already a desire to pay such expenses with outside dollars to preserve the compounding growth of the IRA, the potential for a deduction only makes the result even more appealing.
On the other hand, it’s worth noting that the IRS emphasized in its ruling not the investment advisory nature of the expenses, but the fact that they seemed comparable to administrative and overhead expenses, especially given that the costs allowed for an unlimited number of transactions without incurring additional fees. Thus, although it would appear likely that ongoing investment advisory costs would also be eligible for this same treatment, the focus of the ruling was ultimately on wrap fees that specifically include the benefit of unlimited transactions for the client at no further cost, not "just" investment advisory fees. The risk of a different treatment for investment advisory costs (where transaction costs are separately still passed through to the client) seems low, but nonetheless it is notable that the ruling is not crystal clear on the point (and of course, in any event, private letter rulings cannot be cited as legal precedent).
The bottom line is that the latest private letter ruling appears to continue support for the view that it is acceptable for clients to pay IRA wrap (and investment advisory) fees with outside dollars if they so wish, without having them treated as a deemed contribution to the IRA, and while also being eligible for deductibility as a Section 212 expense. Hopefully, at some point in the future, this treatment will be further clarified by the IRS with a legally binding regulation or revenue ruling, but in the meantime, the footing for this treatment still seems pretty solid.
Either way, though, clients should be cautious never to conduct the transaction the other way around – paying the costs of outside accounts using dollars that are held inside the IRA – or there is a risk of a prohibited transaction under IRC Section 4975 that can disqualify the entire IRA!
So what do you think? Do you have clients pay IRA investment advisory expenses with outside account dollars? Or do you tend to sweep them directly from the IRA?