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Chapter Two
TAX PRACTICE AND RESEARCH
LECTURE OUTLINE
I. INTRODUCTION
Perhaps the best way to start the discussion of the sources of tax law is for the instructor to gather samples of the materials available from his or her library (e.g., bound volumes of the USTCs or AFTRs and Cumulative Bulletins) and take them to the classroom for visual examination by the students. The outline below can be used to review the contents of the various volumes of materials and can serve as an aid in highlighting the chapter.
II. TAX PRACTICE IN GENERAL
A. Compliance.
1. Tax compliance generally encompasses all of the activities necessary to meet the statutory requirements of the tax law. This includes:
a. Preparation of returns and other required filings. Note that there are no special requirements that
must be met to become a tax return preparer.
b. Representation of the taxpayer before the IRS.
B. Planning
1. Tax planning is the process of arranging one's financial affairs so as to minimize potential tax consequences.
2. Failure to plan an impending transaction without considering the tax consequences can result in the taxpayer having to pay more taxes than is otherwise required.
a. There are a number of illustrations of poor planning, but none no more dramatic than one in the
estate planning area: failure to utilize each taxpayer's unified credit for a husband and wife.
When a married couple with a gross estate of $7 million in 2010 fails to take advantage of the
unified credit of both the husband and the wife, the results are disastrous. If all the assets are left
to the surviving spouse, the couple ends up paying hundreds of thousands of dollars more in
taxes than they would have paid had basic estate planning been employed.
b. Another illustration concerns withdrawal of funds from qualified retirement accounts. It is not
unusual for taxpayers to receive distributions from such accounts before age 59 1/2. In such case,
they are subject to a 10 percent penalty which could have been avoided had the taxpayer rolled
the money into an IRA account within 60 days.
C. Litigation
1. A tax practitioner who is not an attorney may represent taxpayers before the Tax Court.
2. What is more likely is that the tax practitioner who is not an attorney will provide support for the attorney who tries the case.
D. Research.
1. Tax research is the process of obtaining information and synthesizing it in order to answer a tax question.
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2. Knowing how to find the answer to a tax question is a critical part of tax practice.
a. Tax practitioners must first develop a framework, a foundation, that enables them to recognize
tax problems.
b. After an issue is identified, practitioners must learn not only how to find authoritative materials
related to the question but be able to evaluate and assess the materials to formulate an answer.
c. For example, assume Bob has two jobs. While going between job 1 and job 2, Bob falls asleep at
the wheel, runs into Bill, and kills him. Bill's wife, Barb, sues Bob and wins. Barb is awarded
$40,000. The tax practitioner must be able to recognize the tax issues in these circumstances and
know how to find a solution. Does the receipt of the $40,000 award for damages have tax
implications? Does Barb have taxable income? And what about Bob? Is he entitled to a
deduction for the payment of the damages since he is traveling between two business locations?
III. TAXATION AS A PROFESSIONAL CAREER
A. Growing industry.
1. The growth in the tax law has created more and more opportunities for careers in taxation.
2. Shifting the burden of what were formally Federal programs to the state level has made state and local income taxes grow in importance.
B. Examples of what tax specialists might do.
IV. RULES OF TAX PRACTICE: RESPONSIBILITIES AND ETHICS
A. Taxpayer penalties in general.
1. Accuracy related penalty. The accuracy related penalty is generally 20 percent of the portion of the tax
underpayment. There are generally three penalties from which the IRS must choose one. They are:
a. Negligence or disregard of rules and regulations.
b. Substantial understatement of the income tax.
c. Substantial valuation misstatement.
2. Fraud penalty. The fraud penalty is much more severe that the accuracy related penalty. The tax law
provides not only a monetary penalty but criminal penalties may also apply.
B. Tax preparer penalties. Preparers are also subject to a wide variety of penalties designed to ensure
compliance and ethical conduct.
V. TAXPAYER PENALTIES
A. Negligence penalty. The negligence penalty is an accuracy related penalty equal to 20 percent of the portion of the tax underpayment attributable to negligence.
1. Negligence is generally defined as any failure to do what a reasonable and ordinarily prudent person would do under the circumstances.
2. To avoid the negligence penalty, the taxpayer must make a reasonable attempt to comply with the law. The negligence penalty is usually imposed when the taxpayer fails to report income or claims large amounts of unsubstantiated expanses.
3. Negligent positions on returns.
a. A negligence penalty can be assessed unless the taxpayer has a reasonable basis for the position
taken on the return regardless of whether it is disclosed on the return.
b. The reasonable basis standard is met if the return position is "arguable, but fairly unlikely to
prevail in court." As a rule of thumb, a position has a reasonable basis if it has at least a 20 percent
chance of succeeding (without regard to the possibility that it might not be discovered at all).
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c. "Too good to be true" rule. Under the regulations, the reasonable basis standard is not met if the taxpayer fails to make a reasonable attempt to determine the correctness of a position that seems too good to be true.
B. Substantial understatement penalty.
1. The substantial understatement penalty is an accuracy related penalty that is 20 percent of the portion of the understatement of tax due to any substantial understatement of income tax.
2. The understatement is considered substantial if it exceeds the larger of (1) 10 percent of the correct tax or (2) $5,000.
3. Undisclosed positions. The substantial understatement penalty applies to the undisclosed positions unless the taxpayer has substantial authority for the position (e.g., more authority than the 1 in 3 test of the realistic possibility success standard discussed below but less demanding than the more-likely-than-not requirement, a more than 50 percent chance, related to certain positions taken with respect to certain tax shelter investments).
a. For purposes of the substantial authority analysis, only materials issued by Congress, the IRS and
the courts are relevant.
b. Treatises, legal periodicals books or similar items are not substantial authorities.
4. Disclosed positions. The substantial understatement penalty does not apply if the taxpayer makes
adequate disclosure and has a reasonable basis for his position.
a. Disclosure is considered adequate if the position is explained on Form 8275 or 8275-R, or on the return in accordance with rules issued by the IRS each year.
C. Substantial valuation misstatement.
1. A 20 percent penalty is imposed on the underpayment of tax attributable to a misstatement of value.
2. The penalty does not apply if the misstatement does not exceed 200 percent of the correct value or the amount of tax underpayment attributable to the misstatement is less than $5,000 ($10,000 for corporations).
D. Fraud.
1. The tax law imposes a minimum penalty equal to 75 percent of the amount of underpayment attributable to the fraud.
2. A taxpayer may also be subject to criminal penalties for fraud which can be as high as $100,000 ($500,000 for corporate taxpayers) and imprisonment for up to five years.
E. Interests on penalties.
1. As a general rule, taxpayers must pay interest of the failure to file penalty, the accuracy related penalties and the fraud penalty beginning on the due date of the return.
2. It should be emphasized that this interest is interest on the penalty. Interest on the tax is also assessed.
VI. TAX PREPARER PENALTIES AND GUIDELINES
A. In general.
1. Those who engaged in tax practice are subject to a variety of rules to ensure appropriate conduct.
2. Rules are contained in the following:
a. Treasury Circular Number 230.
b. Internal Revenue Code § 6694(a).
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c. CPAs engaged in tax practice must also follow the rules of conduct imposed by the American
Institute of Certified Public Accountants (AICPA), including the Statements on Responsibilities
in Tax Practice (SRTP).
d. Attorneys are subject to the rules imposed by the American Bar Association (ABA).
B. Section 6694(a).
1. Undisclosed positions.
a. Section 6694(a) provides that a $1,000 penalty (or if greater, 50% of the income from preparing
the return) is imposed on the preparer of a tax return if any part of an understatement of the
liability on a return is due to an undisclosed position which lacks substantial authority.
b. This standard is met "if a reasonable and well informed analysis by a person knowledgeable in
the law would lead such a person to conclude that the position has more than a reasonable basis
but something less than a preponderance."
c. The AICPA's Statements of Responsibilities in Tax Practice has not yet adopted this standard in
SRTP No. 1, stating that a CPA should not recommend to a client a position (or prepare or sign a
return that contains a position) with respect to the tax treatment of any item on a return unless the
CPA has a good faith belief that the position has a realistic possibility of success (at least one
in three).
d. Circular 230 is consistent with the 6694(a) standard.
e. The significance of the 6694 penalty lies not in the monetary cost but as evidence of practitioner
malpractice should a client sue the preparer.
2. Disclosure positions.
a. The preparer penalty of § 6694(a) does not apply to disclosed positions, as long as they have a
reasonable basis.
b. A reasonable basis position is one where the taxpayer has at least a one in three chance of
prevailing against the IRS if the matter were litigated.
C. Statements of Responsibilities in Tax Practice.
1. SRTP No. 1: Positions on Returns.
2. SRTP No. 2: Answers to Questions on the Return.
a. A CPA should make a reasonable effort to obtain from the client and provide appropriate answers to all questions on a tax return before signing as preparer.
3. SRTP No. 3: Certain Procedural Aspects of Preparing Returns.
a. A CPA ordinarily may rely on information provided by a client or a third party in preparing a
return and is not required to examine or review documents or other evidence supporting client
information in order to sign the return.
b. The CPA cannot ignore the implications of information furnished or information he or she
already knows. The CPA is required to make reasonable inquiries where information provided to
him or her appears to be incomplete or incorrect.
4. SRTP No. 4: Use of Estimates.
a. A CPA may prepare returns using the taxpayer's estimates if it is impracticable to obtain exact data and the estimated amounts are reasonable under the facts and circumstances.
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5. SRTP No. 5: Departure from Position Previously Concluded in an Administrative Proceeding or
Court Decision.
a. A CPA may recommend a tax return position that differs from the way an item was previously treated in an IRS examination, IRS appeals conference, or a court decision for that taxpayer, unless the taxpayer is bound to a specific treatment for the item in the later year.
6. SRTP No. 6: Knowledge of Error (Return Preparation).
a. A CPA should advise the client promptly upon learning of an error in a previously filed return, or
upon learning of a client's failure to file a required return.
b. The advice of the CPA may be oral and should include a recommendation of the measures to be
taken.
c. The CPA is not obligated to inform the IRS and may not do so without the permission of the
client, except where required by law.
d. If the error in a prior year might cause a material understatement of tax liability, the CPA may not
be able to prepare the current year return and, therefore, must withdraw from the engagement.
7. SRTP No. 7: Knowledge of Error (Administrative Proceeding).
a. When the CPA represents a client in an administrative proceeding regarding a return with an error known to the CPA that has resulted or may result in more than an insignificant effect on the client's tax liability, the CPA should request permission from the client to disclosure the error to the IRS. Absent such permission, the CPA should consider withdrawing from the engagement.
8. SRTP No. 8: Form and Content of Advice to Clients.