Using the tax form to prospect for client needs.
As a CPA, I find I have an advantage when meeting
with clients concerning their financial planning needs. This
opportunity lies in the fact that my starting point for client
discussions mainly begins with a reading of Form 1040 to uncover
various planning needs that often go overlooked.
Although most planners would be aware of a lot of information about their clients that a 1040 reveals (whether they are married, have children or participate in a 401(k) plan, for example), a review of the tax form is a good check to ensure that all aspects of their financial concerns are being addressed.
The best approach is to do a line-by-line analysis as follows:
Name and address label section.
A change in address may indicate a change of circumstances. Insurance
questions that can arise from this include whether current homeowners
and umbrella coverage are still relevant for the new address and
whether the client has relocated from, say, a community property state
to a common law one or vice versa. This could trigger an updating of
wills, trusts or other estate planning documents. Investment issues can
be addressed, such as whether the two-year rule ($250,000 for single
taxpayers and $500,000 for married taxpayers) for exclusion of personal
residence gains, or an exception, has been met. Cash flow issues
surrounding the ability to make mortgage payments, or the deductibility
of points or origination fees, should be discussed. Finally, a change
in address also can provide you with a clue as to the wealth of that
individual. For example, a new zip code of 90210 may signify an
increase in wealth or annual income.
Moving to another location can give rise to a significant increase or decrease in expenses. Moving from California to Arizona might free up significant assets, especially if the client downsizes the personal residence. The reverse also is true. Moving to a more affordable location could provide additional money for the client to invest toward their goals.
Filing Status. Marriage indicates that another person will share in the wealth. This could mean that the client must now divide a smaller piece of the pie, or additional funds may be necessary to ensure the same standard of living for each person prior to the marriage.
A widow(er) may have received a life insurance settlement. Determining how that money should be invested is extremely important, especially if it is to make up lost wages of the deceased spouse. Keeping a qualifying widow(er) status (ability to file as "married filing jointly") will help save future tax liability.
Divorce can ruin a person, especially if one spouse had the majority of assets and income. Financial strategies arise, such as what to do with the sale of the personal residence or the vacation house. Other personal assets could become split. If only one spouse has a pension plan, how is it divided? If applicable, a person contemplating divorce should re-establish credit if the other spouse had credit in his or her own name.
A divorce status usually brings tax consequences surrounding future alimony payments, but not for division of property under Code Section 1041 or for child support payments. If there are children, you may not be aware if the parent does not get the dependency deduction. Therefore, ask the client about existing education funding programs or whether one should be set up. Also, ask whether beneficiaries have been changed to reflect the change in status, or whether the estate plan has been modified to reflect this change.
A "married filing separately" status may indicate that one spouse has high amounts of certain itemized deductions, such as medical, miscellaneous or casualty. You also can determine whether the spouses lived together during the year. I have a client who has refused to file "married filing jointly" for the last 18 years (because of an intense distrust for her husband). Here, various planning strategies need to be developed.
Lastly, if single, find out if your client has purchased disability insurance. If not, then who can your client rely on to pay expenses?
Exemptions/List of Dependents. The listing of dependents provides you with names and ages of those individuals your client is responsible for and establishes a basis for estate, insurance and education planning. Exemptions can also identify income-shifting opportunities, such as employing children in business if there is a schedule C, E or F.
With respect to estate planning, are parents or other elderly relatives listed as dependents? Is future long-term care a concern? If so, has your client inquired about long-term care insurance? Has the client spoken with an attorney with respect to living trusts, durable powers of attorney or springing trusts?
With respect to insurance planning, you need to determine whether there is adequate life insurance held on both spouses. Has the client named one or more beneficiaries, other than him- or herself, in order to keep the life insurance proceeds out of the estate? Have the beneficiaries under the current policy been updated to reflect new children born into the family? Do any of the working dependents have disability or health insurance? Does the automobile policy list all drivers over the state's driving age?
With respect to educational planning, was a new child born during the year? If so, should a 529 plan be established? Perhaps the parents may need to reposition their assets by putting funds into growth mutual funds, or other assets whereby the funds would become available when the child is ready to enter college. Or, if funds previously have been transferred to children, does the client understand the consequences of making gifts in trust versus making outright gifts and the impact of the kiddie tax rules? If kids are currently in college, will there be a future reduction in expenditures?
Gross Income. Wages & Self-Employment Income (W-2 & 1099). W-2 wages can tell you if your client is living within means, and whether their income stream is supporting these living expenses. Does the level of income appear sufficient to take into account expenses and/or savings? If not, has a budget been created? Are cash flow problems a concern?
See whether the client is covered through a retirement plan and what employee benefit plans (i.e. flexible spending account, group term life insurance) are being utilized. Determine whether your client is maxing out 401(k) contributions. If not, is your client on track toward funding his retirement?
With respect to insurance needs, is current life insurance appropriate? Is the disability insurance amount adequate for wages earned? Life insurance should cover all your client's objectives (and may equal as much as seven times earnings). Disability insurance covers approximately 60% of income. If your client terminated employment and did not found a suitable replacement, was COBRA elected, thereby extending medical insurance coverage anywhere from 18 to 36 months?
With respect to estate planning, does the amount of income suggest that your client will have a sizable estate? Asking about income patterns may help you back into the size of the gross estate.
Interest and Dividend Income (Schedule B). The types of investments as determined by interest and dividend income can give great insight into your client's risk tolerance level. For example, is your client so risk adverse as to have all funds in CDs? If this is the situation, tell your client about purchasing power risk and interest rate risk that could erode away principal over the long term. If the client has been keeping "all of his eggs in one basket," a proper diversification strategy may be necessary.
Look to see what specific investments generate the dividends. Unnecessary taxable income may indicate a need to rearrange the investment portfolio. Repositioning investments to tax-exempt or tax-deferred, or restructuring toward long-term growth with minimal emphasis on annual income, may be more appropriate.
Reviewing portfolio income could help you determine your client's investment philosophy. Once risk tolerance level and time horizon are identified, will the client's investments be suitable for current and future needs?
Sole Proprietor (Schedule C or F). For 1099 recipients, determine whether schedule C or F is still the most appropriate form of business entity. Explain the differences among sole proprietorships, partnerships, S corporations, C corporations, limited liability companies or limited liability partnerships. Usually, I find that clients are reluctant, or even sometimes too lazy to switch, under the old adage, "If it ain't broke, don't fix it."
Make sure your client has liability insurance (since all assets are subject to risk as a sole proprietor). Determine whether Section 179 deductions for new business equipment have been utilized (which can be as high as $102,000 in 2005), and even whether your client is employing the children. For example, if your client has three children under the age of 18, each child can be paid $9,000, shaving off $27,000 from the bottom line. In fact, each child (whether a dependent or not) can receive a standard deduction equal to earned income plus $250, not to exceed $5,000 per child. Subtracting $5,000 from the $9,000 income will leave $4,000, which can be immediately placed into a traditional IRA, thereby wiping out any tax liability. And children under age 18 are not required to pay any self-employment tax. Even putting that $4,000 in a Roth IRA will result in a tax liability of $400, assuming the child is in the lowest tax bracket.
Does the client have a retirement plan in place, such as a Keogh, SEP or SIMPLE? Is the client properly insured, with errors and omission or malpractice, and property and casualty insurance? Business insurance coverage will show up as a Schedule C business expense? If no insurance coverage deduction is taken on Schedule C, what is your client relying upon for such protection? If your client is a home-based business, will the homeowner or apartment dweller's policy cover business assets when an office-in-home (form 8829) deduction is taken? Is personal liability umbrella coverage appropriate? Are business vehicles used? If sold too soon, will depreciation be recaptured? And finally, does the client have a succession plan in place?
Capital Gain/Loss (Schedule D). In addition to the items listed for schedule B above, if the number of capital gain and loss transactions indicate excessive trading, then the client may need to rethink the investment plan.
Rental and Royalty Income (Schedule E). Is the property held personally or in an LLC? In addition to property and casualty insurance, does your client have an umbrella policy or general business liability policy on the property? If so, do these expenses appear reasonable? Has the return on the investment been sufficient? How has the value on these investments fared over its lifetime? Will decisions made on other forms or schedules increase AGI levels therefore disallowing active participation losses? Does property ownership extend to other states? If so, is it adequately covered in the estate plan? And would a Section 1031 exchange for real estate be appropriate?
Adjustments-"Above the Line Deductions." In determining whether your client should contribute to a retirement plan, you need to determine what the personal cash flow requirements are. If the client has been contributing to a retirement account, are existing retirement assets properly invested to achieve objectives? Do both spouses qualify for traditional or Roth IRA deductions? If the client is divorced, determine what amount would be classified as alimony or child support? If child support is an issue, does the client need to establish an education fund? Would it be advisable to establish a 2503(b) or 2503(c) trust? If paying alimony, when does it end and what will become of the funds when payments end?
Itemized Deductions (Schedule A). If your client does not own a home and perhaps cannot itemize deductions, does it pay to purchase a home? If the client does own a home, is there any need to tap into home equity? Do decisions on other forms and schedules ease deductions limited by a percent of AGI calculations to be lost? Moreover, do such decisions that increase AGI beyond $100,000 result in a loss of itemized deductions? If there is a second home, could your client from converting that to a rental? Were gambling losses taken to the extent of winnings (not subject to the 2% AGI floor)?
Because of the need for the client to exceed the threshold amounts for medical (7.5% of AGI) and miscellaneous (2% of AGI) expenses and stay below the overall base in order to avoid losing part of the full deductible amount, will the bunching of expenses in alternate years better help the client to exceed AGI thresholds in alternate years?
Does the level of interest and debt service represent an acceptable percentage of income? Should the client consider paying off nondeductible/consumer-oriented debt or perhaps consolidating it through a home equity loan? Does it pay to refinance a mortgage now to lower interest rate debt? If so, has a new cash flow analysis been prepared to reflect this change? Does your client have insurance to pay off the mortgage in the event of disability or death? If the client has a new residence, were points correctly deducted? Is investment interest being foregone due to a lack of investment income?
Should your client prepay state and local income taxes and property taxes depending on the AMT consequences? Has your client thought about making gifts of appreciated property rather than selling the property and recognizing the capital gain and then donating the proceeds? Can your client use sophisticated charitable giving strategies, such as charitable lead or charitable remainder trusts?
Overall Increase in Income. If your client's income rose substantially, was an inheritance received? If so, how has the money been invested and was the estate plan changed? You may need to employ asset reallocation strategies to reduce overall tax liability. Consider increasing withholdings to avoid an underpayment penalty.
Overpayment of Taxes. If an overpayment of taxes exists, should amounts paid in withholding or estimated payments be reduced? If it does exist, then why has the client given an interest-free loan to the IRS? Have the client consider changing his or her exemptions.
Overpayments may not necessarily be a bad thing. Sometimes your client may want to receive a big refund check at the end of the year as a forced savings. Sometimes clients can't hold on to extra money received throughout the year, finding it being spent unnecessarily.
What I've shown here is a sampling of the types of information that can be found when analyzing a 1040 from a financial planning perspective. Using this form wisely can be your solid starting point for a discussion resulting in a comprehensive plan that fully uncovers many of your clients' financial needs, which if done properly, can ultimately improve your bottom line.
Jeffrey Rattiner, CPA/PFS, CFP, is founder of JR Financial Group.