Tax Knowledge That Can Make You Stand Out as an Advisor

Written by: Luke Shoemaker, CPA, CFP^® | Gray Stripes Advisors

There’s no way to dance around it: the shortage of tax practitioners, namely EAs and CPAs, is real and it isn’t getting any better. The growing trend of RIAs integrating tax compliance and planning is only going to continue as firms look for ways to increase the “stickiness” of their client base.

The reality is that most tax-focused accounting practices are built on high-volume compliance work (i.e. tax preparation). Many small-firm practitioners simply don’t have the capacity or the skillset to be true tax advisors rather than tax preparers.

Enter forward-thinking advisors.

Now look, I realize that most compliance departments have arcane rules about what is “tax planning” vs. “tax advice.” In most cases, I contend that it’s simply a distinction without a real difference. (By the way, did you know that the bar to be a paid tax preparer in the U.S. is incredibly low and does not require being a CPA, EA, or attorney?)

There is currently a significant gap in the tax planning clients need and what they receive. As already mentioned, most tax practitioners at accounting firms don’t do much proactive planning at all. Clients are increasingly counting on RIAs to fill this gap.

Whether or not advisors agree about adding tax prep in-house or giving “tax advice,” the truth is that taxes are often the red-headed stepchild for clients, and they tend to find tremendous value working with an advisor who can speak to a lot of different tax topics that are relevant to them. Showing value as a tax advisor, beyond low-hanging fruit like loss harvesting and Roth conversions, doesn’t require taking an exam or reading the Treasury regulations in-depth (though many CFP® professionals are indeed adding the EA credential to their name).

Understood at a high level, here are a few areas of tax knowledge that can make you stand out even more as a trusted advisor for your clients:

1. Business entity selection

Many startup founders, freelancers, and even established business owners need help deciding which tax status is most ideal for their company. Misinformation on social media around LLCs (a legal status, NOT a tax status) and the echo chamber about how universally great S Corporations are doesn’t help.

Knowing a little bit about the each of main tax classifications – sole proprietorship, partnership, and corporations (both S and C) can separate advisors from their competition. For example, if your client wants the ability to grant profits interests to key employees or attract different classes of investors, an S Corporation would be a poor choice for their entity. Similarly, if keeping compliance costs low is the most important consideration, sole proprietor status (the default for single-member LLCs) may make the most sense.

Understanding at a high level the pros and cons of all tax entity types allows you to provide more expertise for your entrepreneurial clients that most advisors don’t possess.

2. Asset sales vs. stock sales

Business owners reaching the exit planning phase of their journey almost always need assistance understanding the different M&A structures and how the mechanics of their transaction impacts how much after-tax cash they’ll walk away from their business with. Understanding this allows them to be more effective negotiators and get the most beneficial terms.

Most SMB transactions are structured as asset sales, which means that the buyer is technically purchasing what is inside the company (equipment, customer lists, etc.) rather than the company itself. Asset sales are preferred by buyers because they receive a step up in the basis of the purchased assets based upon the allocation agreed to before closing. Additionally, buyers usually want to execute a purchase free of any liabilities of the selling company.

On the flipside, stock sales are generally simpler because they don’t involve the purchase and retitling of individual assets, and the buyer simply “steps into the shoes” of the seller. And, as you can imagine, sellers strongly prefer stock sales due to favorable tax rates on long-term capital gains as opposed to the ordinary rates from depreciation recapture in an asset sale. However, buyers typically don’t go for stock sales due to the lack of stepped-up basis on the assets inside the company and the transfer of liabilities.

Once advisors understand the value of their clients’ companies and the different transaction structures, they are well-positioned to be able to project after-tax cash flow and how that impacts their financial plan after they’ve walked away.

3. State and local taxes

Federal income taxes tend to get all the attention in planning, but ignoring state and local taxes (also known as SALT) can be a massive mistake given that states can have tax rates as high as 13.3% (California). Add onto that the fact that most planning softwares do a poor job of factoring SALT into their modules, and you have a recipe for costly oversight of additional tax bills.

A high-level knowledge of a few important SALT concepts is undoubtedly rare amongst most planners and can make one stand out. For example, understanding how to explain nexus (physical and economic) when clients consider expanding their business into new states helps them understand how their compliance needs will change. Additionally, knowing the rules that are unique to your state, such as nonconformity with certain federal provisions like bonus depreciation, is an often-overlooked area of entity tax planning. Finally, reviewing business tax returns to see if a state passthrough entity election (PTE) makes sense can be a good check on the work of your clients’ tax preparer.

SALT knowledge can apply on an individual basis, as well. If you have a client who works in Ohio, have you ever reviewed their paystub to make sure that the municipal income taxes are being withheld for the correct cities? Or, do you know how the states treat certain income that can allow you to plan more accurately (such as South Carolina’s 44% exclusion of net capital gains)? Becoming familiar with the tax rules applicable in the states your clients are in displays impressive technical knowledge.

4. Loss limitations

When it comes to tracking tax carryforwards, in the financial planning space, usually capital losses are the ones that get attention. And while the availability of capital losses in future tax years is certainly an important planning consideration, many advisors tend to ignore the other types of carryforwards that can be critical for real estate investors or business owners.

If your client owns an interest in an S Corporation or a partnership, understanding how their basis in their ownership interest is calculated can help you perform tax projections in loss years and future years. Basis is the first of four hurdles that generally must be cleared for shareholders or partners to deduct losses immediately. And, calculating it is generally straightforward – basis increases by capital contributions, taxable and tax-exempt income, and decreases by distributions, nondeductible expenses, and deductible losses (in that order, usually). Additionally, partners receive basis for their share of partnership-level debts, which means disallowed losses due to basis are much more common with S Corps.

The other type of loss to understand is passive activity losses. In general, losses generated from an activity in which a taxpayer does not materially participate (such as a limited partnership interest) can only offset income from other passive activities. Notably, the tax code generally considers real estate to be a passive activity regardless of the level of participation (with limited exceptions), which can be a surprise for investors who expect to offset their primary income through depreciation and other rental expenses. Helping clients navigate these rules adds immense value and can help them make more informed decisions.

Like taking the CFP® exam, knowing a little about a lot is often more beneficial than knowing a lot about a little. It’s impossible to be an expert in every Internal Revenue Code section – but your clients don’t expect you to be an expert on everything.

It’s no longer sufficient to tell clients “talk to your CPA” when they approach you with proactive tax questions that impact their financial plan. The shortage of tax practitioners is only going to continue as legacy accounting firm owners exit and traditional tax prep becomes more commoditized. Being able to display high-level tax knowledge across multiple topics separates advisors amongst their peers and undoubtedly creates stickier relationships.

Related: Income Too High To Contribute to Your Roth IRA? Enter the Backdoor Roth IRA