Tax Return Warning Signs

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The review of your 2015 tax return can provide valuable insight into the nature of the investment strategies employed by financial advisors. The periodic review of client tax returns can detect financial advisor misconduct. Tax returns will not provide information on investments in tax qualified investment accounts. These tax return warning signs should assist you to determine whether an investment accounts has been mishandled, according to Financial Industry Regulatory Authority (FINRA) rules and regulations. FINRA sales practice violations may represent potential causes of action from any the following tax return warning signs:

Account Losses:

Account losses may indicate mismanagement of a client’s investment account, especially when a client has a limited ability to assume such losses. An investment account’s performance measured in relation to a suitable investment benchmark can determine whether the losses are consistent with the overall market or due to unsuitable investment advice. The suitable investment benchmark is determined based upon an investor’s investment objectives, risk tolerance and investment time horizon.

Short-term Holding Periods:

A review of the holding periods for investments may indicate whether the transactions were for legitimate investment purposes or for the generation of additional commissions for the financial advisor. The following are statistical measures of annualized account costs and turnover thresholds that industry experts believe reflect different levels of evidence for an excessive trading or churning claim.

Cost Ratio Turnover Rate Level of Evidence
4% 2 times Inference
8% 4 times Presumption
11% 6 times Conclusive

Margin Interest Expense:

The amount of margin interest expense relative to the size of an investment account is an indication of a client’s exposure to the risk of margin calls. Margin interest increases the breakeven point for any investment strategy and is included in account costs when evaluating the cost ratios for “churning” or excessive trading claims. According to industry standards confirmed by academic studies, the use of margin to diversify a portfolio does not reduce the overall level of risk, therefore, the use of margin is unsuitable in most situations. Margin interest deductions can be found on Schedules A and E.

Using Account for Checking & Credit Card Activity:

It is not suitable for clients to use checks or credit cards offered through brokerage accounts. Clients can lose track of sustainable spending patterns and brokers tend to over invest funds in non-cash securities resulting in excessive use of margin as a source of credit. The itemization of personal expenses paid for through use of margin should be segregated from total margin balance to determine the deduction portion of margin interest.

Winners Sold Quickly, Losing Positions Held:

In some instances, a financial advisor will sell winning positions to book profits to gain client confidence and refer to gains to maintain client support of the recommended trading strategy. It is also common for inexperienced financial advisors to hold losing stock positions too long following the price down for unacceptable losses. Without a disciplined, professional approach to investing by limiting stock losses with GTC stop loss orders and letting stock winners run, client accounts can become mismanaged. A review of the holding periods for account transaction histories reflected on the Schedule D should provide indication of this potential mishandling of a client’s account.

Securities Concentration:

Concentration of your investments into securities of a single issuer, of a single asset category, or a single type of investment product is considered securities concentration. Maintaining a concentrated stock position is unsuitable for any investor because of the risks associated with this strategy. A financial advisor who fails to recommend diversification or risk management strategies may be held responsible for losses sustained. A review of Schedule D will reveal any substantial capital losses relative to a client’s total net worth.

Mutual Fund Switching and Variable Annuity Switching:

An investment in a mutual fund or variable annuity through sales proceeds from a another mutual fund family or variable annuity insurance company with similar features and investment options is prohibited by securities and insurance regulators, unless there is an economic benefit to the investor. If there is no economic benefit to the investor, it is assumed the reason for the recommendation was solely for the generation of commissions. These types of transactions are considered mutual fund and variable annuity “switch” transactions that are violations of securities and insurance industry conduct rules. An IRA rollover account funded with a variable annuity may be considered an unsuitable investment recommendation because a variable annuity simply adds an additional layer of costs with no additional tax benefits. The surrender charges and greater costs associated with the variable annuity are a function of the compensation paid to a financial advisor.

Personal Retirement Plans Funded with Life Insurance:

Non-qualified retirement plans offered to key employees through businesses that are funded with life insurance products are generally suitable. The recommendation for an individual client to purchase large amounts of life insurance as a “retirement” plan raises serious questions of whether adequate disclosure was provided concerning contract provisions, costs and suitability, according to securities industry standards. Taxable events can apply to policies that lapse after years of withdrawals have been made for the amount that withdrawals exceed the premiums paid.

Financial Advisor Employment History:

Financial Advisors who are inexperienced financial advisors or who have frequently switched brokerage firms are faced with pressure to recommend investment transactions in client accounts to generate commissions. Frequent changes in brokerage firms may indicate disciplinary problems and customer complaints. In the interest of protecting the investing public, FINRA publishes information about every registered financial advisor’s employment background which discloses customer complaints and his current broker dealer affiliation. Go to FINRA broker check to learn about your financial advisor’s employment history and whether there are any customer complaints.

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