THE BERGEN BARRISTER (May-July 1996)
USING TAX RETURNS TO SPOT A CLIENT'S
LEGAL, FINANCIAL AND PERSONAL ISSUES.
by
Martin M. Shenkman, Diane L. Rivers, and Howard Kaplan
To properly advise estate planning, matrimonial, litigation and other clients, it is essential to
have complete and accurate financial information. Unfortunately, few clients fully understand their
personal financial picture. Fortunately, there is a simple solution - the client's tax return. This article
will explain how to use a client’s tax return to identify potential legal, tax and estate problems, as
well as provide some of the data you need to ask your client the right questions.
Clients also frequently have related problems that require the services of other
professionals, such as financial planners, accountants, insurance agents and brokers. Such ancillary
issues can be identified from an analysis of your client's tax return as well. Even if not directly
related to your legal services, identifying these ancillary issues can be vital to properly protecting
your client. These referrals can also help you to build your contacts and lead to additional work.
When doing an intake interview of a client where financial data is important, request that
the client bring a copy of a recent federal income tax return. The following checklist will help you
understand how to review your client's Form 1040 to identify financial information you need or
questions to pursue.
LAWYERS FORM 1040 CHECKLIST
I. FORM 1040 ANALYSIS.
A. Page 1, Filing Status - Married Filing Separate Return.
1. If your client is filing separate returns obtain the other spouse's return for a more
complete picture. Ask why a joint return is not being filed. One possible reason for
filing a separate return is that the couple is separated, or contemplating a divorce. Is
your client being properly advised with respect to his or her impending divorce?
Has/should a prenuptial agreement be done?
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2. Has the client moved from another state? If so, estate planning documents need
revision to conform to New Jersey law, and corporations, LLCs or other business
entities may need to be qualified in New Jersey.
3. Saving tax dollars also may be the motivation for separate returns. This can
occur when one spouse has large amounts of itemized deductions (mostly medical)
and usually lower Adjusted Gross Income (AGI). Are the medical expenses a result
of a personal injury that is actionable? Is there a child with special medical needs for
which a special needs trust or other estate planning steps should be taken.
4. For second or other marriages, consider whether marital or other trust
arrangements should be included in the client's estate planning documents to
maintain the same control the client sought to maintain with separate tax returns.
B. Page 1, Dependents.
1. This identifies the ages of the children. Does the client have trusts for minor
beneficiaries in his or her will? Does the client understand the use of trusts and how
the compressed income tax rates applicable to trusts affect investment decisions for
trust assets? Has the client updated the guardian designations under their wills?
2. If there are young children, has the “Kiddie Tax” been properly planned for? Do
the parents have significant funds in custodial accounts for the children? This is
almost always a mistake since at the age of majority, the child will have complete
and total control over the funds. A trust is almost always a better option. A trust can
permit staggering distributions to children so that they receive assets in increments.
Do the investments for the child make sense in light of the child's age, special needs
(if any) and tax bracket? Review trust investment strategies with clients. Consider
growth stock mutual funds designed to minimize current income tax costs. Is the
trustee competent to serve?
C. Page 1, Line 7: Wages.
1. If wages from an employer are listed, pension, deferred compensation, stock
options, death, life and disability benefits may be provided by the employer and are
useful to know about. If the employer is a large corporation, check with their human
resources department for additional information. Are the beneficiaries of each of
these assets properly designated? For pension assets, the surviving spouse should
generally be designated. A trust under the client's will may be appropriate if the
client does not have other assets sufficient to fund a credit shelter trust. Is there a
valid qualified domestic relations order in effect?
2. Does the client have any equity in the company where he/she is employed?
What is the ownership percentage? Is the compensation reasonable? Is there a buy-
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out agreement and shareholders/partnership/operating agreement in effect? Has
succession planning been addressed? Are any family members interested in, and
capable of continuing when the parent leaves? Is insurance coverage sufficient to
address liquidity issues?
3. With salary information available, consider the adequacy of disability insurance.
Is the waiting period reasonable? Is the overall coverage sufficient?
D. Page 1, Line 8, Interest Income.
1. See Form 1040 Schedule B for details of interest income. Total interest can
indicate the amount of liquid assets the client has. Inquire if your client has any taxexempt interest. It will give you an idea of your client's municipal bond holdings.
2. If your client has an excessive number of accounts, administration of his or her
assets in the event of death or disability will be expensive and time-consuming.
Consolidation into a limited number of accounts is often advisable.
3. Has your client reasonably diversified his or her assets? Most clients have not.
An over-reliance on tax-free bonds, or low yielding CDs is common. Does your
client have an investment strategy? Is it appropriate for the client's overall goals,
status, net worth, etc.?
E. Page 1, Line 9, Dividend Income.
1. See Form 1040 Schedule B for details. Large amounts of dividend income may
indicate substantial equity holdings. In such a case, it’s important to determine
values for these holdings. Determine whether any of the dividends received are from
closely held businesses. If so, this raises a few planning issues:
a) Does the business qualify for the estate tax deferral provisions that
permit the payment of estate tax over approximately 14 years? This can
dramatically affect insurance needs.
b) Are there any buy-out and/or shareholders' agreements?
c) Are dividend distributions adequate? Reasonable?
d) Are your client’s corporate records complete?
F. Page 1, Alimony Received.
1. Verify that your client has consulted with their estate planning advisor to revise
their estate planning documents since the divorce, and taken steps to cancel any
outstanding credit cards, durable powers of attorney, or other financial rights that
may have been given to the ex-spouse.
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G. Page 1, Line 12, Business Income.
1. Business income reported here indicates a sole proprietorship. This could be the
client's main source of support, or a side venture. See Form 1040 Schedule C for
details of the business. All of the issues mentioned above about business ownership
apply here, in addition to issues regarding the unlimited liability of the individual for
the business' actions. Consider incorporating your client’s business, or using a
limited liability company. Many clients underestimate the liability exposure of a
home based or other start up business.
2. Does the client use any basic legal documents in the business? Invoices,
purchase orders, receipts, etc. Have they been reviewed by counsel? Often clients
purchase stock forms form an office supply store, or make up their own forms,
without realizing the legal consequences of their actions.
3. A KEOGH or other retirement plan may be appropriate.
4. If it is a home based business, ascertain whether the client has the necessary
business insurance or acceptable riders to his or her personal and homeowners
insurance. Many home based businesses operate without insurance, on the erroneous
assumption that their personal and homeowners insurance will cover their modest
business venture. Often it will not.
5. Has a home office deduction been properly taken? This is a very tricky area, one
you should probably encourage your client to discuss with his or her accountant.
H. Page 1, Line 13, Capital Gain or Loss.
1. See Form 1040 Schedule D. All purchases and sales of securities, bonds and
other capital assets (i.e. real estate) are reported here. Many clients get sloppy about
the carryover of unused capital losses in excess of $3,000 per year. Did the client's
broker churn the client's account? Is the client a “trader”, “gambler” or “buy and
hold” type? The level of activity can help you begin to "peg" your client's
investment philosophy, risk tolerance and determine if there have been any improper
dealings.
2. Any sales of business or investment properties that alert you to legal issues?
I. Page 1, Line 16, IRA Distributions.
1. Is your client properly tracking IRA deductible and nondeductible contributions
so that you can identify taxable and non-taxable distributions?
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2. Individuals over 59 1/2 are eligible to receive their IRA distributions without
penalty, therefore a 60 year old client may be withdrawing funds from his IRA. You
need to determine how much the total IRA value is, how much the client plans to
withdraw annually and the type of assets the IRA is invested in. This will affect how
long your client can rely on this account and can help determine if the investment
strategy is appropriate. It will also allow you to determine if there is any liability for
the excess accumulation tax.
3. For many employees, large pension plans, or rollover IRA plans, etc. can
complicate estate planning. These assets typically name the surviving spouse as
beneficiary to permit the surviving spouse to rollover the proceeds tax deferred into
an IRA of the surviving spouse. If that is the case, these assets cannot be used to
fund a credit shelter trust. To fund a credit shelter trust with plan assets, special
steps must be taken.
J. Page 1. Line 17, Pensions.
1. Amounts listed on line 17a that are not on line 17b (and hence currently not
taxable) usually indicate that a distribution from a pension plan was received and
rolled over into an IRA account. It can also indicate that the client contributed his or
her own money to the plan and is now receiving that portion of the payments taxfree.
2. Ask about the terms of the plan and obtain adequate documentation for your file.
3. If the client is a principal of the employer sponsoring the plan, inquire as to
whether the appropriate minutes and other corporate actions have been taken.
K. Page 1, Line 18, Rents, Royalties, Partnerships, etc.
1. Income or losses from all real estate rental properties, partnerships, passive
activities and "S" corporations, and LLCs are reported here. See Form 1040
Schedule E for details.
2. The structure of your client's entities may have to be rethought. Where funds are
needed for corporate investment (e.g., businesses in a growth phase), it may be
cheaper to have the entity pay a 35% corporate tax, rather than distribute the monies
to the owner-employees as compensation if it will be taxed at the 39.6% maximum
rate. Furthermore, since the health care portion of the Social Security tax of 1.45%
tax is assessed on all wages, both the corporation and the owner-employee will bear
this tax. As a result, the total cost is really 2.9%. Thus, for highly compensated
owner-employees, the incremental tax cost of paying out additional compensation to
an owner-employee will be 42.5% [39.6% + 2.9%].
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3. As noted in above items most clients underestimate the risk of various business
and investment activities. It may be prudent to set up additional entities to insulate
assets, e.g., separate corporations or LLCs for different real estate properties.
L. Page 1, Line 22, Other Income.
Investigate the source of any material amounts on this line and determine their
continued applicability. Do these items raise any legal issues?
M. Page 1, Line 24, IRA Deduction.
A deduction may indicate that the client is not actively participating in an employer
sponsored pension or retirement plan. Confirm beneficiary information, investment
selections, etc. and be certain that they are appropriate.
N. Page 1, Line 27, Keogh or SEP Retirement Plan Deduction.
1. Has the client maximized contributions?
2. Consideration should also be alternative arrangements such as insurance
programs and tax deferred annuities, if appropriate.
O. Page 2, Line 33, Blind/Over 65.
Where a client is over 65 or blind, the use of a living trust for the management of
assets may be warranted. A durable power of attorney and a living will/health care
proxy should absolutely be in place. Have special medical needs been insured or
otherwise addressed?
P. Page 2, line 41, Credit for Child and Dependent Care Expenses.
This can indicate that the client is caring for young children, a disabled spouse or
aging parent. Future needs of these individuals, durable powers, guardianship, etc.
must be considered. Where a parent is being cared for, what are the legal and
financial arrangements? Does your client anticipate a significant inheritance? Does
your client have a significant financial burden for the parent?
Q. Page 2, Line 43, Foreign Tax Credit.
1. This is a credit for taxes paid to a foreign government and could indicate foreign
investments for which information should be obtained. When your client owns
foreign real estate or has a foreign business interest, the legal, economic and other
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considerations of foreign assets should be addressed. Treaties can significantly
affect the tax and legal implications of a foreign investment and you should consider
referring the client to specialized advisers if the amounts involved are sufficient.
2. If no figure is reported, verify whether the client has ignored the international
component of his or her investment planning and legal responsibilities.
II. Form 1040, Schedule A, Itemized Deductions.
For matrimonial and other cases where reconstruction of income is necessary, this Schedule
can be a gold mine. When you combine the information from Schedule A and data from other
sources depending on the engagement (e.g., from a case information sheet in a divorce case where
monthly expenses are listed) you can often make a fairly quick estimate of expenditures and
identify problems. For example, you can add up all expenses on Schedule A and the case
information sheet, eliminate duplications, annualized and estimate the client’s annual expenditures.
Where these are less than what the client reflects as revenues, you know you have a problem (or
winner, depending on your perspective).
A. Line 1, Medical and Dental Expenses.
1. If large amounts are listed on the tax return, it could indicate inadequate health
insurance, since only non-reimbursed amounts are deductible. It could also give
notice of large recurring charges for a family member's illness, such as for a nursing
home. That could be a serious cash drain. Medicaid type planning might be
appropriate. For a child, it may be advisable to establish a special needs trust.
2. Is the client paying for medical care of a parent or child? Careful attention must
be paid to planning for special financial strains. Do the client's estate planning
documents contain provisions for the parent's care (e.g., trust for the parents, or
including the parents as beneficiaries under a credit shelter trust, etc.)? If your client
predeceases, who will care for the parent? Who is handling the parent's planning?
3. Is there a living will/health care proxy in place in the case of disability?
B. Line 6, Real Estate Taxes.
1. Are these taxes only for one residence in the state of residence, or does your
client have a winter/vacation home in another state? If there is real property outside
the state of New Jersey, explain the costs and consequences of ancillary probate
proceedings. The gift tax laws of the other states must be considered before a plan of
action is taken (e.g., New York unified credit is far lower than the federal
$600,000). A trust, partnership or other entity to hold title to the real estate can
eliminate ancillary probate. Is there adequate casualty insurance for the properties
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owned?
2. If the client purchased a house with delinquent property taxes and paid the taxes
they may not be deductible. If the transaction is not closed, try to restructure so that
the seller pays so that the deduction is not lost. Parents sometimes try to help their
children by paying the child’s property taxes. If the parent doesn’t own an interest in
the house, it is not deductible by the parent.
C. Line 9, Home Mortgage Interest.
1. What is the market value of the house? What is the remaining balance on the
mortgage? In whose name is the house(s) titled? What about liability issues?
2. Was there any financing by family members? Many intra-family loans are not
documented or recorded. Explain the tax and legal consequences and try to correct
the situation. If the client has established a qualified personal residence trust
(“QPRT”) and is paying a mortgage, have you addressed the tax implications of
mortgage principal amortization?
D. Line 13, Gifts to Charity.
1. Large donations may indicate the client is charitably inclined. Charitable
planning, such as a charitable remainder trust or a private foundation, may be
appropriate.
E. Line 18, Moving Expenses.
A deduction for moving expenses might indicate a new home in a new state, while
some assets may remain in the old state. Issues of ancillary probate should be
addressed. Has the client begun a systematic plan to readjust municipal bond
investments to reflect the new state? Triple tax-exempt New York City municipal
bonds will not have the same effect for a New Yorker transplanted to New Jersey.
III. Schedule B, Interest and Dividends.
A. Part I, Interest Income.
Large amounts of interest income from one institution may indicate that the
principal is in excess of $100,000, the amount guaranteed by the FDIC. Changes
may be appropriate. Some returns specify which spouse earned the interest or if it
was jointly earned. This can help to determine allocation of assets between spouses,
which is essential to determining whether each spouse can fund a credit shelter trust.
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B. Part II, Dividend Income.
1. All dividends received are listed here, regardless of type. This can give you an
idea of the client's equity and mutual fund holdings. Investment strategies, or the
lack thereof, may become apparent. If the client has a closely held business, inquire
as to any holdings.
2. Dividends from closely held business interests raises numerous issues addressed
above.
3. As mentioned above, in some instances, which spouse earned the dividends is
listed here. This could be important in determining the allocation of assets between
spouses, which is basic to maximize the use of the unified credit in the estate of
each spouse.
C. Part III, Interest in a Foreign Account.
1. If this box is checked "yes", it should raise several questions. What type of
account does the client have, in what country, what is the dollar value, and is there
other property in this country? Is a will or other documentation in that country
necessary? Consider relevant tax treaties.
2. Is the client or their spouse a U.S. citizen? Consider the need for a QDOT, a
qualified domestic trust, which is essential for a bequest to a non-citizen spouse to
qualify for the estate tax marital deduction. These same questions should be asked if
your client is the grantor or transferor to a foreign trust. Obtain a copy of the foreign
trust.
IV. Form 1040, Schedule C, Profit or Loss From Business.
A. Line B, Business Code.
This indicates the client's type of business and affects the kind of planning. For
example, succession planning is more difficult in a personal services business in
which the client is selling his or her expertise. Liability risks, cash needs and other
planning issues can vary dramatically depending on the nature of the business.
B. Line E, Address.
The business address may be in a different state than the client's domicile. The laws
of both states must be taken into account in the estate planning process. Ancillary
probate issues should be addressed.
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C. Part II, Line 10, Car and Truck Expenses.
Insurance coverage must be reviewed to verify that there is sufficient coverage, and
that the correct parties are named. Frequently, insurance policies list business
automobiles as personal automobiles. Sole proprietors are personally liable. Where
significant driving or delivery services are rendered, consider using an entity that
can provide liability protection. Do employees use the car or truck? Does insurance
cover them?
D. Part II, Line 13, Depreciation.
See Form 4562. When a business owns significant assets, consider putting those
assets in trust for the children. This can insulate the value of the assets from
business creditors. It may also permit income tax benefits. For example, the parent
can claim a deduction at a high marginal tax bracket and children over 14 can report
income at a lower bracket. Consider implications to cash flow analysis for budget
purposes.
E. Part II, Line 16a, Mortgage Interest.
This indicates real property owned by the business. Inquire as to the client’s
ownership structure. Is there sufficient amount of insurance? If the real estate is
owned by the business, it may be advantageous from the perspective of liability
protection to split the real estate into an LLC, separate from the business.
F. Part II, Line 26, Wages.
The absence of wages may indicate the improper characterization of employees as
independent contractors. If there are wages, is there adequate insurance coverage?
Your client is responsible for employees' actions. Are there consulting agreements?
V. Form 1040, Schedule D.
1. A large amount of transactions may indicate that the client is an active investor.
If the client has stocks that have been held for many years with large unrealized
gains, consider the step-up upon death (and the increase in taxable estate) instead of
gifting the stocks to the client's children (carryover basis and limited by the $10,000
annual donee exclusion).
2. A client with large unrealized gains and large capital loss carryovers should
consider selling the appreciated stocks to use the carryovers. The carryovers are not
transferable to an estate.
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VI. Form 1040, Schedule E.
A. Part I, Rental Properties.
If the properties are in a different state, this must be considered in the estate plan, in
particular to avoid ancillary probate. Another factor to consider is in whose name
the property is titled, even though it may not be listed on the return, in order to
maximize use of the unified credits. Consider restructuring ownership to take
advantage of the liberalization of the passive loss rules.
B. Part II, Income from Partnerships and S Corporations.
1. For S Corporations, what amount of ownership is involved? What is the
amount of participation and time spent for this business? Is the client drawing a
salary and are family members also on the payroll? Do trusts formed under the will
and any trusts include the necessary QSST -- qualified Subchapter S Trust
language? If not, the tax consequences could be disastrous. Will an LLC provide a
better organizational structure? For all entities, address whether the proper
formalities have been adhered to. Can interests be given by way of gift to younger
family members?
2. For partnerships, unlimited liability concerns should be addressed. Limited
partnerships raise liquidity questions. Will there be additional capital calls and, if so,
when and how much?
C. Part III, Income from Estates and Trusts.
The trust provisions must be obtained as well as the terms of any estate. Generally,
detailed back-up schedules listing the names of these entities, their tax identification
numbers and addresses are attached. If not, call the client for a copy of Form K-1.
This lists income or loss from the entity, the client's ownership percentage and other
information referred to above.
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