Chapter 12 Tax Administration & Tax Planning

1. Chapter 12Tax Administration & Tax Planning Income Tax Fundamentals 2010 Gerald E. Whittenburg & Martha Altus-Buller 2010 Cengage Learning

2. Internal Revenue Service (IRS) • Congress creates tax law and the IRS enforces it • Includes assessment and collection departments • Is a branch of the Treasury Department • Is headquartered in Washington DC • Commissioner of IRS is appointed by president and approved by Congress 2010 Cengage Learning

3. IRS Service Centers • Ten service centers located around country • Responsible for processing information from tax documents • National computing center located in Martinsburg, WV • Information from various service centers is matched with records from other service centers 2010 Cengage Learning

4. IRS Restructuring Act of 1998 • This act sought to structurally and operationally change the IRS by creating operating units along functional lines • Service and Enforcement arm collects taxes and audits tax returns • Small Business/Self-Employed (SB/SE) unit serves SB/SE customers • Wages & Investment (W&I) division helps taxpayers (that primarily pay taxes through withholdings) comply with applicable laws 2010 Cengage Learning

5. Examination of Records • IRS has authority to examine taxpayers’ accounting records and books in a process called an audit • IRS can summon taxpayers and require them to appear before the IRS and produce necessary accounting records • IRS may also summon taxpayer records from third parties (CPAs, brokers, etc.) • Taxpayer should enlist professional tax advice 2010 Cengage Learning

6. Selection of Returns for Audits • Tax returns are selected for audit based upon a multitude of factors • Correspondence audit – handled by mail and usually involves questions about W-2s and 1099s • Office audit – conducted when individual taxpayer (usually without business involvement) is required to take records to district office to substantiate income, deductions and/or credits • Field audit – conducted when records too extensive to take to IRS office (usually involves taxpayer engaged in business) Note: Most common process for selecting returns for audit is based on DIF (Discriminant Function) score 2010 Cengage Learning

7. Appeals Process • When tax return is selected for examination, an agent is assigned • There are three possible results from an audit • Agent determines that there are no changes • Agent and taxpayer agree that there is a change in tax liability • Agent and taxpayer disagree on outcome • In this scenario, taxpayer may appeal through established appeals procedures • See Figures 2 and 3 2010 Cengage Learning

8. Interest • Interest is charged to taxpayer for late taxes • Interest paid is nondeductible consumer interest • Interest is paid to the taxpayer for refund • Prior year audit reveals refund due • Interest received from IRS is income • Interest rate is adjusted quarterly based on the short-term federal rate plus 3 percentage points, sample of recent rates: • First quarter 2009 5% • Second quarter 2009 4% • Third quarter 2009 4% • Fourth quarter 2009 4% 2010 Cengage Learning

9. Failure to File Penalties • If a tax return is not filed by its due date (with extensions) • Penalty of 5% of tax is due per month or 15% if fraudulently failing to file • Limited to 25% in total or 75% if fraudulent • No penalty if no tax due or refund forthcoming • If tax return is not filed within 60 days of due date (with extensions), minimum penalty is: • Lesser of $135 or • Total amount of taxes due with tax return • This penalty is reduced by failure to pay penalty, if both penalties apply 2010 Cengage Learning

10. Other Penalties • Failure to Pay Penalty is 0.5% of tax for each month tax late • Maximum penalty is 25% of tax • Increases to 1% per month 10 days after notice of levy filed • No penalty if there is no tax due or refund forthcoming from IRS • Accuracy-Related Penalty • If calculations on tax return substantially understate income tax or substantially overstate value of an asset, penalty can be imposed • Or for negligence or disregard of rules or regulations 2010 Cengage Learning

11. Fraud Penalty • Fraud penalty is assessed for filing a fraudulent tax return • 75% of the amount of taxes due if the IRS can prove with a ‘preponderance of evidence’ that a taxpayer purposefully evaded tax by committing fraud • When the fraud penalty is assessed, the accuracy-related penalty cannot be imposed 2010 Cengage Learning

12. Other Penalties • Penalties, both civil and criminal, can be imposed for filing false withholding information • For filing a frivolous tax return • For failing to file informational returns on a timely basis (1099s, W-2s, etc) • For not depositing payroll taxes on a timely basis • For underpaying estimated taxes • For issuing a bad check for taxes 2010 Cengage Learning

13. Statute of Limitations • A taxpayer may not amend, nor may the IRS assess additional taxes, on a tax return for which the three year statute of limitations has expired - generally this is three years from due date • Exceptions • No statute of limitations if it is a fraudulent tax return • Six years if amount of gross income omitted exceeds 25% of total gross income • Statute of limitations for deduction of a bad debt or worthless security is seven years 2010 Cengage Learning

14. Statute of Limitations • If IRS and taxpayer agree, Form 872 may be signed that allows for extension of statute of limitations • If tax deficiency has been assessed by the IRS within the period of the statute, then government has ten years from the date of assessment to collect the tax due 2010 Cengage Learning

15. Tax Practitioners • The IRS does not prescribe any minimum level of education for tax preparation • Only CPAs, attorneys or enrolled agents may represent clients at IRS proceedings • There are a multitude of preparer penalties • For example, if tax preparer does not exercise due diligence, tax returns are not signed, or copy is not provided to clients, the tax preparer may be assessed a penalty 2010 Cengage Learning

16. Burden of Proof • In most civil tax cases the IRS has historically placed burden of proof on taxpayer • IRS Restructuring & Reform Act of 1998 changed tax law to shift burden of proof to IRS in many cases • Burden of proof automatically shifts to IRS in two situations • IRS uses statistics to reconstruct an individual’s income • Court proceeding against an individual taxpayer involves penalty/addition to tax • In certain situations, burden of proof still rests with the taxpayer 2010 Cengage Learning

17. Tax Confidentiality Privilege • The attorney-client privilege has been extended in limited circumstances to non-attorneys who are authorized to practice in front of the IRS • CPAs and enrolled agents • This may be asserted only in a noncriminal tax proceeding before the IRS or federal courts • This privilege does not extend to written communications between tax practitioner and a corporation in connection with promotion of tax shelter • Does not automatically extend to state tax situations 2010 Cengage Learning

18. Taxpayer Bill of Rights • Document addresses taxpayers rights • Requires the IRS to inform taxpayers of their rights when dealing with the Service • It provides remedies for resolving disputes with IRS • Part I – Declaration of Taxpayer Rights • Directs taxpayer to other IRS publications for more details • Part II –Examinations, Appeals, Collections & Refunds Note: See pages 12-19 – 12-20 for Taxpayer Bill of Rights 2010 Cengage Learning

19. Tax Planning • Tax planning refers to arranging one’s financial affairs so as to minimize tax liability • If illegal methods are use, this is called ‘tax evasion’ 2010 Cengage Learning

20. Tax Traps • Tax planning can help taxpayers avoid tax traps • Tax trap is a provision that can result in the taxpayer’s loss of an otherwise available tax benefit • Watch for required deduction attributes like reasonableness 2010 Cengage Learning

21. Finished! 2010 Cengage Learning