Unsophisticated Tax Planning

A wealthy investor overpaid her taxes for years, not from a lack of professional tax planning, but, rather, from deficiencies in financial reporting. We are sticklers for detail and by probing her books we discovered a significant error with its origin in sloppy accounting.

When we think about tax planning, we envision attorneys and CPAs huddled around a conference table devising sophisticated strategies detailed in lengthy memos that reference obscure subsections of the tax code. Valuable as that work may be, tax savings often arise from the detection and correction of errors rooted in careless and incomplete accounting. An accurate set of books is often the best source for effective, albeit accidental, tax planning and compliance.

In April of 2011 we acquired a new client, an independently wealthy investor. Her prior Business Manager had already prepared her 2010 Form 1040. We reviewed the tax return prior to filing. One item immediately stood out: dividends. We found it peculiar that 100% of the dividends—a substantial amount—were classified as non-qualified and therefore taxed at the highest ordinary income rate. We dug around and learned that our client was the beneficiary of an offshore trust generating investment income. The annual tax reporting from the trust was sketchy and, as we soon learned, inaccurate. We browsed through the monthly investment statements issued by the trust and it became clear that a significant percentage of the dividends were, in fact, qualified dividends taxed at a lower long-term capital gains rate. We calculated that 89% of the 2010 dividends were qualified.

After discovering the error we engaged an affiliated CPA firm to re-prepare the 2010 tax returns. Reclassification of the dividends reduced our client’s tax liability by over $37,000. We then found that three previous business managers over a 7-year period had made the same error. We spoke with the Trust administrator out of Bermuda and learned that none of the prior Business Managers had ever called their offices to inquire about the tax reporting. Had they done so, they would have learned that the Trust did not vouch for the accuracy of the Form 1099.

It became clear that we needed to proactively manage the Trust accounting.  We created a Quickbooks file for the offshore account, recorded all of the investment activity in detail and prepared a proper book-to-tax reconciliation. In addition to ascertaining the correct character of the dividend income, we discovered that some of the investment income had been double-counted on two previous tax returns. Amending prior tax returns and correcting the current year filing saved our client over $190,000 in tax.

The lesson to be learned is that tax savings do not always arise from high-level, sophisticated planning. In this case the windfall arose from implementing solid, common-sense accounting.  That 100% of the Trust dividends were classified on Form 1099 as non-qualified should have been a red flag to any accountant. Had the underlying investment statements been reviewed, it would have been obvious that the 1099 was wrong and that a significant portion of the dividends were eligible for the lower tax rate.  Good tax compliance and planning is rooted in good bookkeeping. Sloppy or incomplete accounting only confirms the veracity of that oft-quoted adage—garbage in, garbage out.