The Tax-Form Gateway

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.”