General Tax Audit Procedures and Documentation

Assessment Process

1. When does the audit process begin? The audit process commences with the issuance of a Letter of Authority to a taxpayer who has been selected for audit.

2. What is a Letter of Authority? The Letter of Authority is an official document that empowers a Revenue Officer to examine and scrutinize a Taxpayer’s books of accounts and other accounting records, in order to determine the Taxpayer’s correct internal revenue tax liabilities.

3. Who issues the Letter of Authority? Letter of Authority, for audit/investigation of taxpayers under the jurisdiction of National Office, shall be issued and approved by the Commissioner of Internal Revenue, while, for taxpayers under the jurisdiction of Regional Offices, it shall be issued by the Regional Director.

4. When must a Letter of Authority be served? A Letter of Authority must be served to the concerned Taxpayer within thirty (30) days from its date of issuance, otherwise, it shall become null and void. The Taxpayer shall then have the right to refuse the service of this LA, unless the LA is revalidated.

5. How often can a Letter of Authority be revalidated? A Letter of Authority is revalidated through the issuance of a new LA. However, a Letter of Authority can be revalidated—

Only once, for LAs issued in the Revenue Regional Offices or the Revenue District Offices; or

Twice, in the case of LAs issued by the National Office.

Any suspended LA(s) must be attached to the new LA issued (RMO 38-88).

6. How much time does a Revenue Officer have to conduct an audit? A Revenue Officer is allowed only one hundred twenty (120) days from the date of receipt of a Letter of Authority by the Taxpayer to conduct the audit and submit the required report of investigation. If the Revenue Officer is unable to submit his final report of investigation within the 120-day period, he must then submit a Progress Report to his Head of Office, and surrender the Letter of Authority for revalidation.

7. How is a particular taxpayer selected for audit? Officers of the Bureau (Revenue District Officers, Chief, Large Taxpayer Assessment Division, Chief, Excise Taxpayer Operations Division, Chief, Policy Cases and Tax Fraud Division) responsible for the conduct of audit/investigation shall prepare a list of all taxpayer who fall within the selection criteria prescribed in a Revenue Memorandum Order issued by the CIR to establish guidelines for the audit program of a particular year. The list of taxpayers shall then be submitted to their respective Assistant Commissioner for pre-approval and to the Commissioner of Internal Revenue for final approval. The list submitted by RDO shall be pre-approved by the Regional Director and finally approved by Assistant Commissioner, Assessment Service (RMOs 64-99, 67-99, 18-2000 and 19-2000).

8. How many times can a taxpayer be subjected to examination and inspection for the same taxable year? A taxpayer’s books of accounts shall be subjected to examination and inspection only once for a taxable year, except in the following cases:

When the Commissioner determines that fraud, irregularities, or mistakes were committed by Taxpayer;

When the Taxpayer himself requests a re-investigation or re-examination of his books of accounts;

When there is a need to verify the Taxpayer’s compliance with withholding and other internal revenue taxes as prescribed in a Revenue Memorandum Order issued by the Commissioner of Internal Revenue.

When the Taxpayer’s capital gains tax liabilities must be verified; and

When the Commissioner chooses to exercise his power to obtain information relative to the examination of other Taxpayers (Secs. 5 and 235, NIRC).

9. What are some of the powers of the Commissioner relative to the audit process? In addition to the authority of the Commissioner to examine and inspect the books of accounts of a Taxpayer who is being audited, the Commissioner may also:

Obtain data and information from private parties other than the Taxpayer himself (Sec.5, NIRC); and

Conduct inventory and surveillance, and prescribe presumptive gross sales and receipts (Sec. 6, NIRC).

10. Within what time period must an assessment be made? An assessment must be made within three (3) years from the last day prescribed by law for the filing of the tax return for the tax that is being subjected to assessment or from the day the return was filed if filed late. However, in cases involving tax fraud, the Bureau has ten (10) years from the date of discovery of such fraud within which to make the assessment.

Any assessments issued after the applicable period are deemed to have prescribed, and can no longer be collected from the Taxpayer, unless the Taxpayer has previously executed a Waiver of Statute of Limitations.

11. What is “Jeopardy Assessment”? A Jeopardy Assessment is a tax assessment made by an authorized Revenue Officer without the benefit of complete or partial audit, in light of the RO’s belief that the assessment and collection of a deficiency tax will be jeopardized by delay caused by the Taxpayer’s failure to:

Comply with audit and investigation requirements to present his books of accounts and/or pertinent records, or

Substantiate all or any of the deductions, exemptions or credits claimed in his return. A jeopardy assessment is illegal.

12. What is a Pre-Assessment Notice (PAN)? The Pre-Assessment Notice is a communication issued by the Regional Assessment Division, or any other concerned BIR Office, informing a Taxpayer who has been audited of the findings of the Revenue Officer, following the review of these findings.

If the Taxpayer disagrees with the findings stated in the PAN, he shall then have fifteen (15) days from his receipt of the PAN to file a written reply contesting the proposed assessment.

13. Under what instances is PAN no longer required? A Preliminary Assessment Notice shall not be required in any of the following cases, in which case, issuance of the formal assessment notice for the payment of the taxpayer’s deficiency tax liability shall be sufficient:

When the finding for any deficiency tax is the result of mathematical error in the computation of the tax appearing on the face of the tax return filed by the taxpayer; or

When a discrepancy has been determined between the tax withheld and the amount actually remitted by the withholding agent; or

When a taxpayer who opted to claim a refund or tax credit of excess creditable withholding tax for a taxable period was determined to have carried over and automatically applied the same amount claimed against the estimated tax liabilities for the taxable quarter or quarters of the succeeding taxable year; or

When the excise tax due on excisable articles has not been paid; or

When an article locally purchased or imported by an exempt person, such as, but not limited to, vehicles, capital equipment, machineries and spare parts, has been sold, traded or transferred to non-exempt persons.

14. What is a Notice of Assessment/Formal Letter of Demand?

A Notice of Assessment is a declaration of deficiency taxes issued to a Taxpayer who fails to respond to a Pre-Assessment Notice within the prescribed period of time, or whose reply to the PAN was found to be without merit. The Notice of Assessment shall inform the Taxpayer of this fact, and that the report of investigation submitted by the Revenue Officer conducting the audit shall be given due course.

The formal letter of demand calling for payment of the taxpayer’s deficiency tax or taxes shall state the facts, the law, rules and regulations, or jurisprudence on which the assessment is based, otherwise, the formal letter of demand and the notice of assessment shall be void.

15. What is required of a taxpayer who is being audited? A Taxpayer who is being audited is obliged to:

Duly acknowledge his receipt of the appropriate Letter of Authority upon its presentation by the Revenue Officer authorized to conduct the audit by affixing in the Letter of Authority the name of the recipient and the date of receipt.

Present within a reasonable period of time, his books of accounts and other related accounting records that may be required by the Revenue Officer; and

Submit the necessary schedules as may be requested by the Revenue Officer within a reasonable amount of time from his (Taxpayer’s) receipt of the Letter of Authority.

16. What is the recourse of a Taxpayer who cannot submit the documents being required of him within the prescribed period of time? If a Taxpayer, believing that he cannot present his books of accounts and/or other accounting records, intends to request for more time to present these documents in order to avoid the issuance of a Jeopardy Assessment, the Taxpayer may execute what is referred to as a Waiver of the Statute of Limitations.

17. What is a Waiver of the Statute of Limitations? The Waiver of the Statute of Limitations is a signed statement whereby the Taxpayer conveys his agreement to extend the period within which the Bureau may validly issue an assessment for deficiency taxes. If a Taxpayer opts to execute a Waiver of the Statute of Limitations, he shall likewise be, in effect, waiving his right to invoke the defense of prescription for assessments issued after the reglementary period.

No Waiver of the Statute of Limitations shall be considered valid unless it is accepted by a duly authorized Bureau official.

18. If a Taxpayer does not agree with the assessment made following an audit, can he protest this Assessment?Yes, he can. A Taxpayer has the right to contest an assessment, and may do so by filing a letter of protest stating in detail his reasons for contesting the assessment.

19. What are the characteristics of a valid protest? A protest is considered valid if it satisfies the following conditions:

It is made in writing, and addressed to the Commissioner of Internal Revenue;

It contains the information, and complies with the conditions required by Sec. 6 of Revenue Regulations No. 12-85; to wit:

a.) Name of the taxpayer and address for the immediate past three (3) taxable year.

b.) Nature of request whether reinvestigation or reconsideration specifying newly discovered evidence he intends to present if it is a request for investigation.

c.) The taxable periods covered.

d.) Assessment number.

e.) Date of receipt of assessment notice or letter of demand.

f.) Itemized statement of the findings to which the taxpayer agrees as a basis for computing the tax due, which amount should be paid immediately upon the filing of the protest. For this purpose, the protest shall not be deemed validly filed unless payment of the agreed portion of the tax is paid first.

g.) The itemized schedule of the adjustments with which the taxpayer does not agree.

h.) A statement of facts and/or law in support of the protest.

The taxpayer shall state the facts, applicable law, rules and regulations or jurisprudence on which his protest is based, otherwise, his protest shall be considered void and without force and effect on the event the letter of protest submitted by the taxpayer is accepted, the taxpayer shall submit the required documents in support of his protest within sixty (60) days from date of filing of his letter of protest, otherwise, the assessment shall become final, executory and demandable.

It is filed within thirty (30) days from the Taxpayer’s receipt of the Notice of Assessment and formal Letter of Demand.

20. In the event the Commissioner’s duly authorized representative denies a Taxpayer’s protest, what alternative course of action is open to the Taxpayer? If a protest filed by a Taxpayer be denied by the Commissioner’s duly authorized representative, the Taxpayer may request the Commissioner for a reconsideration of such denial and that his tax case be referred to the Bureau’s Appellate Division. The Appellate Division serves as a “Court”, where both parties, i.e. the Revenue Officer on one hand, and the Taxpayer on the other, can present testimony and evidence before a Hearing Officer, to support their respective claims.

21. What recourse is open to a Taxpayer if his request for reconsideration is denied or his protest is not acted?

Should the Taxpayer’s request for reconsideration be denied or his protest is not acted upon within 180 days from submission of documents by the Commissioner, the Taxpayer has the right to appeal with the Court of Tax Appeals (CTA).

Any appeal must be done within thirty (30) days from the date of the Taxpayer’s receipt of the Commissioner’s decision denying the request for reconsideration or from the lapse of the 180 day period counted from the submission of the documents. (Sec. 228 of the Tax Code, as amended).

22. If the Taxpayer is not satisfied with the CTA’s decision, can he appeal the decision to a higher Court? Yes, he can. Decisions of the Court of Tax Appeals may be appealed with the Court of Appeals within fifteen (15) days from the Taxpayer’s receipt of the CTA’s decision. In the event that the Taxpayer is likewise unsatisfied with the decision of the Court of Appeals, he may appeal this decision with the Supreme Court.

23. Can a Taxpayer claim a refund or tax credit for erroneously or illegally collected taxes? Yes, he can. The Taxpayer may file such a claim with the Commissioner of Internal Revenue (Sec.229, NIRC), within two (2) years from the payment of the tax or penalty sought to be refunded. Failure of the Taxpayer to file such a claim within this prescribed period shall result in the forfeiture of his right to the refund or tax credit.

24. If a Taxpayer has filed a claim for refund and the Bureau has yet to render a decision on this claim, can the Taxpayer elevate his claim to the CTA?

25. What means are available to the Bureau to compel a Taxpayer to produce his books of accounts and other records? A Taxpayer shall be requested, in writing, not more than two (2) times, to produce his books of accounts and other pertinent accounting records, for inspection. If, after the Taxpayer’s receipt of the second written request, he still fails to comply with the requirements of the notice, the Bureau shall then issue him a Subpoena Duces Tecum.

26. What course of action shall the Bureau take if the Taxpayer fails to comply with the Subpoena Duces Tecum?

If, after the Taxpayer fails, refuses, or neglects to comply with the requirements of the Subpoena Duces Tecum, the Bureau may:

File a criminal case against the Taxpayer for violation of Section 5 as it relates to Sections 14 and 266, of the NIRC, as amended; and/or

Initiate proceedings to cite the Taxpayer for contempt, under Section 3(f), Rule 71 of the Revised Rules of Court.

27. What alternatives are open to Government for the collection of delinquent accounts?

Once an assessment becomes final and demandable, the Government may employ any, or all, of the following remedies for the collection of delinquent accounts:

Distraint of personal property;

Levy of real property belonging to the Taxpayer;

Civil Action; and

Criminal Action.

28. What is “Distraint of Personal Property”? Distraint of personal property involves the seizure by the Government of personal property – tangible or intangible – to enforce the payment of taxes, followed by the public sale of such property, if the Taxpayer fails to pay the taxes voluntarily.

29. What is “Levy of Real Property”? Levy of real property refers to the same act of seizure, but in this case of real property, and interest in or rights to such property in order to enforce the payment of taxes. As in the distraint of personal property, the real property under levy shall be sold in a public sale, if the taxes involved are not voluntarily paid following such levy.

30. In what time period must collection be made? Any internal revenue tax, which has been assessed within the period prescribed shall be collected within three (3) years from date of assessment. However, tax fraud cases may be collected by distraint or levy or by a court proceeding within five (5) years from assessment of the tax or from the last waiver.

 

Robert Kiyosaki: From Rich Dad to Bankrupt Dad?

I first heard about Robert Kiyosaki was when I was in high school. My older brother was raving about it during one of our Sunday family gatherings. He was so amazed with the unorthodox ideas that Mr. Kiyosaki shared in his first book, Rich Dad, Poor Dad. However, being young and carefree back then, it wasn’t until after several years when I was already in law school that I began reading his books. Indeed, in communicating his point of view on why ‘old’ advice – get a job, save money, get out of debt, invest for the long term, and diversify – is ‘bad’ (both obsolete and flawed) advice, Robert has earned a reputation for straight talk, irreverence and courage. So revolutionary were his teachings that when I shared them with my dad, he simply shot them down for being a bunch of nonsense. Of course, now that I am a licensed attorney and financial planner, I realized that Mr. Kiyosaki’s teachings actually made a lot of sense.

Nevertheless, in late A.D. 2012, news began to spread all over social media that Rich Dad® Robert Kiyosaki is now a bankrupt dad because in August of that year, his company, Rich Global LLC, just filed for bankruptcy. So does this really mean that one of the world’s most famous, if not the most famous, personal finance gurus, the one who was allegedly mentored by his best friend’s rich dad several decades ago as a child, failed and became poor all of a sudden? Before we get to that, let me first give you an idea on what filing for corporate bankruptcy really means.

Title 11, of the United States Code, a.k.a. the United States Bankruptcy Code, is the main source of bankruptcy law in the United States. Chapter 7 thereof governs the process of liquidation and is the most popular and common form of bankruptcy. When a troubled business is badly in debt and unable to service that debt or pay its creditors, it may file for bankruptcy in a federal court under Chapter 7. A Chapter 7 filing means that the business ceases operations unless continued by the Chapter 7 trustee. A trustee is appointed almost immediately, with broad powers to examine the business’s financial affairs. The trustee generally liquidates all the assets and distributes the proceeds to the creditors. In a Chapter 7 case, a corporation or partnership does not receive a bankruptcy discharge—instead, the entity is dissolved. Only an individual can receive a discharge. Once all assets of the corporate or partnership debtor have been fully administered, the case is closed.

Here in the Philippines, our laws refer to bankruptcy proceedings as ‘insolvency’ proceedings. In fact, just five years ago, the Financial Rehabilitation and Insolvency Act of 2010 or FRIA was passed. The new law provides for the substantive and procedural requirements for the rehabilitation or liquidation of financially distressed enterprises and individuals. The FRIA defines “insolvent” as the “financial condition of a debtor that is generally unable to pay its or its liabilities as they fall due in the ordinary course of business or has liabilities that are greater than its or his assets.” Now you may ask, why would a very rich man like Robert Kiyosaki allow the company he built to go bankrupt or insolvent?

It was reported that the founder of Learning Annex, Bill Zanker, sued Rich Global for $24 million. Learning Annex was one of his supporters when he was still starting as a businessman. Actually, Robert Kiyosaki owns many businesses and Rich Global LLC is just one of those corporations. Robert now runs most of his businesses under his other company, Rich Dad Co. In fact, Rich Dad Co. CEO Mike Sullivan informed the New York Post in an interview that Robert Kiyosaki would not be putting any of his personal fortune toward the settlement. Now, that is the beauty of using a corporate entity as a vehicle for one’s business. It provides a layer of protection against asset raiders such as legal plaintiffs. You see, when a company files for bankruptcy or insolvency, its creditors, including its judgment creditors, cannot just simply collect from the company nor seize it assets legally without first complying with the requirements of the law. That is why Robert Kiyosaki is still quite rich even after filing for bankruptcy with an estimated net worth of $80 million. Having his company Rich Global LLC file for bankruptcy was merely a legal strategy in order to protect his personal assets.

Instead of losing his credibility as a personal finance coach and wealth advisor, such a bold move by Robert Kiyosaki just proves that he is indeed financially intelligent. So much so that he is certainly more financially intelligent than most people, especially those who immediately jumped the gun in judgment against him upon reading the news headlines about his company filing for bankruptcy. Although I have my differences with some of his theories, I along with my colleagues in the financial services industry consider his books as indispensable reading in personal finance and entrepreneurship. It is truly undeniable that all of us, in one way or another, were illuminated and inspired by his teachings.

I am so excited about his upcoming event, Robert Kiyosaki Live in Manila: Masters of Wealth, which will be held on November 30, 2015 at the SMX, Mall of Asia. It’s a once in a lifetime opportunity to learn not only from the master himself but also from other world class wealth coaches, economists, businessmen and educators. I believe that to be financially successful, the first asset that we should invest in is ourselves.

Kiyosaki Live

Effects of the Different Property Regimes in the Computation of the Estate Tax Due

Someone asked: “Atty. Terence, I just wanted to ask, what if there was a prenup agreement? How do you divide the properties and compute the estate tax due? Will a prenup supersede the law of a community property with regard to estate tax?”

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Answer: A prenuptial agreement, otherwise known legally as a marriage settlement, is a contract entered into by the parties intending to get married, which must be executed by them prior to the wedding, otherwise, the same shall be void. The primary purpose of a marriage settlement is to determine the property regime of the parties to the future marriage other than that provided for by law by default.

Estate tax, also known as inheritance tax, is a tax on the right of a deceased person to transmit his estate to his lawful heirs and beneficiaries. Contrary to popular belief, it is not a tax on property but on the right to transmit property at death, and is measured by the value of the property.

Now that we know what estate tax is, we should then consider the different kinds of property regimes that a married couple can enter into in order for us to properly compute the value of their respective gross estates and ultimately, their net taxable estates.

For marriages celebrated after or on the effectivity date of the Family Code, which is on August 3, 1988, in the absence of a valid marriage settlement, the default property regime of absolute community of property (ACP) shall govern. In a regime of ACP, the community property shall consist of all the property owned by the spouses at the time of the celebration of the marriage or acquired thereafter. However, the following are excluded therefrom: (1) Property acquired during the marriage by gratuitous title by either spouse, and the fruits as well as the income thereof, if any, unless it is expressly provided by the donor, testator or grantor that they shall form part of the community property; (2) Property for personal and exclusive use of either spouse; however, jewelry shall form part of the community property; and (3) Property acquired before the marriage by either spouse who has legitimate descendants by a former marriage, and the fruits as well as the income, if any, of such property.

On the other hand, for marriages celebrated before the effectivity of the Family Code, the default property regime of conjugal partnership of gains (CPG) provided for under the Civil Code, the effectivity of which began on August 30, 1950, shall prevail. The same is true in case the future spouses agree in the marriage settlements that the regime of conjugal partnership of gains shall govern their property relations during the marriage. In a regime of CPG, the husband and wife place in a common fund  the proceeds, products, fruits and income from their separate properties and those acquired by either or both spouses through their efforts or by chance, and, upon dissolution of the marriage of the partnership, the net gains or benefits obtained by either of both spouses shall be divided equally between them, unless otherwise agreed in the marriage settlements. Hence, the following shall be the exclusive property of each spouse: (1) That which is brought to the marriage as his or her own; (2) That which each acquires during the marriage by gratuitous title; (3) That which is acquired by right of redemption, by barter or exchange with property belonging to only one of the spouses; and (4) That which is purchased with exclusive money of the wife or of the husband.

Lastly, in a regime of complete separation of property (CSP), each spouse retains ownership of his or her own properties including the fruits thereof. In short, what’s yours is yours and what’s mine is mine. Article 134 of the Family Code provides that in the absence of an express declaration in the marriage settlements, the separation of property between spouses during the marriage shall not take place except by judicial order. Such judicial separation of property may either be voluntary or for sufficient cause.

So, after determining the share of each spouse from the mass of the community or conjugal property, we can now compute for their respective individual gross estates. Section 85 of the National Internal Revenue Code provides that “the value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated; Provided however, that in the case of the non-resident decedent who at the time of his death was not a citizen of the Philippines only that part of the entire gross estate which is situated in the Philippines shall be included in his taxable estate.”

Having determined their respective individual gross estates, we can now proceed to computing their net taxable estates taking into consideration the applicable exclusions and deductions provided for by law.

Some of the Things that a Professional Financial Advisor Does

Financial Planning:
• Cares more about you and your money than anyone who doesn’t share your last name
• Asks questions in order to understand your needs and objectives
• Helps you determine where you are at present
• Guides you to think about areas of your financial life you may not have considered
• Helps organize your financial situation
• Formalizes your goals and puts them in writing for you
• Helps you prioritize your financial opportunities
• Helps you determine realistic goals
• Studies possible alternatives that could meet your goals
• Prepares a financial plan and/or an investment policy statement for you
• Makes specific recommendations to help you meet your goals
• Implements those recommendations
• Suggests creative alternatives that you may not have considered
• Reviews and recommends life insurance policies to protect you
• Assists you in setting up a company retirement plan
• Assists in preparing an estate plan for you
• Persuades you to do the things you know you ought to do, even if you don’t feel like doing them

Investments:
• Prepares an asset allocation for you so you can achieve the best rate of return for a given level of risk tolerance
• Does due diligence on money managers and mutual fund managers in order to make appropriate recommendations
• Stays up to date on changes in the investment world
• Monitors your investments
• Reviews existing annuities
• Reviews your investments in your company PERA plans
• Reviews and revises portfolios as conditions change
• Guides you through difficult periods in the stock market by sharing historical perspective
• Works with you to improve your investment performance
• Can look inside your mutual funds to compare how many of their holdings duplicate each other
• Converts your investments to lifetime income
• Helps you evaluate the differences in risk levels between various fixed-income investments such as government bonds and corporate bonds.
• Provides research on stocks from both affiliated firm and third parties
• Holds and warehouses stocks, bonds and other securities
• Records and researches your cost basis on securities
• Provides you with unbiased stock research
• Provides you with personal stock analysis
• Provides you with a written sector-based evaluation of your portfolio
• Determines the risk level of your existing portfolio
• Helps you consolidate and simplify your investments
• Can provide you with technical fundamental and quantitative stock analysis
• Gives you strategies for trading options
• Provides you with executive services involving restricted stock and employer stock options
• Provides introductions to money managers
• Show you how to access your statement and other information online
• Shops top rates from financial institutions throughout the country
• Provides access to answers from a major investment firm

Taxes
• Suggests alternatives to lower your taxes
• Review your tax returns with an eye to possible savings in the future
• Stays up to date on tax law changes
• Helps you reduce your taxes
• Repositions investments to take full advantage of tax law provisions
• Works with your tax and legal advisors to help you meet your financial goals.

Person-to Person:
• Monitors changes in your life and family situation
• Proactively keeps in touch with you
• Remains only a telephone call away to answer financial questions for you
• Serves as a human glossary of financial terms such as beta, P/E ratio, and Sharpe ratio
• Makes sure that the he/she and the firm provide excellent service at all times
• Provides referrals to other professionals, such as accountants and attorneys
• Refers you to banking establishments for loan and trust alternatives
• Provides you with a chart showing the monthly income from all of your investments
• Suggests alternatives to increase your income during retirement
• Listens and provides feedback in a way that a magazine or newsletter writer does not
• Shares the experiences of dozens or hundreds of clients who have faced circumstances similar to yours
• Helps educate your children and grandchildren about investments and financial concepts
• Holds seminars to discuss significant and /or new financial concepts
• Helps with continuity of your family’s financial plan through generations
• Facilitates the transfer of investments from individual names to trust or from an owner through to beneficiaries
• Keeps you on track
• Identifies your savings shortfalls
• Develops and monitors a strategy for debt reduction
• Educates you on retirement issues
• Educates you on estate planning issues
• Educates you on college savings and financial aid options
• Is someone you can trust and get advice from in all of your financial matters
• Is a wise sounding board for ideas you are considering
• Is honest with you
• Saves you time

Guest Blog: Defending Your Fee in an Angry Marketplace

When clients average 9% a year, it’s easy to pay a 1% fee. When they lose money, those fees become harder to stomach. Here’s a four-part action plan for reestablishing your worth and protecting clients from further damage.

It’s not easy being a financial advisor these days. For some, you’re about as popular as members of Congress or the Bush administration. Within the last few weeks, millions of investment clients received third-quarter statements. Those who dared open the envelope found portfolios hammered by the recent market free fall. Trillions of dollars have evaporated from the markets.

Will clients stick with you?

A study released this month by Prince and Associates was not encouraging—at least, not for the wealthiest sectors of the financial services industry. The survey showed that an alarming 81% of investors with at least $1 million in discretionary assets at private banks were planning to pull at least some of their money from their advisors in the wake of Black September and Blacker October. Nearly half said they planned to change advisors and warn others about that professional.

Prince attributed this loss of confidence to the uncertainty caused by the credit crisis, the banking bailout, the market collapse, and the election. The good news in that? Factors such as the personal style and service approach of an advisor and the reputation of the advisory firm can greatly help shape an investor’s attitude. And their willingness to keep paying you, Prince said.

Advisor Beth Blecker, CEO of Eastern Planning in Pearl River, New York underscores the importance of steady service in this rough market: “I am not having any trouble defending my fee with 95% of my clients, but service is the key,” she notes. “I see my best clients every quarter, and I host special volatility-education events and appreciation events. I tell clients this is the time that I really have to earn my fees by keeping them long-term-goal-oriented. We do not believe in timing the market, so it is up to me to keep them invested.”

Taking charge of your message

What can you do now to keep clients happy, defend your fees, and attract new clients? Here’s an action plan for tough economic times.

Go back to the investment policy. When you initially establish an investment policy statement, it can be used to remind clients of potential losses they agreed to accept. This is especially valuable in a down market. An investment policy statement might include a statement like this: “Client X could accept losing 15% in any single year. Over a five-year period, she could tolerably lose 3% annualized.”

When the market falters, you can point back to the risk range outlined in the investment policy statement, as well as to the benchmarks chosen to help put the client’s investment performance into perspective. “It puts in plain English what risks they were willing to take,” said one advisor about his IPS. “It also provides a measurable standard by which we can reasonably be evaluated in a down market.”

Action step: Review clients’ investment policy statements. If you don’t have an IPS process, consider developing one to formally outline your approach.

Host an education summit. Perhaps no time would be more appropriate than now to gather your clients together at your home or office for a special “volatility event” to educate them about your market outlook and how you plan to address the current crisis. An education workshop should include the following elements:

  • A small number of attendees. Unlike a mass-marketed seminar, a client education workshop involves only a select group of your best clients—15 to 30 at the most.
  • Shared interests. When inviting clients to attend your exclusive workshop, choose those who share common interests and concerns. Your knowledge of their unique needs and issues will create a more effective event.
  • Educational purpose. Your education summit should not be tied to a product push. Clients should be able to ask questions and speak their minds. “Since this crisis hit, we have hosted special volatility events with my son, who is a certified financial analyst,” explains Blecker of Eastern Planning. “Clients were very happy that they could ask him whatever they wanted related to the market downturn.” You could bring in your own expert.

Action step: Determine which of your clients to invite. Consider hosting a series over several weeks for small client groups. Saturday mornings often work well. Limit attendance to 30 at the most. Find a guest speaker, if possible, but be sure you remain in charge of the message.

Remind clients about the benefits of fees. Clients don’t pay you a fee just for market performance. And while paying a fee in a down market can be frustrating, clients need to remember all the advantages of fees. Here are a few benefits you can remind them about:

  • Risk management. In a down market, your job is still to manage client risk and optimize their long-term strategic portfolio planning. This service becomes even more important when the market goes down as client confidence is low.
  • Portfolio flexibility. In declining markets, slight modifications to a portfolio can help your clients manage risk. A fee arrangement allows you to fine-tune their holdings without worrying about costs.
  • Constant advice. Paying a fee does not assure a positive return any more than paying for a doctor’s services guarantees the treatment will be successful. Clients pay for the process and the constant attention you give them. As one advisor notes, “Markets go down. This fact cannot be confused with the failure of the consultant.”
  • Excellent service. Clients rely on your service team to answer their questions and handle their requests promptly. Remind clients about the excellent service you strive to provide, that you have the best in the business handling their day-to-day financial needs. Point out that they can reach a member of your team at any time, and emphasize the level of personal service that distinguishes your practice.
  • Tax management. You play an important role in minimizing your clients’ tax bill. Making portfolio adjustments for tax purposes is more easily done under a fee arrangement because you don’t have to worry about transaction costs. Sometimes the tax savings can pay for a year’s worth of fees. A client can also write off your advisory fee, while mutual fund expenses are not deductible.
  • Shared economic interest. Remind your clients that as a result of your fee-based relationship, you’re feeling the pain along with them. One advisor told me his client assets were down 13% last quarter, meaning he just took a 13% pay cut. Your goal is to increase your clients’ wealth, and you share in their success and have every motivation to help them reach their goals.

Action step: If you encounter concerns about your management fee, make it your priority to listen first. Once you have understood and acknowledged the client’s objection, you can respond appropriately with the above advantages of fee-based advisory relationships.

Consider new hedging strategies. Finally, however well you defend your fees, it may be time to take a new investment approach. While focusing on long-term goals and staying invested has long been a mantra for financial advisors, a growing subset of advisors are embracing alternative risk management strategies and hedging to reduce short-term portfolio volatility. They’re basically saying, Forget the long run; we gotta stop the pain now.

“In order to justify your fee, you must bring something new to the table,” argues Otto Federen, an independent registered investment advisor in Lexington, Ky. “Buy and hold equals ‘hope and hold’—and hope is not a strategy.”

Federen completely revamped his investment approach after the 2002 bear market, when he saw fundamentally sound companies and managers beaten down by the market. “We recognized that we had to have downside protection.” He has had his clients in Treasury money funds since February, and he uses some managers who use short strategies.

Thomas Norris, president of NFI Advisors, manages risk with structured accounts comprised of Treasury bonds and call options on the S&P 500 Index to participate in upward swings. His clients have not lost money during the downturn. “If you don’t lose, you don’t have to make it up. I’m not in the market. We’ve protected them on the downside.”

Norris sees his no-risk strategy as the only approach during what may be a rough time ahead. “The average investor has been told to just stay invested, that the market will recover. But look at 1973-74. The market lost 50% of its value. People and advisors were devastated. And over 10 years during the ’70s, the market died slowly.”

And some advisors, recognizing the flat market over the last decade worry about another decade with little forward progress. David Hoelke, CFP, of Focus Financial in St. Paul, Minn. explains: “It’s not the wild swings up and down that concern me. I’m more concerned about a longer-term stagnant period, where clients might only make 2-3% because of a deflationary recession. If all asset classes perform poorly, 2-3% could be strong compared to inflation. “But if I’m taking one of those points as my fee, it might not sit well. I don’t worry about my clients becoming angry, but rather that they become pragmatic and learn that CDs might a safer alternative. And while that’s shortsighted on their part, some clients are frazzled enough that they might not care.”

Action step: Investigate alternative investment approaches on Horsesmouth and elsewhere. Explore the costs and potential advantages of these absolute return strategies.

Senior Editor Nicole Coulter specializes in helping financial advisors manage their businesses more effectively. She has previously written about practice management issues for publications such as Registered Representative and Bank Investment Representative. She holds an MBA from the University of Nebraska at Omaha.

Words of Wisdom From Master Advisor Nick Murray

1. If you are still prospecting, no matter what else is wrong with your business, you will yet succeed. If you stop prospecting, in the absence of a steady flow of referrals/introductions, then no matter what else appears to be right with your business at the moment, you are ultimately going to fail.

2. “Rejection” does not hurt, other than to the extent we allow it to do so. The only way to hear “yes” is to risk hearing “no.”

3. Most people who invest most of their capital in fixed income investments as they go into retirement will run out of money well within their lifetimes, and will die destitute and dependent upon their children. Equities: life. Bonds: death-in-life.

4. Optimism is the only realism. It is the only world view that squares with the facts, and with the historical record.

5. Get a year’s living expenses in a money market fund as quickly as you can, even if you have live on coffee and rice while you’re saving toward this goal. This will allow you to turn down business that doesn’t feel 100% right to you. It will give you the strength to tell any prospect to go to the devil, and make it stick.

6. It is infinitely easier to turn a one-million dollar client into a two-million dollar client than it is to turn ten one-hundred thousand-dollar clients into two-hundred-thousand dollar clients.

7. Money is love. The wise advisor will always look for clients who wish to use their money as an expression of love.

8. Your price is only an issue to the extent that your value is in question.

9. Every year on your birthday, fire the client who has given you the most grief since your last birthday.

10. Never take part of an investment account. Win it all, or pass on it all. It’s not just the gaps, the overlaps and the lost fee efficiencies that make divided accounts a no-no: it’s that you’re getting sucked into a performance derby.

11. When we are telling prospects and clients exactly what they need to do in order to achieve their most deeply-held financial goals, it is not possible for them to counter with valid objections, because there are no valid objections.

12. The origin of all wealth is threefold: personal initiative, hard work, and thrift. Tell me the percentage of your income that you’re putting away, and I’ll tell you whether you’re going to achieve your financial goals.

13. The world does not end. It only seems to be ending. This time is never different.

14. Americans say they want safety and income. What they really want is all the income they can get, and the illusion of safety. More money has been lost in the quest for the chimerical combination of safety and high yield than in all the stock market crashes in history.

15. Stop trying to prove anything. You can’t prove the sun’s coming up tomorrow, nor that you or your client will be here to see it even if it does. A great advisor never accepts the burden of proof.

16. There is no such thing as a “standard” deviation. Reality always comes at us out of deep left field.

17. The only sane investment objective in retirement is an income that grows at a minimum of the same rates at which one’s cost of living is rising.

18. There is no statistical evidence fore the persistence of performance.

19. Disciplined diversification is a pact with heaven: I will never own enough of any one thing to make a killing in it; I will never own enough of any one thing to be able to be killed by it.

20. All investment “new eras” end in ruin, because all inventions follow the same arc, from miracle to commodity.

21. Never take your business problems home with you. That way you can never take them out on the people who love you.

22. Price and value are inversely correlated. When the price of any investment sector is rising, its value is declining; the converse is also true.

23. The most fascinating aspect of all financial crises is their essential sameness.

24. Life is too short to work with anyone you don’t like, and /or who doesn’t like you.

25. Get our of debt, and stay out of debt. This can be a very cyclical business. If you’re a genuinely high-quality advisor, you will lose accounts and AUM in a “new era” speculative orgy. Keep you nut as low as you possibly can.

26. What goes around comes around, even if it’s on a very long, elliptical orbit.

27. Inflation is always and everywhere a monetary phenomenon.

28. The iron law of the commodity cycle is: supply responds directly to price, even as demand responds inversely to it.

29. The advance is permanent. The declines are temporary. There have been twelve bear markets with a mean decline of 25% since the end of World War II. The first one started on May 29, 1946. that day, the S&P Index closed at 19.5. As I write, twelve ends-of-the-world later, it is 1400. Stocks are up seventy times over these six decades because earnings are up seventy times.

30. Almost all of life is in the Grateful Dead dong “Uncle John’s Band.” The rest is in “Box of Rain.”

31. The dominant determinant of the real long-term returns real people really get isn’t investment performance. It’s investor behavior.

32. Every Christmas, assemble your entire family and watch the A&E move The Crossing, about Washington’s attack across the Delaware on Christmas night, 1776. This, and not It’s a Wonderful Life, is the true American Christmas classic. Every April 13, assemble them all again, and watch Apollo 13.

33. Protectionism always raises consumer prices above where they would otherwise be; it also invariably destroys more jobs than it “saves.”

34. All investments are income investments. They are made for the production either of current income, or of future income, or of income for someone else. The only sane test of an investment’s long term income producing potential is its long term total return, not its current yield. By that one sane test, stocks are a far better income investment than bonds.

35. The computer in your cell phone is a million times smaller, a million times cheaper, and a thousand times more powerful than the mainframe computer used by E.F. Hutton & Company on the day I joined that firm, May 1, 1967. This is a billion fold increase in computing power per dollar. In the next quarter century, there will be another such billion fold increase, at which point technology will have essentially solved all our current problems: energy, the environment, poverty and disease. This is the exact worst moment in human history to turn pessimistic.

36. Freedom is never free.

37. No one who really understands baseball ever referred to the 1969 World Series champions as the Miracle Mets. They were anything but a miracle. Indeed, from the middle of the 1968 season on, they were well nigh inevitable.

38. There is no completely bad time to be prospecting, but the very best time to be prospecting is when the market is down 20%. Amateurs will have stopped calling their clients, and your timeless wisdom will never get a better hearing.

39. The only sure way to be trusted is to be single-mindedly, relentlessly trustworthy. The only way to be sure you’re always absolutely trustworthy is to tell the pure, unvarnished truth all the time, and let the chips fall where they may.

40. Stop asking for referrals. Ask for introductions.

41. And in the end, the love you take is equal to the love you make.