Tax Planning

Experts highlight the tax issues every financial adviser should know

Are your wealthy clients prepared when the IRS comes knocking?

Although the IRS's budget is shrinking, its efforts to audit high-net-worth individuals are increasing

Sep 21, 2017 @ 11:40 am

By Debra Estrem and Spencer Paul

The IRS budget may be shrinking, but its examinations of high-net-worth taxpayers are surprisingly robust. These examinations often yield favorable results for the IRS, and high-net-worth taxpayers may increasingly find themselves and their businesses facing IRS inquiry. However, careful planning and preparation may significantly reduce the impact of an IRS examinations.

CHANGES TO IRS EXAMINATIONS

The IRS is changing. Since 2010, the IRS budget has been cut about 18%, after adjusting for inflation, and it has lost about 14% of its employees. The cuts are expected to continue. Diminishing resources have altered the way IRS examinations are conducted in several ways, including: 1) more electronically-generated examinations, and 2) even in traditionally-generated examinations, more focus on specific, high-yield issues rather than overall tax return review. These issues are more likely to impact the high-wealth individual.

(More: Kiddie tax rules can catch both advisers and investors by surprise)

In addition to increased scrutiny of high-wealth individuals and their related entities, in 2010 the IRS created the Global High Wealth Industry Group within the Large Business and International Division of the IRS. Rather than focus only on an individual's tax return, the GHW Group may also wrap in related businesses, foundations, trusts and even gifts using a large team of specialists. We are seeing a growing expertise in this group as they navigate numerous technical areas in one examination; for example, individual, corporate, partnership, tax exempt and transfer tax.

Moreover, the IRS's Small-Business/Self-Employed Division continues to examine high-net-worth taxpayers, notably many large estate and gift returns. There are also normal correspondence examinations, typically generated by the IRS Service Centers. In 2016, the IRS as a whole examined nearly one-fifth of individual returns with $10 million or more in adjusted gross income.

CONDUCTING RISK ASSESSMENTS

It is helpful for advisers to do periodic risk assessments before an examination begins. These risk assessments can range from a simple discussion with the client about IRS procedures, to a detailed examination readiness assessment that includes document reviews, interviews and assessment of recordkeeping procedures. The goal is to identify material issues that could become a focus on examination, prepare for an examination of these items, confirm that there is a system in place for addressing potential government information requests and consider who will represent the taxpayer before the IRS.

(More: Changing state residency: Tax planning headaches and opportunities)

The following are steps advisers can consider to proactively prepare clients for a risk assessment:

1. Examine publicly available information.

Start by reviewing publicly available information on the client. The IRS routinely searches the internet and other public sources to find taxpayers to audit and to research taxpayers under audit. It is not unusual for an opening meeting to include the sharing of a magazine or newspaper article related to possible tax issues. The IRS may also use online real estate valuation sites and access real property and permit records to determine land use and ownership. Online descriptions can also impact taxpayers, for example when a taxpayer's described job duties or statements do not conform to the positions taken on tax returns.

2. Identify areas most likely to be examined.

The increasing IRS focus on issues, rather than general tax return review, does have a silver lining for taxpayers. It is easier to anticipate what will likely be scrutinized when an IRS examination begins, and this allows advisers to more easily help their clients identify exposure areas. These areas include valuation, management fees between related entities, the hobby-loss rules under IRC 183, the at-risk rules under IRC 465, the material participation rules under IRC 469, basis substantiation, charitable contributions, reasonable compensation and use of private aircraft.

3. Organize documentation for sensitive areas and understand leading practices for contemporaneous recordkeeping.

When reviewing the client's financial structure, pay attention to tax positions that have stringent documentation requirements, as those are particularly fruitful for the IRS. For example, substantiation of charitable contributions and material participation in a business or activity. In particular, the material participation rules require contemporaneous records, like a calendar, documenting hours spent on the activity. Contemporaneous is the key word, as it refers to documentation collected as the activity occurred, not recreated during the examination. More complex taxpayers can establish specific procedures and formats for retaining tax-related documents, as well as intervals for document destruction. Commercially available technology products can be valuable in environments that face multiple audits.

(More: Tax reform could be expensive for middle class)

WHAT'S NEXT?

Critical decisions early in the exam can have a tremendous bearing on the ultimate outcome. Discuss ahead of time who should represent the taxpayer in the examination. It is wise to choose an experienced representative who understands IRS protocol and expectations. A skilled representative can make all the difference.

Debra Estrem is managing director and Spencer Paul is management development program — tax senior at the Tax Controversy Group at Deloitte Tax LLP.

0
Comments

What do you think?

View comments

Recommended for you

Upcoming Event

Mar 13

Conference

WOMEN to WATCH

InvestmentNews is honoring female financial advisers and industry executives who are distinguished leaders at their firms. These women have advanced the business of providing advice through their passion, creativity, inclusive approach and... Learn more

Featured video

INTV

Celebrity adviser David Bach: Here's what every adviser should be talking about with clients right now

New York Times best-selling author David Bach says every financial adviser should be talking to clients about how they are going to weather a market downturn.

Video Spotlight

Help Clients Be Prepared, Not Surprised

Sponsored by Prudential

Recommended Video

Path to growth

Latest news & opinion

RIAs struggle to keep clients grounded amid stock market euphoria

With equities at record levels, financial advisers are confronted with realities of greed and fear.

Regulators showing renewed interest in cracking down on investment fees

SEC, Finra targeting high-fee share classes, 12b-1 fees and failure to give sales load discounts and waivers to investors.

Tax update: Brady says sales tax deduction in final bill

Taxpayers will be able to deduct state income taxes or state sales taxes in addition to property levies — up to a $10,000 cap.

Complexity of new indexed annuities causing concern

Insurers are using 'hybrid' indices as a way to differentiate themselves, but critics contend the products are less transparent, more confusing and don't add financial benefit.

Critics say regulation hasn't curbed overly rosy projections for indexed universal life insurance

They say rule didn't go far enough and more stringent measures may be necessary.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print