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Financial Planning > UHNW Client Services

How to Help Wealthy Clients Avoid Audits as IRS Cracks Down

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What You Need to Know

  • The Internal Revenue Service has announced it plans to hire an additional 3,700 agents to scrutinize high-income taxpayers.
  • Meticulous recordkeeping is key for all clients, but especially for those who might find themselves as the target of these new efforts.
  • Pass-through entities and many alternative investments are likely focal points of this initiative.

The IRS recently announced that it is hiring 3,700 new agents as part of its focus on wealthy taxpayers, partnerships and other high earners. Related to this, the IRS has also announced that it has launched an initiative to focus on tax dodging by pass-through entities that are used by many high-earning taxpayers.

These groups have seen a sharp decline in audit rates over the past decade, according to the IRS, and an increased scrutiny on high earners could affect some of your clients.

While documentation for tax purposes is not necessarily changing, working with your clients to ensure that they have proper paperwork and that they understand the rules surrounding their investments is now a bit more critical.

Here are some thoughts on these new IRS initiatives and the potential impact on your clients.

Documentation Is Key.

As far as investments go, be sure that your client receives and keeps all documentation. This is standard for conventional investments such as stocks, bonds, ETFs and mutual funds held at a custodian like a broker.

Even here, though, this new enforcement initiative means that your clients need to be sure they receive and have access to all records surrounding transactions, gains and losses as well as year-end statements. 

When clients invest in alternatives including real estate and other investments in a pass-through entity or more complex scenarios, documentation can sometimes be lacking.  

“I wouldn’t think most publicly traded investments would be cause for concern,” says Jim Blankenship, owner of Blankenship Financial Planning and publisher of the popular blog Getting Your Financial Ducks in a Row. 

“I would imagine that just about any Schedule C enterprise, Sub-S Corp, limited partnership or rental activity is going to be subjected to additional scrutiny, as these have long been a haven for, let’s say, creative accounting,” he adds.

“This is especially true if there doesn’t seem to be consistent income from the enterprise over time. All of these have lots of opportunity for underreported income that could help justify the expenditures associated with hiring the additional agents,” Blankenship explains.

This points to the need for spotless recordkeeping, accounting and documentation for these types of investments.

Real Estate Investing

Investing in real estate can involve a number of expenses and revenue streams. For example, if clients own a duplex as a rental property, they will receive rental income and incur a range of expenses. These can include repairs and maintenance on the property, as well as depreciation and property taxes.

Depreciation and expenditures for maintenance and upkeep should be documented so they can be proved to the IRS if needed. Ideally, your client would treat property ownership as a business with separate accounts for revenues and expenditures.

If the rental property is owned inside a self-directed IRA, it is even more important that all revenues go into the IRA and all expenses are made from the IRA.

If clients decide to pay for an item to be used in the property or to do repair work themselves, this can result in a prohibited transaction that could trigger a disqualification of the property as part of the IRA and result in an unwanted tax hit.

Pass-Through Entities

Pass-through entities can include C-corps, S-corps, partnerships, LLCs and sole proprietorships. Often these are used by high-earning taxpayers as a conduit to invest in businesses, real estate, private equity, private debt and a host of other alternatives. Or they might just be the form in which their own business is set up.

These businesses pass their tax liability through to the individual owners of the business and onto their personal tax returns. With added IRS scrutiny directed toward pass-throughs, it’s important that these entities have an accurate set of books and that all revenues and expenses are properly documented.

Over the years, pass-throughs have been cited as contributors to a shortfall in tax collections reflected in the new IRS emphasis on higher-income taxpayers.

Cryptocurrencies

Cryptocurrencies have been an area of enforcement emphasis for the IRS, with taxpayers required to indicate if they have transacted in digital assets on their tax return since 2020. It’s important that your clients who trade in cryptocurrencies, nonfungible tokens (NFTs) and other digital assets fully document all aspects of their activity.

Beyond this, there are rules surrounding the use of cryptocurrencies to pay for transactions. Clients may still have a tax liability for capital gains on these assets even though they did not sell them for cash.

As recordkeeping on digital exchanges can vary widely in quality and accuracy, it is incumbent upon clients to keep accurate records to avoid misreporting crypto activity.

Employee Stock Options

Many higher-income clients may receive stock options or other stock-based compensation. In many cases, your client may exercise an option to buy shares and sell them shortly thereafter. While this quick turnaround will often result in little to no gain, the sale must still be reported to the IRS.

Many employees fail to report the exercise price as the cost basis for this sale, so all the IRS sees is a sale and a gain for the full amount of the proceeds. While this is fixable, the IRS might initially look at these sales as short-term capital gains and expect tax payments to match.

It is important to emphasize that your clients keep good records for these transactions and report them properly to the IRS.

Art and Collectibles

Many higher-earning taxpayers own art or other collectibles such as gold coins, sports memorabilia and comic books. For such investors, the long-term capital gains tax rate is a flat 28% rather than varying by income for gains on investments such as stocks and bonds.

This also includes taxes on ETFs that invest in gold, silver and other precious metals. Investors in collectibles can deduct any losses, as well as professional expenses such as restoration costs, fees to auction off their collectibles and appraisal fees.

Those deemed to be collectors as opposed to investors cannot deduct these expenses and will only pay taxes on any gains on selling the artwork or collectible. The difference between an investor and a collector lies with what they do with the art or collectible while they own it.

An investor will typically wait for the collectible to appreciate in value and then sell it. A collector will typically display the piece for their enjoyment.

This area will likely draw scrutiny under the new IRS initiatives. Be sure your clients are aware of the documentation they need to have.  

Conclusion

Higher-earning clients may find themselves the focus of increased IRS enforcement of high-income taxpayers and those who use pass-through entities in their business or investing. There are additional types of investments beyond those discussed above that could invite added IRS attention.

Whether you work with clients directly on their recordkeeping or tax compliance, you will want to discuss these increased IRS enforcement efforts with them. Urge them to work closely with their tax professionals to ensure they have all required documentation of income and expenses to avoid problems with the IRS going forward.

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