Financial Advisors Duties:  Suitability & Tax Consequences

Does a financial advisor have to factor in taxes when making a recommendation?

Before recommending an investment, financial advisors are required by FINRA Rule 2111 to ensure that the recommendation is suitable for that customer based on several important factors including tax status.  The tax implications of the investment must be considered.

FINRA Suitability Rules (See FINRA Regulatory Notice 11-02)

Suitability refers to an investment adviser or broker-dealer’s obligation to only recommend investments for customers that are appropriate for that particular customer.  If, for example, selling an investment would trigger a large tax consequence that must be factored in by the financial advisor.

FINRA Rule 2111 states that a brokerage firm or an investment adviser must “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”

The customer’s investment profile includes information that may determine whether a specific investment or investment strategy is suitable for an investor.  The investment profile for a customer may include, but is not limited to the following:

• age;
• other investments;
• financial situation and needs, which might include questions about annual income and liquid net worth;
• tax status, such as marginal tax rate;
• investment objectives, which might include generating income, funding retirement, buying a home, preserving wealth or market speculation;
• investment experience;
• investment time horizon, such as the expected time available to achieve a particular financial goal;
• liquidity needs, which is the customer’s need to convert investments to cash without incurring significant loss in value; and
• risk tolerance, which is a customer’s willingness to risk losing some or all of the original investment in exchange for greater potential returns.

Three Elements of Suitability

The rule also specifies three elements of suitability:  reasonable-basis suitability, customer specific suitability and quantitative suitability.

(1) Reasonable Basis – firms must have a reasonable basis to believe, based on adequate due diligence, that a recommendation is suitable at least for some investors;
(2) Customer Specific – firms must have reasonable grounds to believe a recommendation is suitable for the specific investor; and
(3) Quantitative – firms must have a reasonable basis to believe the number of recommended transactions within a certain period is not excessive (i.e., that the investor’s account is not being churned).

Since an investor’s age, their investment time horizons, goals, risk tolerance and tax status may change, these components have to be re-evaluated on an ongoing basis.

Unsuitable Investment Recommendations and Negative Tax Consequences

Financial advisors must consider tax implications of any investment before recommending the investment.

For example, some financial professionals may improperly recommend that a customer switch or trade variable annuities in order to generate a commission. It is most commonly used to take advantage of seniors who may be planning for retirement. While variable annuity switching is not illegal, and is often not in the client’s best interest, and it could have negative tax consequences as well.

In May 2014, FINRA reportedly suspended a financial advisor in New York, NY, after he was named a respondent in a FINRA complaint. The complaint alleged that the advisor recommended that a customer surrender her fixed annuity and invest the proceeds in a bond fund.

According to FINRA the advisor “had no reason to believe that the bond fund would provide greater financial benefit to the customer than the fixed annuity despite knowing that it exposed the customer to greater risk than the fixed annuity.” After the customer switched investments, she reportedly incurred surrender and sales charges and suffered tax consequences.

In March 2018, a financial advisor in Sarasota, Florida, was reportedly suspended and fined by FINRA for allegedly recommending an unsuitable investment strategy to an elderly customer on a fixed income with conservative investment goals, causing the customer to suffer unnecessary tax liability of over $33,000.

As a senior living on a fixed income, the investor had relatively low reportable income on her federal tax return, and avoiding the payment of unnecessary federal income taxes was critically important to her long-term financial stability.

According to FINRA, the advisor made this recommendation without regard for the fact that several of the customer’s assets were in tax-deferred accounts.  FINRA’s findings state that the advisor “was aware of and understood the negative tax consequences of her unsuitable recommendations, which resulted in unnecessary tax liability of more than $33,000 and a reduction of her customer’s 2016 monthly social security benefit.”

Free Consultation with a Securities Attorney

The White Law Group continues to file FINRA arbitration cases on behalf of clients who have suffered losses as a result of unsuitable investment recommendations and negative tax repercussions.

Prior to making recommendations to an individual investor, brokerage firms are required by the Financial Industry Regulatory Authority (FINRA) to disclose all the risks of an investment.

Recommendations should only be made if the investment is suitable for an individual investor given their financial status, tax status, and investment objectives.

Brokerage firms that do not perform adequate due diligence on an investment and/or make unsuitable recommendations can be held accountable for investment losses through FINRA arbitration.

If you believe that you have suffered losses due to an unsuitable investment recommendation by your financial advisor, please call the securities attorneys of The White Law Group 888-637-5510 for a free consultation.

The White Law Group is a national securities fraud, securities arbitration, and investor protection law firm with offices in Chicago, Illinois and Franklin, Tennessee.

For more information on The White Law Group, visithttps://whitesecuritieslaw.com.