Life at its core is really quite simple: We are born, we exist for a time, and we die. It is only in the human mind that life becomes complex. We make life out to be a puzzle to be figured out. Yet, to our consternation, the puzzle is unsolvable; for life, at most untimely occasions, will deviously add new puzzle pieces to the game. Ontology, the philosophy of reality, seeks to know if complexity exists in the real world. The Greek philosopher and skeptic Carneades proposed that no assertion is ever known with certainty and humans live in a universal uncertainty. This prescient state of not knowing is stressful. Do we then create complexity in a futile attempt to relieve our stress?
Leopold Bloom’s now iconic saunter through Dublin on June 16, 1904 was made a heroic Odyssey by James Joyce in his groundbreaking novel Ulysses. In Homer’s Greek epic poem, The Odyssey, Ulysses’ journey is heroic because he achieves his goal of getting home to Ithaca, overcoming magic, monsters and the God’s anger. Does our workaday life require heroic effort to survive the day? Perhaps, but our mental convolutions certainly exacerbate the daily distress making the journey more arduous than it need be.
Eleanor Roosevelt said, “A little simplification would be the first step toward rational living, I think.”
COMPLICATING YOUR TAX LIFE
Many individuals violate the KISS principle (keep it simple stupid) and unnecessarily complicate their tax lives by trying to appear sophisticated or outsmart the IRS or simply without thinking about what it is they are seeking to accomplish and the full consequences of their actions. Some choices that often accomplish little but complicate one’s tax existence are:
1. FOREIGN BANK OR BROKERAGE ACCOUNTS
Foreign accounts are troublesome whether or not one reports the account and income from the account.
a. If you own or have signature authority or a financial interest in an unreported foreign financial account, the posse is on your trail and getting closer. Well seasoned IRS bloodhounds have your scent. If you haven’t already come in from the cold, seek knowledgeable tax counsel and clean up your act. See my earlier articles “Come in from the Cold” and “The Cold Gets Colder,” which may be viewed on my website WWW.STEINERGTAXLAW.COM.
b. If you own foreign accounts that have been reported or if you have made a voluntary disclosure to IRS you undoubtedly have learned that foreign accounts present reporting problems:
i. The foreign bank or broker likely does not give you a Form 1099 leaving it to you to determine required tax information from monthly statements or reports not geared to U.S. tax reporting and often in a different format from statements supplied by U.S. financial institutions. Among the problems encountered:
1. Capital gains. Foreign brokerage statements often refer to the unrealized appreciation in an account as a capital gain. They do not provide realized gains and losses in reports or on statements because most foreign countries do not tax capital gains, as defined under U.S. tax law. In fact, if you ask about capital gains they do not understand what you mean.
2. Currency exchange gains and losses will often be embedded in transaction results but have a potentially different tax treatment than is accorded the net gain or loss from the sale before foreign exchange conversion.
3. Foreign taxes paid may not be readily identifiable on the statements.
4. Qualified dividends will not be identified as they are by U.S. mutual funds requiring your tax preparer, if he or she is attuned to the problem, to research the company, security and sometimes a tax treaty to determine whether the dividends are eligible for the lower tax rate.
5. The statements may be in a language other than English. There may be no precise foreign language equivalent to a U.S. tax term.
6. Mutual fund accounts may be considered by IRS to constitute a Passive Foreign Investment Company requiring additional reporting.
7. Beginning with 2011 returns, U.S. persons with an interest in specified foreign financial assets with an aggregate value greater than $50,000 will have to attach a new disclosure statement to their Form 1040, in addition to filing the Foreign Bank Account Report with the Treasury Department.
2. SMALL INVESTMENTS IN PUBLIC LIMITED PARTNERSHIPS (e.g. $5,000)
You will receive a Schedule K-1 that will make your accountant’s eyes light up, bulge and then circle in the sockets. What diversification is achieved may not be worth the added aggravation, namely:
a. The Schedule K-1 usually will report many distinct items, some being arcane items like Section 1256 contracts or tax straddles, all small amounts, that must be reported in your tax return.
b. You become subject to more complicated and protracted dispute procedures should IRS disagree with the partnership’s tax return.
c. You become subject to possible extended statute of limitations, for example, if the partnership engages in options trading and does not separately report its short and long trades.
d. You may have to file returns in one or more states and pay state income tax on local sourced partnership items.
e. Your tax preparation fee will increase.
3. DAY TRADING IN SECURITIES MARKETS
Day trading by most individuals is a high risk activity. Day trading also complicates tax reporting:
a. You must attach to your return a summary of each trade. Many brokers provide the summary to you. Some like Vanguard and Options Xpress still do not and you will be saddled with a burdensome task or will pay your tax preparer handsomely to summarize the trades for you.
b. What is worse very few are capable of beating the market. Day traders compete for winners against hedge funds, mutual funds and other large financial players that move enormous blocks of stock in seconds through program trading. Rarely, do I see one over time consistently generate profits through day trading.
c. Losses from day trading cannot be recouped by market upswings as will be the case for investors who buy and hold making only strategic balancing changes in portfolios.
d. Net loses from individual stock trading cannot be carried back to recoup gains in earlier tax years.
e. Loses exceeding capital gains can only be used against $3,000 of ordinary income and the balance carried forward indefinitely (but are lost upon death) to offset future gains, if any.
f. Day traders often forget the commission costs attached to their activity, both in terms of the economic and tax basis impact.
I strongly recommend those who engage in the above activities to carefully study the benefits versus the downside of these endeavors. That said, I acknowledge that there are individuals who defy the odds by becoming successful day traders. Those who decide to day trade should either employ a broker who provides the information or develop a system to track gains and losses, long term and short term. For 2011 brokers will have to report for stock sold not only the gross proceeds (Form 1099B) but also the adjusted basis and whether the sale is short term or long term. Mutual funds will have to report such information in 2012.
TOO MANY FINGERS IN THE POT
Having too many investment accounts can both complicate and add expense to your tax filing and inhibit a most effective investment strategy. I will not offer an optimal number of accounts or mutual funds. I will say that most overstate the diversification accomplished by owning many mutual funds and keeping multiple investment accounts. Some like to hedge their bets by having more than one investment advisor. That may or may not be a good hedge, but, if you maintain multiple investment accounts, you absolutely must designate one investment advisor to receive all statements and periodically rebalance your entire portfolio. Otherwise, each account will be rebalanced independently and you may wind up with a portfolio that does not reflect your risk tolerance, risk capacity or take properly into account your position in life’s cycles.
Needlessly complicating your tax life adds to the misperception that you are accomplishing something and often creates tax problems instead of solving them. Our human perception limitations suggest that we ought to try to simplify our lives wherever and however possible. The normal tension that exists between order and chaos is not relieved by adding needless complexity. The balance point called “the edge of chaos” is not a stable position, however. Constant effort is required to keep one’s balance in life. Perhaps, the trick is to focus, as Marie Dressler said, on the “few things (that) are really important.” In tax matters I believe, for most circumstances, Leonardo da Vinci was correct in saying, “simplicity is the ultimate sophistication”.