Filing taxes is more hellish than ever.
It's March. Do you know where your clients' corrected 1099s are?
Since Congress created qualified dividends in 2003, the rate at which brokers have had to revise Internal Revenue Service Form 1099, the tax document they send investors showing interest, dividends, capital gain distributions and other items, has approximately doubled to between 12% and 14%. And in past years, "a significant number" of the corrections were sent to clients in March, according to the Securities Industry and Financial Markets Association, the trade group born of the recent merger between the Bond Market and Securities Industry associations. So it may not be safe, for reasons we shall see, for clients to file their 2006 tax returns just yet.
Frankly, anything but smooth sailing was expected heading into this filing season. The pall was cast as early as last spring with enactment of the Tax Increase Prevention and Reconciliation Act. It added two boxes to Form 1099-INT. This will let the IRS verify that victims of the alternative minimum tax are declaring interest from private-activity municipal bonds like they're supposed to.
But the form change chilled the financial industry's already overburdened systems departments. "Any time there is a major tax-reporting change in the middle of the year, you can anticipate disruption the following filing season," says Patricia McClanahan, a vice president and director of tax policy at SIFMA.
Then the lame-duck Congress enacted tax legislation in late December, after 2006 forms had been sent to the printer. Therefore, to deduct college tuition or educator expenses above-the-line on Form 1040, or sales tax as an itemized deduction on Schedule A, clients filing paper returns must follow special instructions. See http://www.irs.gov/newsroom/article/0,,id=165779,00.html?portlet=2.
But probably the surest sign things were out of control came January 24, when the IRS announced that every taxpayer in America was affected by what a small band of lawmakers who govern a whopping 61 square miles had done. It certainly was commendable of the city government of Washington, D.C., to set aside April 16 as a municipal holiday commemorating the freeing of slaves. But this year Emancipation Day falls on a Monday, which also happens to be the regularly scheduled due date for taxes, because April 15 is a Sunday.
Well, when the nation's capital is off from work so is the IRS, as far as taxpayers need be concerned. By law, the federal deadline for 2006 taxes and IRA contributions, as well as 2007 first-quarter estimated taxes, advances to Tuesday, April 17, for all Americans.
The Advisor's Role
The talk of the town this filing season, though, is 1099s. What will the correction rate be? What's causing the problem? And more to the point, what can advisors do about it? The last question is quickest to answer: Urge clients not to file until late March, at soonest. Gary Butler, the vice president in charge of tax services at Wilmington Trust, illustrates what can happen.
Suppose a client filed in February and has already received her refund. If she finds a corrected 1099 in today's mail that increases her tax bill by a significant amount, the return will have to be amended-a hassle and accounting cost that some coached patience could have precluded. Furthermore, says Butler, after April 17 interest will start accruing on the unpaid tax. Nice little mess. Even if the 1099 change favors the client, she may still need an amended return to get her due.
"It's frustrating for clients who are expecting refunds to have to wait to file," laments Michael Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md. "But we explain that all taxpayers face this, that you really are stuck waiting for corrected 1099s in the current environment," Kitces says.
"Managing client expectations is the best step the advisor can take," adds planner Johnne Syverson, a principal at Syverson Strege & Company in West Des Moines, Iowa. Word on the street is the vast majority of revised documents will be out by the vernal equinox.
Crux Of The 1099 Problem
You might further allay client angst by pointing out the industry is striving to ameliorate the problem. To understand how, it's necessary to recognize how we arrived where we are.
The starting point is a flaw in the tax code. The rules for delivering 1099s are circular. Mutual funds and brokers must send the forms to their investors by January 31, assuming they don't apply for a 30-day extension. Yet in order to accomplish that, they must first obtain 1099 data from the companies whose securities they own or custody-information that likewise doesn't have to be disseminated until January's end.
Think about it. Even in this age of supercomputers, it still takes funds time to aggregate the data provided by their underlying holdings, calculate profit for the year and then categorize it by tax treatment on the 1099, says Ted Jahn, executive director of client reporting in Morgan Stanley's global wealth management division. Brokers similarly must assimilate data from myriad sources.
"The brokerage houses and mutual funds like to have at least three weeks, including weekends, to prepare their 1099s," says Tony Edwards, executive vice president and general counsel of NAREIT, the REIT-industry trade organization. "The amount of data that has to be processed is mind-boggling," he says.
The shared 1099 deadline also means that when players at the front end of the chain are late with data, or have to modify it, the anomaly cascades through the entire system. Take REITs. The asset class has quietly become synonymous with 1099 issues, but consider the challenges REITs face in closing their books, something they must do before distributions' tax status can be determined.
For instance, a REIT that is a minority partner in a joint venture is at the mercy of the controlling partner to furnish year-end results for the project, says Edwards. Sometimes such figures aren't finalized until the March-April timeframe, which effectively prevents the trust from completing its accounting until then. That holds up funds, brokers and ultimately, clients.
The bottom line is that many 1099 issuers do not have the data they need on January 31. This presents a tough business decision: Send out the documents late under an extension, or mail them out on time with estimated figures that might have to be revised?
Better A Late 1099 Than A Corrected One
The soaring correction rate and attendant unhappiness led many brokers (including three of the five largest, as measured by capital) and funds to delay issuing tax documents this year. "A few extra days lets you capture a lot more information," says Jahn. Morgan Stanley is hoping that having waited to mail 1099s until the week of February 5 will halve its correction rate from last year.
But that's a more optimistic tune than most are singing. There is sentiment that the new tax-exempt interest reporting requirements could wreak some havoc. Many believe filing will go smoother in '08-provided Congress doesn't fiddle with the tax code any more-thanks to lessons being learned at this precise moment. But brokers expected the 1099 correction rate to retreat to its historic 5% to 8% range after the first year that qualified dividends had to be accounted for, and it didn't.