Individual investors, family offices, investment funds and investment advisors should consider reviewing their investment-related expenditures to identify fees and costs that may be capitalized and treated as part of the cost basis of investments acquired by (or for) the investor. In that way, the tax benefits associated with such costs can be recovered when the asset is sold – or sometimes earlier.
If such costs or expenses are not properly identified and capitalized they will be treated as if they were the regular or recurring expenses of monitoring or safeguarding an investor’s portfolio – which cannot be deducted due to the limits on section 212 expenses – also known as “miscellaneous itemized deductions.”
Most importantly – individuals and their advisors should be aware that capitalizable costs include the costs of “investigating or pursuing” investments acquired by (or for) an investor – directly or through a managed account or investment partnership. Capitalization is not limited to items like closing costs or commissions – that are typically incurred only after a transaction has been agreed to by the parties. They can also include the cost of such activities as assessing the value of a non-traded or thinly traded security for purposes of making a bid or offer – or other costs of investigating or pursuing the potential acquisition of an investment.
Whether any particular expenditure qualifies as an ‘investigatory’ cost is a question of fact. Where the amount of potentially capitalizable expenses is substantial – for any particular individual or advisor or fund or family office – a study to identify, analyze and document the particular costs, fees or portions of fees subject to capitalization may make sense.
Such studies may not have made sense for some investors in the past, but with recent legislative changes disallowing itemized deductions for investment management fees and expenses, the cost/benefit calculus may have changed.
Detailed analysis of the capitalization issue
Individual investors may not claim an itemized deduction for investment advisory fees or similar amounts paid for advice or assistance in managing an investment portfolio.
That limitation does not apply, however, to expenses properly treated as capital expenditures – including amounts paid to lawyers, accountants, advisors, appraisers and other service providers to facilitate the acquisition of an investment. Such amounts are added to the purchase price paid to the seller or issuer of the investment and become part of its cost basis. They are generally recovered when the investment is sold or in some cases earlier – as in the case of a premium paid for the purchase of a debt instrument.
The current environment, with miscellaneous itemized deductions completely disallowed, places a premium on identifying the portion of an investor’s costs or fees properly treated as capital expenditures. An obvious example would be a fee paid to an attorney to prepare the documents needed to complete the purchase of an investment at a price upon which the parties have agreed.
A very important but less obvious example would include amounts paid to third parties to ‘investigate or pursue’ investments that are acquired by (or for) the investor. That would include investments acquired directly by an investor, investments acquired through a managed account and investments acquired through an investment partnership. As the applicable regulations explain:
- An amount is paid to facilitate the acquisition or creation of an intangible (the transaction) if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate a transaction, the fact that the amount would (or would not) have been paid but for the transaction is relevant, but is not determinative. An amount paid to determine the value or price of an intangible is an amount paid in the process of investigating or otherwise pursuing the transaction.
The question of whether any particular amount is properly treated as a cost of “investigating or pursuing” requires an examination of the ‘facts and circumstances.’ This includes determining whether amounts paid by an investor to a service provider as a salary, fee or retainer are properly treated – in whole or in part – as a cost of “investigating or pursuing” the investments that are actually purchased by (or for) the investor.
In determining whether any particular cost is capitalizable, important and generally helpful guidance is provided by the regulations, case law and general tax principles. For example:
- At one end of the spectrum, if a particular advisor’s investment selection activities were limited to annually rebalancing the percentage of a client’s ‘passive’ portfolio held in broad equity or debt index funds it is unlikely that substantial amounts paid for such rebalancing could be considered to be associated with the cost of ‘investigating’ or ‘valuing’ potential investments.
- At the opposite end of the spectrum, the regulations suggest that if an investor or group of investors agreed to hire an advisor as an independent contractor on a full-time and exclusive basis for a specified term, and the advisor’s sole function was to identify, select and acquire for the investors pools of loans offered for sale to private investors by commercial banks, all or a portion of those fees would be capitalized into the cost of any loan pools acquired by the advisor for the investor group. There is no reason to believe the treatment would be any different for services provided to identify other types of investments for which similar investigatory services were needed -- such as equity interests, derivatives, royalty streams, etc.
- If the advisor were hired as an employee of the investor group (or as an employee or managing general partner of their partnership), the investor group could elect whether or not to capitalize all or a portion of the otherwise capitalizable portions of his salary or his guaranteed payment.
- In either event, the regulations suggest that costs that were properly allocable entirely to the investigation of investments that were rejected would not be capitalized and would remain non-deductible. However, where multiple, alternative or mutually exclusive investments were being investigated and compared the regulations suggest that all or portion of such costs might be properly allocable to the investment actually selected and acquired.
- Case law suggests that if an advisor were paid a nonrefundable annual retainer or similar fee for the potential provision of more than one type of service during the year, only some of which would be properly capitalized, an allocation of the fee would be required, presumably based on the nature of the services actually provided by the service provider and how important or necessary they were to the acquisition of a capital asset.
- Some cases decided before the issuance of new regulations in 2003 appear to be superseded by those regulations. Of particular importance to investors, the regulations applicable to the investigation or pursuit of all types of assets – including intangible assets like securities as well as tangible property – provide that the fact that an amount would (or would not) have been paid “but for” an acquisition is relevant, but is not determinative of whether the amount is properly treated as a cost of investigating or pursuing an acquisition. In other respects, however, some of the capitalization rules differ depending on whether one is applying them to the purchase of an intangible asset, the creation of an intangible asset, the purchase of tangible personal property, the purchase of real property, the purchase of an intangible asset representing a controlling interest in a trade or business, and other specific situations.
- Although the requirement to capitalize is theoretically the same whether a taxpayer is an investor or is engaged in a trade or business, both the IRS and the courts have been more lenient to businesses, particularly where certain costs, like salaries and overhead, are involved, or where the “long term” benefits of a particular, theoretically capitalizable cost are “incidental” or immaterial – such as shovel or rake purchased by a farmer or an advertising expense whose benefits may theoretically extend beyond the end of the year but are mostly short term.
Action steps to be considered and other practical implications
Although these rules have been in place for many years, their relevance to investors was much less important before the enactment of legislative changes “suspending” so-called “miscellaneous itemized deductions” for taxable years between 2018 and 2025. That change may have changed the calculus for many investors and their advisors.
As many investors are aware their miscellaneous itemized deductions for amounts incurred between 2018 and 2025 are not “suspended” they are permanently disallowed. This puts a premium on identifying costs that are properly subject to capitalization. Absent proper identification the tax benefits otherwise associated with such costs will not be suspended, they will be permanently disallowed.
If the amount of potentially capitalizable costs or fees (or portions thereof) is substantial, investors, advisors, funds, investment partnerships, and family offices should consider undertaking a review to analyze and document their potentially capitalizable items.
In most cases, no change in the way the taxpayer or advisor does business would be required. Depending on the facts and circumstances, a change in the taxpayer’s treatment of certain items could be a change in accounting methods – but in many cases, a change would be subject to the “automatic consent” or similar IRS procedures.
In some cases business arrangements might be prudently modified in light of these issues – for example special, more flexible rules apply to amounts paid for “overhead” and to “employees” including “general partners” of partnerships.
Other approaches to avoiding the overstatement of disallowed deductions
Where an investor becomes a direct or indirect partner in a business that qualifies as a trade or business – such as by acquiring a 2% interest in a private equity (PE) fund that holds a 60% interest in an LLC engaged in the business of manufacturing ball bearings – case law suggests that the investor is treated as engaged in the ball bearing business for certain purposes. One such purpose may be the ability to deduct as business expenses the investor’s share of any costs incurred by the PE fund in helping to operate or manage the underlying business. Such costs are to be distinguished from costs the fund incurs in deciding whether to buy, sell or hold the investment.
For example, a PE fund might loan one of its staff members to serve as the CFO or CTO of the ball bearing company for a period of time. If that staff member’s salary were paid by the PE fund out of the annual management fee paid by the investors, each investor’s share of that expense may be deductible as a section 162 business expense, and not disallowed as a section 212 expense.
The key point is that such expenses provide value to the operating company itself, and to anyone holding an interest in that company. The expenses are not incurred for the benefit of the PE fund as an investor – such as gathering information to help decide whether to increase or decrease the PE fund’s stake in the operating business. Thus, implementing such an approach will likely involve application of the case law to the particular facts, as well as documenting that particular expenses were incurred in operating the pass-through business in which the investor was a direct or indirect partner.