Ch.2: The Tax Practice
Environment
An Introduction to Tax Practice
Tax practice involves:
Tax compliance Tax planning
(Tax preparation)
It is the process of It is the process of
gathering, evaluating, and evaluating the tax
classifying relevant consequences associated
information for filing with a transaction that has
a taxpayer's tax returns yet to take place
and and
representing clients at an making recommendations
internal revenue service that will achieve the
(IRS) audit. desired objectives at
minimal tax cost.
It primarily deals with It primarily deals with
transactions that have future transactions.
already taken place.
They are performed by
certified public accountants (CPAs).
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Effective tax planning generally requires
effective tax research
which can be divided into two categories:
Closed-fact Open-fact
transactions transactions
is one in which all of is one in which all of
relevant transactions have relevant transactions have
been completed not yet been completed
therefore therefore
research usually consists of there are opportunities to
finding support for control the tax liability by
the action that the client affecting the form of the
has already taken so that transactions .
the client receives the best
possible tax outcome.
They are arising from They often involve
a conflict with the two or more alternatives
internal revenue service that can be evaluated using
(IRS). the net present value
concepts to find
the optimum strategy.
Tax Planning Strategies
Timing Income Income Changing the
and Shifting Character of
Deductions Income
(1)-Timing Income and Deductions:
It is the process of determining the time at which
income and deductions should be recognized or claimed
to lower the total tax paid by:
deferring accelerating
recognition of income recognition of deductions
subsequently subsequently
benefiting from benefiting from
time value of money time value of money
by by
delaying tax payments. accelerating tax savings
recognizing income deducting expenses
in in
the years with the years with
the lowest anticipated the highest anticipated
marginal tax rate marginal tax rate
subsequently subsequently
benefiting from benefiting from
changing marginal tax changing marginal tax
rates. rates.
Note that:
The marginal tax rate is the rate that applies to the next
dollar of income.
(2)-Income shifting:
It is the process of lowering the total tax paid by splitting
income
among two or more between different
taxpayers in or entities owned by
the same family the same individual
Note that:
There are many legal techniques of income shifting may be
used by
Parents Owner-employees
of a corporation
They can shift their They can split their income
income to their children between themselves
by and
transferring ownership of the corporation
their income-producing by
property Paying themselves salaries
to which are deductible by
their children. the corporation.
(3)-Changing the character of income:
It is the process of lowering the total tax paid by changing
one type of income into another type.
For example
Capital gains, resulting from disposition of capital assets,
are subjected to tax by using
Regular tax rates Special long-term
found in the tax rate capital gains tax rate
schedules or (15%)
that is less than
the regular tax rates
If the capital assets If the capital assets
held held
one year or less. more than one year.
Factors Affecting Tax Planning
When planning to minimize the tax costs of a transaction,
a tax planner must consider following factors:
(1)- Net cash flow which is affected by:
Discount rate Inflation Uncertainty
(2)- Non-tax (personal) consideration:
There are some situations in which saving taxes are not
always the most important consideration for a client.
For example
Willing of a wealthy grandmother to continue control her
all properties outweighs
any tax savings resulting from transferring all of her
assets to her grandchildren while she is still alive.
(3)- The cost of implementation:
The cost of implementing a sophisticated plan may
exceed the potential tax savings.
(4)- Judicial doctrines:
The tax planner must consider three legal doctrines that
the IRS can invoke when taxpayers attempt to avoid
taxation.
(4)- Judicial doctrines:
(a)- Business purpose doctrine:
It states that a transaction will be recognized
for tax purposes only if it is made for some business
or economic purpose other than a tax avoidance
motive.
(b)- Substance-over-form doctrine:
It states that the taxability of a transaction is
determined by the reality of the transaction, rather
than its appearance.
For example
A huge bonus, paid to the sole owner-manager by
a profitable corporation that has never paid
dividends, can be re-characterized by IRS as a
dividend because its substance is that of a dividend
although the payment in the form of a bonus.
(c)- Step transaction doctrine:
It states that IRS can collapse a series of
intermediate transactions that are dependent on
each other into a single transaction to determine the
tax consequences.
Sources of Tax Authority
They are generally classified into two groups:
(1)- Primary sources of tax authority:
They are consisting of the following sources:
Statutory Administrative Judicial
sources sources sources
(2)- Secondary sources of tax authority:
They are unofficial sources of tax information used to
locate and interpret primary sources of authority. They
are consisting of the following sources:
Tax services Text books
(Reference services)
Journals and Newsletters
Magazines
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1 Statutory sources of tax authority include:
U.S. Tax Treaties Internal
Constitution (Conventions) Revenue Code
(IRC)
It is They are It is
the source of all agreements the most
federal tax laws. negotiated important
It gives between source of tax
Congress the countries for law.
power to impose eliminating the It includes tax
a federal income double taxation laws passed by
tax. that would be Congress.
faced by
taxpayers
if their income
was subject to
the tax in both
countries.
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2 Administrative sources of tax authority:
They are issuances of the Internal Revenue Service
division of the Treasury Department. These issuances can be
classified into two groups:
(1)- Treasury Regulations:
They provide explanations, interpretations, definitions
and examples for the language of the Internal Revenue
Code. They include two types:
Legislative Interpretative
regulations regulations
They provide the They provide
details of the meaning examples and detailed
and rules for explanations to help in
a particular Code interpreting the Code.
section as directed by
the Code.
They have the same They have not the
level of authority as same level of
the Code. authority as the
legislative regulations.
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(2)- Rulings:
They include two types
Letter rulings Revenue rulings
They are issued by IRS They are issued by IRS
to a specific taxpayer as general guidance to
who is uncertain about clarify ambiguous tax
the correct tax situations for which
treatment of the public needs
a transaction. administrative guidance.
They are generally Although the facts of
applied only to the published revenue
taxpayer to whom they rulings are
were issued and may not highly individualized,
be necessarily applied to taxpayers with similar
another taxpayer in situations can rely on
a similar situation. them for guidance.
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3 Judicial sources of tax authority:
They are judicial interpretations and decisions regarding
litigated tax controversies. These tax controversies may be
decided by
Trial Appellate U.S.
Court Court Supreme Court
4 Tax services (Reference services):
They are a multi-volume, loose-leaf, comprehensive set
of reference information
that relate to the tax laws that can be used to assist in
the tax research process.
They contain an index to aid the researcher in locating
the relevant discussions of tax problems.
These services now come in electronic format.
Tax Compliance
Tax payers must file their annual tax returns by
specific due dates:
For For
individuals, corporations
partnerships,
estates, and
trusts
Tax returns must be filed Tax returns must be filed
on or before on or before
the fifteenth (15th) day the fifteenth (15th) day
of the fourth (4th) month of the third (3rd) month
following the close of following the close of
taxpayers' tax year corporation's tax year
(April 15 for calendar- (March 15 for calendar-
year taxpayers). year corporate
taxpayers).
They are allowed They are allowed
a four-month extension of a six-month extension of
time to file their tax time to file their tax
returns upon their returns upon their
request. request.
Note that:
Extensions of time to file do not extend the time for paying
the tax.
Late Filing and Late Payment Penalties
The IRS may impose one of the following types of
penalties on taxpayers:
A failure–to-pay A failure–to-file A combined
penalty penalty failure–to-pay/
failure–to-file
penalty
0.5% 5% 5%
of the tax return of the tax return of the tax return
due for each month due for each month due for each month
or part of month or part of month or part of month
that the payment that the filing tax that the filing and
is late. return is late. payment of tax
return is late
till the end of first
5 months of delay
and
0.5% thereafter.
Up to Up to Up to
25% 25% 47.5%
maximum limit maximum limit maximum limit
If the taxpayers If the taxpayers If the taxpayers
fail to pay tax fail to file tax fail to pay and file
return on time. return on time. tax return on time.
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1 If a taxpayer files a return
more than Less than or equal
60 days late 60 days late
A minimum There is no minimum
failure-to-file penalty of limit for
$100 failure-to-file penalty.
is applied.
If no tax is owed,
2 there is
no failure-to-file penalty
Fraudulent failure-to-file
3 can increase
late-filing penalty to 15% a month
(up to 75% maximum).
Statute of Limitations
It is the period of time beyond which
legal actions or changes to the tax return
cannot be made by either the taxpayer or IRS.
It is differentiated between whether
The tax-payer The tax-payer
inadvertently (accidentally) advertently (deliberately)
omits gross income omits gross income
in an amount in excess of There is no
less than or equal 25% time limit for
25% of gross income fraud.
of gross income reported
reported
The statute The statute i.e.
limitations equal limitations equal the IRS can bring
3 years 6 years charges of fraud
from the date of from the date of against
filing tax return filing tax return a taxpayer at any
or or time.
its due date its due date But the burden of
whichever is whichever is proof is on the
later. later. IRS to prove that
the tax return
was fraudulent.
Types of Audits
There are three types of audits performed by IRS
personnel:
Correspondence Office Field
audit audit audit
It is It involves It is more
the simplest audit one or more comprehensive
that is conducted issues than office audits
when that is and is usually
only one or two too complex for limited to
relatively a correspondence an examination of
straightforward audit and require business returns.
items on some analysis . It generally
a selected return involves
are questioned. a complete review
of the entire
financial
correspondence Office audits
operations of the
audits are conducted on
business. This
are usually the district
type of audit is
handled entirely office.
usually used for
by mail. i.e.
corporations.
The taxpayer is
asked to come to
a district office
Field audits
for an interview
are usually
and to bring any
conducted on
records and
the taxpayer’s
documents that
premises.
support the
questioned items.
Tax Avoidance versus Tax Evasion
Tax avoidance Tax evasion
It is the minimization of It is the minimization of
the tax burden the tax burden
by using by using
acceptable, legal not acceptable, illegal
alternatives to determine means.
the tax owed.
Ch.3: Determining
Gross Income
Taxable versus Gross income
Gross income Taxable income
It includes It is
realized income the base against
from which tax rates
all sources are applied to
that is not excluded compute
for the tax-payer's tax
social, economic, and liability.
political reasons. It is
gross income
(net of exclusions)
less
allowable deductions.
Taxable versus Financial Accounting Income
There are many differences between financial accounting income
and taxable income. These differences fall into two categories:
Temporary or timing Permanent
differences differences
They include They include
income that is taxed in income that is not
different period than taxed but is included in
it is accrued for the financial accounting
accounting purposes. income.
For example For example
Prepaid rent generally Interest on bonds
is taxable when issued by local or state
received government generally
but is not taxed
it is included in but
financial accounting it is recorded as
income only income in financial
as it is earned. statements.
The Basic Tax Principles That Govern
Determination of Gross Income
Include the following
Realization Return of capital
principles principles
It states that It states that
no income is recognized a tax-payer's amount
(included in gross income) invested in an asset
until (basis)
the tax-payer realized it can be recovered
through some form of tax-free
exchange transaction, and
such as is not included in gross
a sale of goods or income
rendering of services. but only
the exceed amount in
return of capital over the
basis (capital gain)
is taxed.
Determining the Taxable year
Tax-payers (business or individuals) can choose to use:
Calendar Fiscal 52-to-53 week
year year fiscal year
It is It is It ends on
12 month period 12 month period the same day of
starts ending on the week
on January 1 the last day of (such as Friday),
and ends any month other which is either
on December 31. than December. the last day of
the month
or
the day closest to
the end of the
month each year.
The choice of tax year usually depended on
the organization's operating cycle.
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If a taxpayer has valid business reasons for
1 changing its tax year, it can change its tax year
after receiving a permission from IRS to do so.
If a business is granted permission to
change its tax year,
2 it will have a short-year tax return
which reports
less than 12 months of operating results.
A taxpayer must annualize income for a
short-tax year.
3 i.e.
adjusted the income to reflect
12 months of operations to calculate tax).
4 Annualized income is
required by not required by
a business that a tax-payer that
makes a change either
in begins or ends business
its tax year. in the tax year
(its first or its last tax year).
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5 Tax liability for the short-tax year is
calculated by doing the following steps:
Actual taxable income
(1)- Computing = X 12 months
an annualized the number of months in
taxable income the short-tax year
(2)- Computing a tax liability on the annualized taxable
income by using regular corporation tax rates.
Tax liability on the
annualized
taxable income Number of
(3)- Computing = X months in the
a Tax liability 12 months short-tax year
for the
short-tax year
Accounting Methods
Tax-payers can use different methods for tax purposes:
Cash Method Accrual Method Hybrid Method
Under this method Under this method It is a combination
the income is the income is of cash and accrual
recognized in recognized in method
the year in which the year in which Under this method
cash it is earned the accrual method
or rather than is used for
cash equivalent the year in which recording sales of
is received it is received inventory
and and and
deductions are the all-events test determining
permitted during has been met. cost of goods sold,
the year in which but
cash the cash method
or is used for
cash equivalent all other income
is paid. and
expense items.
Taxpayers must use the same accounting method
from one year to the next,
unless they receive permission from the IRS
to change the accounting method.
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1 Cash equivalents:
They are any property and services with a market
value. They are included in income at their fair market
value.
2 All-events test:
It denotes that income is earned when
All events have occurred The income amount
that establish and can be determined
the right to the income with reasonable accuracy
If the liability for payment is in dispute, the all-events test is not
satisfied until dispute is resolved.
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3 The constructive receipt doctrine:
It modifies the normal rules for the cash-basis taxpayers
by
requiring taxpayers to recognize income
when
the cash or cash equivalent is
credited to set aside for made available
the taxpayer’s or the taxpayer or to the taxpayer
account
4 The claim of right doctrine:
It modifies the normal rules for the accrual-basis taxpayers
by
requiring taxpayers to recognize income
when
the income is received regardless of whether the income may
have to be repaid later.
i.e.
It is applied whenever there is a dispute regarding the
taxpayer’s right to keep some or all of the income received by
him.
And not applied to the disputed amounts that the taxpayer
has not yet received.
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If the taxpayer must return all or part of the income
5
in a later year, it is differentiated between whether
The repayment The repayment
less than or equal greater than
$3000 $3000
The taxpayer can The taxpayer can either choose to
deduct
the repaid amount deduct the reduce the
in the repaid amount current year's
repayment year in the or tax liability by
repayment the tax paid in
year the prior year
on the disputed
income.
Depending on the taxpayer's marginal tax
rates in the two years.
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Prepaid income items received by
6
accrual-basis taxpayers
are recognized and taxed
when received
as an exception to the accrual method of accounting.
Such as:
Prepaid rent, royalties, and interest.
7 Refundable security deposits received by landlords
are not considered prepaid income and are not taxed
because
the landlord is obligated to return them if
all rent is paid
and
no damage is done to the apartment.
Accrual-basis taxpayers is allowed to
defer recognition of the prepayments for services
to be performed
8
beyond the current year until the tax year
following the prepayment year
(as a special exception).
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9 Assignment of income doctrine:
It denotes that a taxpayer cannot assign income
earned by him to a third party to escape taxation.
therefore
It restricts income-shifting techniques
by
precluding the taxpayer from shifting income from
service rendered by him or income from property
owned by him to another.
Sources of Income
The most common sources of income for a business and individuals
include the following:
Interest Income Dividend Income
Annuity Income Transfers from others
Income
Interest Income
It may be resulting from
Savings Certificates Loans Corporate Treasury
accounts of deposit bonds bills
They are included in gross income of businesses and individuals.
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Interest on bonds issued
1 by
state and local (municipal) government
For For
governmental or private
activities activities
It is excluded from gross It is taxable and included in
income of the taxpayer. gross income of the taxpayer.
The aim for this exemption is These bonds are obligations
to enable issued by
state and local governments a governmental unit
to finance that
their governmental activities at fund development project
much lower interest rates than that
they would be required to pay if will be leased to private
they were competing with enterprises once completed.
corporate bonds.
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Taxpayers in high marginal tax bracket
should consider
investing in tax-free state or local bonds
2 that
offering a lower interest rate than taxable bonds
because
the after-tax cash flow may be higher.
Capital gains (or losses)
resulting from
3 the disposition of the state and local bonds
are
taxable and included in gross income (or deductible).
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4
Bonds may be
issued purchased after issue
at Original Issue Discount in the open market
(OID) at Market Discount
if they were issued if they were purchased after
at a price issue in the open market
lower than at a price
their stated maturity value. lower than
their stated maturity value.
The OID is considered
additional interest paid at
maturity date of bonds
rather than
periodically.
The taxpayers The excess of
(cash-basis or accrual-basis) stated maturity value of
must amortize the excess of bonds (redemption value)
stated maturity value of over
bonds over their issue price their purchase price
(OID) (market discount)
over is recognized as
the life of bonds. ordinary income in the year
of redemption
for
The annual amortization of the
original issue discount (OID) is
the benefit of the taxpayer
taxable in addition to the annual due to
interest every year over the life the time value of money .
of bonds.
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5
Interest-free loans include:
Loans made Loans made
between by a corporation
individuals
(family members
or to to
friends) an employee a share-holder
Gift Employee Share-holder
loans. loans. loans.
An imputed interest income
(that is not actually received or accrued
but
it is treated as received or accrued)
is calculated on these loans
at
applicable federal rate of interest (AFR)
that
is published monthly by IRS (internal revenue service).
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6 Tax treatment of imputed interest calculated on
(1)- Gift loans:
For lender
It is treated as
taxable interest income received from the borrower
followed by
non-deductible gift paid to the borrower.
For borrower
It is treated as
Deductible interest expense paid to the lender
(depending on whether the loan is used for personal
expenses or investment)
followed by
non-taxable gift received from the lender.
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6 Tax treatment of imputed interest calculated on
(2)- loans to employee:
For lender
It is treated as
taxable interest income received from
the borrower (employee)
followed by
deductible compensation expense paid to
the employee.
For borrower
It is treated as
Deductible interest expense paid to
the lender (corporation)
(depending on whether the loan is used for personal
expenses or investment)
followed by
taxable compensation income received from
the corporation.
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6 Tax treatment of imputed interest calculated on
(3)- loans to share-holder:
For lender
It is treated as
taxable interest income received from
the borrower (share-holder)
followed by
non-deductible imputed dividend paid to
the share-holder.
For borrower
It is treated as
Deductible interest expense paid to
the lender (corporation)
(depending on whether the loan is used for personal
expenses or investment)
followed by
taxable imputed dividend received from
the corporation.
Dividend Income
It is a distribution made by a corporation to its shareholders
out of its earnings and profits.
It can be received in form of
Cash Property Stock
or or
dividends dividends dividends
They are subjected to the income tax
For For
corporation individuals
Using Using reduced tax rates
corporation's
ordinary
marginal tax
5% 15%
rates
for taxpayers in for taxpayers in
10% or 15% 25% or more
marginal tax brackets marginal tax brackets
The reduced tax rates for dividend income
make
stocks a more attractive investment than
interest income from corporate bonds that is taxed at
the individual's ordinary marginal tax rate.
Annuity Income
An annuity is a fixed series of periodic payments that
generally contain two components
a non-taxable a taxable portion
return of representing interest on
investment in the annuity and the investment
representing
cost recovery
Investment in annuity contract
Non-taxable = Annuity X
Portion received Expected return from the annuity
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The annuitant may live for a period
More than Less than
his/her expected life his/her expected life
In this case In this case
the annuitant recovers his/her the annuitant did not recover
full investment before death his/her full investment
So before death
The annuitant will be taxed fully So
on each payments received after The un-recovered cost is
recovering the full amount of deducted from the
his/her investment. annuitant's final tax return.
Determining the Gross Tax Liability
For Corporations:
Income tax rates applied by the corporations are as
follow:
0 - $50 000 15%
$50 001 - $75 000 25%
$75 001 - $100 000 34%
$100 001 - $335 000 39%
$335 001 - $10 000 000 34%
$10 000 001 - $15 000 000 35%
$15 000 001 - $18 333 333 38%
Over $18 333 333 35%
For Individuals:
Income tax rates applied by the individuals are based on the
taxpayer's filing status as follow:
Tax Married Married
Rates Filing Jointly Filing Separately
10% 0-$14 600 0-$7 300
15% $14 601-$59 400 $7 301-$29 700
25% $59 401-$119 950 $29 701-$59 975
28% $119 951-$182 800 $59 976-$91 400
33% $182 801-$326 450 $91 401-$163 225
35% Over $326 450 Over 163 225
Tax Head of Single
Rates Household Individual
10% 0-$10 450 0-$7 300
15% $10 451-$39 800 $7 301-$29 700
25% $39 801-$102 800 $29 701-$71 950
28% $102 801-$166 450 $71 951-$150 150
33% $166 451-$326 450 $150 151-$326 450
35% Over $326 450 Over 326 450