Chapter 12

Chapter 12Chapter 12Tax Administration & Tax Tax Administration & Tax

PlanningPlanning

Income Tax Fundamentals 2011

Gerald E. Whittenburg & Martha Altus-Buller

2011 Cengage Learning

Learning ObjectivesLearning Objectives Identify organizational structure of the IRS Understand IRS audit process Define common penalties for taxpayers and

preparers Apply general rule for statute of limitations on

tax returns Describe rules that apply to tax practitioners

and the Taxpayer Bill of Rights Understand basic concepts of tax planning


Internal Revenue Service (IRS)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


IRS Service CentersIRS Service Centers

Ten service centers located around country° Responsible for processing information

from tax documentsNational computing center located in

Martinsburg, WV° Information from various service centers

is matched with records from other service centers


IRS Restructuring Act of IRS Restructuring Act of 19981998

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, including two factions:• 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

See Figure 12.1 on page 12-3 for complete IRS organizational chart


Examination of RecordsExamination 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 if IRS summoning records from third parties!!


Selection of Returns for AuditsSelection 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/1099s, certain itemized deductions or the earned income credit

◦ 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), generally for taxpayers with substantial business activities

Note: Most common process for selecting returns for audit is based on statistical sampling, called DIF (Discriminant Function) score


Appeals ProcessAppeals Process

When tax return is selected for examination, an agent is assigned

There are 3 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

The IRS claims that through its recalibration process, fewer no-change audits are now conducted and larger assessments are levied

See Figures 12.2 and 12.3 on pages 12-8 and 12-9


InterestInterest

IRS charges interest to the taxpayer for late taxes ◦ Interest paid is nondeductible consumer interest

IRS pays interest to the taxpayer for refunds◦ If the prior year’s 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 and is compounded daily for underpayment of taxes

Sample of recent rates:◦ First quarter 2010 4%◦ Second quarter 2010 4%◦ Third quarter 2010 4%◦ Fourth quarter 2010 4%


Failure to File PenaltiesFailure to File Penalties If a tax return is not filed by its due date (with

extensions), IRS will impose penalties◦ Penalty of 5% of tax is due per month or 15% if

fraudulently failing to file

◦ Limited to 25% in total (or 75% in total 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 return

The failure-to-file penalty is reduced by failure-to-pay penalty, if both penalties apply


Other PenaltiesOther PenaltiesFailure-to-Pay Penalty is 0.5% of tax for each

month tax late◦ Up to maximum penalty of 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 can be levied for negligence or disregard of rules or regulations

If taxpayer can demonstrate reasonable cause for understatement of tax and that he/she acted in good faith, penalty will not be assessed


Fraud PenaltyFraud Penalty

Fraud penalty is assessed for filing a fraudulent tax return

Calculated as 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

If taxpayer can demonstrate reasonable cause for understatement of tax and that he/she acted in good faith, penalty will not be assessed


Other PenaltiesOther Penalties

Both civil and criminal penalties can be imposed for filing false withholding information

Also, assorted penalties foro Filing a frivolous tax return o Failing to file informational returns on a timely basis

(1099s, W-2s, etc)o Not depositing payroll taxes on a timely basiso Underpaying estimated taxeso Issuing a bad check for taxes


Statute of LimitationsStatute of Limitations

A taxpayer may not amend, nor may the IRS assess additional taxes, on a tax return for which the 3-year statute of limitations has expired

Exceptions to 3-year statute ◦ No statute of limitations if it is a fraudulent tax

return◦ 6-year statute of limitations 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 7 years


Statute of LimitationsStatute 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


Tax PractitionersTax Practitioners The IRS will begin regulating paid preparers by

requiring registration, competency exams and continuing educationo CPAs, enrolled agents, attorneys and all paid

preparers will be required to register and pay fee if engaged in paid preparation after 12/31/10

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

See pages12-15 and 12-16 for full list of preparer penalties


Burden of ProofBurden 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 (such as corporations, partnerships or estates with a net worth in excess of $7 million).


Tax Confidentiality Tax Confidentiality PrivilegePrivilege

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


Taxpayer Bill of RightsTaxpayer Bill of Rights

Document addresses taxpayers rights Requires the IRS to inform taxpayers of their

rights and remedies when dealing with the Service◦ It provides remedies for resolving disputes with IRS

◦ Has been amended several times since issuance

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 and 12-20 for Taxpayer Bill of Rights


Tax PlanningTax Planning Tax planning refers to arranging one’s financial affairs

so as to minimize tax liability There are two types of financial transactions

o In an “open” transaction, tax planning may still occur as transaction has not been culminated

o In a “closed” transaction, tax consequences are already finalized and presentation to the IRS is limited to identifying facts in the most favorable light possible

Tax planning based on marginal tax rateo This is the rate applied to the “next dollar of income” or the

“next dollar of deduction” and should be used when engaging in tax planning (not the average tax rate)

If illegal methods are used, this is called ‘tax evasion’


Tax Traps Tax Traps A “tax trap” is a provision in tax law

that can result in the taxpayer’s loss of an otherwise available tax benefit◦Watch for required deduction attributes

like reasonableness or “ordinary and necessary”

◦Be aware of limitations such as at-risk loss limitations

Tax planning can help taxpayers avoid tax traps


Finished!


Chapter 12

Education

Transcript of Chapter 12