ch 3 slides

Fundamentals of Taxation: Individuals and Business Entities

Chapter 3: Tax Authority, Compliance Rules, and Professional Responsibilities

Chapter Outline

• Learning Objectives:
  • LO 1: Classify sources of tax authority among legislative, administrative, and judicial.
  • LO 2: Properly evaluate sources of tax authority when making a tax recommendation.
  • LO 3: Apply the rules for tax penalties to individual scenarios.
  • LO 4: Distinguish between professional and unprofessional actions related to tax professionals’ role with clients.
  • LO 5: Identify the steps in the audit and appeals processes within the Internal Revenue Service.

Sources of Tax Authority

LEARNING OBJECTIVE 1: Classify Sources of Tax Authority

• Tax professionals rely on two types of authority when performing tax research:
  • Primary Authority:
  • Comes from actions taken by the three branches of the federal government.
    • Legislative Authority: Congress.
    • Administrative Authority: The executive branch.
    • Judicial Authority: The courts.
  • Secondary Authority:
  • Consists of commentary on the tax law, found in treatises, journals, and publications.

Legislative Sources of Tax Authority

• Congress: Creates all tax laws through the legislative process.
• Sources of Legislative Authority (higher to lower):
  • U.S. Constitution
  • Internal Revenue Code (IRC) and Treaties
  • Congressional Committee Reports (often considered secondary authority).

U.S. Constitution

• The only source of tax authority that outranks laws promulgated by Congress.
• All laws passed by Congress MUST be permissible under the Constitution.
• 16th Amendment:
  • Passed by Congress in 1909 and ratified by states in 1913.
  • Establishes Congress's right to impose a federal income tax on incomes, from whatever source derived.

Internal Revenue Code (IRC)

• Codifies new laws approved by Congress and signed by the president.
• Organized by chapters and subchapters.
• Key Subchapters relevant to this course:
  • Subchapter A: Determination of Tax Liability
  • Subchapter B: Computation of Taxable Income
  • Subchapter E: Accounting Periods and Methods
  • Subchapter O: Gain or Loss on Disposition of Property
  • Subchapter P: Capital Gains and Losses

Internal Revenue Code Citations

• Example of an IRC code section citation is illustrated in the text.

Legislative Process Steps

1. Tax bills originate and are approved by the House of Representatives Ways and Means Committee.
2. House of Representatives debates and votes (requires majority approval).
3. If approved, bill goes to the Senate Finance Committee, then to the full Senate.
4. Senate debates and votes on its version of the bill.
5. Joint Conference Committee is created if House and Senate versions differ; drafts a compromise bill.
6. Compromise version goes back to House and Senate for another vote.
7. President either signs or vetoes the bill.
8. Congress can override a veto with a two-thirds vote in each chamber.

Treaties

• Formal written agreements between countries, specifying rights and obligations including income taxation provisions.
• The U.S. has treaties with about 65 countries.
• IRC and treaties have equal authority; in case of conflict, the one enacted last has precedence.

Congressional Committee Reports

• Developed by:
  • House Ways and Means Committee
  • Senate Finance Committee
  • Joint Conference Committee
• Not primary sources but useful for understanding congressional intent.

Administrative Sources of Tax Authority

• Day-to-day responsibility for tax law administration rests with the IRS Commissioner.
• Sources of administrative authority issued by the IRS (in order):
  • Legislative Regulations
  • Interpretative Regulations
  • Procedural Regulations
  • Revenue Rulings
  • Revenue Procedures
  • Private Letter Rulings

Treasury Regulations

• Highest authority issued by the Treasury.
• Sequentially numbered.
• Citation examples are provided in the text.

Treasury Regulation Classifications

• Types:
  • Legislative: Created to deal with issues directly related to statute.
  • Interpretive: Provide guidance for achieving desired results from Congressional statutes.
  • Procedural: Address procedural issues, such as return information submissions.

Revenue Rulings, Revenue Procedures, and Private Letter Rulings

• Revenue Rulings: Address specific issues related to fact patterns.
• Revenue Procedures: Official statements affecting taxpayer rights or duties.
• Private Letter Rulings: Issued to individual taxpayers upon request; not applicable to others but can establish substantial authority.

Judicial Sources of Tax Authority

• Taxpayers can take disputes with the IRS to court.
• Three levels of court:
  • Courts of Original Jurisdiction
  • Appellate Courts
  • United States Supreme Court

Courts of Original Jurisdiction

• Tax disputes start in one of the three courts:
  1. U.S. Tax Court
  2. U.S. District Courts
  3. U.S. Court of Federal Claims
• Courts must respect precedents set by others, defined as decisions in previous cases that bind subsequent cases with similar facts.

Statutory Notice of Deficiency

• Issued by the IRS when a deficiency is asserted post-audit; allows 90 days for the taxpayer to file a petition with the Tax Court.
• Taxpayer need not pay the deficiency before trial if the petition is timely.

U.S. Tax Court

• One national court with 19 judges in smaller traveling groups.
• Non-jury trials.
• Acquiescence policy for IRS on decisions lost at Tax Court; signifies IRS will follow decisions in similar future cases.

U.S. Tax Court—Golsen Rule and Small Cases Division

• Decisions are appealed to U.S. Court of Appeals.
• Golsen Rule indicates the Tax Court follows the law of the Circuit Court of Appeals for appeal purposes.
• Small Cases Division limited to deficiencies of $50,000 or less; no appeals allowed.

U.S. District Courts

• 94 U.S. District Courts that handle all legal matters, including tax.
• Requires taxpayers to pay the deficiency first before any refund request.
• Decisions are appealable to U.S. Court of Appeals.

U.S. Court of Federal Claims

• National court located in D.C. with 16 judges; hears various legal matters.
• Similar payment procedure as District Courts; follows precedents set by U.S. Court of Appeals for the Federal Circuit and Supreme Court.

Appellate Courts

• Comprise two major appellate courts (no jury trials).
• U.S. Court of Appeals: 11 courts including D.C. Circuit; hears appeals from Tax Court and District Court.
• U.S. Court of Appeals for the Federal Circuit: Hears appeals solely from Claims Court.

U.S. Supreme Court

• Highest court; hears appeals from all appellate courts.
• Consists of nine justices; rarely hears tax cases, typically those with conflicting opinions across Circuit Courts.

Evaluating Judicial Sources of Tax Authority

• Consider factors:
  • Level of court
  • Legal residence of taxpayer
  • IRS acquiescence to decisions
  • Date of decision
  • Whether subsequent decisions concurred with the opinion

Secondary Sources of Tax Authority

• Include comments on the law; should not be cited as legal support for tax opinions.
• Examples: Commercial tax services, textbooks, and journal articles.

Sources of Tax Authority Review Question

• Which is NOT a primary tax authority?
  a. U.S. Tax Court decision
  b. Revenue Ruling
  c. IRS publication
  d. Treaty
  c: IRS publication is the correct answer.

Practice Problem 3.1.2: Evaluating a Treasury Regulation

• Question: Can you rely on a proposed regulation?
  • Solution: No, the proposed regulation does not have the effect of law but indicates the IRS's view on a tax issue.

Locating and Evaluating Authority

LEARNING OBJECTIVE 2: Properly Evaluate Sources of Tax Authority

• In researching tax issues, multiple sources of primary authority may exist and must be weighed.

Federal Tax Law Hierarchy

• The Internal Revenue Code generally has a greater authority than Supreme Court opinions if constitutional.
• Judicial decisions often retain greater weight than Treasury regulations or Revenue rulings.

The Research Process

• Steps for effective research:
  1. Identify all relevant facts.
  2. Clearly state the problem.
  3. Locate applicable tax authority.
  4. Evaluate relevance and weight of authorities.
  5. Identify alternative solutions.
  6. Identify the most appropriate solution.
  7. Communicate results to the client.

Step 1: Identify All Relevant Facts

• Relevant Facts: Facts that impact the outcome and must be gathered carefully.

Step 2: State the Problem Clearly

• Problems should be stated narrowly to ensure clear answers, avoiding ambiguity.

Step 3: Locate Applicable Tax Authority

• Utilize secondary sources for guidance to primary sources; inexperienced researchers should consult experienced colleagues.

Step 4: Evaluate Relevance and Weight

• Evaluate how closely each authority's facts align with the client's circumstances using the Federal Tax Law Hierarchy.

Step 5: Identify Alternative Solutions

• Gather possible solutions based on legal findings and consult with professionals for additional input if necessary.

Step 6: Identify Most Appropriate Solution

• Formulate a recommendation; ultimate decision rests with the client on reporting tax issues.

Step 7: Communicate Results

• Notify clients of research results; a written summary should always be provided.

Locating and Evaluating Authority Review Question

• Which statement is correct regarding locating and evaluating tax authority?
  b: The Federal Tax Law Hierarchy should be considered.

Practice Problem 3.2.1: Conducting Research

• Question: Can the decision from the Colorado case be relied upon by a taxpayer in Oregon?
• Solution: Evaluation needed; conclusion drawn must address differing Circuit Court rulings.

Compliance Responsibilities

LEARNING OBJECTIVE 3: Apply Tax Penalty Rules

• Individual tax returns are due 3.5 months after the year-end (April 15).
• Extensions possible via Form 4868; uses Form 1040 or For 1040-SR for filing.

Statute of Limitations

• Defines the time frame for filing amended returns and IRS assessment of tax deficiencies.
• General limitation: 3 years; 6 years if >25% gross income is understated; indefinite for fraud/failure to file.

Statute of Limitations for Refund

• Refund claims hinge on the later of 2 years after tax payment or 3 years post-return due date/filing.

Taxpayer Penalties

• Types of penalties faced include:
  1. Failure to file
  2. Underpayment of estimated tax
  3. Failure to pay
  4. Accuracy penalties

Failure to File Penalty

• Imposed if the taxpayer does not file by due date (April 15).
• Penalty Rate:
  • 5% per month on tax due; minimum penalty of lesser of $525 or tax due; max is 25%.
  • Intentional fraud incurs 15% per month up to 75%.

Underpayment of Estimated Tax

• Imposed for inadequate payments throughout the tax year; payments due quarterly.
• Dates for Estimated Payments:
  • April 15, June 15, September 15, January 15.

Underpayment of Estimated Tax Penalty Amount

• Calculated using federal short term rate plus 3%.
• Exceptions include payments under $1,000 or meeting specific prior year tax conditions.

Reasonable Cause

• IRS may waive penalties if the taxpayer provides a reasonable cause, defined as external to their control. Examples include:
  • Mail irregularities
  • Death/illness
  • Unavoidable absence
  • Disaster

Failure to Pay Penalty

• Imposed if tax shown due isn’t paid by the due date.
• Penalty Rate: 0.5% per month on underpayment, with a maximum penalty of 25%.

Accuracy Penalties

• Imposed for inaccuracies in the tax return.
• Key Terms in Accuracy Penalties:
  • Inaccurate Position: Disregard of rules without reasonable cause.
  • Reasonable Basis: At least one primary authority supports the position.
  • Substantial Authority: Likely support if taken to court.
  • More Likely than Not: >50% chance of success in court.

Types of Accuracy Penalties

Tax Preparer Penalties

• Imposed for inaccurate positions taken in prepared returns.
• Penalties for Unreasonable Positions: Greater of $1,000 or 50% of income from return preparation.
• Willful Undermining Penalty: Greater of $5,000 or 75% of income earned from preparing tax return.

Tax Preparer Penalties Scenario

Compliance Responsibilities Review Question

• Which statement is incorrect?
  a: Taxpayer penalties are only imposed when fraud happened.

Tax Professional Responsibilities

LEARNING OBJECTIVE 4: Professional Responsibilities

• Tax professionals are bound to ethical standards.
• Tax Preparer: Prepares returns for compensation and must have a PTIN.
• Tax Practitioner: Authorized to represent before the IRS.
• Enrolled Agent: Qualified through IRS examination or substantial experience.

Circular 230

• Contains IRS rules for practitioners.
• Individuals allowed to practice include CPAs, attorneys, enrolled agents, actuaries, and retirement plan agents.
• Violations may result in censure, fines, suspensions, or being barred.

Practice Before the IRS

• Includes actions related to federal tax responsibilities.
  • Must have power of attorney for representation.

Common Provisions of Circular 230

1. Furnishing Information: Requirement to provide records requested by IRS unless privileged.
2. Correcting Client’s Omission: Errors communicated to the client, not IRS.
3. Due Diligence: Practitioners should exercise care and supervise staff effectively.
4. Conflicts of Interest: Must be avoided to protect the integrity of representation.
5. Ethical Solicitation: False advertising is prohibited; accurate fee schedules are allowed.
6. Negotiation of Client Refund Checks: Not allowed.
7. Tax Return Standards: Must inform clients of potential penalties and cannot ignore inconsistencies.

Penalties and Procedures for Tax Professionals

• Circular 230 authorizes IRS actions against incompetent or disreputable practitioners.
• Penalties can equal 100% of income from involved conduct.

Statements on Standards for Tax Services (SSTSs)

• Issued by AICPA, detailing CPA responsibilities.
• Violations could lead to expulsion or suspension.

SSTS Standards Summary

1. General Standards: Ensure compliance with tax advice; safeguard taxpayer data.
2. Tax Compliance Services: Adhere to standards while preparing or signing.
3. Consulting Services: Use competent judgment; no obligation to update previous advice post-developments.
4. Representation Services: Obtain technical competence; consider termination for known fraudulent conduct.

Tax Professional Responsibilities Review Question

• CPAs should follow both Circular 230 and SSTSs.

Practice Problem 3.4.1: Representing Clients Before the IRS

• Question: Can a non-CPA represent a client in an IRS audit?
• Solution: No, representation requires credentialed status.

Tax Practice and Procedure

LEARNING OBJECTIVE 5: Identify Audit and Appeals Steps

• IRS audits a small percentage of returns; audit rate varies based on income levels.


• IRS Audit Statistics
  

• All returns undergo automatic review.
• Types of Audits:
  1. Correspondence Examination: Simple audits at IRS Service Center.
  2. Office Examination: Conducted at IRS district offices.
  3. Field Examination: Complex audits at taxpayer’s business.

Revenue Agent’s Report

• Findings on Form 4549 with a Revenue Agent’s Report (RAR).
• If the taxpayer accepts, the agreement cannot appeal in Tax Court.

Appeals Process

• If no agreement on RAR, IRS issues a 30-day letter encouraging resolution.
• Steps in Appeals Process:
  1. Written protest for appellate conference.
  2. Conference held to resolve issue.
  3. If settled, Form 870-AD is signed.
  4. If unresolved, IRS issues Statutory Notice of Deficiency (90-day letter).

Other Audit Issues

• Offer in compromise is an IRS program for settling tax debts.
• Communication between taxpayer and attorney is privileged in matters practiced before the IRS.

Signing a Return

• A return signed under penalty of perjury must be signed by the preparer.
• Joint returns require signatures from both spouses, creating shared liability.

Tax Practice and Procedure Review Question

• What indicates the taxpayer has 90 days to appeal Tax Court?
  b: Statutory Notice of Deficiency.

Practice Problem 3.5.1: The Audit Process

• Question: Does audit notification indicate IRS must audit at their office?
• Solution: Letters provide instructions; basic inquiries can often be handled electronically or by mail.