2 - 1 ©2004 Prentice Hall, Inc. The Tax Practice Environment Chapter 2

2 - 2 ©2004 Prentice Hall, Inc. Tax Practice Tax compliance  Preparing returns  Representation of client 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 ©2004 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 ©2004 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 The marginal tax rate is the rate that applies to the next dollar of income and is used when evaluating transactions that increase or decrease taxable income

2 - 5 ©2004 Prentice Hall, Inc. Tax Planning Strategies Timing income and deductions  Defer recognition of income and accelerate recognition of deductions Income shifting  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

2 - 6 ©2004 Prentice Hall, Inc. Tax Planning Strategies Changing the character of income  Structure transaction to qualify for favorable long-term capital gains rate Other factors affecting tax planning  Discount rate  Inflation  Uncertainty  Nontax (personal) objectives  Cost of implementation

2 - 7 ©2004 Prentice Hall, Inc. Judicial Doctrines Business purpose doctrine  Transaction must have some business or economic purpose other than a tax avoidance motive 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 - 8 ©2004 Prentice Hall, Inc. Sources of Authority Primary authorities – statutory, administrative, and judicial Secondary authorities – tax services, books, journals, and newsletters  Secondary authorities used to locate and interpret primary sources

2 - 9 ©2004 Prentice Hall, Inc. Sources of Authority Statutory sources – U.S. Constitution, tax treaties, and Internal Revenue Code Legislative process – revenue bills begin in the House of Representatives Committee reports indicate the legislative intent of a bill  House Ways & Means Committee  Senate Finance Committee  Joint Conference Committee

©2004 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 The Internal Revenue Code is divided into subtitles, chapters, subchapters, and sections Citations to the Code usually are to sections (Sec. or §)

©2004 Prentice Hall, Inc. Administrative Sources Treasury regulations provide explanations, definitions, examples, and rules that explain the language in the Code  The root element of the regulation number (to the right of the decimal) corresponds to the related section of the Code Revenue rulings are published by IRS to clarify ambiguous tax situations Letter rulings (PLR) can be requested by taxpayers who are uncertain about the correct tax treatment of a transaction

©2004 Prentice Hall, Inc. Judicial Sources Case first heard by a trial court (U.S. Tax Court, District Court, U.S. Court of Federal Claims) If either party is dissatisfied with the trial court decision, that party may ask an appellate court to review that decision The controversy may be appealed to and decided by the U.S. Supreme Court Each case has precedential value for future cases with the same fact pattern

©2004 Prentice Hall, Inc. Judicial Legislative Primary Sources of Authority Administrative

©2004 Prentice Hall, Inc. Legislative Sources Committee Reports & Floor Statements The Internal Revenue Code

©2004 Prentice Hall, Inc. Administrative Sources Internal Revenue Service Revenue Rulings Treasury Regulations Revenue Procedures Letter Rulings & other pronouncements

©2004 Prentice Hall, Inc. Judicial Sources U. S. Court of Federal Claims U. S. Court of Appeals for Federal Circuit U. S. District Court U. S. Tax Court U. S. Court of Appeals The Supreme Court

©2004 Prentice Hall, Inc. Tax Research Purpose of research is to find solutions to tax problems Steps in research process 1.Gather the relevant facts and identify the issues 2.Locate and evaluate the relevant authority 3.Communicate the recommendations

©2004 Prentice Hall, Inc. Tax Research 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 Tax services (reference services) can be used to locate the authorities (refer to Appendix A for step-by-step instructions)

©2004 Prentice Hall, Inc. Tax Research Reading the Code – read every Code section that is applicable and watch for language that indicates quantities or 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 the current Code

©2004 Prentice Hall, Inc. Tax Research Revenue rulings – reflect current IRS policy and carry considerable weight Letter rulings – apply on the taxpayers to whom they were issued Acquiescence – IRS acquiesces when it agrees with a court decision it has lost and it issues a nonacquiescence when it disagrees with a decision

©2004 Prentice Hall, Inc. Tax Research 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 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

©2004 Prentice Hall, Inc. Tax Research 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

©2004 Prentice Hall, Inc. Communicating the Recommendations Memo to the file  Facts  Issues  Conclusions  Discussion of reasoning and authorities Client letter

©2004 Prentice Hall, Inc. Filing a Tax Return Returns for individuals, partnerships, estates, and trusts due 15th day of 4 th month (April 15) Corporate returns due 15 th day of 3 rd month (March 15) Extension of time to file  Individuals: 4 months + 2 extra months  Corporations: 6 months

©2004 Prentice Hall, Inc. 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) up to 25% maximum If both apply, rate is combined 5 percent for first 5 months and ½ percent thereafter (47½ percent maximum)

©2004 Prentice Hall, Inc. Penalties No failure-to-file penalty if no tax is owned 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)

©2004 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 fraud

©2004 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

©2004 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

©2004 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

©2004 Prentice Hall, Inc. 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

©2004 Prentice Hall, Inc. Appeals 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

©2004 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

©2004 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

©2004 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

©2004 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

©2004 Prentice Hall, Inc. The End