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

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In a recent Financial Industry Regulatory Authority (FINRA) arbitration case, an elderly woman and her power-of-attorney holding daughter were awarded more than $50,000 in total payments for what the arbitrator deemed insufficient advice regarding the tax consequences of an IRA distribution. The $50,000-plus in payments was awarded even though the claimants had only suffered an increase in taxes of about $9,000 as a result of the total distribution of a roughly $30,000 IRA CD, and despite the fact that no investment had been purchased from the advisor in question.

Facts of the case

Marilyn Green owned a certificate of deposit (CD) in an IRA that was held with her bank. As Marilyn was already in her 80s and suffering from dementia and depression, her financial affairs were largely tended to by her daughter, Melissa Green, who had been granted power of attorney. Sometime close to the maturity date, Melissa Green discussed her mother’s CD with Samuel Izaguirre, a Registered Representative of LPL Financial. LPL and Izaguirre had entered into an agreement with the bank that issued Marilyn’s CD to provide investment advice and brokerage services to its clientele.

During Melissa’s conversation with Izaguirre, he recommended that Melissa withdraw the roughly $30,000 held in the maturing IRA CD and place the funds in a personal checking account. He did not provide any information with respect to the potential tax consequences of such a transaction.

Following Izaguirre’s advice, in August of 2014 Melissa closed the IRA CD and transferred the funds to her mother’s personal checking account. The following year, when Melissa visited her mother’s tax preparer to complete her 2014 return, she learned that the $30,000 IRA distribution resulted in roughly $9,000 of additional income taxes.

The Greens sought a veritable laundry list of awards and remuneration, including:

 • Compensatory damages of $9,000

 • All cost and expenses associated with the FINRA arbitration

 • All attorneys’ fees incurred in connection with the arbitration proceeding

 • Punitive damages of at least three times compensatory damages

 • Additional amounts to cover the tax bill resulting from any award

In what came as a bit of a surprise to many in the financial services industry, arbitrator Barth Satuloff determined that the Greens were entitled to significant awards. Satuloff determined that the Greens showed an actual and implicit business relationship with Izaguirre and that he held a “position of trust.” He further concluded the relationship of trust was breached when they were not given enough information about the possible tax consequences of his recommendation.

A $52,000 award for a $9,000 tax bill!

Amazingly, the Greens were awarded a grand total of more than $52,000. The $52,000-plus award included $10,260 in compensatory damages, $20,202 in attorneys’ fees and $21,240 in treble damages pursuant to a Florida state law preventing the “exploitation of an elderly person,” words no advisor wants to see anywhere near their name.

What now?

The question that should be on every advisor’s mind now is, “Where do we go from here?” To answer that question, it’s important to understand exactly what happened, or perhaps more appropriately, did not happen in this case.

The advisor in this case was not accused of recommending an investment gone awry. He was not accused of providing the Greens with incorrect tax information or advice. Instead, he was accused of “failing to notify Claimants regarding the adverse consequences” of an IRA distribution.

By all accounts, the advisor does not appear to be a CPA, enrolled agent or other tax professional. So the question becomes, did he really have a responsibility to address the tax consequences of his recommendation with clients? This arbitrator certainly thought so… and he’s not alone.

The final Department of Labor Fiduciary Rule, released in early April, makes significant changes to the advisor landscape when it comes to giving “rollover” advice. Under the rule, advice received by a client in connection with a distribution from their retirement account can be considered advice, subject to a fiduciary standard, separate and apart from any recommendation made with regard to an investment. Thus, advisors will be held to an even higher standard of care with regard to acting in clients’ best interests when it comes to recommending rollovers and distributions from retirement accounts.

Also worth keeping in mind is that while the Greens, themselves, claimed that the advisor’s failure to provide them with adequate tax information led to a $9,000 tax bill, their ultimate award was for more than $52,000. That’s more than the entire IRA CD was worth!

That begs the question, what if the investment in the CD hadn’t been $30,000, but instead, was $300,000? Instead of a $52,000 award, it could have been a $520,000 award. And, what if the mistake had involved a million dollar IRA?

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



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