3 Costly Tax Mistakes Professionals Make Every Year

Tax season — it's a time that invokes anxiety and distress across the country until April 15th comes and goes. When we advise our clients, we review their tax returns for tax planning opportunities and often find previously made errors that result in incorrect amounts of additional tax due.  These errors range in severity and difficulty to fix, but they can be significant enough to cause sizeable tax ramifications if not addressed quickly and effectively. This article addresses three tax reporting errors that we see most often, how they're brought about, and how they can be addressed.

 

Mistake #1 Getting Taxed Twice for Your Restricted Stock or Stock Options

Many executives receive restricted stock or stock options of their employer’s stock as part of their compensation package. When these shares are granted, or received by the executive, the value of the shares is included in their Form W-2 as taxable compensation. This value then becomes their “basis” in the shares and should reduce the gain when the shares are ultimately sold. The error we see far too often is the use of the incorrect basis when the shares are subsequently sold, which results in an incorrect tax liability from double-taxation of the gain. 

This error is best illustrated through the use of a simple example. 

Example. Under your employer’s compensation plan, in 2015 you were granted the opportunity to purchase 1,000 non-qualified stock options at $10 per share.  The stock was worth $50 per share at the time of grant.  

The difference between the value at the time of grant ($50 x 1,000 shares = $50,000) and what you paid ($10 x 1,000 = $10,000) is called a bargain element. The bargain element of $40,000 is considered taxable compensation to you in the year of grant.  

In 2020, you sell the stock at $95 per share.

To break this down:

Action

Year

# of Shares

Share Price

Total

Shares are granted

2015

1,000

$10

$10,000

Shares are sold

2020

1,000

$95

$95,000

 

In 2015, the year of grant: 

When your employer granted you 1,000 shares of stock valued at $50 in 2015, the bargain element ($40,000) was considered taxable compensation and was included in box 1 of your 2015 Form W-2. When you filed your 2015 tax return, you reported the amount in box 1 of your W-2 on line 7 (salaries and wages) of the return.

In 2020, the year of the sale:

When you sell the shares in 2020, you will receive a Form 1099-B from your brokerage company showing the sale of those 1,000 shares for $95,000. The brokerage company is required to report on the Form 1099-B what you paid for the stock as “cost basis”. You paid $10 per share for 1,000 shares, so your basis is $10,000. Therefore, $10,000 is shown as your cost basis on the Form 1099-B. You report this sale on your 2020 tax return as follows:

Sale ($95,000) - Cost Basis ($10,000) 

This results in $85,000 of income for you in 2020, which is taxable at long-term capital gain rates.

All good, right? You're using the information provided on Form 1099-B for your tax return and it seems pretty straightforward.

However, in doing so, you've actually made a costly mistake — Double-Taxation. You have reported the $40,000 of bargain element into taxable income twice. 

The Tax Impact of Incorrect Cost Basis for Performance Shares 

In our example, the bargain element of $40,000 was included in taxable income in 2015 as taxable compensation on the Form W-2. It was again included in taxable income when the shares were sold as long-term capital gain of $85,000. Assuming that, as an executive, you are taxed at the highest capital gains rate of 20%, plus the additional 3.8% net investment income tax, this will result in an incorrect tax liability on the sale of $20,230. 

The correct method of reporting this grant of 1,000 shares to you is as follows: 

Year

Form of Income

Line or Schedule of Form 1040

Amount of income

2015

Salary

Line 7 of 2015 Form 1040

$40,000

2020

Long-term capital gain

Form 8949

$45,000

 

You may be asking why only $45,000 in capital gains for 2020? You have already paid tax on the grant of the stock in 2015 because your employer included the $40,000 in your Form W-2. Any amount that you’ve already paid tax on should be added to your cost basis. 
Therefore, your total cost basis in the shares is computed as follows:

Amount you paid for shares in 2015 ($10 per share): $10,000

Amount of income taxed in 2015 as compensation: $40,000

Total cost basis: $50,000

So you will only be taxed on the actual gain incurred as follows

Sale of 1,000 shares at $95 in 2020: $95,000

Less:  total cost basis: ($50,000)

Total long-term capital gain: $45,000

Most taxpayers (and sometimes their CPAs) report exactly what is shown on their Forms 1099-B when they prepare their yearly tax returns. However, a little known regulation of the IRS is that brokers (like Fidelity, Edward Jones, UBS, Charles Schwab, etc.) are not allowed to include ordinary income on Forms 1099-B. This is why, in our example, the Form 1099-B reflected only  $10,000 as cost basis. If a taxpayer is not keeping track of which shares are being sold, they will get this wrong every time.

How to Prevent Double-Taxation On Your Performance Shares

selling company stock and reporting cost basis incorrectly can cause double taxation

What is a solution? Many brokers, like Fidelity, provide important details in their Supplemental Information included with the yearly Forms 1099-B. Taxpayers (and their CPAs) need to look beyond the Form 1099-B and into the Supplemental Information for information that will prevent double-taxation.

Fidelity has online resources to walk taxpayers through both Forms 1099-B and the accompanying Supplemental Information. This publication can be found here

Going back to our example, when you sell your 1,000 performance shares in 2020, you will need both the Form 1099-B and the Supplemental Information section included with your Form 1099-B when you prepare your tax return. 

By reporting this sale correctly, you will only recognize into income the $45,000 of capital gain income resulting from the sale of the shares. Assuming you are in the 20% capital gains rate, with the additional 3.8% net investment income tax, this results in a tax of $10,710. This is $9,520 less than the tax liability incurred by the double-taxation from incorrect reporting. 

If you're receiving performance shares as part of your executive compensation, you should consult the Supplemental Information included with your Form 1099-B when preparing your tax return.If you're using a tax preparation software, this information will guide you in entering the data correctly. If you use a CPA, you should provide them with this Supplemental Information section of the Form 1099-B to ensure accuracy in the preparation of your tax return.

How to Address Double Taxation on Previous Tax Returns

If you have made this error on a prior year’s tax return, you can amend the three most recently-filed tax returns by filing a Form 1040-X, Amended U.S. Individual Income Tax Return to get a refund of any taxes you may have overpaid. 

If you choose to amend a return to correct the error, it must be filed within three years of that return's original filing date. For example, if you made a double-taxation error on your 2017 return, you would need to file an amended return no later than April 15, 2021.

 

Mistake #2 Incorrectly Completing or Filing Form 8606

When discussing tax returns with our clients, the most common mistakes we see from corporate executives and small business owners are related to Form 8606.

Form 8606, "Nondeductible IRAs," is filed with your Form 1040 and is used to report:

  1. Nondeductible contributions you make to traditional IRAs
  2. Distributions from traditional, SEP, or SIMPLE IRAs (if you’ve ever made nondeductible contributions to traditional IRAs), 
  3. Roth conversions, and 
  4. Distributions from Roth IRAs. 

The two most common errors we have encountered are: 

Failure to complete Form 8606 and attach to Form 1040 

If you make a nondeductible contribution to a traditional IRA, you should complete Form 8606 to track your basis in the IRA. The basis is composed of amounts that have already been taxed (“after-tax” amounts). Without Form 8606, you don't have the necessary or sufficient documentation to prove your basis in the IRA. This results in double-taxation when you receive distributions from the IRA.

For example: Joanna’s taxable income is too high to receive a deduction for a contribution to an IRA. In 2018, when she was 64 years old and still employed, she contributed $6,500 as a nondeductible contribution to her traditional IRA. Because she receives no deduction for the contribution, the $6,500 is considered after-tax money. She should include this into her “basis” of her IRA. 

Since Joanna will not receive a deduction for the contribution, she forgets to tell her CPA, and her CPA doesn’t ask her whether she made a nondeductible contribution. Therefore, no Form 8606 is filed with her tax return tracking this contribution. 

The IRA earns a total of $500 in 2018 and 2019. In 2020, Joanna distributes the entire balance of $7,000. She receives a Form 1099-R for the distribution of $7,000 with the “Taxable Amount Not Determined” box of Form 1099-R is checked. The CPA reports the entire $7,000 distribution into taxable income.

The problem is that Joanna has already paid income tax in 2018 on the original contribution of $6,500 since it was made with after-tax money. Assuming she has no other traditional IRAs, the only amount that should be taxed is the cumulative earnings of $500.  If she doesn’t correct this error, her mistake can cost her upwards of $2,220 in additional taxes if she is taxed at the highest tax bracket.

To report a nondeductible contribution to your traditional IRA, use lines 1 - 5 of Form 8606. If you use a tax return preparer, make sure you tell your CPA about your non-deductible contribution. 

Failure to Report Backdoor Roth Conversion

Taxpayers whose modified Adjusted Gross Income (AGI) exceeds certain thresholds are prohibited from contributing directly to a Roth IRA. The IRS does permit these taxpayers, however, to make a nondeductible contribution to a traditional IRA and then convert that traditional IRA to a Roth. This is called a Backdoor Roth IRA conversion

If you have performed a Backdoor Roth conversion, you must tell your CPA and provide the Form 1099-R, and the Form 5498 (which details this conversion). Otherwise, your CPA will not know about the conversion. This error in not sharing information results in either 1) no Form 8606, or 2) an incomplete Form 8606. 

The Backdoor Roth requires all sections of the Form 8606 to be completed. Parts I and II of the form report both the nondeductible contribution to the traditional IRA and the conversion to the Roth, computing the taxable portion of the conversion if any. Part III of the form tracks your basis in the Roth IRA.  

If you have incorrectly completed the Form 8606 on previously filed tax returns, you can amend the three most recently-filed tax returns. If you have filed no Forms 8606 for nondeductible contributions, the IRS may accept a filing of Forms 8606 for all years to establish correct basis in your Traditional IRA.   

incorrectly reporting a backdoor roth contribution can result in double taxation

Mistake #3 — failure to report foreign financial assets.

Many executives live overseas as expatriates, either working for US employers or foreign employers. While overseas, they may open bank accounts, investment accounts owning mutual funds and securities, participate in the pension plans of foreign employers, own precious metals, and possibly own rental property. 

Many US taxpayers believe that if the asset is held outside the US, then the income does not need to be reported on the US tax return. However, this is a very costly error. 

Here are two general rules to know:

  1. US citizens report worldwide income and foreign financial assets on their Form 1040 regardless of where they live in the world; 
  2. Non-US citizens report worldwide income and foreign financial assets on their Form 1040 if they reside in the US or within a US territory. 

The IRS began to scrutinize this issue several years ago and has implemented costly penalties for failure to report not only the income from foreign assets, but also information about foreign assets. The penalties are costly, beginning at $10,000 per reporting violation

The Financial Impact of Failing to File Foreign Financial Assets

For example, Joe is a U.S. citizen residing in Belgium working for a foreign employer. He has a bank account, a savings account, and a pension account being held in Belgium. The combined amount of the accounts is $545,000.

Not understanding the U.S. foreign filing requirements, he failed to report these accounts on a yearly FinCEN 114 (FBAR), and Form 8939. His potential penalty is $10,000 per account per year he failed to file. If Joe is found by the IRS to have willfully failed to file, the penalties could be much higher.

foreign bank accounts tax reporting

Handling Delinquent Foreign Filing Requirements

Through the years, the IRS has implemented various amnesty programs to help taxpayers comply with the delinquent foreign filing requirements without becoming bankrupt from IRS penalties. One of the simplest programs is the Delinquent International Information Return Submission Procedures (DIIRSP), and is for taxpayers who:

  • have not filed one or more required international information returns,
  • have reasonable cause for not timely filing the information returns,
  • are not under a civil examination or a criminal investigation by the IRS, and
  • have not already been contacted by the IRS about the delinquent information returns

Taxpayers who qualify for the DIIRSP should speak with a tax professional or tax attorney about the proper procedures for filing the delinquent information returns. At Willis Johnson & Associates, we have a strong network of experts who can guide you in this area. 

3 situations that could double your taxes if handled incorrectly: performance shares, tracking nondeductible contributions, and foreign financial assets

Have questions? Connect with us to get them answered.


 

 

Common Foreign Filing Requirements

If you:

Then file:

Have financial interest or signature authority over foreign financial accounts with aggregate values at any time during the year exceeding $10,000

FinCen 114, Report of Foreign Bank and Financial Accounts. 

Deadline is April 15, with automatic extension to October 15.

Must be filed separately from your tax return with the Department of the Treasury.

Own any of the following:

1.  Financial accounts (bank, investment, etc.) maintained in a foreign financial institution,

2.  Foreign stock and securities not held in a foreign financial institution,

3.  Any interest in a foreign entity (including capital or profits interest, and an equity or debt interest)

4.  Any financial instrument or contract that has an issuer or counterparty that is not a US person,

5.  Any cash value life insurance or annuity contract maintained by an insurance company or foreign financial institution,

6.  A note, bond, debenture, or other form of debt issued by a foreign person,

7.  An interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement with a foreign counterparty,

8.  An option or other derivative instrument entered into with a foreign counterparty or issuer.

 

Form 8938, Statement of Specified Foreign Financial Assets, if you meet the filing threshold levels provided in the instructions to the Form 8938. 

File with your Form 1040.

Own an interest in a Passive Foreign Investment Company (PFIC) —  including foreign mutual funds — and receives direct or indirect distributions or dividends from the PFIC (including a foreign mutual fund) or recognizes a gain or a direct or indirect disposition of the PFIC stock or foreign mutual fund.

You may be required to file Form 8621, Information Return by a Shareholder of a Passive Investment Company or Qualified Electing Fund.

File with your Form 1040.

Need to report information with respect to a Qualified Electing Fund (QEF) or Section 1296 mark-to-market election

You may be required to file Form 8621, Information Return by a Shareholder of a Passive Investment Company or Qualified Electing Fund.

File with your Form 1040.

Are an officer, director, or shareholder in foreign corporation(s)

You may be required to file Form 5471, Information Return of U.S. Persons With Respect To certain Foreign Corporations.

File with your Form 1040.

Own or are beneficiary of a foreign trust

You may be required to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.

File with your Form 1040.

Receive bequests or gifts in a certain amount from a foreign individual, estate, corporation or trust.

You may be required to file Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.

File with your Form 1040.

Own an interest in a foreign partnership. 

You may be required to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.

File with your Form 1040.

 

These tax mistakes are the ones we often see impacting our clients the most. Failing to report foreign assets, double taxation, and failure to include correct documentation are only a few of the many potential tax filing mistakes that can significantly impact your wealth accumulation over time. At Willis Johnson & Associates, we believe that optimizing your taxes is an important piece of your financial plan and is essential to helping you achieve your financial goals. Learn more about the services we offer and our commitment to helping your family make the most of your resources at every stage of life. 

 

 

Willis Johnson & Associates is a registered investment advisor. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Corporate benefits may change at any point in time. Be sure to consult with human resources and review Summary Plan Description(s) before implementing any strategy discussed herein. Willis Johnson & Associates is not a CPA firm.