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Tips on Choosing a Tax Advisor Legal Tax Angles: How to Save Taxes Without Going to Jail
Tax Planning Versus Tax Preparation
Where can you get the best help to keep your taxes as low as possible - without getting into trouble with the IRS? And, which of the different kinds of advisors are the most cost effective? There isn’t anyone who will be more motivated than you in keeping your taxes to a minimum. Nor is there any-one else who truly understands your risk tolerance with regard to financial risk and to the risk of an audit or some other kind of confrontation with the dreaded IRS. If you could spend the time and were so inclined, you would be the best possible tax guru for your family. There is an abundance of information sources you can use to get ideas to reduce your taxes. At least half a dozen national magazines such as Money and Worth offer monthly tips on saving taxes. There are dozens of consumer/taxpayer newsletters available. The bookstore or the library will have hundreds of books on how to save taxes. If you have access to the internet, you can find many thousands of free sources of information about various aspects of taxes. All you need to make use of these resources is a little bit of money, a lot of time and some serious motivation. However, there are two problems with doing-it-yourself in addition to the time that’s required. The first is that you need to overcome the language barrier, which can be a formidable task. The second is that you need to have a personal interest in the subject. Frankly, a great many people just don’t want to get bogged down in the morass of the tax laws and the quasi-devious ways of trying to beat the tax collector out of a few bucks. It’s one thing to spend a few hours with a consultant once or twice a year, but it’s something else to make it into a personal crusade or part time job. Few people seem to think about the difference between tax preparation and tax planning, but most people seem to expect a tax preparer to be able to help them “save taxes”. It’s my opinion that preparing a tax return and finding legal ways to pay less taxes are totally different processes. First of all, almost anyone with a calculator can prepare a tax return by following the IRS instructions. I started preparing tax returns before I even finished college or had any tax training. All I had to do was to take the time to read the IRS instructions. With the new computer software that’s available, it’s much easier than it used to be. Preparing a tax return is a lot like cooking. In both cases, you can do it by carefully following the instructions, but it’s a lot faster and less frustrating when you have had a lot of experience. But experience in preparing a tax return isn’t the same as having experience in helping taxpayers to find legal ways to reduce their taxes. Because most people don’t utilize very many legal methods of tax avoidance, most tax preparers don’t get to see many examples of how it’s done. When I’m immersed in preparing a lot of tax returns under the pressure of a tight deadline, I have little time to even think about how my clients might be able to pay less taxes. Instead, I generally recommend a meeting to discuss tax avoidance alternatives in the fall, after most of the tax return deadlines are behind me. (In the past few years, I’ve greatly reduced the number of tax returns that I do so that I can spend more time working as a writer and consultant.) Finding ways to legally avoid taxes involves knowing the law, knowing what has been tried and failed, and knowing the penalties for being too aggressive. While the IRS instructions may tell you how to fill out a tax form, they don’t explain the economic advantages and disadvantages of investing in a low income housing program, transferring income producing assets to children, investing in various kinds of investments other than stocks and bonds, contributing appreciated assets to a charitable annuity trust, electing to take part of your salary as a medical expense reimbursement and dozens of other alternatives. The IRS does not want to make it easy for you to find the financial alternatives that result in the least tax. They prefer that you do the opposite - that you pay the most possible tax. Some people who prepare tax returns may not be interested in helping you to find ways to pay less taxes. There’s a lot less expense, time, stress, work and potential risk from just filling out your tax return according to the IRS instructions. And many tax preparers seem to believe that any deviation from the IRS instructions is going to get them and their clients in trouble. So, if you can’t always rely on a tax preparer to help find legal ways to avoid or reduce your taxes, who can help? The focus of this report is to offer you some candid observations about the different kinds of professional tax advisors you are likely to encounter, including: Contrary to popular belief, not all CPAs are tax experts. In fact, the majority of CPAs work for large firms in which only a few of the partners and other CPAs are considered to be tax specialists. The others spend most of their time doing audits of financial statements, compilations of financial information or reviews of financial information. In the past twenty years, more and more CPAs have become specialists in computer services or business valuations. In the early sixties, when I went to work for one of the “big eight” CPA firms (now one of the “big four”), I was assigned to prepare individual tax returns in my first year on the staff. The second year, I graduated to doing the preparation of small corporate returns. The personal returns were assigned to the newer staff members. My daughter went to work for a different “big eight” firm about twenty five years later and had the same experience. I have no reason to believe it’s any different today. While the returns were reviewed by a member of the tax department, the personal tax returns were reviewed by the least experienced members of the tax department. The CPAs who specialize in taxes for large or medium size firms are likely to be very well qualified, but their greatest expertise involves tax issues of concern to businesses. To a lesser extent, the tax accountants will also be well qualified to assist the owners or executives of their client corporations. Using their services may be a lot like using a heavy gauge shotgun to kill an insect. The small firm or sole practitioner is the most likely to do a significant amount of tax preparation work and to provide tax advice for their business clients. Generally, most of their client companies will be S corporations, partnerships or sole proprietorships. These CPAs do tend to do a lot of tax related work for their client’s as well as for the businesses their clients own. However, not all of them are really interested in tax planning for people who don’t own a business. Before you rely on this kind of CPA to help you with your tax planning, find out if he or she spends most of his or her time on taxes or on other tasks like auditing or computer services. CPAs and lawyers are automatically permitted by the IRS to represent clients in audits or other appeals processes within the IRS. Anyone else either has to have a power of attorney from the client or has to be an “Enrolled Agent”. An “enrolled agent” is a person who has taken an extensive test administered by the IRS to determine that they are qualified to represent taxpayers. Generally, most enrolled agents (EAs) are accountants who didn’t happen to go through the process to become a CPA. (The CPA firms generally hire only a few of the accounting graduates each year.) Some of the non CPAs have a Masters Degree in Tax Law. With few exceptions, taxes will be their main business and it will often be their full time business. By contrast, a lawyer or CPA may not have any meaningful experience with the tax law, but is still presumed to be able to represent a taxpayer in a dispute or appeal within the IRS. For the individual who doesn’t own a fairly large business, an EA may be a much better qualified tax preparer and advisor than a CPA or lawyer. It’s been my experience -- in the past 35 years as a CPA -- that lawyers are either the worst tax advisors or the best. If a lawyer works full time as a tax lawyer, he or she is far more likely to be better informed on tax avoidance methods than a CPA or an Enrolled Agent. However, the lawyer who is a general practitioner and who does whatever legal work may come in the door is someone I would avoid for help with tax planning. Of course, there are exceptions, but you have to work hard to find them. I’ve had to fix more problems caused by lawyers than by other accountants. The best tax lawyers tend to specialize, so it’s very important to find out what their specialty is. Do they focus on estate taxes, partnership taxes, corporate taxes, pension taxes, etc., etc. etc.? Some of them specialize in taxpayer defense services and are best qualified to help you if you have a problem with the IRS. They may not be equipped to help you with finding ways to save taxes. My father was a stockbroker. Previously, he had been a salesman of various products and services. I respect him for never having forgotten that his job was to sell the securities that were being brokered by his firm. He didn’t try to pretend that he was a tax expert or financial planner in order to induce prospects into buying something. For a few years during the tax shelter era, I was a “registered representative” - which is what individual brokers are called. Before I became a broker, I was providing advice to clients about various kinds of tax shelters for a few hundred dollars. After I helped the client to identify a suitable opportunity, the client would proceed to place an order with a stock broker who would then get a hefty commission. In nearly every case, the commission was many times greater than my fee. The grass looked a lot greener on that side of the fence, so I took the tests to become a broker. I had a license to sell virtually any kind of investment but as it turned out, I’m not a very good salesman. While I was trying to evaluate a tax shelter to see if it was suitable for a potential customer, some other stock broker would “slip in the back door” and sell something to my prospect. Basically, I was trying to give potential customers the same kind of treatment I would give to a client. Needless to say, I wasn’t a financial success as a stock broker. After a few years, I decided to go back to being a tax accountant and consultant. In the brokerage business, you can’t make a good living giving objective advice. And, the firm you work for will constantly pressure you for more production. A stock broker is a salesman, pure and simple. The broker may be a really nice person, a very caring person or even a relative, but they can’t make a living until they sell something. (There are a few brokerage firms that pay brokers a salary instead a commission but the firm still expects the broker to help generate buy or sell orders.) I realize this will infuriate a lot of stock brokers who make a living by persuading their prospects that they are tax experts or financial consultants, but everyone is entitled to their own opinion and it’s my opinion that you should not ever expect a stock broker to be an objective tax or financial advisor. They may be able to show you some tax favored investments, but you should get a second opinion from an objective and qualified tax advisor before buying more than a modest amount of what the broker has to offer. There may be one exception out of a hundred, but all but a few successful brokers are highly focused sales-people. They have the “killer instinct” to get the order. Those that lack that trait don’t last very long. Since the great majority of them will use you as a meal ticket whenever they can, I suggest that you reciprocate by using them to track down leads for tax advantaged investments. Just be sure to have enough sales resistance to get an objective opinion before you buy. Put the broker to work for you instead of working for the broker. In addition to spending a few years as a stock broker, I was also licensed to sell most kinds of life and health insurance as well as various kinds of annuities. Despite my having spent 12 years on the inside of a life insurance company as the Chief Accountant, Internal Auditor or V.P./Controller, and in spite of being a Chartered Life Underwriter and Fellow of the Life Management Institute, I was a lousy insurance agent. The problem was basically the same as the problem I had with trying to sell tax shelters. I was pre-occupied with trying to provide objective advice instead of trying to close a sale. An insurance salesperson doesn’t get paid until they sell something to someone. More than any other industry, the life insurance industry consistently comes up with the most creative products to help people to reduce their taxes. At the time I was a licensed agent, the “hot” product was the single premium variable life insurance policy. In fact, it was so hot that the Congress changed the law to take away some of the tax benefits. Annuities still offer generous tax benefits as compared to other investments. Variable life insurance also has a lot of attractive tax benefits. Life insurance can be combined with a charitable trust or gifts of retirement plan assets to a charity in a way to avoid estate taxes. There are numerous uses of life insurance for executives and owners of closely held businesses. Unlike the stock brokers, insurance agents can represent multiple insurance companies and can be a true buyer’s broker. The stock broker can only represent one company at a time. The insurance broker can represent hundreds. I’ve known a lot of successful life insurance agents who work for their clients and who shop the market-place to find the best insurance products for those clients. Some of them also offer some financial planning services but the fact still remains that they don’t get paid until you buy something. And, it will be very hard for them to advise you to buy something that doesn’t offer them a commission. The insurance salesman will seldom advise you to buy some bonds or stocks or other securities unless he or she is also licensed to sell those products. Some wag once said that a financial planner is an insurance agent who also sells securities or a stock broker who also sells life insurance and annuities. As a general rule, it’s very hard for the same person to be successful at selling equities and insurance products. Insurance and annuities are generally low return, low risk investments. The stock broker is mentally tuned in with customers who want higher returns even with the potential for higher risk. But there are a few financial planners who have been able to represent both kinds of products as a spectrum of choices to a client. They represent a special kind of broker/dealer firm that caters to financial planners and that offer an extensive selection of securities. These brokerage firms usually do not serve as the syndicator of new stock issues and therefore don’t exert pressure on their representatives to “move the inventory.” The brokerage firm charges their reps a fee for the services they provide instead of getting their money from selling securities. To a large extent, the financial planning service industry evolved out of the lack of advisors for the middle to high income employees and the two income families that don’t own a business. Business owners generally get most of their advice from their CPAs and their lawyers. The employees were generally being neglected by the CPAs and that gave the upstart financial planners a chance to get their “foot in the door.” After a few years, the CPA industry responded with a specialty service which includes financial planning. A small percentage of financial planners have elected to work entirely on a fee-for-service basis, like CPAs and most lawyers. As a part of their service, they help their clients to locate investment and insurance products with a very low sales commission. (Without the help of a professional, it’s often hard to locate and to evaluate these products.) This group of fee only financial planners are (in my opinion) the best source of objective and well rounded advice about various methods of avoiding taxes. Helping you to reduce your taxes is one of the primary ways in which the fee only planner can show you substantial financial benefits for the fees you are paying. The majority of the fee-for-service financial planners are primarily investment managers. They generally get a fee based on a percent of assets under management. A typical annual fee might be 2% of the first $500,000 of assets under management and 1% of the excess or with an even lower rate for assets in excess of $2 million. Obviously, they have to generate enough savings or extra investment income to justify their fees. If they can also show you how to reduce your taxes each year, that will help to justify the fee you are paying them. When I worked for an insurance company as the Chief Accountant and later as the company Controller, one of my duties included the preparation of the company tax return. The President frequently asked me if I had any ideas on how the company could reduce its taxes. From time to time, I’d come up with an idea and the President would arrange a meeting with the outside tax counsel to discuss it. As it turned out, the tax lawyer was a very conservative advisor and I was often suggesting some fairly aggressive tactics. On many occasions, the President would leave the two of us in the board room to “fight it out” and would return later to see what kind of compromise we had worked out. I would suggest a similar approach in your use of different advisors. The commission compensated stock brokers and insurance agents and some of the financial planners are likely to offer you the most creative and aggressive ideas on how you can reduce your taxes. Your tax lawyer and tax preparer are more likely to be on the conservative side. Instead of being irritated and frustrated by their different points of view, look on the tension between them as a benefit to you. If you can get them to work through to the point of a mutually satisfactory compromise, you are most likely to get the best results.
A number of years ago, a wealthy investor was introduced to a stockbroker who claimed to be able to solve a big tax problem in the form of a large capital gain. The investor didn’t have an accountant or lawyer at the time, so the broker referred him to one of each. It turned out that the lawyer worked for the broker and the accountant wasn’t qualified to evaluate this complex tax shelter being proposed by the broker. I’m convinced the broker recommended an inept accountant who would be willing to go along with whatever the broker suggested. So the investor ended up with advice from a tax accountant, lawyer and broker to proceed with the investment - which later turned out to be a flagrant fraud. To avoid paying $2 million in taxes, the investor risked more than $7 million in cash and debt obligations on the tax shelter. The investor justified his actions on the grounds that he had relied on the advise of three separate professionals and they all urged him to make the investment. The problem is that they were all connected to the broker and were not able to offer independent advice. In addition, the investment was so complicated that none of them really understood the economics of the deal, let alone the tax aspects of it. Not only should you get opinions from different advisors when there’s a lot of money at stake with a tax strategy, you should be sure that all the different advisors were selected by you rather than being recommended by whichever advisor is going to make the big bucks if you do the deal. Sometimes, you will ask a trusted advisor to suggest another professional, but don’t ask for a referral from the advisor who will receive a large commission or fee from what you buy from him or her. Another basic rule that this investor ignored was that he should not have put all of his net worth at risk in one deal. A rule of thumb that I got from a risk management and investment expert is that you should never let any one person or organization have discretionary control over more than 10% of your net worth (or whatever percentage you are willing to lose.). No matter how appealing something seems to be, and no matter how honest the promoters seem to be, the safest course of action is to spread your risk among different investments and different companies. Trying to save taxes is NOT a good reason to depart from this rule.
At first blush, a great many clients presume that they have to pay a commission to someone so they conclude it would be cheaper to get their advice from the person who is getting the commission. Why not make the salesperson “earn” their commission? There are three fallacies with that. First, the best advice may be to not buy the investment at all, in which case there won’t be any commissions to pay. But you aren’t likely to get that advice from the salesperson who is trying to sell it to you. Secondly, there may be other ways to buy the same investment at a much lower cost, without a commission to anyone. Examples include no-load mutual funds and low load life insurance. Third, there may be entirely different ways to accomplish the same goal without buying any investment or product. Most accountants and lawyers charge by the hour. In the Midwest, the fees charged by independent public accountants who are CPAs range from a low of about $75 an hour to as much as $150 an hour (in 1998). The rates for CPAs with large firms are likely to be half again as high. Fees on the East or West coast are likely to be from 50% to 100% higher than in the Midwest - for the same level of skill. Generally, the lawyers will charge more than the accountants and the CPAs will usually charge more than the Enrolled Agents. Financial planners who work on a fee-for-service basis will usually quote you a flat fee for a “financial plan”. Most fee only planners also offer investment management services for an annual percentage of the assets under management. The rates range from ½% on larger accounts to 2% on smaller accounts. The last time I checked, the S.E.C. prohibits investment advisors from charging more than 3% of the assets under management. When you hire consultants to give you some advise, you will get the best advise at the least cost by doing two things. First, define your questions or objectives very precisely. Second, spend most of your time searching for the consultant with the best reputation as a specialist in the subject. As a general rule, a specialist is someone who devotes 50% or more of their time to a particular subject specialty. The major benefit of a specialist is that they will accomplish a specific task much faster than a non-specialist and will usually do a better job for you. A financial planner is more of a financial generalist, but there are some financial planners who focus on taxes rather than on investments. For general tax advise, a CPA who is also a financial planner (on a fee only basis) is likely to be able to give you the best tax advise at the least cost. But the most cost effective way to find ways to legally reduce your taxes is by learning to be your own tax advisor. You can do that by subscribing to a number of the popular financial magazines like Money , Worth, The Individual Investor or various newsletters. You will learn a great deal by reading two or three books about tax planning and by learning to prepare your own tax return. Then, you can use the consultants to help you resolve ambiguous issues or to clarify things that aren’t clear. You can also get a huge amount of free tax advise from various internet discussion groups. If your time is more valuable that the fees charged by tax professionals, then it makes more sense to find an advisor who can help you to locate the tax breaks a lot faster than you can. Actually, if the professional can solve your problem in 1/10 of the time it would take you to do-it-yourself, and if that professional charges $150 an hour, then using the professional would be cost effective as long you are making more than $15 an hour. Vern Jacobs Copyright, 2003 |
Books and Services by Vern Jacobs
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