Uncle Sam — specifically the Internal Revenue Service — wants your clients' money.
The IRS increased its audits of taxpayers earning between $1 million and $5 million by about 45% last year to 18,585, from 12,746 in 2008, according to data released last month. The agency also performed 17% more audits of taxpayers who earned between $5 million and $10 million last year (2,090 versus 1,784) and 9% more among those earning $10 million or more (1,473 versus 1,347).
While the chances of an audit in each income category are still relatively low compared with the number of returns filed — 5% for those earning between $1 million and $5 million, 7.5% for those earning between $5 million and $10 million and under 11% for those earning $10 million and above — the concentration on high earners represents a change in thinking at the IRS.
Until recently, the IRS was “tripping over millionaires to get to grandma's Social Security check,” said Richard Boggs, founder and chief executive of Nationwide Tax Relief, a tax resolution and preparation service.
Last fall, in fact, the IRS created the Global High Wealth Industry Group to examine sophisticated financial, business and investment vehicles for tax avoidance.
Things are only expected to get worse as the federal and state governments look for ways to increase revenue, Mr. Boggs said.
For financial advisers, providing suggestions and recommendations that minimize a client's audit odds are turning into solid ways to attract and retain clients. Some advisers start with investment-related activities.
Clients should not deduct margin-related interest if the proceeds are used for anything other than taxable securities or business expenses, said David Levi, a director with CBIZ MHM LLC, an accounting, financial services and business consulting firm that manages over $1 billion of client assets via CBIZ Financial Solutions Inc.
Margin-related deductions are a common mistake because many investors assume that any margin interest expense can be deducted as an investment expense, he said.
If investors try to deduct it when it's used for personal expenses, the IRS will “start asking for documentation to prove the interest on that margin account is taxable,” said Mr. Levi, who also deals with another common audit trigger among wealthy clients: the use of S corporations.
Unlike C corporations, which pay tax at the corporate level (and whose shareholders also pay taxes on corporate dividends), S corporations are not subject to corporate income taxes. Their shareholders report the flow-through of income and losses on their personal tax returns, and are assessed tax at their individual income tax rates. Money retained within an S corporation isn't subject to Social Security or Medicare taxation.
The S corporation is an attractive structure because it avoids the double taxation of corporate income, but it has the potential for abuse, Mr. Levi said.
A surefire way to attract the attention of the IRS, he said, is for the S corporation's owner-employee to appear to be taking too little salary in exchange for too much profit in an attempt to dodge taxes.
In cases where an adviser has the personal tax expertise to provide S corporation suggestions and other complex tax advice, the knowledge can help strengthen the adviser-client bond. But even when the adviser is neither an accountant nor a tax specialist, there are many other ways to help wealthy clients avoid an audit, the experts said.
For example, an adviser can stress the importance of keeping personal and business expenses separate, said Bryan Hopkins, founder of Hopkins Wealth Management Group, a financial advisory firm with $50 million under management that grew out of Bonnie Hopkins & Bastardi LLP, an accounting and business consulting firm.
Mr. Hopkins tells his clients to keep separate checking and credit card accounts for their personal and business expenses.
“Many times, their internal record keeping causes confusion,” he said, noting that in an audit, there's nothing more important than having proper documentation.
“Even when a story sounds reasonable, if it's not supported by documents, there's a strong likelihood it will be disallowed by the IRS,” Mr. Hopkins said.
Poor documentation is one reason Harry Scheyer believes that the IRS is more likely to go after businesses than individuals.
“Individuals are messy; businesses have records,” said Mr. Scheyer, whose firm, Pinnacle Financial Advisors LLC, manages more than $200 million in assets and provides both investment management and tax planning.
E-mail David Hoffman at [email protected].
