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2 - 1©2005 Prentice Hall, Inc.
The Tax PracticeEnvironment
Chapter 2
2 - 2©2005 Prentice Hall, Inc.
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
2 - 3©2005 Prentice Hall, Inc.
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
2 - 4©2005 Prentice Hall, Inc.
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
2 - 5©2005 Prentice Hall, Inc.
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
2 - 6©2005 Prentice Hall, Inc.
Tax Planning Strategies
Shifting income Lower the total tax paid by splitting income
among two or more taxpayers in the same family or between different entities owned by the same individual
Changing the character of income Structure transaction to qualify for favorable
long-term capital gains rate
2 - 7©2005 Prentice Hall, Inc.
Tax Planning Strategies
Other factors affecting tax planning Discount rate Inflation Uncertainty Nontax (personal) objectives Cost of implementation
2 - 8©2005 Prentice Hall, Inc.
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
2 - 9©2005 Prentice Hall, Inc.
JudicialJudicial
StatutoryStatutory
Primary Sources of Authority
AdministrativeAdministrative
2 - 10©2005 Prentice Hall, Inc.
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
2 - 11©2005 Prentice Hall, Inc.
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
under closed rule If passed, bill is sent to the Senate Referred to the Senate Finance Committee
2 - 12©2005 Prentice Hall, Inc.
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
If compromise bill passed by both houses of Congress, the bill is submitted to the President for his signature
2 - 13©2005 Prentice Hall, Inc.
Internal Revenue Code
A tax bill passed by Congress is usually enacted as a revenue act that amends the existing Internal Revenue Code
Code divided into subtitles, chapters, subchapters, and sections
Citations to the Code usually are to sections (Sec. or §)
2 - 14©2005 Prentice Hall, Inc.
Administrative Sourcesof Authority
Internal RevenueService
Revenue Rulings
TreasuryRegulations
Revenue Procedures
Letter Rulings& other pronouncements
2 - 15©2005 Prentice Hall, Inc.
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
2 - 16©2005 Prentice Hall, Inc.
Tax Research
Purpose of research is to find solutions to tax problems
Steps in research process1. Gather the relevant facts and identify the
issues
2. Locate and evaluate the relevant authority
3. Communicate the recommendations
2 - 17©2005 Prentice Hall, Inc.
Identify the Issues
Identifying the issues is the most difficult step for many new researchers
Experienced professionals can state the relevant questions in terms of specific statutory authority and their questions frequently suggest the location of answers
2 - 18©2005 Prentice Hall, Inc.
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
2 - 19©2005 Prentice Hall, Inc.
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
2 - 20©2005 Prentice Hall, Inc.
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
2 - 21©2005 Prentice Hall, Inc.
Evaluating Judicial Authorities
Acquiescence – IRS acquiesces when it agrees with a court decision it has lost and it 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
2 - 22©2005 Prentice Hall, Inc.
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
2 - 23©2005 Prentice Hall, Inc.
Completing Your Research
When to stop searching What is level of authority located? Is position supported in IRS rulings? Do different authorities cite the same
authority?
2 - 24©2005 Prentice Hall, Inc.
Communicating Recommendations
Memo to the file Facts Issues Conclusions Discussion of reasoning and authorities
Client letter
2 - 25©2005 Prentice Hall, Inc.
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)
Extensions of time to file Individuals: 4 months + 2 extra months Corporations: 6 months
2 - 26©2005 Prentice Hall, Inc.
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)
2 - 27©2005 Prentice Hall, Inc.
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)
2 - 28©2005 Prentice Hall, Inc.
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 No time limit for fraudulent returns
2 - 29©2005 Prentice Hall, Inc.
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
2 - 30©2005 Prentice Hall, Inc.
Selecting Returns for Audit
Information document matching program Mathematical/clerical error program Unallowable items program Discriminant function (DIF) formula Information provided by informant
Up to 10% reward Undercover operations
2 - 31©2005 Prentice Hall, Inc.
Audits and Appeals
Types of Audits Correspondence audit Office audit Field audit
30-day letter 30 days to request conference with Appeals
Division Appeals officer can consider hazards of
litigation
2 - 32©2005 Prentice Hall, Inc.
Audits and Appeals
90-day letter (statutory notice of deficiency) File petition with Tax Court within 90 days Pay the tax; can then go to court to sue for
refund Take no action and be subject to IRS enforced
collection procedures
2 - 33©2005 Prentice Hall, Inc.
Going to Court
Trial Courts Tax Court is the only court that does not require
the taxpayer to first pay the tax and then 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 a suit 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
2 - 34©2005 Prentice Hall, Inc.
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
2 - 35©2005 Prentice Hall, Inc.
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
2 - 36©2005 Prentice Hall, Inc.
Professional Responsibilities
Avoidance versus evasion Preparer penalties
Penalties may not be covered by malpractice insurance
Penalties are not deductible Penalties may result in an IRS review of the
preparer’s entire practice Criminal tax evasion penalties include fines
and prison
2 - 37©2005 Prentice Hall, Inc.
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
2 - 38©2005 Prentice Hall, Inc.
The End