Practice Management—How Not to Give Tax and Legal Advice
Advisors are often caught between a rock and a hard place. They often propose complex transactions involving property transfers and the creation of legal entities. Not surprisingly, clients want to know the likely tax ramifications. That’s the rock. Most Advisors are prohibited by their firms, state laws, or limitations in malpractice insurance from giving tax and legal advice. In addition, advising clients on tax consequences requires expertise and skill. That’s the hard place.
Here are some tips for helping you navigate the narrow passage between this proverbial rock and a hard place.
Not Giving Tax Advice
First, make it clear to the client both verbally and in writing that you are not a tax expert and that he or she must rely on the advice of his or her own tax and legal counsel. Most firms already contain a similar disclaimer in their training and presentation materials, and most clients already have other professional advisers involved. Still, it’s important to delineate boundaries with confidence and clarity.
Having said that, clients expect you to know and be able to articulate the likely tax consequences of proposed transactions, in general. It’s a fine line between describing the likely tax consequences of a proposed transaction and giving tax advice, but the key to walking on the right side of that line is that tax consequences vary depending on individual circumstances.
Understand the Economics of the Underlying Transaction
It should go without saying, but it’s easy to get so caught up in the tax benefits of a family limited partnership (FLP), Grantor Retained Annuity Trust (GRAT), or other transaction that the underlying economics are overlooked.
However, before recommending any tax strategy, make sure you understand who gets what and where the money flows. Draw a picture illustrating the flow of cash, other assets, and services. Ask yourself how each party realizes value from the transaction, and when that value is obtained. If a child needs cash today, a Charitable Lead Trust (CLT) that passes assets to him twenty years down the road may look good on paper, but it fails to make sense economically.
Develop an Appreciation of Tax Risk
Remember that nearly every transaction or strategy designed to save taxes has risk associated with it. One aspect of the risk is controllable, but the more complex the transaction, the more likely an error will be made in drafting, timing, valuation, or execution. For example, a client who wishes to realize the benefits of a “charitable bailout” by donating closely held stock to a charitable trust and having the issuing corporation redeem the stock would be well-advised to utilize an independent trustee and avoid any commitment by the trustee to sell and the corporation to redeem the donated stock prior to the donation. However, even a well-advised client may write a “memo to file” indicating that the plan all along was for the trustee to sell and for the corporation to redeem that can result in an adverse ruling by the IRS or a court.
Another aspect of the risk is uncontrollable. Even if everything is accurately documented and properly executed to follow the path indicated by favorable IRS rulings and case law, there is no guarantee the IRS or the courts won’t change their minds, or say that they meant one thing when the tax professional believed they meant something else.
No one can eliminate the risk that a tax strategy will go wrong. Instead, your job is to accurately gauge the amount of risk in a transaction and adequately communicate the level of risk to a client.
Obviously, this means being forthright. No one wants to be the Advisor of whom a client says, “I was led to believe this was a no-brainer, but now I’ve got the IRS on my back.”
But it also implies the flipside. Just because you assess a transaction to be too risky, don’t assume your client will. Clients are often accustomed to taking risk. They are capable of making judgments about the potential for reward. Just because you wouldn’t engage in a particular transaction doesn’t mean the client won’t love you for bringing it to his or her attention.
Speak the Client’s Language
The Internal Revenue Code is long, tedious, and complicated. It is shored up by countless rulings, regulations, and court cases. To be understood, make sure that you articulate your advice at the appropriate level of sophistication for the audience. Generally, you can use shorthand tax section references when speaking with the client’s tax counsel, but it generally is inadvisable to be a “codehead” with clients.
Saying, “there is a Section 2042 risk” just makes you look arrogant and impedes real communication. Translate ‘‘tax-ese’’ into English. Consider instead, ‘‘If you retain any benefits of ownership of your life insurance policy the death benefit will likely be included in your gross estate and may result in estate taxes.
You can’t manage a client’s wealth and avoid talking about taxes, but it’s important to understand how to talk taxes. Know your boundaries. Understand the underlying economics—most deals won’t work out unless they also address the client’s non-tax objectives. Develop an appreciation of tax risk and realize that the client’s ability to tolerate risk may be greater, or less, than yours. Finally, speak the client’s language.
Practice Management and similar topics are covered in great detail in many of Cannon’s professional development solutions. To find out more visit: www.cannonfinancial.com.
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Disclaimer: The materials and information contained herein are intended for educational purposes, to stimulate thought and discussion so as to provide the reader with useful ideas in the area of wealth management planning. These materials and information do not constitute and should not be considered to be tax, accounting, investment, or legal advice regarding the use of any particular wealth management, estate planning, or other technique, device, or suggestion, nor any of the legal, accounting, tax, or other consequences associated with them.
While the content herein is based upon information believed to be reliable, no representation or warranty is given as to its accuracy or completeness. For this reason, the program of study should not be relied upon as such. Although effort has been made to ensure the accuracy of these materials, you should verify independently all statements made in the materials before applying them to your particular fact pattern with a client. You should also determine independently the legal, investment, accounting, tax, and other consequences of using any particular device, technique, or suggestions, and before using them in your own wealth management planning or with a client or prospect. Information, concepts, and opinions provided herein are subject to change without notice.
The strategies contained within these materials may not be suitable for all clients. For many concepts discussed herein, clients are strongly urged to consult with their own advisors regarding any potential strategy and will need to strategy described herein is suitable for their particular circumstances.
Examples, provided throughout these materials, are for illustrative purposes only, and no representation is being made that a client will or is likely to achieve the results shown. The examples shown are purely fictional and are not based upon any particular client's circumstances.