Chapter 18Chapter 18

The Tax Compliance ProcessThe Tax Compliance Process

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ObjectivesObjectives

• Determine the filing date and extended filing date for a tax return

• Compute a late-filing and late-payment penalty• Describe the statute of limitations for a tax return• Identify the three types of IRS audits• Discuss the reasons why the IRS imposes a negligence or

civil fraud penalty• Identify the three judicial levels in the tax litigation process• Define the term transferee liability• Explain the purpose of the innocent spouse rule

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Taxpayer ResponsibilityTaxpayer Responsibility

• The tax laws are so complex that most taxpayers engage a tax practitioner to prepare their returns

• Taxpayers who rely on professional help remain responsible for complying with the law and must bear the consequences of failure to comply

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Filing RequirementsFiling Requirements

• Required filing dates• Individual: 15th day of 4th month following close of tax year

(April 15th for calendar year taxpayers)• Corporate: 15th day of 3rd month following close of tax year

• Individuals and corporations may apply for an automatic 6-month extension of time to file a return• No explanation necessary!

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Payment RequirementsPayment Requirements

• Taxpayers must pay their tax during the year• Individuals pay in the form of withholding (from salary

and wages) or through quarterly estimated tax payments• Corporations pay through quarterly estimated tax payments

• Any unpaid balance of tax must be paid by the unextended filing date of the return for the year• Automatic extension of filing date does not extend

payment date for any balance of tax due• The government charges interest on delinquent tax

payments

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Late-Filing and Late-Payment PenaltyLate-Filing and Late-Payment Penalty

• Amount of the penalty is based on the unpaid balance of tax due for the year • If taxpayer is due a refund, there is no late filing penalty

• Penalty:

• 5% of unpaid tax per month or portion thereof that the return is late (five months maximum)

• .5% of unpaid balance for up to 45 additional months or portion thereof

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Example of PenaltyExample of Penalty

• Ms. Burke filed her unextended 2013 Form 1040 on December 6, 2014• She had no reasonable cause for filing late• She paid the $19,200 balance of tax due with the return

Penalty:• $19,200 × (5% for five months) = $4,800

• $19,200 × (.5% for two additional months plus a portion of a third month) = $288

• Total penalty = $5,088

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Return ProcessingReturn Processing

• Income tax returns are processed by 10 IRS service centers

• Returns are checked for mathematical accuracy and cross-checked against information returns (e.g., W-2s, 1099s, Schedule K-1s)

• The fact that the IRS cashed a taxpayer’s check or mailed a refund does not mean that the IRS has accepted the accuracy of the return – only that it has been processed!

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Statute of LimitationsStatute of Limitations

• IRS may select a return for audit three years from the later of:• Unextended filing date or• Date actually filed

• If the taxpayer omits > 25% of gross income, the statute of limitations extends to six years

• Fraudulent returns are open indefinitely

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Statute of Limitations ExampleStatute of Limitations Example

• Sylvia filed her 2013 return on February 6, 2014. When is the last day that the IRS can select her return for audit?

• April 15, 2017

• What if Sylvia had requested an extension and filed her 2013 return on August 2, 2014?

• August 2, 2017

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Statute of Limitations ExampleStatute of Limitations Example

• What is the last day that the IRS can select his return for audit?• April 15, 2020

• What if Ed has never filed a return because all his customers pay cash? • There is no statute of limitations for Ed’s

tax years

• Ed, a self-employed roofer, filed his 2013 return on March 9, 2014. Ed omitted income that equaled 40% of gross income reported on the return

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Record KeepingRecord Keeping

• Taxpayers should keep all documentation such as receipts and canceled checks for at least three years after the return is filed

• Records substantiating the tax basis of property, any legal documents containing tax information, and copies of tax returns should be retained permanently

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The Audit ProcessThe Audit Process

• Corporate returns are selected for audit based on taxable income and net assets

• Individual returns are scored under the discriminant function (DIF) system• The higher the DIF score, the greater the chance that the return

contains an error causing an understatement of tax

• Returns audited most frequently have the following characteristics:• High income• High deductions• Self-employed business income (Schedule C)

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Three Types of AuditsThree Types of Audits

• Correspondence exams are conducted by mail• Office exams take place at an IRS office and are

limited in scope• Field exams take place at the taxpayer’s place of

business and are broader in scope with a complete analysis of the taxpayer’s books and records

• A deficiency is additional tax assessed as a result of an audit• Interest charged on the deficiency is deductible only by

corporate taxpayers.

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Audits and PenaltiesAudits 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

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Taxpayer Bill of RightsTaxpayer Bill of Rights

• IRS must deal with every taxpayer in a fair, professional, prompt, and courteous manner

• IRS must provide the technical help needed to comply with the law

• Taxpayers’ information is confidential. However, the IRS may share information with other governmental authorities

• National Taxpayer Advocate office assists taxpayers in resolving problems and helps taxpayers who suffer hardship due to IRS actions

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Noncompliance Penalties - NegligenceNoncompliance 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 negligence

• Negligence versus mistake? • Based on the complexity of issues, taxpayer’s education

and experience, cooperation with IRS, and advice from professionals

• IRS must show a preponderance of evidence

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Noncompliance Penalties - Civil FraudNoncompliance Penalties - Civil Fraud

• Penalty = 75% of any underpayment attributable to fraud• IRS must show clear and convincing evidence

• Fraud is the willful intent to cheat the government by deliberately understating tax liability • Systematically omitting income• Deducting nonexistent expenses• Keeping two sets of books

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Noncompliance Penalties - Criminal FraudNoncompliance Penalties - Criminal Fraud

• Tax evasion = criminal fraud = felony offense!

• Penalty = up to $100,000 for individuals, $500,000 for corporations

• Prison time may result

• Government must demonstrate guilt beyond a reasonable doubt

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Tax Return Preparer PenaltiesTax Return Preparer Penalties

• Tax return preparer is any person who prepares returns for compensation

• Preparer penalties include:• Failure to sign a return as preparer - $50 per failure• Taking a unreasonable legal position in preparing a return

• greater of $1,000 or 50% of compensation for return

• Intentional disregard of the law in preparing a return• greater of $5,000 or 50% of compensation for return

• Monetary fines are not large, but the detriment to the preparer’s reputation is HUGE!

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Contesting Audit Results - AppealContesting Audit Results - Appeal

• Contact the IRS Problem Resolution department

• Administrative appeal is the next step• See Publication 5, Appeal Rights and How to Prepare a

Protest If You Don’t Agree

• If administrative appeal fails, litigation is the next step

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Contesting Audit Results - LitigationContesting Audit Results - Litigation

• Trial courts include:• U.S. Tax Court (single judge or panel of judges)

• Taxpayer does not pay deficiency

• 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

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Contesting Audit Results - LitigationContesting Audit Results - Litigation

• U.S. Circuit Courts of Appeal (13 in number)

• U.S. Supreme Court (hears very few tax cases)

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Small Tax Case DivisionSmall Tax Case Division

• Congress established a Small Tax Case Division to make judicial relief more accessible to the average person

• Available for deficiencies of $50,000 or less

• Filing fee is only $60, and the taxpayer may act as his own counsel

• Appeals are not allowed

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Frivolous Tax PositionsFrivolous Tax Positions

• Congress has little tolerance for people who waste federal time and money by initiating foolish lawsuits against the IRS

• The Tax Court can impose a penalty up to $25,000 on a taxpayer who takes a frivolous position before the court

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IRS CollectionsIRS Collections

• IRS can seize property, levy bank accounts, and garnish wages

• If individuals can’t pay, IRS mayagree to an installment payment planor accept an offer in compromise for lesser amount

• When corporations are dissolved, shareholders have transferee liability for unpaid taxes up to the value of any assets received on liquidation

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Innocent Spouse RuleInnocent Spouse Rule

• One spouse may not be responsible for deficiencies attributable to the other spouse if three conditions are met• Deficiency must be attributable

to erroneous items of other spouse• Spouse must establish that he or she

didn’t know that the return understatedthe correct tax

• It is inequitable to hold the spouse liable for deficiency• Relief is unavailable if spouse received any benefit from

evaded/avoided taxes

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