Tax Planning Exam #1

Three types of Function of Regulation

1. Procedural Regulations 2. Interpretive Regulations 3. Legislative Regulations

Three types of Stages of Adoption

1. Proposed Regulation 2. Temporary Regulation 3. Final Regulation

2 types of Treasury Regulations

1. Stages of Adoption 2. Function of the Regulation

Triads of Income Taxation

1. Three types of income 2. Three types of tax accounting 3. Three key tax principlesterm-15 4. Three components for classifying gains 5. Three types of assets 6. Three uses of assets 7. Three types of rental real estate 8. Three methods of tax planning 9. Three anti-abuse provisions 10. Three types of administration rulings 11. Three courts to resolve disputes

Three Types of Assets

1. capital assets 2. ordinary income assets 3. IRC section 1231 assets

When attempting to determine the tax consequences resulting from the sale of property, an advisor should:

1. determine the type of asset 2. determine how the asset was used by the taxpayer

Categorization of income is important for two reasons. What are those reasons?

1. different tax consequences apply to each type of income 2. the "bucket rule" limits a taxpayer's ability to write off losses in one income bucket against the gains in that same bucket

When tax legislation arrives at the oval office, what are the three options that the President can take?

1. sign the bill and enact it into law, -now part of the Code) 2. veto the legislation, or -Congress can override with a 2/3s majority vote from both houses. If successful, the legislation becomes part of the Code. 3. refuse to sign the bill. -If president fails to sign within 10 days, it becomes part of law without signature. -If Congress is in suspension and the president does not sign bill within 10 days, the bill does not become law

Three Primary Sources of Tax Law

1. statutory 2. administrative 3. judicial

Three Types of Tax Accounting

1. the cash method 2. the accrual method 3. the hybrid method

Three Key Tax Principles

1. the doctrine of constructive receipt 2. the economic benefit doctrine 3. the doctrine of fruit and the tree

The Three Income Tax Systems

1. the three tax systems 2. basic rules of income taxation 3. the triads of income taxations

Three Components for Classifying Gains

1. the type of asset that was held 2. the use to which the asset was put 3. how long the asset was held

Collection of Deficiency by IRS Tax Return

10yrs

The 16th Amendment

A constitutional amendment was proposed that would allow the federal government to impose tax on individuals' income without regard to the population of each state. By 1913, 36 states had ratified the 16th Amendment to the Constitution. To permit imposition of income tax. Soon there after, Congress passed a new income tax law with rates beginning at 1% and rising 7% for taxpayers with income in excess of $500,000 (assuming a 3% inflation rate).

The President's primary duties is to enforce the law and is responsible for collecting taxes in a manner as discussed in the Internal Revenue Code. -delegates this authority to the Treasury Department, which in turn created and delegated tax-collection authority to the Internal Revenue Service.

Administrative Source of Tax Law

Three Methods of Tax Planning

Advisors need to know the income tax rules so they can help clients minimize exposure to taxation while achieving their desired financial goals. There are three primary ways to engage in this type of planning which include: 1. the advisor and client legally avoid taxation. In addition, the advisor may be able to help clients: -shift income to related taxpayers in lower income tax brackets, or -realize income in a form that is taxed at lower tax rates 2. the advisor and client can deduct expenses to reduce taxable income and take tax credits to reduce taxes due. 3. The advisor and client can defer income and thus defer taxation.

Three Uses of Assets

An individual can use an asset in one of three ways: 1. they can use it for personal purposes (car, furniture, residences, etc.) 2. they can use it in the active conduct of a trade or business (machinery, equipment, and real estate) 3. they can use it for the production of income (stocks and bonds)

Exceptions to All Accretions to Wealth Constitute Income

An individual will NOT have to pay income tax on income that is NOT measurable, or realized.

All Accretions to Wealth Constitute Income

Any increase in wealth, from any source and in any forms, is subject to income taxation. - U.S. citizens are subject to income tax on their worldwide income whether or not that income is reported to the IRS. -Income can be received as cash, property, or even as an exchange of services, or as forgiveness of a debt that is due

Temporary Regulations

Are issued when Treasury feels that that guidance must be provided quickly to taxpayers. Typically imposed when the regulations will impact a large number of taxpayers, and the IRS wishes to give taxpayers guidance on how a particular provision of the tax code will be interpreted. Does not have to meet the requirements of Administrative Procedure Act Are binding on taxpayers pending the adoption of final regulations in accordance with the APA.

Final Regulations

Began as proposed or temporary regulations but have been formally adopted with the requirements of the APA. Have full force and effect of law provided that they are consistent with the IRC provisions they interpret. Are binding on taxpayer and the Treasury. Courts, however, are not bound by final regulations. If courts deem that the Code is NOT consistent, that the regulation exceeds the intent of Congress, or unconstitutional, a court can invalidate the Treasury regulation.

Doctrine of Constructive Receipt Exemption

Cash-basis; even if you have NOT actually received the income, but have constructively received it, then it is income. For example, if taxpayer open mail January 1st and receives check for work performed the income is reported as of December 31st.

Three Anti-Abuse Provisions

Congress has imposed three sets of anti-abuse rules that limit the benefit that can be obtained from wealthy individuals seeking tax minimization planning 1. the alternative minimum tax 2. the at-risk limitations 3. the passive activity rules

16th Amendment

Congress shall have (1) the power to lay and collect taxes on income, (2) from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Preparer Penalties

Created by Treasury. If a tax preparer takes an unrealistic position on a tax return and the preparer knew or reasonably should have known of the position, then the penalty is the greater of $1,000 or 50% of the income derived by the preparer for preparing the return. If the understatement was due to willful or reckless conduct, the penalty is the greater of $5,000 or 50% of income derived by the preparer of the return.

Revenue Procedures

Detail internal practices and procedures within the IRS, and make important announcements to taxpayers

Most common type of Audit

Discriminant Inventory Function which is a computer generated audit. If a tax return filed by a taxpayer does not include at least the amounts reported to the IRS through employer-filed forms, independent contractor 1099 forms, or banks and brokerage information source forms, the return is flagged for review. -DIF assigns scores to each tax return based on the estimated degree of compliance. Scores are highly confidential but are based on averages for particular income categories.

True or False. A low DIF score increases the likelihood that the return will be selected for audit.

False. A high DIF.

True or False. Private letter rulings are binding on the IRS with respect to all taxpayers, but revenue rulings are only binding on the IRS with respect to the transaction and taxpayer discussed in the ruling.

False. A private letter ruling binds the IRS with respect to the particular transaction and taxpayers discussed in the letter. A revenue ruling, on the other hand, is binding on the IRS with respect to all taxpayers.

Proposed Regulation

First draft of final regulations which are drafted by the Treasury, but have not yet gone through the process of adoption in being formally in compliance with the provisions of APA. Have no legal precedence and are NOT binding on taxpayers

Accrual Method

Frequently used by larger businesses. Income taxed when EARNED, and deductions claimed when INCURRED ; no manipulation in recording of earned income (can maneuver taxable income to another yr).

Procedural Regulations

Housekeeping instructions indicating how the Treasury and the IRS will conduct their affairs. However, does NOT deal with substantial issues of the law but administration of the tax system.

Statute of Limitations

IRS examination of income tax returns generally 3 yrs. from the date a tax return is filed.

The Internal Revenue Service

IRS has administrative source of tax law in the form of: 1. Revenue Rulings 2. Private Letter Rulings 3. Determination Letters 4. Revenue Procedures

"Bucket Rule"

If a taxpayer incurred $5,000 in investment gains and $20,000 in investment losses, $5,000 of the losses could offset the investment gain but could NOT, under the bucket rule, be used to offset other types of income (such as ordinary or passive income).

"Bucket Rule" Exception"

If have portfolio losses, up to $3000 of net losses incurred by an individual taxpayer in the portfolio bucket, it can be used to offset either active or passive income for most taxpayers.

Dispute Resolution

If the taxpayer does not agree with the tax amount imposed for a given tax year, the IRS issues a 30-day letter with a copy of the examination report and explanation of changes. The taxpayer has 30-days to appeal IRS' decision to IRS in internal appeals process to the Office of Appeals; a second evaluation in which they have to request a conference. However, if there is no response of the 30-day letter from the taxpayer or no agreeance, then the taxpayer is given a 90-day letter. The taxpayer has 90-days to petition to Tax Court for a hearing. If no petition made by taxpayer within 90-days, IRS assess taxes and start collection efforts. If taxpayer pays taxes within 90-days, can file claim for refund against U.S in U.S. District Court or U.S. Court of Federal Claims; the tax deficiency must be paid in advance to bring tax action into U.S. Court.

Failure to File

If the taxpayer fails to file his income tax return on time, the failure to file penalty applies. 5% of the unpaid tax balance for each month or part thereof that the tax return is late. The maximum penalty is 25% of the unpaid tax balance (or, alternatively stated, the failure to file penalty will reach its maximum once five months have passed.) -If the return is more than 60 days late, then the minimum penalty is the lesser of $210 or 100% of the unpaid tax. -The failure to file penalty is reduced by a failure to pay penalty if it applies to the same month.

Accuracy-Related Penalty

Imposed when taxpayers fail to file incorrect returns as a result of: 1. a failure to make a good faith effort to comply with the tax law 2. a substantial understatement of tax liability 3. a substantial valuation understatement, or 4. a substantial estate or gift tax valuation understatement.

Three Types of Administrative Rulings

In attempt to administer the tax system efficiently, and provide taxpayers with information about how to treat various transactions, the IRS issues three types of written rulings 1. Revenue Rulings 2. Private Letter Rulings 3. Determination Letters

Three Types of Income

In the U.S. income tax system, there are three types of income: 1. active (ordinary) income 2. portfolio income 3. passive income

The Three Tax Systems

In the U.S., there are three separate and distinct tax systems that are relevant to tax planning: 1. the income tax system 2. the estate and gift tax system 3. the generation skipping transfer tax system

Private Letter

Is issued at the request of an individual taxpayer who would like to know how the IRS would treat an individual transaction that the taxpayer plans to engage in. Taxpayer can solicit advice from the IRS before entering into the transaction. Ruling is binding on IRS and taxpayer. However, IRS can change their minds when there is another ruling with the same transaction, thus, taxpayers entering the transaction may differ.

Yes. However, the employees will not report the income in the current year - they will report and pay tax on the income when they take distributions from the qualified plan many years later.

Is this an Exception of Every Deduction, There Must be an Inclusion? When a business makes a contribution to a qualified retirement plan on behalf of its employees. Yes. However, the employees will not report the income in the current year - they will report and pay tax on the income when they take distributions from the qualified plan many years later.

Yes, the taxpayer does NOT recognize the gain on the property and include gain in income.

Is this an Exception of Every Deduction, There Must be an Inclusion? When a taxpayer makes a gift of cash or property to charity, a charitable deduction can be claimed on his or her income tax return, but the charity, as a tax-exempt entity, is NOT required to pay income tax on the amount received. Yes, the taxpayer does NOT recognize the gain on the property and include gain in income.

Yes.

Is this an Exception to All Accretions to Wealth Constitute Income? A car accident and the person in the car gets money for damages

Yes, because Congress wants to encourage individuals to purchase life insurance to protect their families in the event of their untimely death.

Is this an Exception to All Accretions to Wealth Constitute Income? A receipt of life insurance proceeds upon the death of an insured person.

Yes, because the taxpayer's actual increase in wealth is NOT measurable until the stock is sold or transferred.

Is this an Exception to All Accretions to Wealth Constitute Income? If a taxpayer purchases a stock today, and its value increases by $10 by the end of the year, the taxpayer will NOT have to pay income tax on the increased value.Yes, because the taxpayer's actual increase in wealth is NOT measurable until the stock is sold or transferred.

Yes, exempt from tax to prevent the taxpayer from being subject to double tax on the same income.

Is this an Exception to All Accretions to Wealth Constitute Income? If a taxpayer sells a stock that they purchased, the amount that they paid for the stock, or their taxable basis, will be received income tax free. Yes, exempt from tax to prevent the taxpayer from being subject to double tax on the same income.

Yes, it is overreaching because Congress did not grant the enforcer to impose licensing requirements on tax preparers.

Is this considered overreaching of the IRS and Treasury Department? IRS attempted to require all individuals who prepare tax returns for compensation to meet competency requirements of passing a licensing examination and completing 15 hours of continuing education on an annual basis.

Financial Status Audits

Look at taxpayer lifestyle and see if sufficient with earned income

Cash Basis Tax Returns

Normally have a calendar-year tax period and must file their individual income tax returns by the 15th day of the 4th month following the close of a yr.; April 15th. -Returns that are received by the IRS on or before the due date of the return are deemed to be filed on the due date. If a taxpayer does not file by the due date of the income tax return, the statute of limitations does not begin to run until the return is actually filed. If a return is never filed, the statute of limitations never starts and the IRS can review the information at any time.

Statutory

Only Congress can amend the internal revenue code of 1986 law on taxation. Congressionally enacted law through legislative power provided by the 16th amendment to the U.S. Constitution.

Interpretive Regulations

Provide an official interpretation of the IRC. If not consistent with Code, taxpayer may take a position in opposition of regulation within the courts. If courts rule not consistent with Congressional intent, the regulation is invalidated.

Determination Letter

Requested from the district director of the IRS if the taxpayer has already engaged in the transaction. The district director will issue a determination letter only if the resolution of the tax issue is clearly covered by the statute.

Targeted Compliance Audits

Result in checking tax returns of members in "cash-basis businesses" particularly to test compliance with laws

Income tax legislation begins as _______________________.

Revenue bill

Subsequent Claims For Refund

Selected only if 1st tax return was not carefully filed

Three Courts to Resolve Disputes

Sometimes, when a taxpayer and the IRS cannot agree on how to treat a certain transaction for income tax purposes, an independent third party is necessary to resolve the dispute. These courts include: 1. The U.S. Tax Court 2. The U.S. District Court 3. The U.S. Court of Federal Claims

Three Types of Final Regulations

The Treasury provides guidance to the taxpayers in the form of Treasury Regulations. One finalized, the Treasury can take one of three steps: 1. Procedural Regulations 2. Interpretative Regulations 3. Legislative Regulations

Case Law

The body of decisions from the U.S. courts.

Doctrine of Fruit and the Tree

The income is taxed to the -person that earns it, or -the person who owns the asset that produced the income It is an anti-abuse provision so that a taxpayer from a higher tax bracket can't give income/assets to some family member in a lower tax bracket.

Audits

The primary purpose of an audit is to test whether or not the tax return filed by the taxpayer truthfully reflects their income and allowable deductions.

Judicial Sources of Tax Law

The role of our courts in our tax system is to interpret ambiguous provisions of the Code, and ensure that the laws enacted by Congress and enforced by the President are constitutional which is brought about by a controversy between two parties. Once reviewed and amended, the opinion becomes part of the body of law. -Once a court has entered its interpretation on a given case, all lower courts in the same jurisdiction must comply with the opinion ruled. Once U.S. Supreme Court has ruled on an issue, all U.S. courts and the administrative branches of government must comply with its decision.

What is the meaning of "from whatever source derived?"

The worldwide income of U.S. citizens from any source is subject to taxation by the U.S.

Basic Rules of Income Taxation

There are two primary rules that apply to determine the income tax consequences of a transaction. These two rules are: 1. All accreations to wealth, from whatever source derived, constitute income. 2. For every deduction taken for tax purposes, there must be an inclusion in income.

For Every Deduction, There Must be an Inclusion

This principal is important for 2 reasons: 1. to be entitled to deduct something on a tax return, a taxpayer must have included that amount in income, and 2. if a taxpayer claims a deduction, that deduction should be income (and therefore subject to income tax) on someone else's return.

Official interpretations of the Internal Revenue Code, and give taxpayers insight into how the Code provisions will be enforced by the IRS.

Treasury Regulation

True.

True or False. All Treasury regulations are either proposed, temporary, or final regulations.

True

True or False. All revenue bills must arise in the lower house of Congress, the House of Reps., and may not be initiated by the executive brand, judicial, or senate. The House Ways and Means Committee has jurisdiction over tax legislation on the House of Reps. Once tax legislation has passed the House Ways and Means Committee, the entire House of Reps can consider the tax bill. If the tax bill receives a favorable vote in the House, it is then sent to the Senate for further consideration. The Senate Finance Committee will review the bill, and, if it passes through the Committee, the entire Senate may debate and vote on the proposed legislation.

True

True or False. Any accretion to an individual's wealth is income, and is therefore subject to taxation. However, Congress and the Courts have imposed various limitations on what constitutes income for tax purposes.

False. The administrative branch of government cannot change statutory law without congressional action.

True or False. If administrative agencies amend the Code by enacting regulations that go beyond the language of the statue or the intent of Congress, it is okay.

True.

True or False. If the House and the Senate do not come to an agreement of the bill, the proposed tax legislation fails and a workable compromise is reached. The revised bill is sent to both the House and Senate for further action. If the revised legislation is passed, the bill is then sent to the President.

True.

True or False. If the taxpayer's tax return does not report the transaction in accordance with the advice given in the determination letter, there will likely be an audit of the return.

False.

True or False. If the version of the bills from both houses differ, then the bill is sent to the White House for the President's action.

True.

True or False. It is possible, for example, for a single transaction to be treated as a gift for income tax purposes and as a sale for estate and gift tax purposes.

True.

True or False. Other preparer penalties may include failure to sign a return prepared by a tax preparer, failure to provide a copy of the tax return to the taxpayer, failure to keep a copy of the return, and a client list, and failure to comply with due diligence requirements when claiming the earned income credit.

True.

True or False. Taxpayers who choose not to comply with the filing requirements are subject to a series of penalties, including the failure to file, the failure to pay, and the accuracy related penalty.

True or False. The 16th Amendment imposed the income tax on U.S. citizens. False. The 16th Amendment gave Congress the power to impose an income tax, but the amendment itself did not impose an income tax

True or False. The 16th Amendment imposed the income tax on U.S. citizens.

False. The Internal Revenue Code is the only statutory source of federal tax law

True or False. The Internal Revenue Code is one of the many sources of statutory tax law.

True

True or False. The doctrine of constructive receipt states that if income is permanently set aside in an account for the benefit of a taxpayer, or if a taxpayer is given the choice to receive income now or defer it to the future, that income will be taxed to the taxpayer currently even if they do NOT receive it until sometime in the future.

True

True or False. While the 16th amendment gave Congress the authority to "lay and collect" an income tax, it did not actually impose an income tax on the citizenry or does not impose any restrictions on that power, it is rare to find circumstances where provisions of the income tax code as enacted by Congress will be found unconstitutional by the U.S. Supreme Court.

True or False. A three-year certificate of deposit is an example of constructive receipt.

True. Even though the taxpayer does NOT receive the interest until the certificate of deposit matures, they are taxed on the earned interest currently since the interest earnings are permanently set aside in an account for the taxpayer's benefit.

Cash Method

Used by most individuals and small businesses. Income taxed when RECEIVED, and deductions claimed when PAID.

Revenue Rulings

are based on a set of facts that are common to many taxpayers and are issued to the public to give taxpayers insight on how the IRS will treat certain transactions which is binding on the IRS. -If taxpayer does not agree with IRS's position, they both can end up in court. Court decides if the ruling is consistent with the Code.

Role of the IRS

created by the Treasury Department to enforce the IRC and collect taxes imposed by Congress. The IRS receives and audits tax returns of individual taxpayers, and participates in the administration of the tax system by issuing revenue rulings, private letter rulings, determination letters, and revenue procedures.

Legislative Regulation

delegates authority to the Treasury in determining the details of the law because sometimes Congress has a general idea of what would like to be accomplished but have not yet worked out all the details. -These regulations may not be overturned by the Courts only if they are determined to be unconstitutional

Passive Income

derived from dealing in real estate and from the conduct of trade or business in which the taxpayer does NOT materially participate; host to anti-abuse rules

Portfolio Income

derived from investments such as interest, dividends, and capital gains; subject to favorable income tax rates aka long-term

Active/Ordinary Income

derived from labor or income connected with the active conduct of a trade or business; highest tax rates in our system

Substantial Omission Tax Retrun

extended to 6 yrs. Defined as an omission of more than 25% of the gross income reported on the tax return.

The Revenue Act of 1913

imposed the first income tax

Claiming a Refund Tax Return

is 3 yrs. from the date the return was filed, or 2 yrs. from the date the tax was paid, whichever is later.

The U.S. Tax Court

o Only hears tax cases o Since judges can circuit from states, the tax cases are held in the state where the taxpayer resides o Tax Court decisions are non-binding so if either the taxpayer or the IRS are not in agreeance with the decision, they can appeal to the U.S. Court of Appeals o Taxpayer has the option to bring action case to a small tax case division - deficiencies up to $50,000 at taxpayer's request § Informal procedures; after judge decides ruling, no appeal rights

The U.S. District Courts

o Tax deficiency asserted by IRS must be paid in advance o Only forum that allows a jury trial in the federal system; jury not experts in tax law o Bound by decisions of: § Its Appeals Court, and § The U.S. Supreme Court

Administrative Procedure Act

public comments must be solicited, public hearings must be held, and, after taking into consideration the input from the public, the Treasury will redraft and adopt the regulations.

The Economic Benefit

states that if a taxpayer receives an economic benefit as income, the value of the benefit will be subject to income tax. For example, if a taxpayer is provided group term life insurance by an employer, the value of the group term insurance is subject to income tax, since it is an economic benefit received for labor.

Fraud Tax Return

the statute of limitations will never close if the taxpayer intentionally disregarded tax rules or misstated information included on their tax return. -the penalty is up to 75% of any deficiency.

Related Party Audit

when IRS audits a tax return of one individual, and individual claimed deductions for payments made to another person