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Supplementary slides on tax practice and planning

Supplementary slides on tax practice and planning. Tax Practice Tax compliance Preparing returns Representing clients at IRS audit Tax planning

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Supplementary slides on tax practice and planning

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  1. Supplementary slides on tax practice and planning

  2. Tax Practice • Tax compliance • Preparing returns • Representing clients at IRS audit • Tax planning • Evaluating the tax consequences associated with a transaction and making recommendations that will achieve the desired objective at a minimal tax cost

  3. 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 inflow • Expense payment generates an outflow, but deduction generates a tax reduction • Reducing income taxes paid is a pure cash inflow because tax savings are not taxable

  4. Taxes and Cash Flows • Cash flows in future years are discounted to their present value so they can be compared using comparable dollars • When marginal tax rates are expected to change from year to year, timing of transactions should be controlled to minimize tax costs and maximize tax savings

  5. HW3. Marginal Tax Rates.Beta Corporation anticipates $800,000 of taxable income for the year before considering additional projects. What marginal tax rate should it use in evaluating a project that may generate $200,000 of additional income?

  6. Marginal Tax Rates.Beta Corp’s marginal tax rate is 34%. Beta’s income would need to exceed $10,000,000 to step-up to the next tax bracket. Therefore, Beta Corp. should use a 34% marginal tax rate in evaluating a project that would generate an additional $200,000 in income.

  7. Monico Corp., a cash basis calendar-year taxpayer, is in the 25 percent marginal tax bracket this year. If it bills its customers at the beginning of December, it will receive $5,000 of income prior to year-end. If it bills its customers at the end of December, it will not receive the $5,000 until January of next year.

  8. HW31. Monico Corp. a. If it expects its marginal tax rate to remain 25 percent next year, when should it bill its customers? Use a 6 percent discount factor to explain your answer. b. How would your answer change if Monico’s marginal tax rate next year is only 15 percent? Explain. c. How would your answer change if Monico’s marginal tax rate next year is 34 percent? Explain.

  9. Monico Corporation. Solution: a. Monico should wait to bill its customers until the end of December. If Monico’s marginal tax rate is 25%, taxes paid this year would cost $1,250 ($5,000 x 25%) resulting in an after-tax cash inflow of $3,750 ($5,000 – $1,250). When considering the time value of money, the cost of the taxes that are deferred until next year will have a present value (cost) of only $1,179 ($1,250 x .943 PV factor) or $71 less ($1,250 - $1,179).

  10. Monico Corp. Solution: b. If Monico’s marginal tax rate is 15% in year 2, then its after-tax cash inflow would be $4,293 [$5,000 – ($5,000 x 15% x .943 PV factor)]. Monico should defer billing its customers because this will result in a $543 higher after-tax cash inflow ($4,293 - $3,750).

  11. Monico Corp. Solution: c. If Monico’s marginal tax rate is 34% in year 2, then its after-tax cash inflow would be $3,397 [$5,000 – ($5,000 x 34% x .943 PV factor)]. Monico should bill its customers in the beginning of December because deferral would result in a $353 after-tax cost ($3,397 - $3,750).

  12. Two years ago, you paid $20,000 for some land. On January 1, 2007 you sold it for $60,000, with full payment to be paid to you exactly 3 years after the sale. The sales agreement does not provide any interest. Tax law requires that interest be charged or imputed at the rate of 10% compounded semiannually. What is the capital gain on the sale? a. Less than $25,000 b. Exactly $25,000 c. More than $25,000 but less than $40,000. d. Exactly $40,000

  13. You bought some land for $20,000. On Jan. 1, 2007, you sold it for $60,000. You will receive payments of $20,000 on Dec. 31 of 2007, 2008 & 2009. The agreement does not provide any interest. Assume the Tax law requires that interest be charged or imputed at the rate of 10% compounded annually. What is the capital gain on the sale? a. Less than $30,000 b. Exactly $30,000 c. More than $30,000but less than $40,000. d. Exactly $40,000

  14. Randy’s Installment Sale – Slide 1 In year 1, Randy sold land that he had held as an investment for 5 years. The land has a basis to Randy of $8,000. The buyer makes a $6,000 down payment in year 1 and will pay $7,000 in year 2 and $7,000 in year 3. A reasonable rate of interest is charged on the year 2 and year 3 payments. Randy does not make an election regarding a choice of accounting methods for this transaction. How much income will Randy recognize in year 1? a. $3,600 b. $4,200 c. $8,000 d. $12,000

  15. Randy’s Installment Sale – Slide 2 Hint: Compute total selling price. Compute profit on the sale. Determine the percentage of the selling price received in the current year. Compute the amount of total profit recognized in current year, based on current year collections.

  16. A corporation in the 39% marginal tax bracket can pay a marketing consultant $10,000 to develop a campaign that will generate $50,000 in new revenue. Alternatively, the corporation can pay 10,000 to a tax consultant to develop a tax plan that will save $50,000 in taxes. Which alternative provides the highest net after-tax cash flow?

  17. Answer. Marketing consultant. The company can deduct $10,000, but the $50,000 will be included in income. Tax consultant. The company can deduct $10,000. However the $50,000 tax saving will not be included in income. The second alternative is best.

  18. Tax Planning Strategies • Timing income and deductions • General rule - defer recognition of income and accelerate recognition of deductions • Recognize income in year with lowest marginal tax rate • Deduct expenses in year with highest marginal tax rate

  19. Planning- 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)

  20. Tax Planning Strategies Changing the character of income Structure transaction to avoid being taxed at ordinary income rates (up to 35%) & to qualify for favorable long-term capital gains rate (15%)

  21. Judicial Doctrines • Business purpose doctrine • A 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

  22. Step Transactions-Plan A • IBM wants to acquire your appreciated land by giving you an appropriate amount of IBM stock. • Is this a tax-free exchange?

  23. Step Transactions-Plan B • You organize “New Corp.” You invest land (basis of $100,000 & FMV of $800,000). • You receive 100% of “New Corp.” stock worth $800,000. • Then you trade your “New Corp.” stock to IBM for IBM Stock worth $800,000. • Is this a tax-free Sec. 351 transaction followed by tax-free reorganization? Revenue Ruling 70-140

  24. How many ways can you incorporate an existing partnership?

  25. Divider • Compliance: filing, audits, appeals, penalties • Professional ethics and responsibility. SSTS

  26. Statute of Limitations.Jennifer did not file a tax return for 2000 because she honestly believed that no tax was due. In 2007, the IRS audits Jennifer and the agent proposes a deficiency of $500.

  27. Statute of Limitations Solution: Will Jennifer be required to pay the $500 deficiency? Does the statute of limitations apply when no tax return is filed?

  28. Statute of Limitations. On his 2002 tax return, Stewart inadvertently overstated deductions in excess of 25 percent of the adjusted gross income on the return. In 2007, the IRS audits Steward and the agent proposes a deficiency of $1,000.

  29. Statute of Limitations. Solution: Can the IRS collect the deficiency of $1,000? Does the statute of limitations prohibit the assessment of the additional tax?

  30. Filing Deadlines. • 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) • Extensions of time to file • Individuals: 6 months • Corporations: 6 months

  31. Filing Penalties • Failure-to-pay penalty • ½ 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)

  32. 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)

  33. Filing Penalties 6651(a) ADDITION TO THE TAX. -In case of failure- (1) to file any return … on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause …, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate:

  34. Filing Penalties 6651(a) ADDITION TO THE TAX. -In case of failure – (2) to pay the amount shown as tax … on or before the date prescribed for payment of such tax (determined with regard to any extension …), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount shown as tax on such return 0.5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 0.5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate;

  35. FINAL-REG §301.6651-1. Failure to file tax return or to pay tax….. (b) Month defined (1) If the date prescribed for filing the return or paying tax is the last day of a calendar month, each succeeding calendar month or fraction thereof during which the failure to file or pay tax continues shall constitute a month for purposes of section 6651. (2) If the date prescribed for filing the return or paying tax is a date other than the last day of a calendar month, the period which terminates with the date numerically corresponding thereto in the succeeding calendar month and each such successive period shall constitute a month for purposes of section 6651.

  36. Filing Penalties Taxpayer filed 2006 tax return on July 5, 2007, without requesting an extension. What is the total amount of his failure to file and failure to pay penalties if his total tax is $10,000 and he paid $7,500 through timely withholding and $2,500 with return filed on July 5, 2007? a. $75.00 b. $337.50 c. $750.00 d. $375.00 e. None of these

  37. Statute of Limitations • Period of time beyond which legal actions or changes to the tax return cannot be made by taxpayer or IRS • 3 years from date of filing or due date of return (whichever is later) • 6 years if more than 25% of gross income inadvertently omitted (not excess deductions) • No time limit for fraudulent returns(Burden of Proof on IRS)

  38. Statute of Limitations Fred Wrong filed his 2003 income tax return on March 15, 2004, showing gross income of $60,000, and deductions of $40,000. He mistakenly overstated deductions by $18,000. What is the latest date the Internal Revenue Service may assert a notice of deficiency? a. March 15, 2007. b. April 15, 2007. c. March 15, 2008. d. April 15, 2008. e. April 15, 2009

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