1. #17-1 McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 17 The Tax Compliance Process

2. #17-2 Objectives Late-filing and late-payment penalties Statute of limitations 3 types of IRS audits Negligence or civil fraud, criminal fraud penalties Trial and appeal courts Transferee liability and innocent spouse rule

3. #17-3 Tax Liability The tax laws are sufficiently complex that the majority of taxpayers engage a tax practitioner to assist in the preparation of their returns. Nevertheless, even taxpayers who rely entirely on professional help remain responsible for complying with the law and must bear the consequences of failure to comply.

4. #17-4 Filing and Payment Requirements Due dates: Individual: 4/15, extension of filing of return to 8/15 or 10/15 Corporate: 15th day of 3rd month following the close of tax year, extend to 15th day of 9th month Tax payments are due by ORIGINAL due date – even when requesting an automatic extension.

5. #17-5 Filing and Payment Requirements Late payments to IRS incur interest equal to federal short- term rate plus 3%. Refunds paid by IRS within 45 days of filing do NOT carry interest. The IRS rarely pays interest.

6. #17-6 Late-Filing and Late-Payment Penalties These penalties are a function of taxes OWED. If taxpayer is due a refund, there is no late filing penalty. Combined penalty = 5% of balance due per month late for 5 months, then 1/2 of one percent for up to an additional 45 months.

7. #17-7 Return Processing More than 135 million income tax returns are filed and processed by 10 IRS service centers. There the returns are checked for mathematical accuracy and cross- checked against information returns (e.g., W-2s, 1099s, Schedule K-1s) Just because the IRS has cashed a taxpayer’s check or mailed their refund does not mean that the IRS has accepted the accuracy of the return – only that it has been processed!

8. #17-8 Statute of Limitations The IRS may select a return for audit three years from the later of: statutory due date (4/15) or date actually filed. If the taxpayer omits > 25% of gross income, IRS has six (6) years, and fraudulent returns are open indefinitely.

9. #17-9 Statute of Limitations Example Sylvia filed her 2004 return on Feb. 12, 2005. When is the last day that the IRS can select her return for audit. April 15, 2008 What if Sylvia had requested an extension and, thus, did not file until Aug. 2, 2005? Aug. 2, 2008

10. #17-10 Statute of Limitations Example Ed, a self-employed roofer, filed his return on April 11, 2005. However, he underreported his income by one- third. When is the last day that the IRS can select his return for audit? April 15, 2011 What if Ed has never filed a return as all of his work is paid “cash under the table”? The IRS can select the return for audit at any time.

11. #17-11 Record Keeping Taxpayers should keep all supporting paperwork such as receipts and canceled checks for at least 3 years after the return is filed. Records substantiating the tax basis of property, any legal documents containing tax information and a copy of the tax return should be retained permanently.

12. #17-12 The Audit Process Corporate returns are selected for audit based mainly on size of taxable income and net assets. Individual returns are scored by IRS using the discriminant function (DIF) system. The higher the DIF score, the greater the likelihood that the return contains an error causing an understatement of tax. Returns audited more frequently have the following characteristics: high income, high deductions personal business income (Schedule C)

13. #17-13 Three Types of Audits Correspondence - routine audits conducted by mail; taxpayers send in documentation, explanations, etc. Office exams take place at an IRS district office - limited in scope. Field exams take place at the taxpayer’s place of business - these are broader in scope involving a more complete analysis of the taxpayer’s books and records. Deficiency is the additional tax owed. If interest is charged, it is deductible only if the taxpayer is a corporation.

14. #17-14 Audits and Penalties Any person who has made a “good faith effort” to comply with the tax law and has maintained adequate records has nothing to fear from an IRS audit.

15. #17-15 Taxpayer Bill of Rights Requires the IRS to deal with every taxpayer in a fair, professional, prompt and courteous manner. Requires the IRS to provide the technical help needed to comply with the law. Ensures personal and financial confidentiality. Allows the IRS to share information with state tax and federal agencies, and foreign governments. Created the National Taxpayer Advocate office which assists taxpayers in resolving problems and helps taxpayers who suffer hardship due to IRS actions.

16. #17-16 Noncompliance Penalties - Negligence Applies when the IRS determines that the “taxpayer did not make a good faith effort to compute the correct tax.” Penalty = 20% of any underpayment attributable to the taxpayer’s failure to make this reasonable attempt. Negligence versus mistake? A determination is made by examining the complexity of issues, taxpayer’s education/experience, cooperation with IRS, and advice from professionals. The IRS must show a preponderance of evidence.

17. #17-17 Noncompliance Penalties - Civil Fraud Penalty = 75% of tax underpayment due to fraud. IRS must show clear and convincing evidence. Fraud is the “intent to cheat the government by deliberately understating tax liability.” Includes: Systematic omission of substantial amounts of income Deduction of nonexistent expenses Existence of two sets of books

18. #17-18 Noncompliance Penalties - Criminal Fraud Tax evasion = criminal fraud; this is a felony offense. Penalty = up to $100,000 for individuals, $500,000 for corporations Prison time may result. IRS must show guilt beyond a reasonable doubt.

19. #17-19 An Alarming Statistic As many as one in five taxpayers now believe that cheating on their tax return is acceptable behavior!

20. #17-20 Tax Return Preparer Penalties An income tax preparer is any person who prepares returns for compensation. Preparer penalties include: Failure to sign - $50 per failure Taking a position with no realistic possibility of sustaining on its merit - $250 per return. Intentional disregard of rules & regulations - $1,000 per return. The monetary fines are not large but the impact on the preparer’s reputation is HUGE!

21. #17-21 Tax Return Preparer Example Sally, an accounting student, prepared Mary’s taxes in return for one week’s worth of free baby-sitting services. Is Sally an income tax preparer? Yes. The services Sally received count as compensation.

22. #17-22 Contesting Audit Results - Appeal First see the IRS Problem Resolution department. If this fails, then administrative appeal is the next step. See Publication 5, Appeal Rights and Preparation of Protest for Unagreed Case If administrative appeal fails, then litigation is the next step.

23. #17-23 Contesting Audit Results - Litigation Trial Courts include: U.S. Tax Court (single judge or panel of judges) Taxpayer does not have to pay the deficiency first. U.S. District Court (jury trial) or U.S. Court of Federal Claims (single judge or panel of judges) Taxpayer pays deficiency and sues for refund. Advantage - interest stops accruing should taxpayer lose.

24. #17-24 Contesting Audit Results - Litigation Appeal Courts U.S. Circuit Courts of Appeal U.S. Supreme Court (hears very few tax cases)

25. #17-25 Small Tax Case Division To make the tax system more accessible to the average person, Congress established a Small Tax Case Division. It is available to a taxpayer disputing a deficiency of $50,000 or less. The filing fee is only $60 and the taxpayer may act as his own attorney. Appeals are not allowed.

26. #17-26 Frivolous Tax Positions Congress has little tolerance for people who waste federal time and money by initiating foolish lawsuits against the IRS. The IRC authorizes the Tax Court to impose a monetary penalty up to $25,000 on a taxpayer who takes a frivolous position before the court.

27. #17-27 IRS Collections IRS can seize property, levy bank accounts, and garnish wages. If individuals can’t pay, the IRS may accept an offer in compromise for a lesser amount or accept installment payments. When corporations are dissolved, shareholders have transferee liability for back taxes up to the value of any assets received on liquidation.

28. #17-28 IRS Collections Spouses may not be responsible for deficiencies attributable to the other spouse under the innocent spouse rule if three conditions are met: Deficiency must be attributable to erroneous items of the person’s spouse. Person must establish that he or she did not know, and had to reason to know, that the return understated the correct tax. It is inequitable to hold the person liable for the deficiency. Innocent Spouse doesn’t apply if spouse received benefit from evaded/avoided taxes.

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