5 tax pitfalls for wealthy clients this filing season

February 28, 2023 9:34 PM

The tax filing season is in full swing, and things look different on several fronts this year.

Most Americans will see smaller refunds due to the expiration of pandemic credits and rebates. Many investors face jolting capital gains bills on mutual fund distributions, even as their funds lost money in the horrible stock and bond markets that were 2022.

And after unexpectedly telling millions of Americans in early February to hold off filing a federal return while the tax fate of state credit and rebates was sorted out, the Internal Revenue Service switched course.

High net worth investors typically farm everything out to their financial advisors and accountants, so they're probably not among the nearly 3 in 10 Americans who don't know that returns are due by April 18, according to a LendingTree survey.

Many high earners file for an extension to Oct. 15 as the K-1 form, for partnerships and similar entities that pass their tax bills through to shareholders, doesn't arrive until March 15 at the earliest. The document shows an investor's share of income, losses and dividends from a business.

Amid the introduction of two new forms known as K-2 and K-3 that are the IRS's new method of tracking the international side of a pass-through entities business, some wealthy investors can expect a bumpy paper road.

Separately, higher earners may be more likely to cheat on their taxes, according to research by Finder. The personal finance website found that Americans earning at least six figures are more than twice as likely to massage their federal returns compared to those making under $100,000.

Of those who admitted to lying on their returns, 31% said they had hidden additional income from investments. Given that brokerages send a copy of an investor's annual investing activities to the IRS, the omissions could signal fibbing on real estate and cryptocurrency trades.

Audits of the affluent have been declining for years. In 2021, just 4.5 out of every 1,000 individuals who earned between $200,000 and $1 million — less than half of 1% — were audited, according to Syracuse University's Transactional Access Records Clearing House, a research center. A decade earlier, the odds were around 10.5%.

But that doesn't mean filing-season mistakes don't trip IRS wires.

Scroll through our slideshow to read about five tax pitfalls that affluent Americans commonly face when filing their federal returns.

Charitable donations

Making sizable donations to charities is a tried-and-true way to lower your tax bill. But donations to a registered nonprofit yield a tax boost only if you itemize them, and since 2018, that's been a lot more difficult to do.

The 2017 tax-code overhaul roughly doubled the standard deduction, the set amount that single or married people filing jointly use to reduce their taxable income. For tax returns being filed now for 2022, the standard deduction is $12,950 for single filers and $25,900 for joint filers. The standard deduction is a straight write-off, no strings attached.

If your donation, along with your mortgage interest and insurance premiums, state and local taxes, whose deduction is capped at $10,000, major out-of-pocket medical expenses, gambling losses and other assorted deductions exceed the standard deduction, then you itemize them, which gives you a bigger tax bang for the buck. While smaller donations are no longer a lucrative deduction — to claim a deduction, you have to itemize, which means you're over the standard deduction — larger ones are.

That's where the pitfalls emerge, because the IRS rules are very particular.

"One thing that we've seen recently from our own dealings with the IRS is just how active the IRS continues to be with examining charitable contributions and the deductions surrounding those," said Andrew King, the vice president of tax policy and research at Goldman Sachs Ayco Personal Financial Management. "It's like a grammar school teacher checking for your i's to be dotted, your t's crossed; in a lot of these cases, they're not even getting to the point of checking or pushing back on the valuation itself."

Donors of paintings, antiques or other art objects for which a taxpayer claims a deduction of more than $5,000 must include a so-called qualified appraisal from a qualified appraiser attached to a form known as 8283.

A qualified appraiser is not your history-buff uncle who knows everything there is to know about Civil War memorabilia. Rather, it's a person with a professional appraiser credential who has completed professional or college-level coursework in the discipline and has been in business for at least two years, and who can attest to the fair market value of the item on the date of donation.

The IRS urges donors of artwork worth more than $50,000 to request a "statement of value" from the agency before filing a return that reports the donation. The IRS charges a "user fee" of $7,500 for one to three items, and $400 for each additional item. Mess things up, and you only have 30 days to fix the paperwork.

Last January, the IRS issued a memorandum — not a broad ruling, but rather an interpretation of a particular taxpayer's situation that points the way for other taxpayers — that tightened the rules for donating cryptocurrencies. It said that donations of digital currencies, which the IRS considers property, like stocks or real estate, that are worth more than $5,000 must have a qualified appraisal. But there are no formal professional credentials for cryptocurrency appraisers, and picking through the tangle of forks, airdrops and foreign exchanges on which a coin trades is very difficult.

The picky rules extend to seemingly arcane areas.

Mallon FitzPatrick, managing director and head of wealth planning at Robertson Stephens Wealth Management in New York, recalled a client who was a dual U.S.-Swiss citizen and had a Swiss trust. The client's accountant accidentally overstated by $200,000 the value of a Swiss franc-denominated gift he had made by erroneously using an incorrect currency price. The mistake was resolved, but the client owed $80,000 more in tax than expected.

FitzPatrick cautioned that charitable donations and gifts can quickly get complicated when an investor goes "from making a few hundred thousand dollars a year to millions," by selling a business or cashing in stock options. "The accountants don't necessarily grow with that client."

Go pro

Whether mass affluent, getting there or already rich, the wealthy regularly use professional accountants to prepare and file their often-complicated tax returns. So should millions of other taxpayers.

That's not a message that TurboTax, H&R Block and other DIY services will like. But financial advisors routinely say that for many taxpayers who aren't quite yet well-heeled, filling out your own 1040 through online software can be a minefield of costly errors. And that's before the pain factor comes in.

Regardless of how much they make, people who are self-employed, have recently gotten married or divorced, bought a home, inherited assets, own rental property, have foreign accounts or moved to a different state are more likely to need a pro, Janet Berry-Johnson, a certified professional accountant, wrote recently in The New York Times' Wirecutter.

Rob Burnette, an independent advisor and tax return preparer at Outlook Financial Center in Troy, Ohio, who is registered with the IRS, said that for taxpayers who take the DIY approach and "blindly use software," basic human error is the biggest pitfall.

"I've seen returns where clients have data entry errors like missing a decimal and having $1701 in mortgage interest become $170,100," he said, adding that many DIY taxpayers "don't go back to check their data to see if their answer is 'reasonable.'"

Self-filers are usually "just happy" to hit the send button, Burnette said, but are quickly dismayed when their returns are rejected because they fail to match the tax agency's internal data and matching screens.

He cited one client who has multiple W-2 forms, for wages paid to employees, but for which state and local taxes were entered on only one form, thus causing the client to owe more tax.

"It is up to the taxpayer to identify the fix," he said.

The majority of returns are wrangled by professional tax preparers, according to IRS data. Last year, more than 85 million returns were handled by a pro, but nearly 67 million were done by the taxpayer. Last year, TurboTax's parent Intuit settled a lawsuit brought by all 50 states' attorneys general and the District of Columbia over allegations that it deceptively lured customers into so-called free tax prep services that ended up costing money.

Aaron Klein, the co-founder and CEO of Riskalyze, a financial technology company, said that "The biggest mistake that taxpayers make is thinking they can just figure out the tax situation for their investments on their own."

Do not ignore that annoying tax bill!

Don't be an ostrich. If you owe the IRS money and can't pay the bill, putting your head in the sand and putting off filing your return is a bad move.

First, the agency's "failure to pay" penalty is 0.5% of the unpaid taxes for each month or part of a month that the tax goes unpaid. The penalty can reach up to 25% of your unpaid taxes. The "failure to file" penalty is far harsher: 5% of the unpaid taxes for each month or part of a month that a tax return is late. That one also can reach 25% of your unpaid taxes.

If you're slammed by both fines, the filing penalty is reduced by the amount of the payment penalty for the month, for a combined penalty of 5% for each month or part of a month that your return was late. Topping things off, the IRS charges interest on penalties, including 7% a quarter for underpayment.

You can usually set up a payment plan with the tax agency.

Plan those RMDs

Older Americans are required by law to pull out chunks of their retirement savings each year. Starting this year, savers age 73 must take required minimum distributions from their 401(k)s and traditional IRAs by Dec. 31 each year (the prior age of 72, itself boosted from 70½ late last year). The extra time gives portfolios another year or so to grow in value.

But the withdrawals create a perennial tax puzzle: take out too little, and you get slapped with a penalty. The hit is now far less: 25% of the amount that needed to be withdrawn but wasn't. The prior fine, 50%, was cut in half last year under the law known as SECURE 2.0, for Securing a Strong Retirement Act of 2022.

Take out too much, and you can find yourself pushed into a higher tax bracket. The withdrawals are taxed at ordinary rates.

The change means that wealthy investors, along with their financial advisors and clients, need to rejigger the numbers. Flush savers worried about a tax hit can donate up to $100,000 of their RMD to a qualified charity and avoid taxes on the gift, known as a qualified charitable distribution. But while they avert a tax bill, they don't get a deduction.

Original owners of Roth IRAs, whose contributions are made with dollars which taxes have already paid and whose withdrawals are tax-free, don't have to make annual withdrawals.

But for inherited retirement plans of all stripes, things are now truly complicated.

Under a 2019 law, beneficiaries who aren't spouses, minor children, chronically ill, disabled or not more than 10 years younger than the plan's owner must drain inherited accounts, whether traditional or Roth, within 10 years. Before, heirs could "stretch" out withdrawals over a lifetime. The law hits beneficiaries of inherited plans whose original owner died after 2019. Heirs who have to take out big chunks of money can push themselves into a higher tax bracket, particularly if they're still working and earning good income.

There's one bright spot for heirs filing their tax returns this year for 2022's income. Last December, the IRS said they wouldn't face an onerous 50% penalty for not taking minimum distributions from inherited plans for 2022 and 2021.

Derek Miser, an investment advisor and CEO at Miser Wealth Partners in Knoxville, Tennessee, said that not using the filing season to plan for future required minimum distributions ahead of time "can be detrimental to the ability to smooth their incomes in retirement and cause" a client "to remain in top-tier brackets throughout retirement, as these required distributions grow larger each year as they grow older."

Gift tax returns and foreign account disclosures

A taxpayer could give a child, grandchild, other individual or charity up to $16,000 last year, making as many gifts up to that limit as desired without triggering gift taxes. Those range from 18% to 40% depending on the size of the gift, according to The Balance, with transfers of more than $1 million bearing the top rate.

Gifts under $16,000 last year — for 2023, the limit is $17,000 — don't cut into a taxpayer's lifetime exemption from gift and estate taxes. For individuals filing returns, that amount is just over $12 million (twice that for married couples).

Wealthy individuals, or at least their accountants, likely know all of that. Still, they can overlook a key document, known as Form 709, that they must send to the IRS by the same April 18 federal return date.

"Many high net worth clients don't realize that they may have an obligation to file a gift tax return as well as their income tax return," said Beth Shapiro Kaufman, a partner in law firm Caplin & Drysdale's private client group. "Moreover, once she has an obligation to file, she must report all of her gifts, including those under $16,000 and including her gifts to charitable organizations."

Filing for an extension on an income tax return extends the due date for the gift tax return.

Another tripping point for high net worth clients: disclosing foreign bank and investment accounts. The U.S. taxes its citizens, including dual residents, on their worldwide income regardless of where they live and where it's earned.

Under a requirement dating to the Bank Secrecy Act of 1970, Americans are required to file annually a form known as a Report of Foreign Bank and Financial Accounts, or FBAR, disclosing each foreign account with more than $10,000. The form goes to the Treasury Department's Financial Crimes Enforcement Network, not to the IRS, but it's due the same day federal returns.

Taxpayers with foreign bank accounts won a massive reprieve on Feb. 28 when the Supreme Court ruled that a dual American-Romanian citizen who failed to disclose all of his foreign bank accounts as required by U.S. law would not have to pay more than $2.7 million in penalties levied by the IRS. Instead, he's on the hook for just $50,000.

The high court's ruling said the taxpayer owed a single penalty for all the accounts, not a collection of penalties for each account.

Still, Kaufman said, clients may not realize they still must file the forms, even if they owe no tax on the accounts.