Ep. #8: Can CTA customers deduct advisory fees?

If your customers can’t deduct their advisory fees, they’ll pay tax on trading gains that they don’t get to keep. Listen to this episode to learn why customers might not be able to deduct the advisory fees they pay to you, three strategies that can help your customers avoid this situation, and why these strategies may or may not work for your business.

TRANSCRIPT:

Welcome to The Profitable CTA, the only podcast that helps commodity trading advisors grow their businesses and boost their bottom lines. I’m Kelly Hollingsworth and I’m very glad you’re here because too many CTAs are struggling with their profitability, and in this show we talk about how to fix that.

In every episode, we discuss a common problem that undermines CTA profitability, and the problem for today is a question: Can CTA customers deduct the management and incentive fees that they pay to CTAs?

Sometimes they can, and sometimes they can’t, and today we’re going to discuss a little bit about why that’s the case, and some possible strategies to consider when a customer can’t deduct advisory fees.

But first, to understand why this question matters, you must understand what it means to deduct advisory fees.

Why customers want to deduct advisory fees

Imagine you’re trading for a customer and you earn $100 in the customer’s account that is subject to a 30% incentive fee. Picture the money as a stack of cash. If you’re trading a managed account for the customer, what happens is initially all of that money is in his hands. It’s in his account, in other words. So that’s the first transaction—when all the money lands in his account. And then there’s a second transaction when the customer hands you $30 of the $100 as your incentive fee.

Now, there are times when the tax code says your customer can consider both of these transactions in calculating his income tax for that year. He can put first transaction–the $100 gain–on his tax return, as well as the second transaction, when he pays the $30 incentive fee to you. In that case, he pays income tax only on his $70 net profit.

But there are other times when he pays tax on the full $100, because he has to report the first transaction on his tax return—getting the $100 gain in his account—but he’s not allowed to also include the second transaction when he pays you the $30. If this happens, your customer only winds up with $70 in net trading gain in his pocket, but he’s paying tax on the full $100 gross trading gain. So if your customer is in the highest tax bracket when this happens (for 2018, it’s 37%) and he can’t deduct the $30 on his tax return, this is going to represent an additional tax of roughly $11 for him that year.

Obviously, your customers are going to want to pay less tax if they can, so occasionally CTAs will hear from their customers asking, “What can be done about this?” And lately, CTAs are more likely to hear this question because starting in 2018 with the Trump-era tax changes, the issue of not being able to deduct CTA advisory fees is prevalent for almost every taxable customer that you’re going to have, and this Trump-era effect on CTA fee deductibility was an inadvertent byproduct of some other changes in the tax code in 2018, and Congress may act to fix this, but if they don’t, it’s not set to phase out until 2025.

So it’s a good idea for CTAs to be aware that it has always been the case that CTA advisory fees, the management and incentive fees they charge, might not be deductible, but it’s even more of an issue between 2018 and 2025 unless Congress makes a change.

Disclosure

The first thing every CTA should do is disclose to your customers in writing that their advisory fees might not be deductible, and that they should check with their own tax advisors about this.

Why does the disclosure say that they should check with their own tax advisors? One because things change, they change all the time and it’s difficult for CTAs to keep up with that. You are a CTA, not a CPA, and as with all things tax related, this stuff is also complex. It’s your job to trade the customers’ accounts and make money for them, not advise them on their tax returns.

Also, the answer to this question about whether a customer can deduct fees is generally customer-specific. Prior to 2018 and maybe at some point after 2018, some of your customers aren’t going to be worried about this at all because of their particular tax situations. It’s just not an issue for them. But other of your customers may be worried about it, and from time to time they may ask you to restructure your compensation structure, or the way you trade for them, so they can avoid paying the additional tax.

So now I’ll share a couple of strategies to consider if these questions come up, and we’ll also cover some of the downfalls of each particular strategy. And here I’d like to stress that this is very general information and you shouldn’t apply it to your own situation without a specific conversation about exactly what your situation is and whether a strategy will work to accomplish what you want it to.

Trade a retirement account instead

One idea to consider is that customers who have this deductibility problem in their existing accounts generally can swap out those accounts for retirement accounts instead. This helps if the advisory fees are paid directly from the retirement account. This strategy may be complicated depending on what the Department of Labor and other regulators decide to do with their efforts at special fiduciary rules for retirement accounts, but it’s something to consider. If a customer can’t deduct his management fees and incentive from the trading gains you generate for him, that problem can be solved if he has you trade a retirement account for him instead.

Commissions instead of management and incentive fees

Another possible strategy is charging commissions instead of management and incentive fees. Why does this help? Because as things stand now, customers with this deductibility problem report the first transaction on their tax returns—the money that winds up in their accounts as a result of you trading for them (in our example this was the $100)—and that number is always what’s left after commissions and other per-trade transaction fees have been taken out of the account.

It’s the second transaction—where the customer handing your compensation to you—that might not get included in the customer’s tax calculation—the $30 that might not get deducted on his tax return–and this transaction doesn’t happen if all you’re charging is commissions. So then it doesn’t matter if your customer can’t include the second transaction on his tax return because there isn’t a second transaction. He’s only going to pay tax on the actual gains that he got to keep, and not also on what he had to pay to you.

So what are some downfalls to this strategy? There are many. One is giving up that piece of the profit in terms of your incentive fee. That’s generally a huge piece of upside for CTAs, and it could be very difficult to collect this upside through commissions. It’s one thing to take a big incentive fee when the customer is sitting on big profits. That’s pretty palatable to most customers, because they know they wouldn’t have made any of those trading profits without the work you did for them, so although the incentive fee may be a big number in that case, they’re generally happy to pay it, or at least they don’t mind paying it. But it’s an entirely different inquiry for a customer to agree to a commission rate high enough to compensate you for this, when the profits haven’t been earned yet, and might never be earned.

And the other question is, how high does that roundturn rate have to be to make up for a foregone incentive fee? It might have to be so high that people laugh or start to sweat when they hear it, especially if you’re a CTAs that don’t trade frequently. If you trade infrequently but you earn huge trading profits when you do, you might need a roundturn commission rate in the hundreds or thousands of dollars to make up for lost incentive fee that you’re foregoing in lieu of commissions. I definitely see this in practice—even small-ish CTAs that charge commissions instead of incentive fee often leave hundreds of thousands or millions of dollars on the table every year because they don’t have that incentive fee. All they have is the commission.

The other issue is that some if not most customers consider a CTA sharing in commissions to be an unacceptable conflict of interest. If you share in commissions, it gives you the incentive to trade for the sole purpose of increasing your compensation. Not saying that you would do that, but customers worry about it. And of course, regulators consider incentive fees also present a conflict. Incentive fees give the CTA the incentive to take more risk in the hope of generating more profits and thereby increasing the CTA’s incentive fee, but in practice the regulators are generally the only folks who are bothered by incentive fees. For the most part, customers like the idea of CTAs receiving most or all of their compensation only if the CTA has performed and there are trading profits from which to pay the fees.

So CTAs who switch from incentive fees to commissions may find they have customers saying I just don’t want to participate in a trading program like that at all. It could be better for you to stick with incentive fees.

Consider a Partnership/Pool Structure

Another strategy to consider, if you have customers who are worried about not being able to deduct management or incentive fees, is setting up a commodity pool, but here you have to be careful, for reasons I’ll discuss in a second.

First, I’ll tell you why a pool works to solve this deductibility problem. Let’s go back to our $100 gain example, where we imagined the money that you made from trading sitting there in cash. With a pool, there aren’t two transactions for your investor, the first where he gets the $100 and the second where he hands you the $30. There are two transactions in a managed account, but with a pool, the investor just gets the $70. The other $30 goes straight to you. It never passes through your investor’s hands, and as things currently stand in the U.S. tax code, that means there’s no risk that he’s going to pay income tax on it that $30.

But this doesn’t mean that a pool makes sense. It can present a tax savings in years when an investor couldn’t deduct advisory fees that are paid to a CTA due to gains in a managed account, but it also generates a host of additional expenses that could eat up some, most or even all of the tax savings. And the amount that is eaten up depends on the size of the pool and it’s total operating expenses. Very small pools often have an operating expense burden of 10% or more, and if your investor participates in one of these to avoid a fee deductibility problem in a managed account, this will consume most or all of his tax savings, and he’s also going to give up other benefits that we discussed in Episode 6, such as transparency, liquidity, and the risk that you’re going to walk off with his money. With a pool, you have access to his cash and you could take it if you wanted to. If he has a managed account, you have no access to his money. If you haven’t yet heard that episode, you may want to go back and have a listen before you decide to restructure everything.

So that’s what I have for you today. There are some situations, some clients and some tax years, where your customers won’t be able to deduct the management and incentive fees that they pay to you from their trading gains, and that means that they’re going to be paying tax on trading gains that they didn’t get to keep. So if you want to consider strategies to work around that, consider having your customers trade through a retirement account instead of a taxable regular account, have them consider paying commissions to you instead of advisory fees, instead of management and incentive fees, and consider if a pool structure makes sense for you. It might. Maybe it won’t because the pool expenses will eat up the tax savings, and your investors will give up other benefits when they go into a pool, but maybe it will. It’s worth thinking about.

If you want some help thinking about this, get in touch. Before we close, I’d like to clarify, I’m an attorney so this podcast may constitute attorney advertising. Also, although we discuss general business principles in this podcast against a legal backdrop, you shouldn’t take anything I say here as legal advice that’s applicable to your situation unless you actually hire me as your attorney and I know exactly what your situation is. If you want to talk to me about doing that, email me at kelly@profitablecta.com, or go to profitablecta.com where you can access my calendar and schedule a call with me. Thanks so much for joining me this week. I look forward to speaking with you if you’d like some help with your CTA, and I look forward to connecting with you in the next episode.

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