Considering the tax increases we’ve witnessed during the past six years, it’s no surprise that millions of Americans are very concerned about the direction of tax policy, including your clients.

So why is reviewing your clients’ tax returns important? After all, most clients have a CPA and it’s their job to provide tax advice and prepare tax returns. I’m not suggesting an advisor should replace the CPA, but an advisor who is familiar with this part of the tax code may have a stronger value proposition and appeal to the higher-net-worth client. At the very least, the ability to identify tax benefits or problems may place an advisor in a better position to serve as team coordinator for clients with multiple advisors. Finally, looking at your clients’ tax returns may also yield some opportunities for you to show your specific value while benefiting the client’s tax bottom line.

In this article, the first in a three-part series, we’ll look Under the Hood of IRS Form 1040, examining several types of income and discuss a few relevant issues that apply when advising clients. 

Income Items (lines 7-22) 

Line 8a: Taxable Interest

Does the client have a large amount of taxable interest? Are they in a high tax bracket? If the answer to both questions is yes, consider replacing some of their taxable investments with tax-exempt vehicles. Before doing this you should calculate the client’s tax-equivalent yield to see if a tax-exempt investment is warranted.

Form: 1099-INT or 1099-OID

Note: Schedule B is required if the total amount of interest is above $1,500 or if any of the conditions at the beginning of Schedule B apply.

Line 8b: Tax-Exempt Interest

If the client has tax-exempt interest and the figure on line 8b is substantial, check their alternative minimum tax (AMT) status (Form 1040 – line 45). Why? Because tax-exempt interest from private-activity municipal bonds is a tax preference item for purposes of the AMT. If they are subject to the AMT and this type of interest is a factor, it may be prudent to replace these particular bonds.

Form: 1099-INT or 1099-DIV 

Line 9b: Qualified Dividends

Ordinary dividends are taxed as ordinary income. Qualified dividends are taxed at the client’s capital gains rate which will be 20%, 15% or 0%. For more details on long-term capital gains rates, see Line 13 below.

Form: 1099-DIV 

Line 11: Alimony Received

If a client is receiving alimony, they must provide their Social Security number to the person who is making the payments. Failure to comply may result in a penalty. Alimony offers a potential planning opportunity. To explain, consider the following example. Assume the ex-husband is in a low tax bracket and is paying $12,000 per year in alimony. After receiving an income tax deduction for the alimony payments, his cost after taxes is $10,200. The ex-wife must claim the alimony she receives as income. After paying the tax due, her net amount would be $7,800 per year. (See table below). 

 

In lieu of the regular payments, if the ex-husband purchased an annuity to provide the ex-wife’s income, and the cost of it was less than the NPV of his after-tax payments (i.e., $144,967), and if the annuity paid her more than she currently receives (i.e., greater than $7,800 annually after tax), both parties would benefit.

An alternative to this would be for the ex-husband to give the ex-wife a lump sum that is greater than her after-tax NPV (i.e. $110,857), but less than his NPV amount (i.e. $144,967). Of course, any arrangement such as this would need the approval of the court. If all parties agree, it would reduce the husband’s outlay and increase the amount the ex-wife receives. If it isn’t structured as alimony, the gift tax may come into play. However, this could easily be remedied with the client’s lifetime gift tax exemption. 

Line 12: Business Income

Depending on the business entity, the income included on Form 1040, line 12, is the net business income from Schedule C, Line 31. This could present a number of planning opportunities. Is the client receiving all available deductions? Reducing Schedule C income reduces the client’s gross income, which reduces the amount of federal and state income taxes, plus FICA. However, if the income is too small, it may hinder the client’s ability to obtain a business loan, if this is a consideration.

Line 13: Capital Gains

Does the client have a substantial amount of capital gains? Do they have any capital loss carryforwards? If so, they may be able to use the losses to offset capital gains for the current year. If there are no capital gains, or there are capital loss carryforwards remaining after eliminating all capital gains for the year, up to $3,000 of the carryforward can be used to offset ordinary income. 

The applicable capital gains rate will depend on the type of property sold and the length of time it was held. In general, taxpayers in the top marginal bracket will pay 20%, those in the 25% – 35% bracket will pay 15%, and those in the 10% or 15% marginal bracket will pay 0%. Those with an income above a certain threshold may also be subject to an additional 3.8% Net Investment Income Tax (NIIT).

Form: 1099-DIV 

Line 15: IRA Distributions (and other retirement plans)

Line 15a includes the portion of the IRA distribution that is not subject to income tax. Line 15b is the portion that is taxable. How much is the distribution as a percentage of the total IRA? If the distribution is too high, it could cause the client to exhaust the IRA prematurely. Has a Roth conversion been considered? This may be especially prudent if the taxpayer doesn’t need the income.

Form: 1099-R 

Line 17: Rental Real Estate

If the client has rental property, how many years remain on the depreciation schedule? If they are near the end of it, they may want to consider a 1031 Exchange.

Line 18: Farm Income

In addition to the income derived from operating a farm, there are other types of income that may apply here. For example, if the client had crop damage that was covered by insurance and therefore received payment on a claim, this would be taxable. Also, if the farmer sold more livestock than is usual due to weather-related conditions, they may be able to defer some of the sales proceeds until the following year. There are a number of reasons to include income here plus several tax benefits.

Line 19: Unemployment Compensation

This includes unemployment insurance benefits, railroad unemployment, disability benefits that are paid as a substitute for unemployment compensation, and other income sources. This income may trigger quarterly estimated tax payments. For more information, see Publication 525.

Line 20: Social Security Benefits

Line 20a contains the total amount of Social Security received. Line 20b is the amount that is subject to income tax. The amount that is taxable is determined by the taxpayer’s filing status and modified adjusted gross income (MAGI). For more on this, refer to my May 2014 article in Investment Advisor.

Form: SSA-1099 (Railroad retirement benefits are on Form RRB-1099)

Conclusion

The income tax system is a complex maze of rules and regulations. I suspect that as the tax code becomes more complex, the demand for quality tax planning advice will rise. We have just explored a few of the income items found on IRS Form 1040. As you might imagine, there’s much more to grasp and a myriad of rules to digest. Those who know it well will be able to assist clients in minimizing their income tax liability. 

In the next post in this series, I’ll look at deductions from gross income, focusing on lines 23-27 of the 1040.