From the February 2009 issue of Research Magazine • Subscribe!

The Tax-Form Gateway

One advisor has discovered that filings with the IRS can lead to a successful engagement.

Financial planners generally do not prepare tax returns as part of their engagements. But that doesn't mean they can't make use of them. In fact, John Napolitano, president of U.S. Wealth Management in Braintree, Mass., has found that tax returns are full of clues to a client's financial problems -- and their solutions.

"The first issue you look at is the list of dependents," says Napolitano. "You might see children or elderly parents or both." For children, the advisor should think right away about education planning. There are the obvious topics, such as choosing a 529 plan. But advisors should also think about gifting issues -- donating appreciated assets. "And there are domicile concerns," continues Napolitano, for considering residency requirements to take advantage of state schools, for example. "There are lots of savings, but check this carefully -- different states have residency tests."

At the other end are elderly parents. Napolitano says tax returns will show it clearly when clients have made use of the "poor man's estate plan." It's not the clients who are poor -- they may have taken a cheap solution. "Say, a couple went to a local attorney, and told them that one of their mothers was getting very elderly and so was moving in with them. What does the lawyer say? 'Get her out of her house quick and get it into your name!'" But complexities ensue, with basis and gifting issues. For example, a son takes over the house, and whom does he leave it to -- his wife? No, not really--there's his brother, who holds it jointly, even though this was never put in writing. "Is there another gift going on here? It's not clear."

Other signs of bad or no estate plan appear in the 1099. "You see what generated the interest. You have the list. What is the title? Whose name are those accounts in? Your clients may not even know! They probably don't realize that joint assets just don't work in a sophisticated estate plan. Consider asset protection issues: If a spouse works in the hazardous waste removal business with a Schedule C, no one should own anything jointly with that person, because there's a lot of risk involved." (Only half kidding, Napolitano says any job on the Discovery Channel's Dirtiest Jobs show qualifies.)

Income Interests

Moving along the tax return lines, the advisor comes to interest income, an important area for financial planning. "And I don't mean just the insurance guys talking about taking the interest and dividends and sticking them into a variable annuity," says Napolitano. "That's the easy stuff. As advisors, we can think of more sophisticated strategies."

Consider the taxable interest income. Advisors should dig down and discover where it's come from -- a bank, insurance policy, bonds, family loans or all of the above. If family loans are involved, ask what the details are. "If clients have lent money to grown children, is there any paper trail?" The failure to properly document this can lead to tax disaster. "If a client gets audited, the IRS will be certain to ask about imputed interest." Advisors should make sure their clients create a real promissory note with real payback terms. They can even gift the interest. "If the clients lend $20,000 they can state it's at a 6 percent annual rate, and then give back the $1,200 a year." There may be some tax substance-over-form issues, but Napolitano is confident a CPA could work through that.

Beyond the IRS there are other issues, such as the house that could be seized if the clients' son gets into financial difficulty. A promissory note means the parents could get some money back. "They might just be in second place, but better there than no place. And if the money is seized from their son's estate -- well, they can always give it back to him later."

On the tax-exempt income side, there are also opportunities for advice. Look at the source. "Personally, I hate laddered muni bond portfolios," admits Napolitano. "Not because it's a bad thing to do. It might be a great thing to do. But they're usually assembled by do-it-yourselfers with very little knowledge who received their instructions from some guy on TV." He's seen clients who lose 10 percent to 20 percent and then sell them because they have no idea bonds could go down. "They have no idea of how to manage the yield curve or credit-risk changes. They may be unaware of how inexpensively you can buy a high-quality fixed-income manager that will not just ladder munis for you, but will actually buy what's right based on the ebb and flow of rates and credit and ratings of issuers."

Look closely at the dividend lines, advises Napolitano. "Again, where are the dividends coming from? Who picked these stocks? Did your client's father pass them on 40 years ago with strict instructions never to sell? Are your clients even using the dividends they're so attached to?"

He relates a story about an 86-year-old client he had who had become attached to his long-held Exxon-Mobil stock. In fact, 60 percent of his worth was tied up in that one stock and Napolitano finally convinced him of the need to diversify. "He never spent the dividends. We just took the cash and reinvested. But sure enough, as soon as we sold a huge chunk of Exxon Mobil, he comes into the office complaining about his 'missing' checks. He had become psychologically attached to them." So the dividend line could lead to an important, if difficult, conversation with new clients.

Schedule E Jackpot

Napolitano admits that although many tax documents are useful to the advisor, his favorite is Schedule E. "This is the holy grail. It's a gold mine of information, and so complex, many advisors just avoid it altogether."

It lists information on flow-through entities, such as LLCs, partnerships and Subchapter S corporations. "While you're at it, ask for the K-1," says Napolitano. "It has a lot of useful information, such as undistributed earnings and profits. This means there could be dividends to be paid out on a tax-favorable basis. Many clients aren't even aware of this."

Schedule E can lead to a discussion of succession issues and agreements. "Is there a buy-sell agreement between partners? Your clients may have poor or nonexistent valuation clauses." If the client owns business real estate, there may be risk management issues -- there's a good chance the client owns the property individually, so all his assets are subject to creditor claims. "This could lead to disaster, unless the advisor steps in to help fix it."

Of course, no advisor can assemble a financial plan purely by reviewing tax documents. But advisors who take a close look at the returns that new clients or prospects bring to their first meetings will see a wealth of opportunities right away and take an important first step in building a long-lasting relationship. With the investment markets roiling as they have been, you can look like a hero to your clients and win new business by uncovering potential tax savings and planning blunders.

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