The Tax Practice Environment

The Tax PracticeEnvironment Chapter2

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

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

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

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

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 income • Structure transaction to avoid being taxed at ordinary income rates (up to 35%) & to qualify for favorable long-term capital gains rate (15%)

Tax Planning Strategies • Other factors affecting tax planning • Discount rate (cost of capital) • Inflation rate • Uncertainty regarding tax laws or rates • Nontax (personal) objectives • Cost of implementation • Planning costs vs. tax savings • Risk of challenge by IRS

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

Primary Sources of Authority Statutory Administrative Judicial

Statutory Sources of Authority • U.S. Constitution • Internal Revenue Code • Tax treaties • Committee reports that indicate the legislative intent of a bill • House Ways & Means Committee • Senate Finance Committee • Joint Conference Committee

Tax Legislative Process • Tax bill introduced in the House • Referred to the House Ways and Means Committee • Submitted to the full House to be debated (usually under closed rule) • If passed, bill is sent to the Senate • Referred to the Senate Finance Committee

Tax Legislative Process • Submitted to the Senate to be debated under open rule • If House and Senate versions differ, referred to a Joint Conference Committee where a compromise version of the bill is developed • If compromise version passed by both houses of Congress, the bill is submitted to the President for signature

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 §)

Interpretations and specific applications of the IRC Administrative Sourcesof Authority Treasury Regulations Revenue Rulings Revenue Procedures Letter Rulings & other pronouncements

Judicial Sources U. S. Court of Appeals for Federal Circuit U. S. Court of Federal Claims U. S. District Court The Supreme Court U. S. Court of Appeals U. S. Tax Court

Tax Research • Purpose of research is to find solutions to tax problems • Steps in research process • Gather the relevant facts and identify the issues • Locate and evaluate the relevant authority • Communicate the recommendations

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

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)

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)

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 is inadvertently omitted (not excess deductions) • No time limit for fraudulent returns (burden of proof is on the IRS)

Statute of Limitations • Refund claims must be initiated by taxpayer within later of • 3 years of filing date for return • 2 years from date tax is paid

Selecting Returns for Audit • Information Document Matching Program • Computerized matching of information on return with data from 3rd parties (W-2 from employer) • Mathematical/Clerical Error Program • Unallowable Items Program

Selecting Returns for Audit • Discriminant function (DIF) formula • Rating for audit potential • High 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

Audits • Types of Audits • Correspondence audit – verify one or two items in question by mail • Office audit – requires some analysis & IRS judgment through interview • Field audit – typically limited to examination of business returns

Appeals Procedure • 30-day letter • 30 days to request conference with Appeals Division • Appeals officer can consider hazards of litigation • 90-day letter (statutory notice of deficiency) • File petition with Tax Court within 90 days • Pay the tax, then go to court to sue for refund • Take no action and be subject to IRS enforced collection procedures

Going to Court • Trial Courts • Tax Court - only court that does not require the taxpayer to first pay the tax and sue for refund • Small 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

Taxpayer Penalties • Noncompliance penalties • 20% of tax underpayment for negligence • 75% of tax underpayment for civil fraud • Fines and prison for tax evasion (criminal fraud) • Burden of proof is on IRS to establish beyond a reasonable doubt that the taxpayer committed fraud

Collection Procedures • IRS sends bill to taxpayer • If no response, letter demanding payment in 10 days • IRS can impose lien on taxpayer’s property and seize assets • Offer in compromise • Innocent spouse relief

Professional Responsibilities • Avoidance (legal) vs. evasion (illegal) • Preparer penalties • May not be covered by malpractice insurance • Non-deductible • May result in an IRS review of the preparer’s entire practice • Criminal tax evasion penalties include fines and prison

Professional Responsibilities • Tax professionals have responsibilities to both tax system and to clients • Sources of Guidance • Circular 230 • AICPA Code of Professional Conduct • Statements on Standards for Tax Services

Tax Research Appendix 2A

Tax Research • Purpose of research is to find solutions to tax problems • Steps in research process • Gather the relevant facts and identify the issues • Locate and evaluate the relevant authority • Communicate the recommendations

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

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

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 Cases • Tax Court • Federal District Courts • U. S. Court of Federal Claims • Appellate Courts

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

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

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 history • What other courts have said about that case

Completing Your Research • When to stop searching • What 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

Communicating Recommendations • Memo to the file usually contains: • Restatement of relevant facts • Issues addressed • Conclusions (researcher’s recommendations) • Discussion of reasoning and authorities • Client letter

The End

The Tax Practice Environment