Is a performance fee taxed differently in a fund than in a separate account?
RIAs · Video 1 of 8 · 0:41 ·
Usually, yes. In a separate account, a $100,000 gain is taxed to the client, and a $20,000 performance fee is an advisory fee that individuals can't deduct: the deduction has been suspended since 2018, and the suspension is now permanent. In a fund taxed as a partnership, the fee is usually an incentive allocation of profit to the manager, so the investor is taxed on $80,000. The allocation keeps the gain's character; long-term treatment on it generally needs a holding period of more than three years. Illustrative, before tax.
Everything here is for educational purposes only and is not legal, tax or investment advice, or an offer to buy or sell any security. Laws and thresholds change and depend on your facts, so talk to a qualified attorney before acting.
Key facts
- Separate account: the client is taxed on the full gain; the fee is a miscellaneous itemized deduction, disallowed for individuals for years after 2017 (IRC §67(h)).
- Fund taxed as a partnership: the performance fee is typically an incentive allocation; investors are taxed on their allocated share.
- The allocation keeps the character of the fund's income.
- Long-term capital gain treatment on the allocation generally requires a holding period of more than three years (IRC §1061).
- Example: $100,000 gain, 20% fee, before tax.
Transcript
Operator: Same strategy, same 20% fee. In a fund, your client is usually taxed on less.
Founder: How?
Operator: Say a separate account gains $100,000. Your 20% is an advisory fee: $20,000.
Operator: The client is taxed on the whole $100,000. And individuals can't deduct that fee. That's been true since 2018, and it's now permanent.
Operator: In a fund taxed as a partnership, the fee is usually an allocation of profit to the manager. The investor is taxed on their $80,000.
Founder: And what about my side?
Operator: The allocation keeps the gain's character. For long-term treatment, the assets generally have to be held more than three years.
Operator: Same fee. A smaller tax bill for your client.
Operator: Same strategy, same fee...