The quick rule of thumb about what the Internal Revenue Service (IRS) is likely to want to look at or to audit, if so inclined, is the current year plus the prior three years. These are called the “open years.” If fraud may be involved, it is the current year plus six prior years. The timing schedule is called the statute of limitations. It is meant to help compliant taxpayers trying to do the right thing from being subject to audit beyond a reasonable period, hence three open years. However, if items are omitted from a filed return, making the return “false, fraudulent or otherwise represents a willful attempt to defeat or evade tax, the statute of limitations doesn’t start running.”[1] These rules apply to taxes due, interest and penalties.
The criminal, rather than merely financial, aspects have a slightly different set of rules. Here the statute of limitations may start to run but “begins to run when the last affirmative act of concealment occurs.”[2] The facts and circumstances applicable here relate to “whether acts of concealment prevented or delayed” the start date of the statute of limitations. On top of this, if the taxpayer and tax preparer include all relevant information but treat it in a way that knowingly violates a rule or regulation, the parties must highlight the departure on the tax return by “red-flagging” it. In other words, let the IRS know dramatically.
How would this even arise? The same way the alternative valuation date for estates arose, from a dramatic shift in asset values in 1929. “The Revenue Act of 1935 introduced the optional valuation date election… and… allowed an estate to be valued, for tax purposes, one year after the decedent’s death. If the value of a decedent’s gross estate dropped significantly after the date of death—a situation faced by estates during the Great Depression of 1929—the executor could choose to value the estate at its reduced value after the date of death. The optional valuation date, later was changed to six months after the decedent’s date of death.”[3] In 2000 after the dot-com bubble burst, taxes due on a partial sale of a bubble stock during the prior tax year may have been more than the entire value of the remaining holding or all of a taxpayer’s other assets in the following year, when the return had to be filed and final payments made.
Benefits of Direct Indexing
As we’ve noted in previous issues of QMP, direct indexing is becoming a very popular pooled investment vehicle. Direct indexing allows a client or advisor to pick which stocks in an index are to be held in the portfolio, individually. The “No. 1 reason investors turn to direct indexing is tax-loss harvesting benefits.”[4] Even though funds are still in a pooled vehicle, the investment manager can choose to take gains or losses to benefit the individual client, not exclusively for performance reasons.
While taking losses is available to portfolios containing only exchange traded funds (ETFs) rather than mostly individual stocks, a portfolio of individual stock holdings could rack up three times the tax-loss harvesting yield of one composed of ETFs over 20 years.[5]
If you or any of your advisors have questions about the issues raised here, please contact your investment manager or one of us.
William H. Darling, CPA – Chairman & CEO
Jeanne M. Fitzgerald, CPA – Tax Manager
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