the tax practice environment

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The Tax PracticeEnvironment

Chapter 2

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Tax Practice

Tax compliancePreparing returnsRepresenting clients at IRS audit

Tax planningEvaluating the tax consequences associated

with a transaction and making recommendations that will achieve the desired objective at a minimal tax cost

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Taxes and Cash Flow

Tax cost is the increase in tax for the period and is a cash outflow

Tax savings is a decrease in tax for a period and is a cash inflowExpense payment generates an outflow, but

deduction generates a tax reductionReducing income taxes paid is a pure cash

inflow because tax savings are not taxable

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Cash Flows & Present Value

Cash flows in future years are discounted to their present value so they can be compared in today’s dollars

When marginal tax rates are expected to change from year to year, timing transactions accordingly will minimize tax costs and maximize tax savings

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Tax Planning Strategies

Timing income and deductionsGeneral rule - defer recognition of income

and accelerate recognition of deductionsRecognize income in year with lowest

marginal tax rateDeduct expenses in year with highest

marginal tax rate

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Tax Planning Strategies

Shifting income Splitting income among two or more taxpayers

in the same family or between different entities owned by the same individual may lower the total tax paid (progressive tax rate system)

Changing the character of incomeStructure transaction to avoid being taxed at

ordinary income rates (up to 35%) & to qualify for favorable long-term capital gains rate (15%)

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Tax Planning Strategies

Other factors affecting tax planningDiscount rate (cost of capital)Inflation rateUncertainty regarding tax laws or ratesNontax (personal) objectivesCost of implementation

Planning costs vs. tax savingsRisk of challenge by IRS

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Judicial Doctrines

Business purpose doctrineA transaction must have a business or economic

purpose other than tax avoidance Substance-over-form doctrine

Taxability of a transaction is determined by the reality of the transaction, rather than its appearance

Step transaction doctrine IRS can collapse a series of intermediate transactions

into a single transaction to determine the tax consequences

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Judicial

Statutory

Primary Sources of Authority

Administrative

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Statutory Sources of Authority

U.S. Constitution Internal Revenue Code Tax treaties Committee reports that indicate the legislative

intent of a billHouse Ways & Means CommitteeSenate Finance CommitteeJoint Conference Committee

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Tax Legislative Process

1) Tax bill introduced in the House2) Referred to the House Ways and Means

Committee3) Submitted to the full House to be debated

(usually under closed rule)4) If passed, bill is sent to the Senate5) Referred to the Senate Finance Committee

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Tax Legislative Process

6) Submitted to the Senate to be debated under open rule

7) If House and Senate versions differ, referred to a Joint Conference Committee where a compromise version of the bill is developed

8) If compromise version passed by both houses of Congress, the bill is submitted to the President for signature

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Internal Revenue Code

A tax bill passed by Congress is usually enacted as a revenue act that amends the existing Internal Revenue Code (IRC)

Code divided into subtitles, chapters, subchapters, and sections

Citations to the Code usually are to sections (Sec. or §)

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Administrative Sourcesof Authority

Interpretations and specificapplicationsof the IRC

Revenue Rulings

Treasury Regulations

Revenue Procedures

Letter Rulings& other pronouncements

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Judicial Sources

U. S. Court ofFederal Claims

U. S. Court ofAppeals for

Federal CircuitU. S. District Court U. S. Court of

Appeals

TheSupreme

CourtU. S. Tax Court

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Tax Research

Purpose of research is to find solutions to tax problems

Steps in research process1. Gather the relevant facts and identify the

issues2. Locate and evaluate the relevant authority3. Communicate the recommendations

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Filing Deadlines for Tax Returns

Returns for individuals, partnerships, estates, and trusts due 15th day of 4th month (April 15)

Corporate returns due 15th day of 3rd month (March 15)

Extension of time to file – 6 months

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Filing Penalties

Failure-to-pay penalty½ percent for each month (or part of month)

payment is late (maximum 25%) Failure-to-file penalty

5 percent per month (or partial month) return is late (maximum 25%)

If both apply, rate is combined 5 percent for first 5 months and ½ percent thereafter (47½ percent maximum)

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Filing Penalties

No failure-to-file penalty if no tax is owed Minimum $100 failure-to-file penalty if return

more than 60 days late Fraudulent failure-to-file can increase late filing

penalty to 15% a month (75% maximum) Installment agreement possible if unable to

pay tax when due (late payment penalties apply)

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Statute of Limitations

Period of time beyond which legal actions or changes to the tax return cannot be made by taxpayer or IRS3 years from date of filing or due date of return

(whichever is later)6 years if more than 25% of gross income is

inadvertently omitted (not excess deductions)No time limit for fraudulent returns (burden of

proof is on the IRS)

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Statute of Limitations

Refund claims must be initiated by taxpayer within later of3 years of filing date for return2 years from date tax is paid

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Selecting Returns for Audit

Information Document Matching ProgramComputerized matching of information on return

with data from 3rd parties (W-2 from employer) Mathematical/Clerical Error Program Unallowable Items Program

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Discriminant function (DIF) formulaRating for audit potentialHigh DIF score = high probability of

adjustment Information provided by informant

Reward between 10% and 30% of proceeds IRS collects (fully taxable)

Criminal investigations by special agents

Selecting Returns for Audit

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Audits

Types of AuditsCorrespondence audit – verify one or two

items in question by mailOffice audit – requires some analysis & IRS

judgment through interviewField audit – typically limited to examination

of business returns

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Appeals Procedure

30-day letter30 days to request conference with Appeals

DivisionAppeals officer can consider hazards of

litigation 90-day letter (statutory notice of deficiency)

File petition with Tax Court within 90 daysPay the tax, then go to court to sue for refundTake no action and be subject to IRS enforced

collection procedures

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Going to Court

Trial CourtsTax Court - only court that does not require the

taxpayer to first pay the tax and sue for refundSmall Case Division of the Tax Court - can hear

disputes not exceeding $50,000 (but no appeal)District Court and Court of Federal Claims - cannot

hear the case unless suing for refund Appellate Courts - Circuit Court of Appeals and

Court of Federal Claims Supreme Court – chooses the cases it will hear

and accepts very few tax cases

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Taxpayer Penalties

Noncompliance penalties20% of tax underpayment for negligence75% of tax underpayment for civil fraudFines and prison for tax evasion (criminal

fraud)• Burden of proof is on IRS to establish beyond a

reasonable doubt that the taxpayer committed fraud

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Collection Procedures

IRS sends bill to taxpayerIf no response, letter demanding payment in

10 daysIRS can impose lien on taxpayer’s property

and seize assets Offer in compromise Innocent spouse relief

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Professional Responsibilities

Avoidance (legal) vs. evasion (illegal) Preparer penalties

May not be covered by malpractice insuranceNon-deductibleMay result in an IRS review of the preparer’s

entire practiceCriminal tax evasion penalties include fines

and prison

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Professional Responsibilities

Tax professionals have responsibilities to both tax system and to clients

Sources of GuidanceCircular 230AICPA Code of Professional ConductStatements on Standards for Tax Services

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Tax Research

Appendix 2A

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Tax Research

Purpose of research is to find solutions to tax problems

Steps in research process1. Gather the relevant facts and identify the

issues2. Locate and evaluate the relevant authority3. Communicate the recommendations

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Identify the Issues

Identifying the issues and stating the critical tax questions is the most difficult step for many new researchers

Experienced professionals can review a situation and state the relevant questions in terms of specific statutory authority Questions frequently suggest the location of

answers

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Locate & Evaluate Authorities

Tax services (reference services) can be used to locate the authorities Internal Revenue Code – read every Code section

that is applicable and watch for language that indicates quantities or a time period

Committee Reports – it is usually best to start with the Joint Conference Committee report as that will indicate whether the House or Senate version was enacted

Regulations – check the publication date to see if updated for latest amendments to the Code

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Locate & Evaluate Authorities

Revenue rulings – reflect current IRS policy and carry considerable weight

Letter rulings – binding only for taxpayers to whom they were issued

Court CasesTax CourtFederal District CourtsU. S. Court of Federal ClaimsAppellate Courts

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Evaluating Judicial Authorities

When a case involves a number of issues, the court will decide each issue separately

The party who raises an issue generally has the burden of proof (usually the taxpayer, except for fraud)

The opinion is the court’s statement of the reasons for its decision

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Evaluating Judicial Authorities

Acquiescence – IRS agrees with a court decision it has lost IRS issues a nonacquiescence when it disagrees

with a decision A reversal by an appellate court means that

the party who won in the lower court now loses and the other party becomes the winner on that issue

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Evaluating Judicial Authorities

Under the Golsen rule, the Tax Court must follow the decision of the Court of Appeals that has direct jurisdiction over the taxpayer

Citations for decisions should be checked in a citator to find out:The decision’s historyWhat other courts have said about that case

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Completing Your Research

When to stop searchingWhat is level of authority located?Is position supported in IRS rulings?Do different sources cite the same authority?

If unresolved issues exist, inform the client about alternative possible outcomes and give the best recommendation for each

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Communicating Recommendations

Memo to the file usually contains:Restatement of relevant factsIssues addressedConclusions (researcher’s recommendations)Discussion of reasoning and authorities

Client letter

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The End