5 ways to incur a big tax bill (and land you in arbitration)

The bigger the account, the bigger the potential consequences of making a mistake. And of course, the actual award is only a small part of the problem. As evidenced by the Green case, even a mistake with a fairly modest IRA could cause long-lasting, or even irrevocable, damage to a professional reputation.

One also has to wonder in what other situations failure to provide adequate information regarding “adverse tax consequences” could be applied. For instance, all of the following 5 scenarios could result in adverse tax consequences:

• Selling a non-qualified asset and triggering a resulting capital gain.

• Taking a distribution from a non-qualified annuity that results in ordinary income.

• Suggesting a client make salary deferrals to a Roth 401(k) instead of a tax-reducing traditional 401(k) or suggesting an in-plan Roth conversion – both of which are irrevocable elections.

• Failing to suggest a qualified charitable distribution to a 70½+ year-old client who is charitably inclined and making “regular” charitable contributions.

• Not informing a client about the “new” once-per-year rollover rule.

Could we see advisors facing FINRA arbitration or other actions for any of the above? Perhaps. Once Pandora’s Box has been opened there’s no telling where it will lead.

Note that Roth IRA conversions can also create negative tax consequences (although they are often beneficial over the long run). They are not included in the above list, however, because they can generally be undone — recharacterized — even after such tax consequences are discovered by a client’s tax professional.

For instance, if an advisor errantly recommended a Roth IRA conversion in 2016 or failed to adequately explain the “adverse tax consequences” to a client, the resulting tax bill would generally be ascertainable next year, prior to the recharacterization deadline, as the client completed their 2016 tax return. In the event the client was unhappy with the tax consequences of the transaction, there would still be ample time to correct the issue via a recharacterization.

While it’s possible a client could raise the issue after the recharacterization deadline had passed, they’d presumably be in a much weaker position after having seen their tax advisor and not raising the issue at that time. The Greens, on the other hand, raised the issue right away.

Best ways to protect yourself

In the past, advisors have attempted to shield themselves from various liabilities by providing generic disclosures, like “ABC Financial and its Representatives/Advisors do not provide tax or legal advice. For tax and legal advice, please consult with a qualified professional.” The outcome in the Green case shows that such disclosures may play only a very limited role in helping to shield an advisor from potential issues.

There’s probably no single action that advisors can take to completely insulate themselves from potential lawsuits, arbitration or other claims arising from the tax and/or legal matters that are generally outside their primary area of practice. However, there are certainly some steps that can be taken to reduce the chances of such actions becoming reality.

First and foremost, advisors must be armed with up-to-date tax and legal information, and they must be proactive in providing that information to clients. As the Green case illustrates, being passive and passing the proverbial tax and/or legal buck down the road may not be good enough.

While actual tax and/or legal advice should generally still be left to the professionals who practice in those areas, providing information may be the future standard of care to which advisors are held. For example, an advisor might help shield themselves from liability by saying to a client “I think we should sell XYZ stock because I believe it’s going to go down in value, but if we do, you may incur a capital gains tax.” Perhaps that single statement, if well documented, could be enough to protect an advisor.

Another strategy that advisors might consider employing is to work more closely with a client’s tax and legal advisors. If good lines of communication are established, an advisor can simply run a proposed transaction by such advisors to get their blessing or, at the very least, a tacit endorsement that whatever the advisor is proposing won’t have substantially negative consequences.

In truth, this is probably the best line of defense for financial advisors (who don’t also serve as their client’s tax or legal advisor). For starters, if the tax or legal professional does not identify a potential issue with a transaction, one would think that it would be difficult for an arbitrator, or person in a similar position, to hold a financial advisor — a non-tax and non-legal professional — responsible for failing to provide adequate information. Furthermore, establishing a team approach may allow advisors to establish contacts with other professionals, who could become valuable referral sources.

Some final words

A few years from now, it’s possible that the Green case could be little more than a distant memory of the past; an aberration of a single client filing a single claim that was rewarded by a single overzealous arbitrator. On the other hand, it’s also possible that a few years from now, the Green case will be looked upon as the start of a new trend and a tipping point of sorts for advisors, who from then on were held to a higher standard of care with respect to providing adequate tax and legal information.

That, especially in light of the new fiduciary rule, seems the more likely course. Thus, with the Green case in the rearview mirror and the fiduciary rule finally here, there has never been a time where advisor education and knowledge has been at a higher premium.

Read also these articles by Jeffrey Levine:

How the PATH Act changed planning for 2016 and beyond

3 IRA annuity RMD traps you must avoid

Taking RMDs early in the year: the case for and against

After-tax plan funds following IRS Notice 2014-54: basic rules