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Help Your Clients Avoid Paying Taxes They Don’t Really Owe

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While the federal government probably doesn’t collect all lawfully owed tax dollars due to its own inability to fully validate every taxpayer’s claimed write-offs, it also collects a lot of tax revenue to which it’s legally/factually not entitled.

I know what you’re thinking; how does the IRS actually collect and retain tax revenue that isn’t actually owed? The answer is the IRS really doesn’t know it isn’t entitled to these revenues. And it’s costing your clients money! Now that I have your attention, let me elaborate.

In the IRS code (in summarized fashion), it states that the cost basis of an inherited asset takes a step-up in basis to the fair market value (FMV), based on the date of death of the asset’s owner (with, of course, a few exceptions beyond this article’s scope). So what does that mean in the context of the government collecting tax revenues it isn’t owed? Here’s one of many examples that will hopefully help you save your clients’ tax dollars.

Let’s say John and Jane are married and invested money in a joint right of survivorship investment account, held at a major custodian. Sadly, John passes away on November 15, the day the account value is roughly $1 million, with a cost basis of $500,000. With this kind of account, the funds are legally transferred 100% to Jane immediately following John’s death.

After a few months, Jane has all the assets moved to her new, individually owned account at the same custodian. She then quickly decides to sell all the investments while it’s still roughly worth $1 million, so she can invest the money elsewhere. She’ll receive a 1099-Barter Proceeds statement to report the million dollar gross proceeds sale for tax purposes.

Here’s the issue: Because custodians are not legally required to do so, I’ve noticed that in most cases, they don’t adjust the cost basis to reflect John’s date of death step-up to the FMV for the benefit of Jane.

This lack of adjustment results in Jane receiving a tax-reporting statement from the custodian, with the originally owned joint account cost basis of only $500,000, rather than the correct after-death cost basis of $750,000, due to John’s half-owned portion taking a step up in basis to the FMV at his death. (John’s FMV is 50% of $1 million or $500,000 at date of death, plus Jane’s original cost basis of $250,000 = $750,000). 

Therefore, if we quantify the tax actually paid by Jane on the sale – which the IRS isn’t actually owed but was paid using the custodian’s capital gain reporting information – it would be a $500,000 gain x 15% capital gain tax or $75,000 (excluding state taxes).

Yet the correct amount of tax is a $250,000 gain x 15% or $37,500 when the appropriate, adjusted cost basis is correctly overridden on Jane’s tax return.

While the IRS received more money in tax than it’s actually entitled to on the sale, the agency has no way of knowing the overpayment exists, because the law assigns the burden of cost-basis reporting to the actual taxpayer, and not to the custodian, CPA or financial advisor.

Hopefully most advisors don’t view wealth management as just a combination of financial/retirement planning and/or investment management, but also include extensive tax and wealth transfer planning. Perhaps this article offers some insights on how managing the unseen details of clients’ tax situations, can help you preserve more of your clients’ wealth.